Active

What Is Active?

Active, in the context of portfolio management, refers to an investment strategy where a portfolio manager or team makes specific decisions to outperform a given market benchmark index. This approach involves ongoing research, market analysis, and timely buying and selling of securities in an attempt to generate returns higher than those achievable by simply tracking an index. Active managers believe that through skilled security selection and tactical asset allocation, they can identify mispriced assets and capitalize on market inefficiencies to achieve superior performance, often measured as alpha.

History and Origin

The concept of active management largely predates passive investing and is deeply intertwined with the origins of collective investment vehicles. The modern mutual fund industry began with the establishment of the Massachusetts Investors Trust in Boston in 1924, which allowed multiple investors to pool resources for a diversified portfolio. This marked a new approach to collective investment, professionally managed to provide access to financial markets for individual investors.⁸ Early mutual funds were inherently active, relying on the expertise of managers to choose investments and navigate market conditions. For instance, after the market crash of 1929, early active managers strategically altered their holdings to adapt to the challenging economic environment.⁷ The regulatory framework for mutual funds, including standards for disclosure and fiduciary responsibilities, was solidified with the establishment of the U.S. Securities and Exchange Commission (SEC) in 1934 and the Investment Company Act of 1940.⁶

Key Takeaways

• Active management seeks to outperform a specific benchmark index by making discretionary investment decisions.
• It involves continuous research, analysis, and trading by a fund manager or team.
• The goal of active management is to generate "alpha," or excess returns above the market.
• Active strategies typically involve higher fees, such as management fees and trading costs, compared to passive strategies.
• Success in active management depends on the manager's skill in security selection, market timing, and risk management.

Interpreting Active

When evaluating an active fund or manager, interpretation centers on their ability to consistently generate positive alpha after accounting for all fees and expenses. Investors often scrutinize the fund's performance relative to its stated benchmark index over various time horizons, typically three, five, and ten years. A key consideration is the consistency of outperformance, as short-term gains can sometimes be attributed to luck rather than skill. Furthermore, understanding the manager's stated investment strategy and philosophy is crucial for alignment with an investor's own objectives and risk tolerance.

Hypothetical Example

Consider an active equity mutual fund, "DiversiGrowth Fund," whose stated objective is to outperform the S&P 500 index. The fund manager, drawing on extensive research, believes that technology companies specializing in artificial intelligence are undervalued. They decide to allocate a significant portion of the fund's capital to five specific AI-focused technology stocks, while maintaining smaller positions in other sectors for diversification.

Over the next year, suppose the S&P 500 index returns 10%. If the DiversiGrowth Fund, through its manager's specific stock picks and timing, achieves a return of 12% (net of all fees), it has successfully delivered 2% of positive alpha. Conversely, if the fund returns 8%, it has underperformed its benchmark by 2%, indicating a negative alpha for that period. This example illustrates how active management directly links performance to the manager's discretionary decisions and their ability to identify and exploit market opportunities.

Practical Applications

Active management is prevalent across various financial products and services, aiming to enhance returns or manage risk management.

• Mutual Funds and ETFs: Many mutual funds and Exchange-Traded Fund (ETF)s are actively managed, with fund managers making decisions on buying and selling underlying securities. These funds often target specific sectors, geographic regions, or investment styles.
• Hedge Funds and Private Equity: These alternative investment vehicles are almost exclusively actively managed, seeking absolute returns or unique exposures often unavailable through traditional public markets. Regulatory bodies like the SEC have increasingly focused on enhancing disclosure requirements for private funds to increase transparency regarding their operations and fees.⁵
• Separately Managed Accounts (SMAs): High-net-worth individuals or institutions may opt for SMAs, where a financial advisor or portfolio manager manages a dedicated portfolio tailored to their specific goals, tax considerations, and preferences.
• Pension Funds and Endowments: Large institutional investors frequently employ active strategies for portions of their portfolios, often allocating capital to specialized active managers with specific expertise.

Limitations and Criticisms

While active management holds the promise of outperformance, it faces several limitations and criticisms. A primary concern is the higher expense ratio typically associated with active funds, which includes management fees, trading costs, and other administrative expenses. These higher costs can significantly erode potential returns, even if a manager occasionally outperforms their benchmark.⁴

Extensive research, such as the S&P Dow Jones Indices Versus Active (SPIVA) Scorecard, consistently measures the performance of actively managed funds against their respective benchmarks. Over longer periods, a significant majority of actively managed funds have been found to underperform their benchmark indices.³,² For instance, research examining performance between 1991 and 2019 found no statistically significant difference in performance between actively managed and passively managed funds when passively managed funds were compared to competitively priced active funds.¹ Critics argue that achieving consistent outperformance is challenging due to factors like market efficiency, where all available information is quickly reflected in asset prices, making it difficult for any single manager to consistently gain an edge. Moreover, frequent trading, a characteristic of active management, can lead to higher capital gains distributions for taxable accounts, potentially reducing after-tax returns for investors.

Active vs. Passive

The primary distinction between active and passive investment approaches lies in their fundamental objectives and methodologies.

While active managers aim to beat the market, passive investors are content with matching market returns. The debate between active and passive investing often highlights the challenge active managers face in consistently generating alpha after accounting for their higher fees.

FAQs

What does "actively managed fund" mean?

An actively managed fund is an investment vehicle, such as a mutual fund or ETF, where a professional fund manager or team makes ongoing decisions about which securities to buy, hold, or sell. Their goal is to achieve returns that surpass a specific benchmark index.

Why do actively managed funds often have higher fees?

Actively managed funds typically have higher fees due to the costs associated with employing a team of analysts and portfolio managers, conducting extensive research, and the increased trading activity involved in their investment strategy. These expenses are captured in the fund's expense ratio.

Can active funds protect against market downturns?

Some proponents of active management suggest that skilled managers can adapt their portfolios during volatile periods, potentially reducing losses in market downturns. However, this ability is not guaranteed, and performance varies widely among managers. Effective risk management is a core component of this claim.

Is active investing suitable for all investors?

Active investing can be suitable for investors who believe in a manager's ability to consistently outperform the market and are comfortable with the higher fees and potential for underperformance. It is often considered a part of a broader diversification strategy, rather than the sole investment approach.