When should an equity portfolio manager choose active vs passive management?

The active versus passive decision in CFA Level III goes well beyond the simple fee comparison. The curriculum provides a multi-factor framework for determining when active management is more likely to add value.

Conditions Favoring Active Management

1. Market Inefficiency: Active management is more likely to add value in less efficient markets. Small-cap, emerging market, and high-yield bond markets tend to have more mispricing than US large-cap.

1. Manager Skill (Information Ratio): The Fundamental Law of Active Management states:

IR = IC × √BR

Where IC = Information Coefficient (skill) and BR = Breadth (number of independent bets). High IR managers justify active fees.

1. Tax Inefficiency of Passive Approaches: Index reconstitution forces passive funds to trade at predictable times, creating "index front-running" costs. Active managers can time trades more tax-efficiently.

1. Benchmark Limitations: If available passive benchmarks poorly represent the desired exposure, active management may be necessary (e.g., niche sectors, ESG-screened universes).

Conditions Favoring Passive Management

1. Highly efficient markets — Large-cap developed market equities
2. High active management fees — When alpha net of fees is persistently negative
3. Tax-sensitive accounts — Index funds have lower turnover and tax drag
4. Core-satellite approach — Use passive for the core and active for satellite allocations

The Active Management Decision Framework

Example: Crestview Endowment allocates 40% of its equity portfolio passively (US large-cap via S&P 500 index) and 60% actively (15% EM equities, 15% US small-cap, 15% international developed, 15% sector-specific mandates). The rationale: US large-cap is highly efficient with low active success rates, while the other segments offer greater mispricing opportunities.

The Active Risk Budget

CFA Level III also teaches that the total active risk budget should be allocated to managers with the highest expected information ratio. If active risk is 4% and the IR is 0.5, expected alpha = 0.5 × 4% = 2.0%.

For the CFA exam, be ready to recommend active vs. passive for specific market segments and justify using the IR framework. Check our CFA III equity materials.