The investment management world of today can be divided into two broad categories of management style, each reflecting a fundamentally different belief system regarding how modern capital markets behave. These two schools of thought are generally referred to as active and passive management.
Active management is the traditional way of building a stock portfolio, and includes a wide variety of strategies for identifying companies believed to offer above average prospects.
Regardless of their individual approach, all active managers share a common thread: they buy and sell securities selectively, based on some forecast of future events. Passive or index managers - the terms are often used interchangeably - make no forecasts of the stock market or the economy, and no effort to distinguish attractive from unattractive securities.
Passive managers often construct their portfolios to closely approximate the performance of well-recognised market benchmarks such as the FTSE-100 index (large U.K. companies).
To construct a market-beating portfolio, active managers must identify mispriced stocks and in order to do so active managers must have information that is not only accurate, but not shared by other investors. The manager must be willing to share this information with their clients. In order to profit from this insight, other investors must act upon this information at some future date, causing the mispriced stock price to change and reflect its ‘real’ value. In order to add net value, the ‘excess’ return must exceed the cost of information gathering, trading and potentially higher taxation. The manager must repeat this process over and over again.
The challenge comes in identifying winning managers in advance. Many investors attempt this by choosing managers with strong past performance. Historical evidence shows that past top performing active fund managers show little correlation to top performing managers over subsequent periods.
Warren E. Buffett Chairman and CEO, Berkshire Hathaway, Inc
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.”
Warren E. Buffet, Chairman’s Letter, Berkshire Hathaway Corp. 1996 Annual Report, February 28, 1997. Available in www.berkshirehathaway.com/annual.html (accessed May 21, 2007)