For the neophyte, it is difficult to navigate the world of stock market investment. Even for those who know about it, its language remains very technical. A bit like trying to manage to discuss the details of a renovation project with your contractor.
In recent years, access to a multitude of sources of information on autonomous portfolio management has been both a gift, a source of confusion and a factor of potential errors. Fans of passive management will want to sell you the idea that to get rich, all you have to do is copy stock market indices, which will have the effect of reducing your management fees. Robo-advisors can also design portfolios, and since the marketing of these solutions is often based on lower fees, it’s a safe bet that many users believe they are investing in passive management when using exchange-traded funds ( ETFs). But what is it really?
Active management and passive management
Passive management consists in reproducing the composition of a market. Thus, the performance of your portfolio will represent that of this market, both in terms of its rises and its declines. Index ETFs and some mutual funds use this strategy.
In contrast, active management involves a choice in the securities of the portfolio. Inevitably, this will create a difference with market results, which can sometimes be favorable, sometimes unfavourable. Active management is when stocks are selected by you or your stockbroker, or when you use actively managed mutual funds. It is quite possible to find this type of management both in managed portfolios and in ETFs, which are not all passive.
You now know me better and better, and you must have understood that I rarely take a position in favor of one position or another. Several elements can indeed tip the balance in favor of active management or passive management. For large portfolios, however, it seems appropriate to me to combine the two.
Some markets lend themselves better than others to one or other of these strategies. The composition of a portfolio could, for example, favor active management for concentrated and volatile markets, while the very diversified American market would open the door more to passive management.
Two ratios to remember
If you favor active management, how can you determine whether the additional management fees charged are worth it (and the cost)?
The information ratio is a very useful measure for evaluating the “active” return of a portfolio or fund compared to its benchmark index, in relation to its volatility. The higher it is, the greater the manager’s ability to select securities and choose their weighting in order to create value. This ratio therefore measures its ability to compose a portfolio by taking an active risk, through choices based on factual financial information and more qualitative elements — such as data on the economic environment — and by selecting securities that do not not part of their benchmark. It is recommended to use an information ratio based on a long period in order to evaluate the manager over a complete market cycle.
The Sharpe ratio, on the other hand, measures the relationship between a security’s return and its risk. It is useful because beyond the dilemma between active and passive management, it highlights the level of risk (volatility, measured by the standard deviation) to which the investor is exposed. It is thus possible to prioritize investments that offer less risk for more return, or with equal return compared to benchmark indices.
Ideally, the Sharpe ratio is greater than 1, which means that the performance generated is better than that of the risk-free investment rate. A negative Sharpe ratio is therefore a sign that the risk is not really worth the effort. Again, the comparison period must be the same.
Finally, in this type of analysis, we must always pay attention to the reference index used in order to reflect on the limits of this comparison. Collaborating with an expert remains my first recommendation for the majority of investors wishing to find their way around, but you now also have two essential indices to measure.
Now, is active management more expensive? You will find out in an upcoming column. Let’s just say, for now, that like in any industry, some players are very profitable… while others aren’t worth the cost. Nor the blow.