A Stochastic Portfolio Perspective on Utilizing Active and Passive Fund Management

Abstract

The proliferation of liquid, transparent, and inexpensive index-based implementation means that investors of nearly all types of investors, individual and institutional, face a persistent implementation question: how much passive and how much active?

Placing active fund management in the same framework of uncertainty that asset allocators utilize for other portfolio decisions provides a surprising and enlightening answer to the active vs. passive debate that does not match typical discourse on the matter. Instead of a binary “all or none” answer, reasonable (and even optimistic or pessimistic) expectations for active management imply a balanced implementation approach. Only extreme assumptions (e.g. very positive or negative levels of active return, very short or long time horizons) indicate a binary choice.

Keywords: active management, portfolio implementation, active risk, active return, indexing