Active investment

What Is Active Investment?

Active investment is an investment strategy where an investment manager or individual makes specific decisions to buy and sell securities with the goal of outperforming a particular market benchmark. This approach falls under the broader financial category of portfolio management. Unlike strategies that aim to replicate market performance, active investment seeks to generate superior returns through diligent stock picking, market timing, or a combination of both. Proponents of active investment believe that market inefficiencies exist, offering opportunities for skilled managers to identify mispriced assets.

History and Origin

The concept of active investment has been integral to financial markets since their inception, as investors have always sought to gain an edge. Early forms of active investment were characterized by individual investors and rudimentary analytical methods. The formalized study of whether markets can be consistently beaten gained prominence with the development of theories like the efficient-market hypothesis (EMH) in the 1960s, notably by economists Eugene Fama and Paul Samuelson.,¹⁰ The EMH postulates that asset prices reflect all available information, suggesting that it is difficult, if not impossible, to consistently outperform the market. This theoretical challenge underscored the debate surrounding the efficacy of active investment, prompting a continuous evolution in methodologies and research into market behavior.

Key Takeaways

• Active investment aims to outperform a market benchmark by actively managing a portfolio.
• It involves strategic decisions regarding security selection and market timing.
• Active management typically incurs higher expense ratio and transaction costs compared to passive strategies.
• The goal is to generate alpha, or returns in excess of the market.
• Success in active investment is often debated due to the challenges of consistently beating the market after fees.

Formula and Calculation

While there isn't a single universal "formula" for active investment itself, its success is often measured by its ability to generate alpha, which is the excess return of a portfolio compared to its expected return based on its beta and the market's return.

The formula for alpha is:

$\alpha = R_p - [R_f + \beta_p (R_m - R_f)]$

Where:

• (\alpha) = Jensen's Alpha (the return in excess of the market)
• (R_p) = Portfolio's actual return
• (R_f) = Risk-free rate of return (e.g., return on a U.S. Treasury bill)
• (\beta_p) = Portfolio's beta (a measure of its volatility relative to the market)
• (R_m) = Market's return

A positive alpha indicates that the active investment strategy has outperformed its benchmark after adjusting for market risk. This calculation is a critical tool for evaluating the performance of an active manager.

Interpreting Active Investment

Interpreting active investment performance centers on whether the investment manager has successfully generated returns that compensate for the higher costs and risks associated with the strategy. A key metric is the aforementioned alpha, which measures the value added by the manager's decisions beyond what market exposure alone would provide. Investors evaluate active managers not just on gross returns, but on net returns after all fees and expenses, and crucially, on a risk-adjusted basis. Consistent, positive alpha over extended periods is the ultimate goal, signaling genuine skill in security selection or asset allocation. However, achieving this consistently is a significant challenge in efficient markets. Evaluating an active investment also involves understanding the manager's investment philosophy, their approach to risk management, and their adherence to stated investment objectives.

Hypothetical Example

Consider an investment manager overseeing a hypothetical active investment fund focused on large-cap U.S. equities. The fund's objective is to outperform the S&P 500 index. In a given year, the manager employs a strategy combining fundamental analysis to identify undervalued stocks and uses technical analysis for optimal entry and exit points.

Suppose the S&P 500 (the benchmark) returns 10% for the year.
The active fund, after all trading costs and management fees, generates a return of 12%.
The risk-free rate is 2%.
The fund's beta relative to the S&P 500 is 1.1.

Using the alpha formula:
$\alpha = 0.12 - [0.02 + 1.1 \times (0.10 - 0.02)]$
$\alpha = 0.12 - [0.02 + 1.1 \times 0.08]$
$\alpha = 0.12 - [0.02 + 0.088]$
$\alpha = 0.12 - 0.108$
$\alpha = 0.012 \text{ or } 1.2\%$

In this scenario, the active investment manager successfully generated a positive alpha of 1.2%, meaning the fund outperformed its benchmark by 1.2% on a risk-adjusted basis. This demonstrates the potential value creation through active management.

Practical Applications

Active investment is widely applied across various investment vehicles and strategies. Mutual funds are a primary vehicle for active investment, where professional managers oversee diversified portfolios of stocks, bonds, or other assets. Similarly, many hedge funds and private equity funds employ highly active strategies, often with greater flexibility in their investment mandates. Individual investors may also engage in active investment through direct stock and bond trading.

A critical aspect of active investment, particularly for mutual funds, are the associated fees. These typically include management fees, 12b-1 fees, sales loads, and other operating expenses, which can significantly impact an investor's net returns. The U.S. Securities and Exchange Commission (SEC) provides guidance on understanding these various costs, emphasizing their impact on investment performance over time.⁹,⁸ Effective portfolio construction and ongoing monitoring are essential in active investment to attempt to achieve desired outcomes.

Limitations and Criticisms

Despite the appeal of potentially higher returns, active investment faces significant limitations and criticisms. A primary critique revolves around the difficulty of consistently outperforming the market after accounting for fees and expenses. Academic research and industry reports, such as the SPIVA (S&P Indices Versus Active) Scorecard published by S&P Dow Jones Indices, frequently highlight that a majority of active managers underperform their respective benchmarks over various time horizons.⁷,⁶,⁵,⁴

One reason for this underperformance is that the costs associated with active investment, including research, trading, and management fees, can erode any potential excess returns.³,² Furthermore, as more money flows into a successful active fund, it can become harder for the manager to maintain the same level of performance, partly because larger funds can inadvertently move prices when buying or selling significant positions.¹ This phenomenon, coupled with the increasing sophistication and competition within the investment industry, makes sustained outperformance a considerable challenge for active managers. Some critics also point to behavioral biases among fund managers that can hinder rational decision-making.

Active Investment vs. Passive Investment

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

While active investment seeks to beat the market, passive investment aims to achieve market returns by mirroring a chosen index. The confusion often arises because both involve investing in securities, but their underlying philosophies and approaches to portfolio construction are diametrically opposed. Investors choose between these two approaches based on their beliefs about market efficiency, risk tolerance, and cost sensitivity.

FAQs

What is the primary goal of active investment?

The primary goal of active investment is to outperform a specific market benchmark by making strategic investment decisions, aiming to generate returns greater than the market itself.

Why do active investment funds often have higher fees?

Active investment funds typically have higher fees because they involve ongoing research, analysis, and frequent trading decisions by investment managers, incurring greater operational and transaction costs. These costs are reflected in a higher expense ratio.

Can individual investors engage in active investment?

Yes, individual investors can engage in active investment by directly buying and selling stocks, bonds, and other securities. This requires performing their own fundamental analysis or technical analysis, and making their own strategic decisions rather than relying on a fund manager.