What Are Active Funds?
Active funds are a type of investment vehicle, typically mutual funds or exchange-traded funds (ETFs), where a dedicated portfolio manager or a team of managers makes specific investment decisions with the goal of outperforming a particular benchmark index. This approach falls under the broader category of investment management, aiming to generate superior return on investment through strategic stock picking, market timing, or sector rotation. Unlike passively managed funds, active funds seek to capitalize on perceived inefficiencies within the financial markets by actively buying and selling securities.
History and Origin
The concept of actively managed investment funds predates modern indexing, with the first mutual fund, Massachusetts Investors Trust, launching in 1924. These early funds were inherently active, as professional managers were employed to select and manage portfolios. The regulatory framework that governs much of the investment company landscape today, the Investment Company Act of 1940, established rules for the structure and operation of such funds, emphasizing investor protection and transparency.6 This act laid the groundwork for the modern active fund industry in the United States, requiring detailed disclosures and oversight. For decades, active management was the predominant investment approach, built on the belief that skilled managers could consistently identify undervalued assets or predict market movements.
Key Takeaways
- Active funds aim to outperform a specific benchmark index through discretionary trading and security selection.
- They rely on the expertise of professional portfolio managers to make investment decisions.
- Active funds typically involve higher management fees and transaction costs compared to passive alternatives.
- Performance success rates for active funds vary widely across market cycles and asset classes.
- Investors choose active funds hoping for alpha, which is returns in excess of the benchmark.
Interpreting Active Funds
When evaluating active funds, investors often focus on their ability to generate "alpha," which refers to the excess return achieved above the fund's benchmark index. A positive alpha indicates that the portfolio manager's decisions added value beyond what could be achieved by simply tracking the market. Conversely, a negative alpha suggests underperformance relative to the benchmark. Beyond raw returns, it is crucial to consider the fund's adjusted returns, which account for the level of risk tolerance taken to achieve those returns. Consistent outperformance over multiple market cycles is often viewed as a strong indicator of an active fund's management skill. Factors such as the fund's turnover ratio, which measures the frequency of trading within the portfolio, can also provide insight into the intensity of the active management strategy.
Hypothetical Example
Consider an investor, Sarah, who has $10,000 to invest in the stock market. She decides to invest in an active fund, "Growth Opportunities Fund (GOF)," which aims to outperform the S&P 500 index. The GOF's portfolio manager, Mark, actively researches individual companies and sectors, buying stocks he believes are undervalued and selling those he thinks are overvalued.
In a given year, the S&P 500 benchmark index returns 10%. Mark, through his active stock selection and sector bets, manages to guide the GOF to a 12% return. This 2% difference is the fund's alpha for the year, representing the value added by Mark's active management. Sarah's $10,000 investment would grow to $11,200, excluding fees and commissions. Had she invested in a passive fund tracking the S&P 500, her investment would have grown to $11,000 (before fees). This example illustrates how an active fund attempts to generate superior returns through strategic decisions beyond just mirroring a market index, although the hypothetical scenario does not account for the additional fees typically associated with active management.
Practical Applications
Active funds are utilized by investors seeking to potentially outperform market averages or manage specific risks within their portfolios. They are commonly found in various investment products, including equity funds, bond funds, and balanced funds. For instance, an active fund focused on a particular sector, like technology or healthcare, may aim to identify promising companies within that sector, leveraging the manager's specialized knowledge. Investors might use active funds as part of their asset allocation strategy, particularly if they believe in the manager's ability to navigate complex market conditions or uncover mispriced assets. The effectiveness of active funds is routinely assessed by industry reports. For example, Morningstar's Active/Passive Barometer report frequently compares the performance of active funds against their passive counterparts across various categories, providing data on their success rates in outperforming benchmarks over different time horizons.5
Limitations and Criticisms
Despite the potential for outperformance, active funds face several limitations and criticisms. A primary concern is their typically higher expense ratio and increased transaction costs due to frequent trading. These costs can significantly erode any alpha generated, making it challenging for active funds to consistently beat their benchmarks over the long term, especially after fees. Many studies and reports, including the Morningstar Active/Passive Barometer, have historically shown that a majority of active funds underperform their passive equivalents over extended periods.4
Another criticism is that genuine skill in active management is rare and difficult to identify consistently. Some proponents of passive investing argue that attempts to "beat the market" are often a zero-sum game before costs, and a negative-sum game after costs, making it more prudent for investors to focus on minimizing expenses and ensuring broad diversification. The philosophy advocated by the Bogleheads community, for example, emphasizes the importance of keeping costs low through passive investing, arguing that this approach statistically leads to better long-term outcomes for most investors.3 Furthermore, active funds are susceptible to "style drift," where managers deviate from their stated investment strategy, and may struggle to adapt to periods of low market volatility or highly concentrated market gains.
Active Funds vs. Passive Funds
The core distinction between active funds and passive funds lies in their underlying investment approach. Active funds involve discretionary management, where a portfolio manager makes ongoing decisions about what securities to buy, hold, and sell, with the aim of surpassing market returns. This requires continuous research, analysis, and often more frequent trading, which typically translates into higher management fees and operational costs.
In contrast, passive funds (such as index funds or many ETFs) simply aim to replicate the performance of a specific market index. They do not involve a manager making subjective buying or selling decisions; instead, they automatically adjust their holdings to match the index's composition. This "set it and forget it" approach generally results in significantly lower expense ratios and reduced trading activity. Proponents of passive investing often cite the difficulty active funds face in consistently beating benchmarks after accounting for fees. The Bogleheads investment philosophy, for instance, champions low-cost passive index investing as a highly effective long-term strategy, prioritizing cost minimization over attempting to achieve alpha through active management.2
FAQs
What is the main goal of an active fund?
The main goal of an active fund is to outperform a specific benchmark index by generating returns higher than what the index achieves. This is done through the skillful selection of securities and strategic market timing by a professional portfolio manager.
Are active funds more expensive than passive funds?
Yes, active funds generally have higher fees than passive funds. This is because they incur greater costs related to research, analysis, and more frequent trading activities, as well as compensation for the portfolio manager and their team.
Do active funds always outperform passive funds?
No. While active funds aim to outperform, many studies, such as Morningstar's Active/Passive Barometer, show that a majority of active funds struggle to consistently beat their benchmarks over long periods, especially once fees are factored in.1 Success often depends on market conditions and the manager's skill.
How does an active fund try to beat the market?
An active fund tries to beat the market through various investment strategy approaches, including stock picking (identifying undervalued companies), market timing (buying or selling based on market predictions), sector rotation (shifting investments among industries), and diversification to manage risk.
What is "alpha" in the context of active funds?
"Alpha" refers to the excess return on investment an active fund generates above its benchmark index. If a fund's benchmark returns 8% and the fund returns 10%, it has achieved an alpha of 2%. Positive alpha indicates that the manager's decisions added value beyond the market's performance.