What Is Active Fund?
An active fund is an investment vehicle, such as a mutual fund or exchange-traded fund (ETF), that employs a portfolio manager or a team of managers who actively make investment decisions with the goal of outperforming a specific market benchmark. This approach falls under the broader category of investment management, where professionals seek to generate returns superior to those of the overall market through strategic selection of securities, market timing, or other sophisticated investment strategies. Active fund managers conduct extensive research and analysis to identify undervalued assets or anticipate market trends, distinguishing their approach from passive strategies that merely track an index.
History and Origin
The concept of actively managed investment funds dates back to the early 20th century, predating the widespread adoption of passive investment strategies. As financial markets grew in complexity and the number of publicly traded companies expanded, individual investors found it increasingly challenging to manage diversified portfolios effectively. This led to the emergence of professional money managers who pooled capital from multiple investors and actively invested it on their behalf. The formal regulation of investment companies in the United States, including active funds, was significantly shaped by the Investment Company Act of 1940. This legislation established a framework for investment funds, requiring disclosure, regulating operations, and addressing conflicts of interest, thereby laying a foundational structure for the modern active fund industry.5
Key Takeaways
- Active funds aim to outperform a market benchmark through the skill of their portfolio managers.
- They involve a hands-on approach to selecting securities, market timing, and dynamic asset allocation.
- Active funds typically have higher expense ratios compared to passive funds due to research, analysis, and trading costs.
- The performance of an active fund is often measured by its ability to generate alpha—returns in excess of the benchmark.
Formula and Calculation
While there isn't a single "formula" for an active fund's management process, its performance relative to its benchmark is often quantified using metrics like alpha. Alpha measures the excess return of an investment relative to the return of a benchmark index, considering the risk involved.
The formula for alpha is typically expressed as:
Where:
- (\alpha) = Alpha
- (R_p) = The portfolio's actual returns
- (R_f) = The risk-free rate of return
- (\beta) = The portfolio's beta (a measure of its volatility relative to the market)
- (R_m) = The market's expected return (usually represented by the benchmark)
This formula helps determine if the active fund manager's decisions added value beyond what would be expected from market movements and the fund's inherent risk level.
Interpreting the Active Fund
Interpreting an active fund primarily involves assessing its ability to consistently outperform its chosen benchmark and the broader financial market after accounting for fees. A key consideration is the fund's net returns, which are its gross returns minus all operating expenses and management fees. Investors evaluate whether the additional costs associated with active management are justified by the fund's superior performance. Sustained outperformance over various market cycles suggests a skilled portfolio manager. Conversely, consistent underperformance may indicate that the active fund is not providing sufficient value for its cost.
4## Hypothetical Example
Consider an active fund, the "Diversified Growth Fund," which aims to outperform the S&P 500 index. The fund's portfolio manager believes that certain technology stocks and healthcare companies are undervalued and will grow faster than the broader market.
- Fund Objective: Beat the S&P 500.
- Fund Strategy: Concentrated investment in select large-cap growth stocks, with tactical shifts based on market analysis.
- Hypothetical Performance (Year 1):
- S&P 500 return: +10%
- Diversified Growth Fund gross return: +12%
- Fund's expense ratio: 1.5%
- Diversified Growth Fund net return: +10.5% (12% - 1.5%)
In this hypothetical scenario, the active fund achieved a gross alpha of 2% (12% - 10%). After accounting for the expense ratio, its net alpha was 0.5% (10.5% - 10%). This positive net alpha indicates that the active fund, in this specific period, successfully generated returns above its benchmark even after costs, demonstrating the potential value of its investment strategy.
Practical Applications
Active funds are applied in various investment scenarios where investors seek potential for higher returns than passive market averages or specific risk exposures. They are often chosen by investors who believe in the ability of professional managers to capitalize on market inefficiencies. For instance, in less efficient markets, such as small-cap stocks or emerging markets, active managers may have a greater opportunity to identify mispriced securities. Active funds are also used to implement specific investment themes or to provide targeted diversification beyond broad market exposure. The Morningstar Active/Passive Barometer, a semiannual report, regularly evaluates the performance of active U.S. mutual funds against their passive counterparts, offering insights into their practical success rates across different categories.
3## Limitations and Criticisms
Despite their appeal, active funds face significant limitations and criticisms. A primary concern is their generally higher management fees and operating costs compared to passive funds, which can erode any potential outperformance. Furthermore, empirical evidence often suggests that a majority of active funds struggle to consistently beat their benchmarks over the long term, particularly after fees. This aligns with the Efficient Market Hypothesis, a theory proposed by Eugene F. Fama, which posits that financial markets quickly reflect all available information, making it difficult for active managers to consistently find undervalued assets. R2esearch from sources like S&P Dow Jones Indices' SPIVA Scorecards consistently highlights the challenge active managers face in outperforming their benchmarks across various asset classes and time horizons. T1hese findings lead to skepticism about the value proposition of many active funds, especially when considering the increased risk associated with relying on individual manager skill.
Active Fund vs. Passive Fund
The fundamental difference between an active fund and a passive fund lies in their management approach and investment objective. An active fund aims to outperform the market through discretionary investment decisions made by a portfolio manager. This involves actively buying and selling securities, attempting to time the market, and conducting extensive research. This hands-on approach typically leads to higher operating expenses and expense ratios.
In contrast, a passive fund, often called an index fund, seeks to replicate the performance of a specific market index, such as the S&P 500. Its portfolio managers do not make subjective investment decisions; instead, they simply buy and hold the securities that comprise the index in the same proportions. This strategy minimizes trading activity and research costs, resulting in significantly lower fees. While an active fund strives for alpha (outperformance), a passive fund aims for beta (market return) with minimal tracking error.
FAQs
What are the main goals of an active fund?
The main goal of an active fund is to generate returns that are higher than those of a specific market benchmark, after accounting for all fees and expenses. This is typically achieved through security selection, market timing, and strategic asset allocation.
Are active funds riskier than passive funds?
The risk profile can vary, but active funds can introduce additional risks related to manager performance and concentration. While all investments carry market risk, an active fund also carries the specific risk that its manager's decisions may underperform the market.
How do active funds earn money for investors?
Active funds aim to earn money for investors by making strategic investment choices that lead to capital appreciation of the underlying securities or through income generation (e.g., dividends, interest). The goal is for these gains to exceed those of a comparable passive investment after factoring in fees.