We recently met an investor who claimed that he benefited immensely as a passive investor (buy-and-hold) and wondered why people engage in active investments. During our discussion, we realized that the investor had large exposure to diversified active funds. Can buy-and-hold investments in active funds really be called passive investments?
This article discusses the meaning of buy-and-hold investment, differentiating the kind of investment exposure from the management of such exposure. It then shows how it is optimal to engage in active management of passive exposure within the context of the core-satellite portfolio.
A buy-and-hold investor typically takes an exposure and then holds it till the investment horizon. Is such exposure optimal?
The answer lies in the risks associated with such exposure. Suppose an investor decides to allocate 55 per cent of her total investment to equity. She could buy either index funds or diversified funds. The former is a passive exposure (beta) to the market while the latter, an active exposure.
The investor can then decide to hold her active or passive exposure till the investment horizon or rebalance the same at periodic intervals. The former is called passive management of the investment while the latter, active management.
Now, suppose an investor buys diversified funds and holds the exposure till the investment horizon. If stock prices climb through the investment period, the proportion of equity in the portfolio would be more than 55 per cent. If stock prices decline the proportion of equity would be lower than 55 per cent.
Either way, the portfolio would have drifted from the strategic asset allocation policy. A higher equity allocation can expose the portfolio to higher downside risk. A lower equity allocation can lead to higher shortfall risk- the risk that the portfolio value can fall short of the desired amount at the investment horizon.
Rebalancing the portfolio or active management of investment exposure is, hence, important. But should investors consider active management of passive exposure (index funds) or active management of active exposure (diversified funds)?
It is true that active managers generate excess returns (alpha) that more than compensates for their higher management fees. The problem is that an active manager cannot consistently generate excess returns. This makes it difficult for investors to select alpha managers based on their past performance.
Moreover, research shows that it is difficult to differentiate luck and skill within the universe of alpha managers. Besides, generating excess returns is a zero-sum game.
All these factors make it optimal to buy low-cost index funds to generate market returns. This is the primary reason for investors to consider index funds as part of their equity core.
What about the equity satellite portfolio? This portfolio is structured to generate alpha returns- excess returns over the benchmark index. Besides active style and sector funds, an investor can use index funds to generate excess returns for the satellite portfolio as well. How?
Alpha return is generated from security selection and/or market timing skills. Investors can buy or sell ETFs on the Nifty or the Sensex at regular intervals and generate short-term gains for the satellite portfolio.
Investors can engage in active management of passive exposure in two ways. One, they can rebalance equity core at periodic intervals to moderate downside and shortfall risks and align the portfolio with the asset allocation policy. And two, they can continually take profits on equity satellite to generate alpha returns.
Conclusion
The discussion shows that active management of passive investment exposure is optimal. It is, however, important to adopt a rule-based approach for rebalancing portfolios.
Specifically, the equity core can be rebalanced at least every year based on the strategic asset allocation policy. A price-target-based profit-taking for equity satellite would suffice. Such an approach takes away the emotion from the decision-making process. And that leads to less regret.
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