23 October 2015

Multi-asset trading: Active Vs Passive trading

What is the difference between Active and Passive trading?

​​What is Active trading?

Active po​rtfolio management is what most traders will be familiar with – the active buying and selling of financial instruments, with the investor deciding when to move in and out of positions, in line with their trading strategy.

 

An active investor continuously monitors their holdings and seeks to proactively exploit market movements to their advantage. By pursuing this strategy an investor may change the composition of their portfolio and swiftly take advantage of sectors that are coming strongly into favour or pricing anomalies on particular stocks.

Pros: Cons:
Responsive to market movements.Proactive trading can be swayed by market sentiment, resulting in selling in 'down' markets and buying in 'rising' markets. This is an ineffective strategy.
Can implement high-conviction investment strategies.Tendency towards higher trading can create portfolio 'churn', which increases portfolio costs.


 

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Image Source: iStock

What is Passive trading?

Passive trading involves buying and holding a portfolio of securities that automatically track the broader market. Passive investing tends to have low-cost trading structures, is easy to implement and is far less time consuming.​

Pros: Cons:
Lower trading costs.Even small costs, when applied to a passive investment such as index trackers, corrodes more performance than if the same investment has been actively held.
Hassle-free market exposure.Passives have the same exposure to market movements – up and down – but no way of minimizing the down periods.

 

Active and passive management are both legitimate approaches and a mixture of the two approaches can be deployed in a single asset or multi-asset portfolio.

Passive Investing: ETFs and Index Trackers​

There are a range of passive trading products: Exchange Traded Funds (ETFs), Exchange Traded Commodities (ETCs) and Index Trackers, which effectively gain exposure to and track the performance of a specific index without having to buy single stocks. 


 
Literally hundreds of listed ETFs are quoted throughout the trading day on exchanges whereas Index Trackers usually have their net value asset (NAV) calculated at the end of each day.

 

Why consider ETFs?​

ETFs are similar to index mutual funds offering lower cost, lower turnover and broader diversification. Additionally their expense ratios are significantly lower.

 
Intraday trading of ETFs enables investors to buy and sell all of the shares that comprise up an entire market such as the FTSE 100, S&P 500, Dow Jones Industrial Average (DJIA) or the CAC-40 via a single trade. 

 
They provide the flexibility to get in​to or out of a position at any time throughout the trading day, which contrasts with mutual funds that trade only once per day. Whilst still trading an index like a passive investor, active traders may take advantage of short-term movements. For example, if the DJIA zooms when the positive U.S. non-farm payroll numbers are announced, active traders may immediately bag profits by closing out their position. 

 

Portfolio ‘auto pilot’ with algorithmic trading

Algorithmic trading effectively allows traders to pre-determine price parameters for their online trading platform to execute very specific trades. This could be considered a passive trading technique, as it allows the investor to execute their trading strategy - in their absence.

 

Choosing Your Investment Style

Your investment style reflects all of the questions you ask yourself to construct a multi-asset portfolio, exhibiting itself in how you approach on-going management of the portfolio.​
  • Tactical Asset Allocation (TAA)
Tactical Asset Allocation (TAA) is a moderately active strategy that enables investors to create and generate extra value by taking advantage of particular market situations. It is a multi-pronged approach that does not focus only on yield but weighs the trade off between risk and return. 

 
Under TAA the portfolio's original strategic asset mix can be changed dynamically in pursuit of short-term profits. The investment time horizon is unconstrained and can be daily, weekly or monthly. 

 
A particular characteristic of TAA is that it can be used to ensure a balance of risk across various sectors and markets globally in order to help smooth the investment performance at times of market stress. However, the extent to which TAA can enhance performance is open to debate.

 
  • Strategic Asset Allocation
Strategic asset allocation - as pursued by institutional investors such as pension funds - tends to have a longer but flexible time horizon. It tends to be less active as a strategy than TAA. 

 
For example, an investor could decide to allocate 60% to equities, 20% to bonds, 15% to property and leave 5% in cash, then review their strategic asset allocation strategy over a one- to three-year period. 

 
With a TAA approach this can be reviewed more quickly if market conditions change; In a down market, an investor might decide to decrease their exposure to equities from 60%  to 40% and rebalance their portfolio across other asset classes.

 

How to use hedging products within a Multi-Asset portfolio

A diversified multi-asset portfolio including derivative products may further hedge market and currency risk. This can be achieved by use of risk hedging techniques where inexpensive hedges are purchased across various liquid markets. 

 

Using stock as collateral

In margin trading, the securities in your account act as collateral to permit you to purchase additional investments - without having to invest any additional capital; called a margin call.  Basically, to take a margin call one borrows from the broker to purchase more securities and the broker charges the trader interest on the borrowed money and use all the securities.

 
Saxo Capital Markets offer clients the ability to use up to 75% of the value of any shareholding held in their account as collateral for trading in margined products such as FX and Contracts for Difference (CFDs), a derivative. It’s a leveraged/geared investment strategy and therefore considered relatively high-risk.

 

 

 
 

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The value of your investments can go down as well as up.
Losses can exceed deposits on margin products. Please ensure you understand the risks.