Actively managed fund

What Is Actively Managed Fund?

An actively managed fund is a type of investment fund where a fund manager or a team of managers makes specific investment decisions with the goal of outperforming a particular benchmark index or generating returns higher than the broader financial market. This falls under the broader category of investment strategy, differentiating itself from passive approaches by relying on ongoing research, analysis, and tactical adjustments. The objective of an actively managed fund is to generate "alpha," which refers to the excess return earned by an investment or portfolio above the return of a benchmark. Achieving this often involves detailed security selection, market timing, and dynamic asset allocation decisions.

History and Origin

The concept of actively managed funds precedes the rise of modern index investing. Early forms of investment trusts, which pooled money from multiple investors to manage a diversified portfolio, emerged in the Netherlands in the 18th century, with similar vehicles appearing in Switzerland and Scotland in the mid-to-late 19th century. The first modern mutual fund in the U.S., Massachusetts Investors Trust, was established in 1924, operating with a clear mandate for active management.

The philosophy behind active management gained significant traction in the mid-20th century with proponents like Benjamin Graham, often considered the "father of value investing." Graham's work emphasized diligent analysis of individual companies to identify undervalued securities, a cornerstone of many active strategies. He was also an early figure in what is now known as active investing, influencing corporate governance by pressuring management to unlock shareholder value.¹⁰ For decades, active management was the dominant approach to pooled investments. The shift towards passive investing, notably through the introduction of the first index mutual fund by Vanguard in 1976, provided a stark contrast, offering broad market exposure without active stock picking.⁹

Key Takeaways

• An actively managed fund aims to outperform a specific market benchmark through strategic investment decisions.
• Fund managers conduct in-depth research, analysis, and adjustments to the fund's portfolio.
• The goal is to generate "alpha," which is returns in excess of a benchmark.
• Actively managed funds typically have higher expense ratios compared to passively managed funds due to the costs associated with research and management.
• Performance of actively managed funds is frequently evaluated against relevant benchmarks over various timeframes.

Interpreting the Actively Managed Fund

When evaluating an actively managed fund, investors typically look beyond raw returns to assess whether the fund manager has successfully generated alpha. This means determining if the fund's performance is superior to what could have been achieved simply by tracking the market. A key metric is the fund's return relative to its stated benchmark after accounting for fees and expenses.

An actively managed fund's performance can fluctuate significantly year-to-year. Over shorter periods, some actively managed funds may outperform, while over longer periods, consistent outperformance can be challenging. For instance, less than half of actively managed U.S. mutual funds and exchange-traded funds (ETFs) beat their passive counterparts in 2024, and even fewer did so over a decade.⁸ This highlights the importance of scrutinizing long-term track records and understanding the fund's risk management approach and investment philosophy.

Hypothetical Example

Consider an investor, Sarah, who chooses an actively managed fund focused on U.S. large-cap equities. The fund's stated benchmark is the S&P 500.

Scenario:

• Beginning of Year 1: Sarah invests $10,000 in the actively managed fund.
• Fund Manager's Strategy: The fund manager believes certain technology stocks are undervalued and invests heavily in them, while underweighting some traditional industrial sectors. They also make tactical shifts based on economic outlooks.
• End of Year 1:
  • The S&P 500 index returns 12% for the year.
  • Sarah's actively managed fund returns 14% for the year (net of fees).

In this hypothetical example, the actively managed fund successfully generated 2% of alpha by outperforming its benchmark. Sarah's investment would have grown to $11,400, whereas if she had invested in a passive fund tracking the S&P 500, her investment would have grown to $11,200. This illustrates how an actively managed fund aims to add value beyond simply tracking the market.

Practical Applications

Actively managed funds are employed across various asset classes and market segments, from equity and fixed income to real estate and commodities. Investors often use them when they believe a fund manager possesses unique insights or expertise that can exploit market inefficiencies. For instance, in less efficient markets, such as small-cap stocks or emerging markets, active managers may have a greater opportunity to identify mispriced securities and generate excess returns. Active real estate strategies, for example, showed strong success rates in 2024.⁷

These funds are commonly offered as mutual funds, but the landscape is evolving with the increasing popularity of active Exchange-Traded Fund (ETF)s, which combine the active management approach with the intraday trading flexibility of ETFs.⁶ Regulators like the U.S. Securities and Exchange Commission (SEC) impose disclosure requirements on investment funds, including actively managed ones, to ensure transparency regarding their strategies, risks, fees, and performance, empowering investors with necessary information to make informed decisions.⁵

Limitations and Criticisms

Despite the appeal of potentially outperforming the market, actively managed funds face significant limitations and criticisms. A primary concern is their typically higher fees, including management fees and trading costs, which can erode returns. These higher costs mean that an actively managed fund must not only beat its benchmark but also cover its additional expenses to deliver true value to investors. Historically, lower-cost funds have shown a greater likelihood of outperforming their passive peers.⁴

Numerous studies, such as the SPIVA (S&P Indices Versus Active) reports by S&P Dow Jones Indices, consistently show that a significant percentage of actively managed funds fail to outperform their benchmarks over various time horizons, especially longer ones.³,² For instance, less than a quarter of all active funds topped the average of their passive rivals over the 10-year period ending December 2024.¹ Critics argue that achieving consistent alpha is exceptionally difficult due to market efficiency, where all available information is quickly reflected in asset prices. This makes it challenging for any single manager to consistently find undervalued or overvalued assets. The inherent difficulty in beating the market, especially in highly transparent and efficient segments like U.S. large-cap equity, leads many financial professionals to advocate for passive investment strategies, emphasizing the benefits of lower costs and broad diversification.

Actively Managed Fund vs. Passively Managed Fund

The fundamental difference between an actively managed fund and a passively managed fund lies in their core investment objective and approach.

Confusion often arises because both types of funds pool investor money and invest in a portfolio of securities. However, their operational philosophies diverge sharply. Actively managed funds believe that skillful analysis can identify mispriced assets, allowing them to "beat" the market. Passively managed funds, conversely, operate on the belief that consistently outperforming the market is exceedingly difficult, particularly after fees, and therefore, it is more efficient to simply track a broad market index.

FAQs

What is the primary goal of an actively managed fund?

The primary goal of an actively managed fund is to generate returns that surpass a specific market benchmark index or the broader market, often referred to as achieving "alpha."

Why do actively managed funds typically have higher fees?

Actively managed funds generally have higher fees because they require a team of professionals—including fund managers, analysts, and traders—to conduct extensive research, perform in-depth analysis, and make continuous investment decisions. These operational costs are passed on to investors through higher expense ratios.

Can an actively managed fund guarantee higher returns?

No, an actively managed fund cannot guarantee higher returns. While their objective is to outperform, there is no assurance they will succeed. Performance depends on various factors, including market conditions, the manager's skill, and the inherent risk management of the strategy, and many active funds underperform their benchmarks over time.

How is an actively managed fund different from an index fund?

An actively managed fund seeks to beat a benchmark through selective stock picking and market timing, whereas an index fund (a type of passively managed fund) simply aims to replicate the performance of a specific market index by holding its constituent securities.

What are the main risks associated with actively managed funds?

The main risks include the potential for underperformance relative to a benchmark, the impact of higher fees on net returns, and the risk that the fund manager's investment decisions may prove incorrect, leading to losses. Investors bear the risk that the active management fails to add value, and could even detract from returns compared to a simpler, lower-cost passive alternative.