What Is Actively Managed?
An actively managed investment refers to a portfolio management approach where a fund manager or a team of managers makes specific decisions about which securities to buy, hold, and sell, with the primary goal of outperforming a particular benchmark index or the broader financial markets. This falls under the broader category of Investment Management. Unlike passive strategies that simply track an index, actively managed funds employ research, analysis, and forecasting to identify investment opportunities. The actively managed approach aims to generate higher returns through skillful security selection, market timing, or strategic asset allocation.
History and Origin
The concept of actively managed investment strategies predates indexed investing, tracing its roots to the earliest forms of collective investment vehicles. Before the widespread availability of index funds, virtually all pooled investment vehicles, such as early mutual funds, were actively managed. Fund managers would individually select stocks or bonds based on their research and outlook.
A significant moment in the regulation of actively managed funds in the United States was the passage of the Investment Company Act of 1940. This legislation was enacted to regulate the organization and activities of investment companies, including mutual funds, following the speculative excesses of the 1920s and the subsequent market crash. It imposed requirements such as registration with the Securities and Exchange Commission (SEC) and mandated disclosures to protect investors from conflicts of interest and improper practices by fund managers. The Investment Company Act of 1940 is central to financial regulation in the U.S. and provides the framework within which many actively managed funds operate.11, 12, 13, 14
Key Takeaways
- Actively managed funds seek to outperform a specific benchmark through the expertise of fund managers.
- Managers engage in extensive research, market analysis, and security selection.
- These funds typically involve higher operating costs, including management fees and trading expenses.
- Performance is often measured by the ability to generate alpha, which is the excess return above the benchmark.
- Actively managed funds are subject to various market risks and management risks.
Interpreting the Actively Managed Approach
An actively managed fund's performance is often judged by its ability to generate returns that exceed its chosen benchmark, after accounting for all fees and expenses. This outperformance is known as alpha. A positive alpha indicates that the manager's decisions added value beyond what a simple market tracking strategy would have achieved. Investors considering an actively managed fund should carefully review the fund's historical performance, its stated investment strategy, the manager's experience, and the overall expense ratio. Understanding the fund's investment philosophy and how it aligns with personal risk tolerance and financial objectives is crucial.
Hypothetical Example
Consider an actively managed equity mutual fund, the "DiversiGrowth Fund," which aims to outperform the S&P 500 index. The fund manager, drawing on extensive research, believes that technology companies with strong intellectual property and healthcare companies with innovative drug pipelines will grow faster than the broader market.
The manager might decide to:
- Overweight the technology sector by allocating 30% of the fund's assets to tech stocks, compared to the S&P 500's 20% allocation.
- Underweight sectors like energy and utilities, holding less than their S&P 500 representation, believing them to have lower growth potential.
- Select specific stocks within the chosen sectors, such as "InnovateTech Inc." and "BioHealth Pharma," based on fundamental analysis that suggests they are undervalued or poised for significant growth.
Throughout the year, the manager continuously monitors these positions, adjusting holdings based on new market information, company earnings, and macroeconomic trends. If "InnovateTech Inc." releases a disappointing earnings report, the manager might sell some or all of the shares, replacing them with another promising tech company. This ongoing process of research, selection, and adjustment exemplifies an actively managed approach.
Practical Applications
Actively managed strategies are utilized across various investment vehicles, including mutual funds, Exchange-Traded Funds (ETFs), hedge funds, and individual stock portfolios. Investors who believe in the ability of skilled professionals to identify mispriced assets or anticipate market movements often gravitate towards actively managed products. These funds are frequently used by individuals seeking specialized exposure, such as to emerging markets, specific sectors, or investment styles (e.g., growth or value investing), where active management is sometimes argued to have more potential to add value.
However, the efficacy of active management has been a subject of ongoing debate. Research, such as the S&P Dow Jones Indices Versus Active (SPIVA) Scorecard, consistently tracks the performance of actively managed funds against their passive benchmarks across various asset classes and regions. The SPIVA Scorecard reports are a widely referenced source for evaluating this performance.6, 7, 8, 9, 10
Limitations and Criticisms
Despite the potential for outperformance, actively managed funds face several significant limitations and criticisms. The most prominent is the challenge of consistently beating the market after fees. Many studies, including those by Morningstar and S&P Dow Jones Indices, have shown that a majority of actively managed funds fail to outperform their benchmarks over extended periods. For example, a Morningstar analysis found that cheaper actively managed funds had a higher success rate than more expensive ones over a 10-year period, but overall, many active funds underperformed their passive peers.4, 5
Higher operating expenses are another major drawback. Actively managed funds typically charge higher management fees and incur greater trading costs due to frequent buying and selling of securities, which can erode returns. These costs contribute to a higher expense ratio compared to passively managed alternatives. Furthermore, the active trading inherent in this approach can lead to higher capital gains distributions for taxable accounts, potentially reducing after-tax returns for investors. The academic community often points to the concept of market efficiency as a theoretical challenge to active management, suggesting that consistently beating the market is difficult because all available information is already reflected in asset prices. The CFA Institute has also published research exploring the challenges of active management in consistently adding value.1, 2, 3
Actively Managed vs. Passively Managed
The fundamental difference between actively managed and passively managed investments lies in their investment philosophy and execution.
| Feature | Actively Managed | Passively Managed |
|---|---|---|
| Objective | Outperform a specific benchmark index. | Replicate the performance of a specific benchmark index. |
| Strategy | Fund managers make discretionary decisions (security selection, market timing, etc.). | Automatically tracks an index; minimal human intervention in security selection. |
| Costs | Generally higher management fees and trading expenses. | Generally lower management fees and minimal trading expenses. |
| Trading Activity | Higher portfolio turnover due to frequent buying and selling. | Lower portfolio turnover; trades primarily occur when the index rebalances. |
| Goal | Generate alpha (excess returns). | Achieve beta (market returns) with low costs. |
While actively managed funds strive for superior returns through expertise, passively managed funds, often through index funds or ETFs, aim to match market performance at a lower cost, emphasizing broad market exposure and diversification. The choice between the two often depends on an investor's beliefs about market efficiency, cost sensitivity, and investment objectives.
FAQs
What is the main goal of an actively managed fund?
The main goal of an actively managed fund is to outperform a specific benchmark index or the broader market, thereby generating excess returns (alpha) for investors.
Are actively managed funds more expensive than passively managed funds?
Yes, actively managed funds typically have higher operating expenses, including higher management fees and trading costs, compared to passively managed funds. This is due to the extensive research, analysis, and trading activity involved in attempting to beat the market.
How do fund managers try to outperform the market in an actively managed fund?
Fund managers in an actively managed fund employ various investment strategy techniques, such as in-depth research to identify undervalued securities, strategic asset allocation decisions, and market timing attempts, all with the aim of generating returns that surpass their benchmark.