An investment strategy is an approach to investment analysis and security selection. In the broadest sense, investment strategies are passive, active, or semiactive.
In a passive investment approach, portfolio composition does not react to changes in capital market expectations (passive means not reacting). For example, a portfolio indexed to the MSCI-Europe Index, an index representing European equity markets, might add or drop a holding in response to a change in the index composition but not in response to changes in capital market expectations concerning the security’s investment value. Indexing, a common passive approach to investing, refers to holding a portfolio of securities designed to replicate the returns on a specified index of securities. A second type of passive investing is a strict buy-and-hold strategy, such as a fixed, but non-indexed, portfolio of bonds to be held to maturity.
In contrast, with an active investment approach, a portfolio manager will respond to changing capital market expectations. Active management of a portfolio means that its holdings differ from the portfolio’s benchmark or comparison portfolio in an attempt to produce positive excess risk-adjusted returns, also known as positive alpha. Securities held in different-from-benchmark weights reflect expectations of the portfolio manager that differ from consensus expectations. If the portfolio manager’s differential expectations are also on average correct, active portfolio management may add value.
A third category, the semiactive, risk-controlled active, or enhanced index approach, seeks positive alpha while keeping tight control over risk relative to the portfolio’s benchmark. As an example, an index-tilt strategy seeks to track closely the risk of a securities index while adding a targeted amount of incremental value by tilting portfolio weightings in some direction that the manager expects to be profitable.
The Philosophical Difference
There is one huge philosophical difference between active and passive investors. Active investors believe that there are systematic mis-pricing in the market that can be found. Passive investors believe that, at least for the supermajority of people, they can not consistently identify mispricing in the market. Market prices are in equilibrium.