Active investment strategies

What Is Active Investment Strategies?

Active investment strategies represent an approach within the broader field of investment management where a portfolio manager or an individual investor makes specific investment decisions in an attempt to outperform a market benchmark. Unlike passive approaches that aim to replicate market performance, active investment strategies involve frequent buying and selling of securities based on research, market forecasts, and a deep understanding of underlying assets. The primary goal of active investment strategies is to generate "alpha," which refers to returns in excess of what would be expected given the risk taken. This involves continuous security selection and strategic asset allocation adjustments.

History and Origin

The concept of actively managing investments dates back centuries, evolving from individual wealth management to sophisticated institutional practices. Early forms of active investment strategies involved wealthy individuals or families entrusting their assets to advisors who would make discretionary trading decisions. The professionalization of asset management gained significant traction in the 20th century. For instance, in 1937, Thomas Rowe Price Jr. established a firm focusing on fee-based portfolio management, a novel concept at the time⁹. This marked a shift towards structured, professional oversight of investment portfolios. The regulatory landscape also began to form around this time, with the U.S. Congress enacting the Investment Advisers Act of 1940 to regulate investment advisors and address conflicts of interest in the burgeoning industry⁷, ⁸. Throughout the latter half of the 20th century, as financial markets grew in complexity and accessibility, active investment strategies continued to dominate, with portfolio managers leveraging increasingly sophisticated analytical tools and market insights.

Key Takeaways

• Active investment strategies aim to outperform a market benchmark by actively managing a portfolio.
• They involve discretionary decisions regarding buying, selling, and holding securities based on research and market analysis.
• The goal is to generate "alpha," or returns exceeding those of a comparable passive investment.
• Active management typically involves higher fees and trading costs compared to passive strategies.
• Success in active management often depends on the skill of the portfolio manager and their ability to consistently identify mispriced securities or market opportunities.

Interpreting Active Investment Strategies

Active investment strategies are interpreted through their ability to generate returns superior to a relevant market index after accounting for all costs and risk management. A key measure of success is the "alpha" achieved, which indicates the excess return above what a passive strategy tracking the same market would have yielded. For instance, if an active fund delivers an 11% annual return while its benchmark returns 9%, it has generated 2% of alpha. Investors and analysts evaluate active strategies by examining historical performance, consistency of returns, and the level of volatility taken to achieve those returns. They also scrutinize the investment philosophy, research capabilities, and decision-making processes of the managers employing these strategies.

Hypothetical Example

Consider an individual investor, Sarah, who believes that her research and insights can help her outperform the broader stock market. Instead of investing in a broad market index exchange-traded fund, Sarah decides to implement an active investment strategy for a portion of her portfolio.

1. Research: Sarah performs extensive fundamental analysis on several companies within the technology sector, identifying three companies she believes are undervalued due to recent market overreactions. She also employs some technical analysis to time her entry points.
2. Execution: She allocates $50,000 to these three stocks, buying shares in varying proportions. Over the next six months, she closely monitors company news, earnings reports, and market sentiment.
3. Adjustment: When one of her chosen tech stocks announces better-than-expected earnings, its price surges, leading to substantial capital gains. Sarah decides to sell a portion of her holdings in this stock, taking profits, and reallocate the funds into another promising but currently underperforming sector, based on her ongoing research.
4. Comparison: At the end of the year, Sarah compares her portfolio's return to that of a technology sector index. If her actively managed portfolio yielded 15% while the index yielded 10%, her active strategy was successful in generating alpha. However, if her portfolio only returned 8%, her active strategy underperformed the benchmark for that period.

Practical Applications

Active investment strategies are widely applied across various asset classes and investment vehicles. Professional portfolio managers employ these strategies for clients ranging from individual high-net-worth investors to large institutional funds, pension plans, and endowments. Many traditional mutual funds are actively managed, where fund managers seek to beat their respective indexes by selecting specific stocks, bonds, or other assets.

In the real world, active management shows up in:

• Hedge Funds: These funds often utilize highly active and complex strategies, including long/short equity, global macro, and event-driven investing, aiming for absolute returns regardless of market conditions.
• Discretionary Asset Management: Financial advisors or wealth managers who make buy/sell decisions on behalf of their clients often use active strategies tailored to individual goals and risk tolerance.
• Sector-Specific Funds: Managers of sector-specific funds actively pick securities within a particular industry, such as technology or healthcare, based on their expertise and outlook for that sector.
• Fixed Income: In certain fixed-income markets, active managers may seek to capitalize on interest rate movements or credit spread changes by adjusting bond durations or credit quality.

The U.S. Securities and Exchange Commission (SEC) regulates investment advisers who engage in active management, requiring registration and adherence to rules designed to protect investors under the Investment Advisers Act of 1940⁵, ⁶.

Limitations and Criticisms

Despite the potential for higher returns, active investment strategies face significant limitations and criticisms. A primary challenge is the difficulty in consistently outperforming the market over long periods, especially after accounting for fees and trading costs. Academic research, supported by various studies, suggests that a substantial majority of active funds fail to beat their passive counterparts over extended time horizons. For example, Morningstar's U.S. Active/Passive Barometer, a semiannual report, has consistently found that most active funds underperform their passive peers, particularly over longer periods³, ⁴.

One fundamental criticism stems from the efficient market hypothesis (EMH), which posits that financial markets fully reflect all available information, making it impossible to consistently achieve abnormal returns through active trading². Proponents of EMH argue that any outperformance by active managers is largely due to luck rather than skill. While the EMH is a theoretical framework, empirical evidence often leans towards its implications. A 2012 academic study, for instance, examined determinants of success for active versus passive strategies, finding varied results depending on market conditions but generally acknowledging the challenge for active management to consistently outperform¹. Other criticisms include:

• Higher Costs: Active funds typically charge higher expense ratios than passive funds to cover the costs of research, trading, and portfolio manager salaries. These higher fees can erode potential excess returns.
• Tax Inefficiency: Frequent trading can lead to higher capital gains distributions, which are taxable events for investors in non-tax-advantaged accounts.
• Behavioral Biases: Active managers, like all human decision-makers, can be susceptible to behavioral biases, such as overconfidence or herd mentality, which can lead to suboptimal investment decisions.
• Benchmark Hugging: Some active managers may closely track their benchmark to avoid significant underperformance, effectively acting as "closet indexers" while still charging active management fees.

Active Investment Strategies vs. Passive Investment Strategies

The debate between active and passive investment strategies is central to modern investment management. The core distinction lies in their objectives and methodologies:

Confusion often arises because both strategies involve investing in securities, but their underlying philosophies are diametrically opposed. Active managers believe they can exploit market inefficiencies, while passive investors believe that attempting to do so is futile and costly.

FAQs

What is the main goal of active investment strategies?

The main goal of active investment strategies is to achieve returns that are higher than those of a comparable market benchmark, generating what is known as "alpha." This involves making deliberate decisions about which securities to buy and sell.

Why do active investment strategies often have higher fees?

Active investment strategies typically involve higher fees because they require intensive research, analysis, and frequent trading by professional portfolio managers. These costs cover the salaries of analysts and managers, trading commissions, and administrative overhead associated with actively managing the portfolio.

Are active investment strategies always better than passive ones?

Not necessarily. While active strategies aim for higher returns, studies often show that most actively managed funds do not consistently outperform their passive counterparts, especially after accounting for fees. The success of active strategies largely depends on the skill of the manager and market conditions. For long-term investors, diversification through a mix of strategies is often considered.

How does active management affect taxes?

Active management can result in higher tax liabilities for investors in taxable accounts. Frequent buying and selling of securities often leads to short-term capital gains distributions, which are typically taxed at higher rates than long-term capital gains. Passive strategies, with their lower turnover, tend to be more tax-efficient.