Active investors

What Are Active Investors?

Active investors are individuals or entities who engage in an investment strategy involving continuous buying and selling of securities in an attempt to outperform specific market benchmarks. Unlike passive strategies, which aim to replicate market performance, active investing relies on detailed financial analysis, market timing, and selective stock picking to achieve superior returns. This approach falls under the broader category of investment management and is a core component of traditional portfolio management within the stock market. Active investors often employ various techniques, including fundamental analysis and technical analysis, to identify undervalued assets or anticipate market movements.

History and Origin

Active investing has been the dominant approach to managing capital for centuries, long before the advent of modern financial instruments or theories. Early merchants and financiers inherently practiced active strategies, making decisions based on available information, perceived value, and market conditions. The formalization of active investing, particularly through professional money managers, began to take shape with the rise of organized stock exchanges and the increasing complexity of financial markets.

In the United States, the regulatory framework governing professional active investors was significantly shaped by legislation such as the Investment Advisers Act of 1940. This federal law, administered by the SEC.gov, established regulations for firms and individuals who, for compensation, provide advice on securities investments.⁵ This act helped formalize the role of investment advisers and laid the groundwork for the professional active management industry.

Key Takeaways

• Active investors seek to beat market performance by making deliberate investment decisions.
• Strategies include stock picking, market timing, and tactical asset allocation.
• Active management typically involves higher trading activity and research costs compared to passive strategies.
• Success is often measured by outperforming a relevant benchmark index after accounting for fees.
• Active investors believe that market inefficiencies can be exploited to generate excess return.

Interpreting Active Investors

The performance of active investors is primarily interpreted by comparing their portfolio's returns against a relevant market benchmark, often after deducting all associated fees. For example, an active investor managing a U.S. large-cap equity portfolio would typically be measured against the S&P 500 Index. The goal is to generate "alpha," which is the excess return achieved above the benchmark's return. Consistent outperformance is a key indicator of a skilled active investor. However, assessing performance requires careful consideration of the risk taken to achieve those returns, as higher returns may simply reflect greater exposure to market volatility. Investors also look at metrics such as Sharpe Ratio or Information Ratio to evaluate risk-adjusted returns.

Hypothetical Example

Consider an individual, Sarah, who identifies as an active investor. She believes that through diligent financial analysis and thorough valuation of companies, she can identify promising opportunities that the broader market has overlooked.

Sarah sets up a brokerage account with $50,000. Instead of investing in a broad market index, she researches several companies in the technology sector. She spends considerable time analyzing their financial statements, management teams, competitive landscapes, and future growth prospects. Based on her analysis, she decides to invest $10,000 each in five specific technology stocks, believing they are undervalued and will outperform the overall technology sector index. Over the next year, Sarah actively monitors news, earnings reports, and market sentiment related to her holdings. She might decide to sell one stock if its fundamentals deteriorate or if she finds a more compelling opportunity elsewhere, reallocating the funds to a new position. Her success as an active investor will be judged by whether her portfolio of five stocks generates a higher return than the technology sector benchmark over the same period, taking into account any trading costs she incurred.

Practical Applications

Active investors are prevalent across various segments of the financial industry, including:

• Hedge Funds: These funds often employ sophisticated active strategies, using a wide range of securities and derivatives to generate absolute returns, regardless of market direction.
• Mutual Funds: Many traditional mutual funds are actively managed, with fund managers making decisions on behalf of investors to select stocks, bonds, or other assets.
• Individual Investors: Retail investors can also be active investors, engaging in direct stock trading, day trading, or applying their own research to build and manage their portfolios.
• Institutional Investors: Pension funds, endowments, and sovereign wealth funds often allocate a portion of their capital to active managers in pursuit of alpha.

The pursuit of outperformance through active strategies is a constant challenge. For example, an April 2024 Reuters article reported that over 80% of active global equity funds underperformed the S&P World index in 2023, according to SPIVA Europe findings.⁴ Similarly, 71% of active US equity funds did not meet the S&P 500's returns in the same year, with underperformance reaching 98% over a 10-year period.³ Despite these statistics, active investing remains a significant segment of the financial landscape. Data from the S&P Dow Jones Indices "SPIVA U.S. Scorecard Year-End 2023" indicates that 60% of all active large-cap U.S. equity funds underperformed the S&P 500 in 2023.²

Limitations and Criticisms

Despite the appeal of potentially beating the market, active investors face several significant limitations and criticisms:

• Underperformance: A long-standing critique is that the majority of active managers consistently underperform their benchmarks, especially over longer time horizons, after accounting for fees and expenses. This phenomenon is extensively documented by studies such as the SPIVA (S&P Indices Versus Active) scorecard.
• Higher Costs: Active management typically incurs higher fees due to the extensive research, trading activity, and operational overhead involved. These costs, including management fees and trading commissions, can erode potential gains.
• Market Efficiency: The concept of market efficiency suggests that all available information is already reflected in asset prices, making it difficult for active investors to consistently find mispriced securities and generate alpha.
• Behavioral Biases: Active investors can be susceptible to behavioral biases, such as overconfidence, herd mentality, or loss aversion, which can lead to suboptimal decision-making and hinder performance.
• Market Distortion Concerns: Some critics argue that the increasing popularity of passive investing, which directly tracks indices, may lead to market distortions. However, others contend that a sufficient number of active investors will always exist to ensure efficient price discovery. As famed investor David Einhorn suggested, passive investing has "fundamentally broken markets" by promoting a focus on price over underlying value, leading some active managers to adapt their investment styles.¹

Active Investors vs. Passive Investors

The core distinction between active and passive investors lies in their approach to achieving investment goals.

Confusion often arises because both strategies aim for wealth accumulation. However, active investors pursue this through direct market engagement and seeking an edge, while passive investors seek broad market exposure at minimal cost, relying on the overall market's growth.

FAQs

Can an individual investor be an active investor?

Yes, any individual investor can choose to be an active investor by directly managing their own diversification strategy, performing their own research, and making their own buying and selling decisions for securities rather than delegating it to a professional manager or using index-tracking funds. However, it requires significant time, effort, and knowledge.

What is the main objective of active investors?

The primary objective of active investors is to achieve returns that are higher than those of a comparable market benchmark, after accounting for all fees and expenses. This is often referred to as generating "alpha."

Do active investors consistently outperform passive investors?

Historical data, particularly from reports like the SPIVA Scorecard, generally indicates that the majority of active investors and actively managed funds do not consistently outperform their respective benchmarks over longer periods. While some active managers may achieve short-term outperformance, maintaining this edge consistently is challenging, largely due to higher fees and the difficulty of perpetually identifying mispriced assets in increasingly efficient markets.

Are active investors regulated?

Yes, professional active investors, such as investment advisers and fund managers, are subject to significant regulation. In the United States, the Securities and Exchange Commission (SEC) regulates investment advisers with substantial assets under management, requiring them to register and adhere to rules designed to protect investors. These regulations cover aspects such as disclosure, fiduciary duties, and ethical conduct.