The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

ACTIVE VS. PASSIVE PORTFOLIO MANAGEMENT

While earlier in this chapter we distinguished between the extremes of equity portfolio management—passive versus active—in practice there are investors who pursue different degrees of active management and different degrees of passive management. It would be helpful to have some way of quantifying the degree of active or passive management. Fortunately, there is a way to do that.

EXHIBIT 9.3 Measures of Management Categories

Source: Exhibit 2 in John S. Loftus, “Enhanced Equity Indexing,” Chapter 4 in Perspectives on Equity Indexing, ed. Frank J. Fabozzi (Hoboken, N.J.: John Wiley & Sons, 2000), 84.

John Loftus has suggested that one way of classifying the various types of equity strategies is in terms of alpha and tracking error.¹⁷⁶ Based on these measures, Loftus proposes the classification scheme shown in Exhibit 9.3. While there may be disagreements as to the values proposed by Loftus, the exhibit does provide some guidance. In an indexing strategy, the portfolio manager seeks to construct a portfolio that matches the risk profile of the benchmark, the expected alpha is zero and, except for transaction costs and other technical issues discussed later when we cover the topic of indexing, the tracking error should be, in theory, zero. Due to these other issues, tracking error will be a small positive value. At the other extreme, ...