Active fund managers: Meaning, Criticisms & Real-World Uses

What Are Active Fund Managers?

Active fund managers are professional investors who aim to outperform a specific benchmark index through strategic buying and selling of securities. Unlike their passive counterparts, these portfolio managers do not simply track an index; instead, they conduct in-depth research, analyze market trends, and make discretionary decisions about which stocks, bonds, or other assets to include in their portfolios. This approach falls under the broader umbrella of Investment Management, a field focused on maximizing returns while managing risk. The goal of active fund managers is to generate alpha, which is the excess return of a fund relative to the return of its benchmark index.

History and Origin

The concept of pooled investment vehicles, which are often managed actively, has roots extending back centuries. However, the modern form of the mutual fund, a primary vehicle for active fund managers, originated in the United States in the early 20th century. The first open-end mutual fund, Massachusetts Investors Trust, was established in Boston in 1924, introducing the idea of professional management and diversification to individual investors⁸.

The industry's growth spurred regulatory oversight. The establishment of the Securities and Exchange Commission (SEC) in 1934 and the subsequent enactment of the Investment Company Act of 1940 laid the foundational legal framework for mutual funds, requiring disclosure, corporate governance standards, and fiduciary duty ⁷. This regulatory environment facilitated the expansion of active fund management as a legitimate and supervised financial service. By 1966, the assets held by mutual funds had grown significantly, showcasing the increasing trust and participation of the public in professionally managed funds.⁶

Key Takeaways

Active fund managers seek to outperform a specific market benchmark through discretionary investment strategy.
They rely on research, market analysis, and judgment to select securities for a portfolio.
The objective of active fund management is to generate alpha, which is returns above the market benchmark.
Active management typically involves higher fees compared to passive strategies, reflecting the costs of research and trading.
Performance of active fund managers is often evaluated against relevant benchmarks over various time horizons.

Formula and Calculation

While there isn't a single "formula" for active fund management itself, the performance of an active fund manager is frequently evaluated using specific metrics, primarily relative to a benchmark index. One key concept is alpha, representing the manager's skill in generating excess returns.

\text{Alpha} = R_p - [R_f + \beta_p (R_m - R_f)]

Where:

(R_p) = Portfolio's actual return
(R_f) = Risk-free rate
(\beta_p) = Portfolio's beta (a measure of its volatility relative to the market)
(R_m) = Benchmark's return

This formula, part of the Capital Asset Pricing Model (CAPM), helps quantify the portion of a portfolio's return that cannot be attributed to market risk.

Interpreting Active Fund Managers

Interpreting the effectiveness of active fund managers involves assessing whether their investment decisions consistently lead to superior returns after accounting for fees and risk. A key indicator is consistent outperformance of their chosen benchmark index over extended periods. For example, if an active fund manager consistently outperforms the S&P 500 over five, ten, or fifteen years, this suggests successful active management.

However, evaluation must consider the associated costs, particularly the expense ratio, which can significantly erode returns. Higher fees are a common characteristic of actively managed funds, covering the costs of research, trading, and the managers' expertise⁵. Investors should look at net returns (after fees) when comparing active funds to their benchmarks or to passive alternatives. The ability of active fund managers to provide superior risk management in volatile markets is also a consideration.

Hypothetical Example

Consider an active fund manager, Sarah, who manages the "Growth Opportunities Fund." Sarah believes that by thoroughly analyzing company fundamentals and anticipating macroeconomic shifts, she can identify undervalued stocks. Her fund's benchmark is the S&P 500.

In a given year, the S&P 500 returns 10%. Sarah's Growth Opportunities Fund, through her active stock selection, generates a gross return of 12%. However, the fund has an expense ratio of 1.5%.

The net return for investors in Sarah's fund would be:
(12% \text{ (Gross Return)} - 1.5% \text{ (Expense Ratio)} = 10.5% \text{ (Net Return)}).

In this hypothetical scenario, Sarah's active management resulted in a 0.5% outperformance (10.5% net return vs. 10% benchmark return), demonstrating successful alpha generation after accounting for costs. This contrasts with a passive fund aiming to replicate the S&P 500's return, which would likely have a much lower expense ratio.

Practical Applications

Active fund managers are prevalent across various financial products and services, offering diverse investment strategy options for investors.

Mutual Funds: A significant portion of the global mutual fund industry is actively managed, with managers selecting a portfolio of securities to meet the fund's specific objectives. For instance, in 2024, the Investment Company Institute (ICI) reported extensive data on the asset management industry, including trends in mutual funds, which form a core part of actively managed assets.³, ⁴
Hedge Funds: These funds almost exclusively employ active management strategies, often using complex techniques like short selling, derivatives, and leverage to generate returns regardless of market direction.
Separately Managed Accounts (SMAs): High-net-worth individuals or institutions may hire active fund managers to manage a custom portfolio tailored to their specific financial goals, risk tolerance, and tax considerations.
Certain Exchange-Traded Funds (ETFs): While many exchange-traded fund (ETF)s are passive, a growing number of active ETFs exist where a portfolio manager actively selects and manages the underlying securities.
Pension Funds and Endowments: Large institutional investors often allocate capital to active fund managers to manage portions of their vast portfolios, seeking specialized expertise and potential for enhanced returns.

The fees associated with active funds continue to evolve. For example, Morningstar research indicates that the asset-weighted average expense ratio for active US equity funds was 0.60% in 2024, representing a continued decline in fees paid by fund investors over the past two decades.²

Limitations and Criticisms

Despite the potential for outperformance, active fund managers face significant limitations and criticisms, primarily concerning their ability to consistently beat the market after fees.

Underperformance: A long-standing critique is that the majority of active fund managers fail to outperform their benchmarks, especially over longer time horizons. The S&P Dow Jones Indices SPIVA (S&P Indices Versus Active) Scorecard consistently shows that a large percentage of actively managed funds underperform their respective benchmarks across various asset classes and time periods. For instance, the SPIVA U.S. Year-End 2024 report indicated that 65% of all active large-cap U.S. equity funds underperformed the S&P 500, a trend consistent with the 24-year history of the scorecards.¹ This widespread underperformance is often attributed to the concept of market efficiency, suggesting that all available information is already priced into securities.
Higher Costs: Active management typically incurs higher expense ratios compared to passively managed funds (like index funds). These higher costs, which include management fees, trading costs, and administrative expenses, can significantly erode any potential outperformance. Even small differences in fees can compound over time, leading to substantial differences in net returns.
Tracking Error and Style Drift: Active funds may deviate significantly from their stated investment styles or benchmarks, known as "style drift," which can expose investors to unintended risks. Their active decisions also inherently lead to "tracking error," the difference in performance between the portfolio and its benchmark.
Behavioral Biases: Active fund managers, like all human decision-makers, can be susceptible to behavioral biases, such as overconfidence or herd mentality, which may lead to suboptimal investment decisions.

These factors contribute to the ongoing debate about the value proposition of active management versus passive investing, influencing investor behavior and asset allocation decisions.

Active Fund Managers vs. Passive Fund Managers

The distinction between active fund managers and passive fund managers lies fundamentally in their investment philosophy and approach to portfolio construction.

Active fund managers employ a hands-on approach, making discretionary decisions with the explicit goal of achieving returns greater than a specific market index. They believe that markets are not perfectly efficient and that skilled analysis can identify mispriced securities. Their strategies involve in-depth research, fundamental analysis, technical analysis, and frequent trading, all aimed at stock picking or market timing. This intensive effort typically results in higher operating expenses and management fees.

In contrast, passive fund managers (or index fund managers) aim to replicate the performance of a particular benchmark index, such as the S&P 500 or a bond index. Their objective is not to beat the market but to match its returns by holding a portfolio that mirrors the index's composition. This approach involves minimal research and trading, leading to significantly lower expense ratios. The primary vehicle for passive management is an exchange-traded fund (ETF) or an index mutual fund. While active fund managers seek to generate alpha, passive fund managers are content with capturing the market's beta. The debate between active and passive investing often revolves around the consistency of outperformance by active managers versus the lower costs and consistent market-like returns of passive strategies.

FAQs

What is the main goal of an active fund manager?

The main goal of an active fund manager is to achieve investment returns that surpass a specific benchmark index after accounting for all fees. This excess return is often referred to as alpha.

How do active fund managers differ from passive fund managers?

Active fund managers make deliberate investment decisions to outperform the market, whereas passive fund managers aim to replicate the performance of a specific index by holding its constituent securities. Active management involves more research and trading, leading to higher fees, while passive management is characterized by lower costs and a buy-and-hold strategy.

Are active fund managers generally more expensive?

Yes, active fund managers typically charge higher fees, often reflected in a higher expense ratio, compared to passive funds. These fees compensate for the research, analysis, and trading activities involved in attempting to outperform the market.

Do active fund managers consistently outperform the market?

Historical data, such as that provided by the S&P Dow Jones Indices SPIVA Scorecard, suggests that the majority of active fund managers do not consistently outperform their benchmarks, especially over longer time periods, once fees are considered. This highlights the challenges of generating consistent alpha in efficient markets.

What types of funds are typically managed actively?

Many traditional mutual funds, hedge funds, and separately managed accounts are actively managed. While most exchange-traded fund (ETF)s are passive, an increasing number of active ETFs are also available.