Active investing

What Is Active Investing?

Active investing is an investment strategy that seeks to outperform a specific market benchmark index by making deliberate investment decisions. Rather than simply replicating a market index, active investing involves a fund manager or a team of analysts actively researching, selecting, and trading securities with the aim of generating returns superior to those of the broader financial markets. This approach falls under the broader discipline of portfolio management within Portfolio Theory. Proponents of active investing believe that inefficiencies in the market can be exploited to achieve an outperformance, often referred to as alpha.

History and Origin

The concept of active investing has been fundamental to financial markets since their inception, predating the rise of index-based investing. For much of modern financial history, investment professionals have sought to gain an edge through careful security selection and timely market calls. This approach was the primary mode of investing until the mid-20th century. Over time, as financial markets grew in complexity and the efficient-market hypothesis gained traction, the debate between active and passive investing intensified. Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), established guidelines for investment advisers, requiring disclosures about their practices and potential conflicts of interest, further shaping the landscape of actively managed funds and portfolios. SEC Overview of Investment Advisers

Key Takeaways

• Active investing aims to generate returns that exceed a specific market benchmark through strategic security selection and market timing.
• It involves a fund manager or team making intentional decisions about buying and selling investments.
• The goal of active investing is to achieve alpha, which is the excess return above the benchmark.
• Active management typically involves higher fees compared to passive strategies due to the research and trading involved.
• Success in active investing is often measured by its ability to consistently outperform its chosen benchmark on a risk-adjusted returns basis.

Formula and Calculation

While there isn't a single universal formula for "active investing" itself, the success of active investing is often measured by its ability to generate alpha. Alpha is a component of performance measurement in finance.

The formula for alpha, in its simplest form, can be expressed as:

Where:

• (\alpha) = Alpha (the excess return)
• (R_p) = The actual return of the actively managed portfolio
• (R_b) = The return of the relevant benchmark index

A more sophisticated approach, often used in academic contexts, involves regressing the portfolio's excess returns against the excess returns of the market and other factors, as seen in models like the Capital Asset Pricing Model (CAPM) or the Fama-French three-factor model. This aims to isolate the portion of the return that cannot be explained by market movements or other systematic factors.

Interpreting Active Investing

Active investing is interpreted as an attempt to capitalize on perceived inefficiencies within financial markets. A manager engaged in active investing believes they possess the skill or insight to identify undervalued or overvalued securities and make profitable trades. When an actively managed fund consistently delivers returns greater than its benchmark, particularly after accounting for fees and expenses, it suggests that the manager's investment strategy has been successful in generating alpha. Conversely, if an active portfolio underperforms its benchmark, it indicates that the investment decisions did not add value relative to simply tracking the market. The interpretation of success often hinges on comparing net returns (after fees) to the benchmark, as higher fees are a common characteristic of active strategies.

Hypothetical Example

Consider an individual investor who believes that a particular sector of the technology market is poised for significant growth. Instead of investing in a broad market index exchange-traded fund (ETFs), they decide to engage in active investing.

Scenario: An investor has $10,000 to invest.
Active Investing Approach: The investor researches several technology companies, analyzing their financial statements, growth prospects, and competitive advantages. They select three specific tech stocks, allocating $3,000 to Company A, $4,000 to Company B, and $3,000 to Company C, believing these companies will outperform the overall technology sector index. They actively monitor news, earnings reports, and market sentiment, ready to adjust their holdings based on new information.
Outcome (after one year):

• Company A return: +20%
• Company B return: +15%
• Company C return: +25%
• Overall actively managed portfolio return:
  ((0.30 \times 0.20) + (0.40 \times 0.15) + (0.30 \times 0.25) = 0.06 + 0.06 + 0.075 = 0.195) or 19.5%
• Benchmark (Technology Sector Index) return: +12%

In this hypothetical example, the active investing approach yielded a 19.5% return, outperforming the 12% return of the technology sector benchmark. This 7.5% difference represents the alpha generated by the investor's active decisions.

Practical Applications

Active investing is widely applied across various financial products and services, aiming to achieve specific financial goals or exploit market opportunities. It is most commonly found in:

• Mutual funds: Many mutual funds are actively managed, where a professional fund manager selects stocks, bonds, or other assets with the goal of beating a stated benchmark.
• Hedge funds: These investment vehicles almost exclusively employ active investing strategies, often using complex techniques like short selling and leverage to generate high returns.
• Separately Managed Accounts (SMAs): High-net-worth individuals or institutions may use SMAs, where a portfolio manager directly manages a client's portfolio according to their specific objectives and risk tolerance.
• Individual Stock Picking: Retail investors who conduct their own research and buy or sell individual company shares directly are engaged in active investing.
• Asset allocation decisions: Active managers may also make dynamic asset allocation decisions, shifting between asset classes like equities, fixed income, and cash based on market outlook.

These applications leverage research and expertise to navigate financial markets. For example, firms like Fidelity emphasize their history of active management and the expertise of their portfolio managers in identifying undervalued stocks. Actively Managed Funds: Explore Investment Products

Limitations and Criticisms

Despite its appeal, active investing faces significant limitations and criticisms, primarily concerning its long-term performance and higher costs.

• Underperformance: Numerous studies suggest that the majority of actively managed funds fail to consistently outperform their benchmarks, especially after accounting for fees⁷, ⁸. Data from the Morningstar's Active/Passive Barometer report consistently shows that most active managers struggle to beat their passive counterparts over longer time horizons. For instance, a study examining the performance of actively managed U.S. mutual funds versus passively managed funds between 1991 and 2019 found no statistically significant difference in performance when competitively priced active funds were compared to passive funds⁶.
• Higher Fees and Expenses: Active management typically involves higher management fees, trading costs, and operational expenses compared to passive strategies. These costs can erode any potential alpha generated, making it difficult for active managers to deliver superior net returns⁴, ⁵.
• Market efficiency: The efficient-market hypothesis posits that all available information is already reflected in asset prices, making it exceedingly difficult to consistently find undervalued or overvalued securities. This theory underpins a major criticism against the feasibility of long-term active outperformance.
• Lack of Consistency: Even if an active manager outperforms in one period, there is little evidence to suggest they will continue to do so in future periods. Past performance is not indicative of future results, and few managers maintain a winning streak over extended periods³. An academic study found that active management generally does not provide superior performance compared to passive investing, particularly after fees are accounted for². However, it also noted that active mid and small-cap mutual funds sometimes outperformed their passive counterparts in specific periods and that active funds performed better during bear market conditions¹.

Active Investing vs. Passive Investing

Active investing and passive investing represent two fundamentally different approaches to portfolio management. The core distinction lies in their investment objective and methodology.

While active investing seeks to beat the market, passive investing aims to simply match the market's return. The choice between them often depends on an investor's beliefs about market efficiency, their tolerance for fees, and their investment philosophy.

FAQs

What is the main goal of active investing?

The main goal of active investing is to achieve returns that are higher than a specific market benchmark, aiming to generate what is known as alpha.

Who typically performs active investing?

Active investing is typically performed by professional fund managers, investment teams at financial institutions managing mutual funds and hedge funds, or individual investors who actively research and select their own securities.

Are actively managed funds more expensive?

Yes, actively managed funds are generally more expensive than passively managed funds or index funds. This is because they incur higher costs associated with research, analysis, and more frequent trading, which are passed on to investors through higher management fees and expense ratios. These costs can impact overall risk-adjusted returns.

Can active investing guarantee higher returns?

No, active investing cannot guarantee higher returns. While its objective is to outperform a benchmark, there is no assurance that an actively managed portfolio will succeed in doing so. Many studies indicate that most actively managed funds struggle to consistently beat their benchmarks, especially after accounting for fees. Diversification remains important regardless of the investment approach.