Active fund management

What Is Active Fund Management?

Active fund management is an investment strategy where a portfolio manager, or a team of managers, makes specific investment decisions with the goal of outperforming a particular market benchmark. This approach involves ongoing research, analysis, and judgment regarding buying, holding, and selling securities. It falls under the broader financial category of investment management. Unlike passive strategies, active fund management seeks to generate "alpha," which is the excess return above what a benchmark or broad market index provides, often through strategic security selection and market timing. Active fund managers aim to capitalize on market inefficiencies by identifying undervalued assets to buy and overvalued assets to sell.

History and Origin

The concept of actively managing investments dates back centuries, with individuals making discretionary decisions about their assets. However, the formal structure of pooled, actively managed funds gained prominence with the establishment of the first modern mutual fund in the United States in 1924, known as the Massachusetts Investors Trust.¹³ This allowed investors to combine their capital and have it professionally managed by experts who actively chose the underlying securities. The subsequent stock market crash of 1929 and the Great Depression spurred significant regulatory developments, including the Investment Advisers Act of 1940, which established oversight for investment advisers and shaped the mutual fund industry.¹¹, ¹² Early pioneers in active investing, such as Benjamin Graham, often focused on value investing principles, identifying deeply undervalued companies.¹⁰ Throughout the 20th century, active fund management was the predominant investment approach, with professional managers striving to deliver superior returns through their expertise.

Key Takeaways

• Active fund management involves a professional manager making discretionary decisions to try and outperform a market benchmark.
• Managers engage in activities such as security selection, market timing, and asset allocation to achieve their objectives.
• The goal of active management is to generate "alpha," or returns exceeding the chosen benchmark.
• This approach typically incurs higher expense ratios compared to passive strategies due to the cost of research and management.
• Performance of active funds is often evaluated against relevant indices through studies like the S&P Dow Jones Indices Versus Active (SPIVA) reports.⁹

Interpreting Active Fund Management

Interpreting the success of active fund management primarily involves comparing its performance against a relevant benchmark after accounting for fees and expenses. An actively managed fund is considered successful if it consistently delivers returns that exceed its benchmark over various market cycles. The benchmark serves as a standard against which to measure the manager's ability to generate alpha. For instance, a U.S. large-cap equity fund might be benchmarked against the S&P 500 Index. Investors evaluate an active fund's performance by examining its historical returns, volatility, and its expense ratio, which represents the annual cost of operating the fund. A higher expense ratio means the fund needs to generate even greater alpha to provide better net returns than a lower-cost alternative.

Hypothetical Example

Consider an investor, Sarah, who has $10,000 to invest in the stock market. She decides to invest in an actively managed mutual fund, "Global Growth Fund A," which focuses on identifying high-growth companies worldwide. The fund's objective is to outperform the MSCI World Index.

The fund manager for Global Growth Fund A, based on extensive fundamental analysis, decides to allocate a significant portion of the portfolio to emerging market technology companies, believing them to be undervalued despite their growth potential. Simultaneously, they reduce exposure to mature industries in developed markets, anticipating slower growth.

At the end of one year, Global Growth Fund A reports a return of 12% after deducting its expense ratio. The MSCI World Index, over the same period, returned 9%. In this scenario, the active management of Global Growth Fund A successfully generated 3% of alpha, outperforming its benchmark. Conversely, if the fund had returned 8% while the index returned 9%, it would have underperformed, despite delivering a positive return.

Practical Applications

Active fund management is widely applied across various investment vehicles and strategies, including mutual funds, exchange-traded funds (ETFs) with active mandates, hedge funds, and separately managed accounts. It is a cornerstone of portfolio management for many institutional and high-net-worth investors who seek customized solutions or specific risk management objectives.

For instance, a pension fund might employ active managers for specific asset classes, such as international equities or high-yield bonds, where they believe skilled managers can exploit market inefficiencies. Similarly, a wealthy individual might opt for a separately managed account with an active manager to achieve tailored diversification and tax management strategies. In the United States, investment advisers who manage client assets for compensation are regulated by the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940, ensuring they adhere to certain standards, including a fiduciary duty to their clients.⁶, ⁷, ⁸ This regulatory framework helps ensure transparency and accountability in the provision of investment advice and active management services.

Limitations and Criticisms

Despite its appeal, active fund management faces significant limitations and criticisms. A primary critique revolves around its consistent underperformance relative to passive investment strategies over longer periods, particularly after accounting for fees.⁴, ⁵ Annual SPIVA (S&P Indices Versus Active) reports, which compare actively managed funds to their respective benchmarks, frequently show that a majority of active managers fail to outperform their passive counterparts over 5, 10, and 15-year horizons across many asset classes.², ³

The higher expense ratio associated with active management is a significant drag on returns. Managers must generate substantial alpha just to cover these costs before providing any net benefit to investors. Critics also point to the efficient market hypothesis, which suggests that all publicly available information is already reflected in security prices, making it exceedingly difficult for any manager to consistently find undervalued or overvalued securities. Furthermore, active managers may struggle with "persistence," meaning that funds that outperform in one period rarely maintain that outperformance in subsequent periods, suggesting that short-term outperformance may be due to luck rather than skill.¹ Academic research from firms like Research Affiliates often highlights the challenges active managers face in consistently outperforming, particularly in highly efficient markets.

Active Fund Management vs. Passive Fund Management

The fundamental difference between active fund management and passive fund management lies in their investment objectives and methodologies.

While active management aims for superior returns through skilled decision-making, passive fund management, often referred to as index investing, seeks to mirror the performance of a specific market index, such as the S&P 500. Passive funds typically have lower fees and are based on the premise that consistently beating the market is extremely challenging, especially after costs. The confusion often arises when investors consider their overall portfolio goals; both approaches can play a role, but their differing cost structures and performance objectives mean they are not interchangeable.

FAQs

What is the primary goal of an active fund manager?

The primary goal of an active fund manager is to achieve returns that exceed a specific market benchmark, after accounting for all fees and expenses. This outperformance is often referred to as generating alpha.

Are active funds regulated?

Yes, in many jurisdictions, including the United States, investment advisers who engage in active fund management are regulated. For instance, in the U.S., they are typically subject to oversight by the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940, which imposes requirements like maintaining a fiduciary duty to clients.

How do active managers try to beat the market?

Active managers employ various techniques to try and outperform the market. These often include fundamental analysis, which involves evaluating a company's financial health, management, and industry to determine its intrinsic value, and quantitative analysis, which uses mathematical and statistical models to identify investment opportunities. They also use security selection (choosing individual investments) and market timing (deciding when to buy or sell assets).