Active strategies

What Are Active Strategies?

Active strategies refer to an investment management approach where a portfolio manager, or a team of managers, makes specific investment decisions with the goal of outperforming a particular market benchmark. Within the broader field of investment management, this approach involves actively selecting individual securities, employing various market research techniques, and timing market movements. Unlike passive investing, which seeks to replicate the performance of an index, active strategies rely on the expertise and insights of a financial analyst to generate returns that exceed those of the overall market. The core belief behind active strategies is that markets are not always perfectly efficient, creating opportunities for skilled managers to identify mispriced assets.

History and Origin

The concept of active management is as old as organized financial markets themselves, predating the rise of modern portfolio theory. Early investors and merchants continuously engaged in active decision-making, selecting assets based on available information and their own judgment. The formalization of professional money management, however, began to take shape with the establishment of investment trusts and, later, mutual funds in the early 20th century. These vehicles allowed individual investors to pool their money and have it managed by professionals who actively sought out profitable opportunities.

A significant development challenging active strategies emerged with the Efficient Market Hypothesis (EMH), primarily articulated by economist Eugene Fama in the mid-1960s and formalized in his 1970 paper. This theory posits that asset prices reflect all available information, making it impossible to consistently "beat the market" through active selection or timing.⁷ Despite this academic challenge, active strategies continued to evolve, adapting to new market conditions and employing more sophisticated analytical tools.

Key Takeaways

• Active strategies aim to outperform a specific market benchmark through selective investment decisions.
• They involve professional managers actively choosing securities based on research and market timing.
• Success in active management relies on identifying mispriced assets and exploiting market inefficiencies.
• Active management often incurs higher fees compared to passive approaches, due to the intensive research and trading involved.

Interpreting Active Strategies

Interpreting active strategies involves evaluating their effectiveness in achieving their primary goal: generating alpha, which is the excess return above what would be expected given the level of risk. Investors often look at a fund's performance relative to its chosen benchmark over various time horizons, typically three, five, and ten years. A positive alpha suggests the manager successfully added value beyond the market's natural movements. However, evaluating active strategies goes beyond just raw returns; it also considers factors like fee structure, manager tenure, investment philosophy (e.g., fundamental analysis vs. technical analysis), and consistency of process. A successful active strategy will demonstrate repeatable outperformance, rather than just one-off lucky streaks.

Hypothetical Example

Consider an active equity mutual fund, "Growth Achievers Fund," that aims to outperform the S&P 500 Index. The fund manager, drawing on extensive market research, believes that certain technology companies are undervalued despite their strong growth prospects.

Let's say at the beginning of the year:

• The Growth Achievers Fund starts with a $100 million portfolio.
• The S&P 500 Index starts at 5,000 points.

Throughout the year, the manager actively buys and sells stocks, increasing positions in companies they believe will outperform and reducing exposure to those they expect to underperform. They might shift asset allocation within sectors or adjust their holdings based on economic forecasts.

At the end of the year:

• The Growth Achievers Fund's portfolio grows to $112 million, representing a 12% return.
• The S&P 500 Index rises to 5,500 points, representing a 10% return.

In this hypothetical example, the Growth Achievers Fund successfully generated 2% of alpha (12% fund return - 10% benchmark return), demonstrating outperformance through its active strategy.

Practical Applications

Active strategies are widely applied across various investment vehicles and market segments. They form the foundation of most traditional mutual funds and hedge funds, where professional managers are compensated for their ability to make informed investment decisions. Individual portfolio managers working for advisory firms also employ active strategies when managing client accounts, often tailoring them to specific client objectives and risk tolerances.

In the bond market, active management is particularly prevalent, as the fixed-income landscape offers more opportunities for managers to exploit inefficiencies, such as differences in credit quality or interest rate sensitivity, compared to highly liquid equity markets. Active exchange-traded funds (ETFs) are also a growing segment, combining the active management approach with the trading flexibility of ETFs.⁶

Regulatory bodies, such as the Securities and Exchange Commission (SEC), play a crucial role in overseeing investment advisers who employ active strategies. The SEC mandates that investment advisers adhere to a fiduciary duty, meaning they must act in the best interest of their clients and make full and fair disclosure of all material facts related to the advisory relationship.⁵ This oversight helps ensure that active managers prioritize client outcomes and manage conflicts of interest. More information on investment advisers can be found on the FINRA website.⁴

Limitations and Criticisms

Despite their potential for outperformance, active strategies face several significant limitations and criticisms. A primary concern is their relatively high cost, including management fees, trading costs, and other expenses, which can erode any potential alpha. For example, in 2023, less than half of active funds across various categories managed to outperform their passive peers, and over longer periods (10 years), the success rate was even lower.³ This persistent underperformance challenges the core premise that active managers can consistently "beat the market." Over the past decade, active funds have generally struggled to outperform their passive counterparts.² Data from LSEG Lipper Alpha Insight further supports this, showing that while active funds can outperform in certain years, their average annual underperformance over time is often greater than their outperformance.¹

Another significant critique stems from the efficient market hypothesis, which suggests that all publicly available information is already reflected in security prices, making it difficult for active managers to consistently find mispriced assets. While some market anomalies exist, they are often not persistent enough or large enough to be exploited after accounting for trading costs and fees. The emergence of behavioral finance has explored how investor psychology can lead to temporary market inefficiencies, but even these may be hard to capitalize on consistently. The cumulative effect of fees means that, mathematically, the average active fund must underperform the market before costs.

Active Strategies vs. Passive Strategies

The fundamental difference between active strategies and passive strategies lies in their investment approach and objective.

While active strategies aim for superior returns through expertise and timely decisions, passive strategies prioritize broad market exposure and cost efficiency, accepting market returns as their goal. The debate over which approach is superior often centers on the efficient market hypothesis and the persistent challenge active managers face in consistently outperforming their benchmarks after accounting for all costs.

FAQs

Q1: Can active strategies guarantee higher returns?

No, active strategies cannot guarantee higher returns. While their goal is to outperform a benchmark, success depends on the manager's skill and market conditions. Many active funds struggle to beat their benchmarks over the long term, especially after accounting for fees.

Q2: What kind of research do active managers perform?

Active managers engage in extensive market research, including fundamental analysis (evaluating a company's financial health, management, and industry outlook) and technical analysis (studying historical price and volume data to predict future movements). They may also conduct macroeconomic analysis and company visits.

Q3: Are active strategies suitable for all investors?

Active strategies may be suitable for investors who believe in the manager's ability to generate alpha and are comfortable with potentially higher fees and the risk of underperformance. Investors seeking broad market exposure and lower costs often opt for passive strategies. Understanding one's investment objectives and risk tolerance is crucial.

Q4: How do active strategies relate to diversification?

Active managers typically aim to build a diversified portfolio within their chosen investment universe to mitigate specific security risks. However, their active choices mean their portfolio's composition might diverge significantly from the benchmark, introducing different risk factors compared to a purely passively diversified portfolio.