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Strategic Risk Management: A Practical Guide to Portfolio Risk Management by David Iverson

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CHAPTER 10

Active versus Passive Management

When structuring an asset class portfolio, the first issue is whether to invest actively or passively. Here we provide a decision framework that discusses active versus passive management as a range of choices available to an investor.

DECISION FRAMEWORK

Table 10.1 provides a number of decisions available to an investor—from passive (index) management through to traditional active management where skilled investment managers are identified to manage securities within an asset class (Ezra and Warren 2010).

Table 10.1 Decision Framework

Decision Action
1. Start with a passive, cap-weighted index. If reasons for deviating from a cap-weighted index not suitable, invest in this index.
Reasons to deviate:
2. Availability. Easily replicable index not available.
3. Suitability. Cap-weighted index not consistent with investor objectives.
4. Active management believed to outperform. Types of active management: a. Cap weights are inefficient. b. Market favors active management. c. Skilled managers can be identified. Alternative to market cap weighting.

Source: Adapted from Ezra and Warren (2010).

Investing in a market-cap-weighted index is the starting point for structuring an asset class. Index products that replicate cap-weighted indexes are usually available at low cost.

Market Capitalization Starting Point

William Sharpe, a Nobel Prize–winning financial economist, published an article titled “The Arithmetic of Active Management” ...

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