Passive Versus Active Management
There are two contrasting investing styles – active and passive investing. Active investing is an investment style focusing on frequent (active) buying and selling to beat the market (i.e., SPX) or a broad index. Passive management refers to purchasing index and exchange-traded funds that replicate a specific benchmark to match the performance, typically with lower fees and transaction costs.
The difference between the two investment styles is one (i.e., active) looks to beat the benchmark, and the other (i.e., passive) aims to duplicate the performance of an index. Active investing requires a high degree of market analysis and risk management strategies to determine what and when to buy and sell.
Investors continue to debate the merits of active versus passive investing. Some investors have firm beliefs and strong opinions about these two investment styles. As with any choices investors face, it comes down to familiarity, biases, risk tolerance levels, timeframes, and investment goals.
Is an active or passive portfolio management strategy better?
Investing over the exceptionally long term, passive index funds tend to generate higher returns. For instance, over 20 years, nearly 90% of index funds have outperformed their counterparts. In the past 10-year period, only a quarter of active funds beat the average of their passive rivals.
Passive investments have gathered the bulk of the investment flows in recent years. One of the primary reasons for the difference in performance is active managers have higher costs than passive managers. Also, active managers tend to underperform due to concentrated and dominant positions in specific winners and losers.
Broad losses across stock and fixed-income markets, rising geopolitical tensions, and persistent inflationary pressures have created a situation that may favor active investing. A recent S&P Global study found nearly half of large-cap domestic equity funds performed better than the SPX Index during the first half of 2022, resulting in the best rate in over 13 years.
With growth and large-cap technology names pulling down the benchmark indexes (SPX, INDU, COMPQ, NDX, etc.), passive investments have fared poorly this year. When the performances of a handful of individual stocks influence the broader market, bottom-up factors such as corporate news and financial information from companies do not impact the market as much. Also, when major stock market indexes lack a discernable trend, investors will be more stock selective, focusing on solid technical patterns, robust fundamentals, and relative outperformance.
Markets are cyclical by nature and will return to the mean. Index-driven or passive investing has been the dominant investment style, outperforming passive investing over the past decade.
Can structural forces developing today merit a change from index-based or passive investing toward active investing?
Stock selection becomes increasingly critical to outperformance in a challenging economic and volatile stock market environment. Stock pickers excel when the internal correlation between stocks is relatively low. The dislocations between individual stocks create opportunities for astute active investors who are successful in leadership names that outperform the benchmark index.
When the macroeconomic forces drive the stock market, correlations tend to rise. Money managers have fewer opportunities to differentiate themselves from the rest of the market. Stock correlations were high, and return dispersions were low in the past decade, leading to active managers underperforming benchmark indexes.
Starting with the Covid-19 pandemic in 2020 may have been one of the catalysts that led to active managers performing better, as widely dispersed stock returns favored the stock pickers. With the stock market remaining in a primary downtrend as the Fed continues to hike rates to fight inflation, will investors stay with passive investing or turn toward active management?
Very few investors are 100% passive or 100% active. Investors tend to fall along the spectrum. Whether investors favor an active or passive approach to investing should not matter as much as adhering to a disciplined investment and risk management strategy.
Chart reading remains an integral part of technical research. Prices reflect current and future corporate news, financial information, and other data. However, different chart patterns convey bullish, bearish, or neutral tendencies.
No one chart pattern works best for all market conditions. Some favor choppy and directionless markets and others favor stable trending markets that trend up or down.
It remains crucial to utilize the appropriate chart pattern based on specific market conditions. Deploying the wrong patterns or not knowing which one to apply may result in missed opportunities and losses. These patterns are not guaranteed to work all the time as they are indications of the likelihood of the outcome.
Chart patterns fall into three (3) categories - a continuation, reversal, and non-trending trading range. Some technical formations include head and shoulders bottom/top, double top/double bottom, rounding bottom/top, cup and handle, rising/falling wedge, pennant or flag, ascending/descending triangle, symmetrical triangle, etc.
Chart patterns can identify the next directional trend of a stock. But can also provide critical support (accumulation) and resistance (distribution), enabling investors and traders greater confidence to act before the trend reversal occurs.
After all, successful investing is anticipating the anticipations of others – John Maynard Keynes.
Stock screens can also help the stock pickers identify stocks currently in intermediate-to-longer-term uptrends. Although it may be a simple stock screening process involving stocks trading above their respective 50-day and 200-day moving averages, they can be equally effective in identifying stocks in dominant uptrends.
Enclosed are stock screens of leading names in three markets, including the S&P 500 Index (SPX), the S&P 400 Midcap Index (MID), and the S&P 600 Small cap Index (SML).