What Is Actively Managed Fund?
An actively managed fund is a type of investment vehicle, such as a mutual fund or exchange-traded fund (ETF), where a dedicated fund manager or team makes investment decisions with the goal of outperforming a specific market benchmark or index. This contrasts with passively managed funds that aim to replicate the performance of an index. Within the broader field of investment objective and portfolio theory, actively managed funds strive to generate superior returns through strategic stock picking, market timing, and tactical asset allocation based on in-depth research and analysis. The investment adviser behind an actively managed fund continuously monitors market conditions and makes adjustments to the fund's holdings, aiming to capitalize on perceived inefficiencies or opportunities.
History and Origin
The concept of professional money management, which underpins actively managed funds, has roots stretching back centuries. However, the modern form of collective investment vehicles, particularly mutual funds, gained prominence in the early to mid-20th century in the United States. Before the formalized regulatory framework, such as the Investment Company Act of 1940, funds operated with less oversight, sometimes leading to conflicts of interest between managers and shareholders. The Investment Company Act of 1940 was a landmark piece of legislation designed to regulate these collective investment schemes, promoting transparency and protecting investors by establishing rules for fund operations, including governance and fee structures.7 This act helped formalize the structure and oversight of what would become the prevalent model for actively managed funds. Initially, virtually all mutual funds were actively managed, as the idea of simply tracking a market index was not yet widespread. Fund managers sought to demonstrate their expertise by selecting individual securities they believed would outperform the broader market.
Key Takeaways
- Actively managed funds seek to outperform a market benchmark through the decisions of a fund manager.
- They typically involve higher operating costs, including a management fee and an expense ratio, compared to passively managed funds.
- Fund managers engage in activities like security selection and market timing.
- Performance of actively managed funds can vary significantly based on manager skill, market conditions, and fees.
- The goal of active management is to generate alpha, which is returns in excess of a benchmark.
Interpreting the Actively Managed Fund
When evaluating an actively managed fund, investors typically assess its performance relative to its stated benchmark and peer group. It is important to consider the fund's net returns—that is, returns after all fees and expenses have been deducted—as these costs can significantly erode potential gains. A fund consistently outperforming its benchmark after fees suggests effective management, while underperformance may indicate that the active strategy is not delivering sufficient value to justify the higher costs. Inv6estors also consider the fund's consistency in meeting its investment objective, its level of market volatility, and how well it aligns with their own risk tolerance and financial goals. Tools for performance measurement are crucial in this assessment.
Hypothetical Example
Consider an investor, Sarah, who is evaluating two hypothetical equity mutual funds, Fund A and Fund B, both focusing on large-cap U.S. stocks.
Fund A (Actively Managed Fund):
The manager of Fund A, Mr. Johnson, actively researches individual companies, aiming to identify undervalued stocks. In a given year, Mr. Johnson identifies several companies he believes are poised for significant growth, purchasing their shares for Fund A's portfolio. He sells shares of other companies that he believes are overvalued or have deteriorating fundamentals.
Let's assume the S&P 500 Index, the benchmark for both funds, returns 10% in a year.
- Fund A's gross return (before fees): 12%
- Fund A's expense ratio: 1.0%
- Fund A's net return: (12% - 1.0% = 11%)
In this scenario, Fund A's active management successfully outperformed its benchmark by 1% after accounting for its higher expense ratio. This demonstrates the potential for an actively managed fund to generate alpha. However, it's important to remember that such outperformance is not guaranteed and often fluctuates.
Practical Applications
Actively managed funds are widely used by investors seeking to benefit from professional expertise and potentially achieve returns exceeding market averages. These funds are prevalent across various asset classes, including equities, fixed income, and alternative investments. They are often utilized by individuals and institutional investors who believe that certain markets or segments are inefficient enough for skillful managers to identify mispriced securities. For instance, in less efficient markets like small-cap stocks or emerging markets, active management might be seen as having a greater opportunity to add value through diligent research and analysis.
However, the marketing and presentation of an actively managed fund's performance are subject to strict regulatory oversight, particularly by the U.S. Securities and Exchange Commission (SEC). The SEC's modernized Marketing Rule, effective since late 2022, requires investment advisers to provide clear, balanced, and substantiated information in their advertisements, prohibiting misleading statements and mandating the prominent presentation of net performance alongside any gross performance. Thi5s rule aims to ensure that investors receive comprehensive and fair information, preventing cherry-picking of favorable results or the omission of material risks.
Limitations and Criticisms
Despite their appeal, actively managed funds face significant limitations and criticisms. A primary concern is their tendency to underperform their respective benchmarks, particularly over longer time horizons, after accounting for fees. Data from various studies, such as the Morningstar Active/Passive Barometer, frequently show that a majority of actively managed funds fail to beat their passive counterparts over extended periods., Th4i3s underperformance is often attributed to the higher fees associated with active management, trading costs, and the inherent difficulty of consistently outsmarting efficient markets.
Academics and market observers have highlighted that the average actively managed fund's returns are often lower than those of index funds. One academic study noted that active fund managers often underperform the S&P 500 due to factors like size and skewness biases in their portfolios, even before considering costs. Fur2thermore, high expense ratio and frequent trading can lead to increased capital gains distributions, which may be less tax-efficient for investors in taxable accounts. While some active funds may outperform in specific periods, consistently identifying these outperformers beforehand remains a challenge for individual investors and professional allocators. The increased transparency and competition from low-cost passive options have also put pressure on the fees and performance of actively managed funds.
Actively Managed Fund vs. Passively Managed Fund
The fundamental difference between an actively managed fund and a passively managed fund lies in their investment strategy and management approach. An actively managed fund employs a fund manager or a team who actively makes investment decisions—buying, selling, and holding securities—with the explicit aim of outperforming a particular market index or achieving a specific investment objective that deviates from broad market performance. This involves detailed research, analysis, and tactical adjustments in response to market conditions.
In contrast, a passively managed fund (often referred to as an index fund) seeks to replicate the performance of a specific market benchmark, such as the S&P 500. It does this by holding all, or a representative sample, of the securities in that index, typically in the same proportions. Passive funds do not involve discretionary stock picking or market timing by a manager. Consequently, they generally have significantly lower operating costs and expense ratios because they require less ongoing research and trading activity. Confusion often arises because both types of funds pool investor money and invest in portfolios of securities, but their underlying philosophy—to beat the market versus to match the market—is distinct.
FAQs
What is the main goal of an actively managed fund?
The main goal of an actively managed fund is to generate returns that exceed those of its chosen market benchmark or index. This is achieved through the expertise and strategic decisions of a fund manager.
Are actively managed funds more expensive than passively managed funds?
Yes, actively managed funds typically have higher fees and expense ratio compared to passively managed funds. These higher costs compensate for the ongoing research, analysis, and trading activities undertaken by the fund manager in an attempt to outperform the market.
Do actively managed funds always outperform the market?
No, actively managed funds do not always outperform the market. While they aim to generate superior returns, many studies indicate that a significant percentage of actively managed funds fail to beat their benchmarks, especially over long periods, after accounting for fees.
How do1 fund managers try to outperform the market in an actively managed fund?
Fund managers in an actively managed fund use various strategies, including in-depth research to identify undervalued or overvalued securities, market timing to anticipate economic shifts, and tactical asset allocation to position the portfolio for perceived opportunities or risks. Their goal is to achieve diversification while also maximizing returns.