The debate on whether active management is better than passive investment is unlikely to rest for now. But rather than argue which is better, it is optimal to look at how investors can benefit from having an exposure to both.

The question is: How can investors derive the benefits of active management inside a passive structure?

This article briefly explains the four-box approach to investment exposure. It then discusses how investors can, as an alternative to index funds, create a passive-active structure as part of their core portfolio.

Active management is risky but rewarding. Passive management, on the other hand, provides low-cost exposure but generates zero excess returns. The choice between the two is, hence, not easy.

Fortunately, there is the 4-box matrix which separates the security selection and the market timing factors to offer investors a wider choice of investment exposure.

The active-active decision refers to actively managing a portfolio (market timing) created through active security selection. Passive-active decision refers to passively holding a portfolio of actively selected securities. Likewise, active-passive decision refers to active management of index (passive) funds. Passive-passive decision refers to passively holding the index funds till the investment horizon (passive management of passive exposure).

In the core-satellite framework, an investor builds the core portfolio with a passive-passive exposure and the satellite portfolio with active-active or active-passive exposure. Some investors do not prefer index funds because they underperform active funds during trending markets and in any case do not provide excess returns at all. For such investors, an alternative is the passive-active portfolio.

This portfolio is created through active security selection process and held passively till the investment horizon. Investors have to either self-create the passive-active structure to suit their requirement or mandate their private wealth mangers to follow such strategies.

The question is: How can investors engage in security selection, given their limited resources?

Emulation Strategies

It is, indeed, difficult for individual investors to select securities on a consistent basis due to lack of time and effort. In the absence of such resources, the optimal choice is to create a portfolio that resembles the alpha-generating funds.

To do this, an investor has to first choose 3 to 5 funds that have consistently generated alpha . Then she has to apply pre-determined filters to select securities from these fund portfolios. These securities form the passive-active portfolio.

It is an active strategy because the investor has engaged in security selection and it is passive management because the investor will hold the securities till the investment horizon.

This strategy can emulate the returns of active funds net of fees. The cost of setting up the portfolio is lower . There are, however, obvious issues associated with this strategy.

For one, selecting funds based on expected alpha is not so easy. This requires attributing sources for the excess returns and testing the alpha sustainability in the future.

For another, investors have to apply pre-defined filters to select securities from these fund portfolios. This could range from selecting the top 5 to 7 securities in each fund to taking buying only those securities that these funds have in common.

This strategy would be easier to set-up for discerning investors with fair understanding of the markets and application of analytical tools.

Emulation strategies are similar to clone funds that are offered by asset management firms in the US — funds that replicate the returns of an active fund at a lower cost. Such strategies are difficult to implement but are rewarding.

Two issues are important to remember. One, such strategies are set-up based on the reported portfolios of active funds. Gross returns could be, hence, lower than that of active funds which the strategy is trying to replicate. And two, the strategy requires large capital outlay, as investors have to take direct exposure to equity.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at > enhancek@gmail.com)

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