Active vs. Passive Investment Strategies. Is either one superior?

TABLE OF CONTENTS

1. INTRODUCTION

2. THE EFFICIENT MARKET THEORY

3. ACTIVE INVESTMENTS
3.1. Definition
3.2. Strategies
3.2.1. FundamentalAnalysis
3.2.2. TechnicalAnalysis
3.3. Benefits
3.4. Limitations

4. PASSIVE INVESTMENTS
4.1. Definition
4.2. Strategies
4.2.1. Buy and Hold Strategy
4.2.2. Index Funds (Indexing)
4.2.3. ExchangeTradeFunds(ETFs)
4.3. Benefits
4.4. Limitations

5. CONCLUSION

REFERENCES

1 INTRODUCTION

Over the past half-decade, capital markets have gained a growing importance for econ­omy and society. More and more business enterprises decide to enter the capital market to finance themselves rather than borrowing money from credit institutions.¹ Simultane­ously, more and more investment opportunities for institutions and private persons arise. In general, investments are made to create return in order to increase wealth. Over the past decades, the number of investments has increased sharply, and the trend is still going strong.

This trend causes constantly growing, moving and changing financial markets all over the world. As a result, investors have to overcome many (new) challenges and have to put a lot of factors into consideration in order to be able to make the best investment choices with the brightest promising future.

During the selection procedure and weighting up options, investors face a lot of questions and have to make decisions. Which investment vehicle fits the best for my investment project in order to fulfill my investment goals? Which of the various securities works best for me? How can I create the highest return? What about risk? How much does the asset management cost me?² This process of making investment choices is called investment management. The term investment management is an overall term for the way an investor realizes investment plans from theory into practice and how he administers, regulates and supervises his investments. There are two different approaches underlying investment management: active and passive investment strategies.

This paper analyzes these two different schools of thought when facing portfolio man­agement and whether either one is superior.

I want to start this paper with a short insight into the Efficient Market Theory because it the basis of the argumentation between the active versus passive strategies. After under­standing the groundwork, I want to look deeper into the two different approaches, start­ing with the active on. In order to be able to compare and evaluate the two approaches, it is necessary to understand, what they consist of and how they work, which strategies each approach uses to accomplish their objectives and what kind of advantages or disad­vantages can occur.

2 THE EFFICIENT MARKET THEORY

The debate between active versus passive investment strategies has its origin in the effi­cient market theory.³

Eugene Fama is considered as the father of Efficient Market Hypothesis. In his article “Efficient Capital Markets: A Review of Theory and Empirical Work“ (1970), Fama de­scribes an efficient market as “[...] a market in which [...] investors can choose among the securities that represent ownership offirms' activities under the assumption that se­curity prices at any time "fully reflect" all available information”⁴ In other words, no technical or fundamental analysis, no insider information or other activity done by market participants (investors) can lead to higher returns than a comparison benchmark⁵ because the stock market security price does already reflect all relevant information.

Furthermore, Famas theoretical approach describes the price changes of stocks as random and unpredictable. This concept of stocks price behavior is called “random walk” and is based on the understanding, that any (new) information gets immediately reflected in a stocks’ price change and that it's impossible to predict upcoming information.⁶ So spec­ulative profits are basically nonexistent.

Even though many studies - which tested the empirical evidence of the Efficient Market Hypothesis - rejected the appearance of Famas theory and the existence of a stock market efficiency,⁷ it is still a used approach in the investment world.

But how is the Efficient Market Hypothesis connected to active and passive investment strategies?

Contrary to the Efficient Market Hypothesis, an active management strategy is based on the assumption that market inefficiencies exist. This condition allows investment manag­ers to be able to “beat the market” and achieve greater returns than a given benchmark.

On the other hand, investors using a passive investment strategy believe in market effi­ciency and support the Efficient Market Hypothesis. Passive approaches do not assume that it is possible to “beat the market” and to create greater returns through manger ex­pertise.⁸

These fundamental ideas behind active and passive investment strategies are essential to understand how to differentiate the two concepts and are the groundwork for my follow­ing analysis.

3 ACTIVE INVESTMENTS

The first portfolio investment strategy I want to analyze is the active approach.

3.1 Definition

“We can beat the market. We can maximize return and minimize the risk of loss, because we have superior understanding of financial markets and therefore exclusive access to information about a markets (upcoming) movements.” - Portfolio managers who use ac­tive strategies advertise themselves with their analytical and professional abilities.

Because - in their perception - market inefficiency exists, they believe that they can use their superior know-how and abilities as well as their experiences to create an informa­tional advantage. This additional knowledge and greater pool of information allows them to identify market anomalies and trends which brings them into an exclusive position to make decisions and opens up new and greater chances and opportunities to invest/manage a clients’ money.⁹ Additionally, their better and more detailed forecasts can reduce risk,¹⁰ but how well targets get achieved depends on how accurate and early managers can an­ticipate shifts and trends in the economy.

So active investment management is a hands-on approach where the manager actively monitors and adjusts the investments (portfolio) frequently with the goal to create a return rate which surpasses a given benchmark (usually a market index, e.g. S&P 500). The key to rise future returns is active trading (buying and selling) of securities at the right time.

To decide which securities are most efficient and when to buy and sell, managers use in­depth fundamental analysis as well as technical and quantitative investigations. Their tasks especially include the evaluation of (present) values, growth opportunities, upcom­ing risks ofloss, profitability progressions and the identification of upcoming trends.

3.2 Strategies

As mentioned before, making the right decisions is considered essential for the active approach. Therefore, investors can choose from a pool of different active strategies to pursue their investment goals. These strategies are used to optimize the decision-making process, because knowledge about the financial system, capital markets and economy is solely not enough be able to make the best investment decisions to create the most prom­ising portfolio.¹¹

Each strategy uses (slightly) different concepts and principles, but the ultimate goal to beat the market is the same. Only the way of how this goal is going to get fulfilled differs, depending on individual circumstances, objectives and other individual factors.

This subsection 3.2 consists of a more into depth look on the most common active anal­yses investors use to get into a superior position when considering investments: The fun­damental and technical analysis.

3.2.1 Fundamental Analysis

Active investors use fundamental analysis to get a deeper understanding of the finan- cial/stock market and its movements. Therefore, they put external and internal aspects, such as the industry, the market and its environment and firms (financial) performances, into consideration to identify mispriced securities in order to purchase them to make profit and achieve superior returns.

Mispriced securities occur in two different ways: A value-driven and a quality-driven way.

One way to identify mispriced securities is to examine a stocks’ value in more detail to determine stocks which true value is above their prices. The vast literature dispute whether financial metrics (e.g. earnings, cash flow, dividends) and the value of stocks is correlated and if so, how strong - opinions are highly divided.¹²

For example, Frankel and Lee (1998) assumed that companies with high V/P ratios are valued to low and therefore their stocks are more likely to accomplish higher returns in the future - strong correlation between value and financial metric.¹³ On the other hand, Bradshaw (2004) came to conclusion, that forecasts done by analysts are only weakly correlated to the true value of stocks.¹⁴

According to todays’ standards and scientific evidence, it is possible to achieve greater returns when investing in underpriced stocks, but there is no absolute certainty.

The second dimension looks for quality. A companies’ accounting fundamentals and their future performance is considered as quality. So, the aim is to identify those firms, which will perform well in the future because this would lead to rising stock value. The question is if it is possible to anticipate a company’s future performance in terms of returns through research and financial analysis. The literature and past scientific tests show that financial ratios can indeed help to anticipate trends and movements of stock markets and firms.¹⁵ Ou and Penman (1989) find that analyzing a company’s profitability and margins in depth makes predicting future returns and changes in return conceivable.¹⁶

If investors are able to identify one or both of these dimensions and can anticipate future performances accurately, they are able to improve returns. Data and experiences from the past show that combined strategies (value and quality-based analysis) can generate supe­rior return in comparison of using only one strategy.¹⁷

3.2.2 Technical Analysis

Besides fundamental analysis, investors might also undertake the effort do a technical analysis. Technical analyses use (historical) data such as stock prices and their behavior as well as returns and firms’ performances under certain circumstances to create statistics and charts. They use the collected and sorted data to get an insight on behavior patterns of stocks and/or prices. As a result, they hope to be able to anticipate future price behav­iors better and more accurate.¹⁸

But why do prices change at all? This is a result of supply and demand. Securities get sold because it is assumed that the current price is greater than it will be in the future and that value increases are not expected in the future. On the other hand, buyers belief the opposite. They think prices and value will grow in the future and therefore they decide to purchase.¹⁹

As Thomsett (2019) discussed, a technical analysis consists of three approaches: First, using (technical) data makes it possible to reproduce and understand current price behav­ior and the correlated risks. Second, the collected data can be used to anticipate todays movements. Third, the created charts allow investors to forecast what is most likely to happen in the future in terms of upcoming movements and trends. Meaning, they use technical analysis in order to be able to predict a security markets’ future behavior - called the most likely movement. As a result, they can prepare their investments for possible upcoming threats and benefit from future changes.²⁰

But it's an inexact analysis, because a markets’ movements are not fully controllable or with full certainty predictable. Nevertheless, technical analysis allows investors to iden­tify certain signals in order to prognose the most likely movement of prices. The more information from past behaviors and the more data goes into the creation-process of charts and statistics, the exacter will be the prediction for the most likely movement.

According to Thompsett (2019) the detectable signals (occurring from the collected data) are price, volume, momentum and the average changes of those main determinates. Price and volume and their behavior is easily to interpret in terms of anticipating the most likely movement and making decisions towards investment opportunities. If the data shows, that trends in terms of prices changes occur repeatedly due to specific circumstances and in­vestors are able to recognize corresponding signals, they are able to time investments and weight shifting very well and promising. In comparison, evaluating the momentum is more complex. The momentum shows the strength and pace at which prices change. It provides a more into depth look into trends and allows to identify trends, which wouldn't be detectable by only monitoring price and volume. If momentum rises, it is fairly likely that a price incline is upcoming - so a strong momentum is considered a good time to buy shares of stock.

A more accurate prediction can improve returns, reduce risks (of future losses) and opens up the view on the most promising investment opportunities.²¹

3.3 Benefits

Now that we know what active investing is and which strategies investors use, I want to discuss the corresponding benefits.

Active investment strategies need a lot of preparation, effort, skills and time in order to perform well. But what (superior) performances can we expect if active investing works out as expected?

The main reason why active investment strategies get chosen is the outlook for superior, greater returns. If active investors do their research (fundamental and technical analysis) well and have great skills in terms of anticipating a markets’ movements, there is a po­tential that their investment can produce above-normal returns.²²

Another reason why clients hire active investment managers is because it allows fre­quently risk adjustments - if necessary. Because the active approach includes active trading and weight shifting of stocks in a portfolio towards more promising combinations, it allows investments/portfolios to adjust to the constantly changing environment and market conditions. Meaning, a portfolio has certain flexibility and is able to respond and take action if threats or opportunities appear.

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¹ Günther, S. & Moriabadi, C. & Schulte, J. & Garz, H. (2012): p. 1

² Seddik Meziani, A. (2006): p. xviii

³ SeddikMeziani, A. (2006): p. 2

⁴ Fama, E. (1970): p. 383

⁵ Seddik Meziani, A. (2006): p. 2

⁶ Malkiel, B. G. (2003): p. 59

⁷ Seddik Meziani, A. (2006): p. 2 et seq.

⁸ Seddik Meziani, A. (2006): p. 2 et seq.

⁹ Seddik Meziani, A. (2006): p. 2 et seq.

¹⁰ Slawski, J. (2013): p. 12

¹¹ AminNaseri, M. R. & Rafiee, F. M. & Moghadam, S. K. (2020): p. 39 et seq.

¹² Li, K. & Mohanram, P. (2019): pp. 1263-1298

¹³ Frankel, R. & Lee, C. M. C. (1998): pp. 283-319

¹⁴ Bradshaw, M. T. (2004): pp. 25-50

¹⁵ Li, K. & Mohanram, P. (2019): pp. 1263-1298

¹⁶ Ou, J. A. & Penman, S. H. (1989): pp. 111-144

¹⁷ Li, K. & Mohanram, P. (2019): pp. 1263-1298

¹⁸ Thomsett, M. C. (2019): p. 13 et seq.

¹⁹ Thomsett, M. C. (2013): p. 3 et seq.

²⁰ Thomsett, M. C. (2019): p. 3 et seq.

²¹ Thomsett, M. C. (2019): 3 et seq.

²² SeddikMeziani, A. (2006): p. 3