Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index. In passive management, investors expect a return that closely replicates the investment weighting and returns of a benchmark index and will often invest in an index fund.
Ideally, the active manager exploits market inefficiencies by purchasing securities (stocks etc.) that are undervalued or by short selling securities that are overvalued. Either of these methods may be used alone or in combination. Depending on the goals of the specific investment portfolio, hedge fund or mutual fund, active management may also serve to create less volatility (or risk) than the benchmark index. The reduction of risk may be instead of, or in addition to, the goal of creating an investment return greater than the benchmark.
Active portfolio managers may use a variety of factors and strategies to construct their portfolio(s). These include quantitative measures such as price–earnings ratios and PEG ratios, sector investments that attempt to anticipate long-term macroeconomic trends (such as a focus on energy or housing stocks), and purchasing stocks of companies that are temporarily out-of-favor or selling at a discount to their intrinsic value. Some actively managed funds also pursue strategies such as risk arbitrage, short positions, option writing, and asset allocation.
Using the concept of asset allocation, researchers divide active management into two parts; one part is selecting securities within an asset class, while the other part is selecting between asset classes. For example, a large-cap U.S. stock fund might decide which large-cap U.S. stocks to include in the fund. Then those stocks will do better or worse than the class in general. Another fund may choose to move money between bonds and stocks, or some country versus a different one, et cetera. Then one class will do worse or better than the other class.
The case where a fund changes its class of assets is called style drift. An example would be where a fund that normally invests in government bonds switches into stocks of small companies in emerging markets. Although this gives the most discretion to the manager, it also makes it difficult for the investor (portfolio manager) if he also has a target of asset allocation.
The effectiveness of an actively managed investment portfolio obviously depends on the skill of the manager and research staff but also on how the term active is defined. Many mutual funds purported to be actively managed stay fully invested regardless of market conditions, with only minor allocation adjustments over time. Other managers will retreat fully to cash, or use hedging strategies during prolonged market declines. These two groups of active managers will often have very different performance characteristics.
Approximately 20% of all mutual funds are pure index funds. The balance are actively managed in some respect. In reality, a large percentage of actively managed mutual funds rarely outperform their index counterparts over an extended period of time because 45% of all mutual funds are "closet indexers" — funds whose portfolios look like indexes and whose performance is very closely correlated to an index (see the term R2 or R-squared to determine correlations) but call themselves active to justify higher management fees. Prospectuses of closet indexers will often include language such as "80% of holdings will be large cap growth stocks within the S&P 500" causing the majority of their performance to be directly dependent upon the performance of the growth stock index they are benchmarking, less the larger fees.
The Standard & Poor's Index Versus Active (SPIVA) quarterly scorecards demonstrate that only a minority of actively managed mutual funds have gains better than the Standard & Poor's (S&P) index benchmark. As the time period for comparison increases, the percentage of actively managed funds whose gains exceed the S&P benchmark declines further. This may be due to the preponderance of closet-index funds in the study.
Only about 30% of mutual funds are active enough that the manager has the latitude to move completely out of an asset class in decline, which is what many investors expect from active management. Of these 30% of funds there are out-performers and under-performers, but this group that outperforms is also the same group that outperforms passively managed portfolios over long periods of time.
Due to mutual fund fees and/or expenses, it is possible that an active or passively managed mutual fund could under-perform compared to the benchmark index, even though the securities that comprise the mutual fund are outperforming the benchmark, because indexes themselves have no expenses whatsoever. However, since many investors are not satisfied with a benchmark return, a demand for active management continues to exist. In addition, many investors find active management an attractive investment strategy in volatile or declining markets or when investing in market segments that are less likely to be profitable when considered as a whole. These kinds of sectors might include a sector such as small cap stocks.
Advantages of active management
The primary attraction of active management is that it allows selection of a variety of investments instead of investing in the market as a whole. Investors may have a variety of motivations for following such a strategy:
- An investor may believe that actively managed funds do better in general than passively managed funds.
- Investors believe that they have some skill for picking which active managers will do better after they have invested.
- They may be skeptical of the efficient-market hypothesis, or believe that some market segments are less efficient in creating profits than others.
- They may want to manage volatility by investing in less-risky, high-quality companies rather than in the market as a whole, even at the cost of slightly lower returns.
- Conversely, some investors may want to take on additional risk in exchange for the opportunity of obtaining higher-than-market returns.
- Investments that are not highly correlated to the market are useful as a portfolio diversifier and may reduce overall portfolio volatility.
- Some investors may wish to follow a strategy that avoids or underweights certain industries compared to the market as a whole, and may find an actively managed fund more in line with their particular investment goals. (For instance, an employee of a high-technology growth company who receives company stock or stock options as a benefit might prefer not to have additional funds invested in the same industry.)
- Investors may gain some psychic benefit from firing a manager that has underperformed, and replacing them with a different manager.
Several of the actively managed mutual funds with strong long-term records invest in value stocks. Passively managed funds that track broad market indices such as the S&P 500 have money invested in all the securities in that index i.e. both growth and value stocks.
The use of managed funds in certain emerging markets has been recommended by Burton Malkiel, a proponent of the efficient market theory who normally considers index funds to be superior to active management in developed markets.
Disadvantages of active management
The most obvious disadvantage of active management is that the fund manager may make bad investment choices or follow an unsound theory in managing the portfolio. The fees associated with active management are also higher than those associated with passive management, even if frequent trading is not present. Those who are considering investing in an actively managed mutual fund should evaluate the fund's prospectus carefully. Data from recent decades demonstrates that the majority of actively managed large and mid-cap stock funds in United States fail to outperform their passive stock index counterparts.
Active fund management strategies that involve frequent trading generate higher transaction costs which diminish the fund's return. In addition, the short-term capital gains resulting from frequent trades often have an unfavorable income tax impact when such funds are held in a taxable account.
When the asset base of an actively managed fund becomes too large, it begins to take on index-like characteristics because it must invest in an increasingly diverse set of investments instead of those limited to the fund manager's best ideas. Many mutual fund companies close their funds before they reach this point, but there is potential for a conflict of interest between mutual fund management and shareholders because closing the fund will result in a loss of income (management fees) for the mutual fund company.
Real active management
Most mutual funds do not have board members and directors with an equity stake in the mutual fund that their manager(s) are administrating. In other words, the directors and board members don't directly impact the future performance of the fund. Real active management, then, is when every manager and director has a vested interest in the success of the fund. Private equity is often real active management since a privately owned company usually has just one owner that make strategy decisions at the board level.
- Active Management: Back to the Stone Age? on www.indexuniverse.com
- "Persistence Scorecard - S&P Dow Jones Indices" (PDF). S&P Dow Jones Indices.
- "Are Fund Managers Getting Better? Yes, But … They’re Merely Less Bad". Barron's.
- Can anything save active management?
- Burton Malkiel. Investment Opportunities in China. July 16, 2007. (46:28 mark)
- Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2
- John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
- Mark T. Hebner, Index Funds: The 12-Step Program for Active Investors, IFA Publishing, 2007, ISBN 0-9768023-0-9
- The Experts: When Does Active Management Make Sense?
- Article: Do Active Mutual Fund Managers Have An Inherent Conflict of Interest?
- The Arithmetic of Active Management, where William F. Sharpe demonstrates that passive management will always outperform active management on average.
- National Association of Active Investment Managers