Active management

What Is Active Management?

Active management is an investment strategy where a portfolio manager or team makes specific investment decisions with the goal of outperforming a particular benchmark index. This approach involves ongoing research, analysis, and adjustments to a portfolio's holdings, aiming to capitalize on perceived market inefficiencies or specific opportunities. Unlike strategies that seek to simply replicate market performance, active management strives to generate superior portfolio performance through tactical asset selection and timing. It falls under the broader category of portfolio management, focusing on strategic choices to achieve investment objectives. Proponents of active management believe skilled managers can consistently "beat the market" by identifying undervalued securities or anticipating market trends.

History and Origin

The practice of active management has been fundamental to investing since the inception of organized financial markets. Early investment professionals, often individuals or small groups managing capital for wealthy clients, inherently engaged in active decision-making, selecting stocks and bonds based on their research and judgment. The formalization of active management gained significant traction with the rise of mutual funds in the mid-20th century, which allowed a broader range of investors to pool their capital and access professional management.

A pivotal moment in the regulation of investment professionals involved in active management occurred in the United States with the passage of the Investment Advisers Act of 1940. This federal law was created to regulate the activities of investment advisers and is administered by the U.S. Securities and Exchange Commission (SEC).⁷ The Act aimed to monitor those who, for a fee, advise people, pension funds, and institutions on investment matters, reflecting growing concerns about investor protection and potential conflicts of interest within the industry.⁶ This legislation, alongside the Investment Company Act of 1940 which regulates pooled investment vehicles like mutual funds, helped establish a framework for the professional conduct and disclosure requirements that underpin much of modern active management.⁴, ⁵

Key Takeaways

• Active management seeks to outperform a specific benchmark index by making deliberate investment decisions.
• It involves continuous research, analysis, and adjustments to a portfolio's composition.
• Active managers aim to identify undervalued securities or capitalize on market trends.
• This approach typically incurs higher expense ratios compared to passive strategies due to the intensive research and trading involved.
• Success in active management is often measured by its ability to generate alpha, or excess return, relative to its benchmark.

Formula and Calculation

While there isn't a single formula for "active management" itself, its success is often quantified by how much it outperforms a benchmark. This outperformance, after accounting for the risk taken, is commonly referred to as alpha.

Alpha ((\alpha)) is calculated as:

Where:

• (R_p) = Portfolio's actual return
• (R_f) = Risk-free rate of return
• (\beta_p) = Portfolio's beta (a measure of its volatility relative to the market)
• (R_m) = Benchmark market's return

A positive alpha indicates that the portfolio has generated returns in excess of what would be expected given its risk management level and the market's performance. Conversely, a negative alpha suggests underperformance.

Interpreting Active Management

Interpreting active management primarily revolves around assessing whether the manager's skill has added value beyond what a passive approach would have delivered. A key metric for this evaluation is alpha, as outlined above. If an actively managed fund consistently generates a positive alpha after all fees and expenses, it suggests that the manager's decisions have successfully contributed to superior returns.

However, interpreting performance also requires considering the investment's asset allocation and risk characteristics. For instance, a fund might outperform its benchmark simply by taking on more risk, which might not be a desirable outcome for all investors. Therefore, a comprehensive evaluation often includes examining risk-adjusted returns and comparing them to those of a suitable benchmark index that reflects the fund's investment style and objectives. The goal is to determine if the manager's active decisions are truly generating value or if the returns could have been achieved with a lower-cost, passive strategy.

Hypothetical Example

Consider an active fund manager, Sarah, who manages the "Global Tech Innovators Fund." Her fund's stated objective is to outperform the Nasdaq 100 Index. At the beginning of the year, Sarah believes that while large-cap technology stocks have been strong, specific mid-cap software companies are undervalued and poised for significant growth.

Instead of simply holding all stocks in the Nasdaq 100 in their market-cap weights, Sarah decides to underweight some of the largest, well-known tech giants and overweight her selected mid-cap software companies. She also diversifies into a few international tech companies she believes have strong intellectual property, even though the Nasdaq 100 is primarily U.S.-focused.

Throughout the year, Sarah's team conducts intensive research, holding meetings with company management and analyzing financial reports. When one of her chosen mid-cap software companies announces a breakthrough product, its stock price surges, contributing significantly to her fund's return. Later in the year, she might decide to trim positions in companies that have become overvalued or reallocate capital to new opportunities, demonstrating her dynamic diversification approach. By the end of the year, her fund returns 22%, while the Nasdaq 100 Index returns 18%. In this scenario, Sarah's active management decisions, specifically her stock selection and deviation from the index, resulted in a 4% outperformance before fees.

Practical Applications

Active management is prevalent across various facets of the financial industry, appearing in:

• Mutual Funds and ETFs: Many traditional mutual funds and some actively managed Exchange-Traded Funds (ETFs) employ active strategies, with professional managers seeking to outperform their benchmarks.
• Hedge Funds: These investment vehicles almost exclusively utilize active management, often employing complex strategies, leverage, and short selling to generate absolute returns regardless of market direction.
• Pension Funds and Endowments: Large institutional investors frequently allocate portions of their portfolios to actively managed mandates, hoping to achieve specific return targets or better manage risk.
• Wealth Management: Financial advisors often recommend or manage actively allocated portfolios for individual clients, tailoring investment choices to specific client goals, risk tolerances, and tax situations.
• Private Equity and Venture Capital: While distinct from public market investing, these fields are inherently active, involving direct investment in private companies and significant operational involvement to enhance value.

Despite its widespread application, studies consistently show the challenges faced by active managers. For example, S&P Dow Jones Indices' SPIVA (S&P Indices Versus Active) U.S. Year-End 2023 Scorecard reported that a majority of actively managed funds underperformed their assigned benchmarks in most categories over the full year. Specifically, 60% of all active large-cap U.S. equity funds underperformed the S&P 500 in 2023.³ Over longer periods, the underperformance rates tend to increase, with more than 70% of equity funds across various vehicles underperforming their respective benchmarks over the 10-year period ending December 31, 2023.²

Limitations and Criticisms

Active management faces several significant limitations and criticisms, primarily concerning its ability to consistently outperform market benchmarks after accounting for fees and trading costs.

One of the most persistent criticisms is the difficulty in generating consistent alpha. The efficient market hypothesis posits that all available information is already reflected in asset prices, making it nearly impossible for any investor to consistently "beat the market" without taking on additional risk. This concept of market efficiency suggests that any apparent outperformance is often due to luck or higher risk exposure rather than skill.

Higher costs are another major drawback. Actively managed funds typically have higher expense ratios compared to passively managed index funds or ETFs. These higher fees cover the costs of research teams, sophisticated analysis tools, and frequent trading (which also incurs transaction costs like commissions and bid-ask spreads). These costs can significantly erode any gross outperformance, making it difficult for active funds to beat their benchmarks on a net-of-fees basis.

Furthermore, active management can be susceptible to behavioral biases, where managers might make suboptimal decisions due to emotional influences or cognitive shortcuts. Performance chasing, where investors (and sometimes managers) flock to funds that have recently performed well, can also lead to poor outcomes if that past performance is not sustainable. As highlighted by the Bogleheads community, focusing on time-tested principles rather than chasing past performance is crucial for long-term investing success.¹ The challenge for active managers is to deliver net returns that justify their higher costs and overcome the inherent difficulty of outperforming broadly diversified, low-cost passive alternatives.

Active Management vs. Passive Management

The distinction between active management and passive management lies in their fundamental approach to investment. Active management involves a manager making deliberate decisions to select investments and time trades with the goal of outperforming a market benchmark index. This requires continuous research, analysis, and adjustments to the portfolio. The aim is to generate alpha, or returns in excess of the market.

In contrast, passive management, often associated with index funds, seeks to replicate the performance of a specific market index. A passive fund manager's role is not to pick individual securities or time the market, but rather to ensure the portfolio accurately mirrors the composition of its chosen index. This typically involves holding all or a representative sample of the index's constituents in proportion to their weight in the index. As a result, passive strategies generally have lower expense ratios and lower trading costs because they do not require extensive research or frequent rebalancing beyond what is necessary to track the index. While active management attempts to beat the market, passive management aims to capture market returns.

FAQs

What is the primary goal of active management?

The primary goal of active management is to outperform a specified market benchmark index and generate superior portfolio performance through strategic investment decisions.

Why is active management typically more expensive than passive management?

Active management is generally more expensive due to the higher costs associated with ongoing research, detailed analysis, portfolio adjustments, and the salaries of the professional investment advisers and their teams. These activities lead to higher expense ratios and transaction costs compared to passive strategies that simply track an index.

Can active management guarantee higher returns?

No, active management cannot guarantee higher returns. While its goal is to outperform, many studies indicate that a majority of actively managed funds fail to consistently beat their benchmarks after fees, especially over longer time horizons. The competitive nature of financial markets and the impact of costs make consistent outperformance challenging.