What Is Active Management in Investing?

What Is Active Management?

The term active management implies that a professional money manager or a team of professionals is tracking the performance of a client's investment portfolio and regularly making buy, hold, and sell decisions about the assets in it. The goal of the active manager is to outperform the overall market.

Active managers may rely on investment analysis, research, and forecasts as well as their own judgment and experience in making decisions on which assets to buy and sell.

The opposite of active management is passive management, better known as indexing. Those who adhere to passive management maintain that the best results are achieved by buying assets that mirror a particular market index or indexes and holding them long-term, ignoring the day-to-day fluctuations of the markets.

Understanding Active Management

Investors who believe in active management do not follow the efficient market hypothesis, which argues that it is impossible to beat the market over the long run. That is, stockpickers who spend their days buying and selling stocks to exploit their frequent fluctuations will, over time, do no better than investors who buy the components of the major indexes that are used to track the performance of the wider markets over time.

Active managers, on the other hand, measure their own success by measuring how much their portfolios exceed (or fall short of) the performance of a comparable unmanaged index, industry, or market sector.

For example, the Fidelity Blue Chip Growth Fund uses the Russell 1000 Growth Index as its benchmark. Over the five years that ended June 30, 2020, the Fidelity fund returned 17.35% while the Russell 1000 Growth Index rose 15.89%. Thus, the Fidelity fund outperformed its benchmark by 1.46% for that five-year period.

Strategies for Active Management

Active managers believe it is possible to profit from the stock market through any of a number of strategies that aim to identify stocks that are trading at a lower price than their value merits.

Investment companies and fund sponsors believe it's possible to outperform the market and employ professional investment managers to manage the company's mutual funds.

Disadvantages of Active Management

Actively managed funds have higher fees than passively managed funds. The investor is paying for the sustained efforts of investment advisers who specialize in active investment, and for the potential for higher returns than the markets as a whole.

There is no consensus on which strategy yields better results: active or passive management.

Passive management requires a one-time effort to pick the right assets for an individual investor, followed by the occasional rebalancing of a portfolio and due diligence in tracking it over time.

An investor considering active management should take a hard look at the actual returns after fees of the manager.

Advantages of Active Management

A fund manager’s expertise, experience, and judgment are employed by investors in an actively managed fund. An active manager who runs an automotive industry fund might have extensive experience in the field and might invest in a select group of auto-related stocks that the manager concludes are undervalued.

Active fund managers have more flexibility. There is more freedom in the selection process than in an index fund, which must match as closely as possible the selection and weighting of the investments in the index.

Actively managed funds allow for benefits in tax management. The flexibility in buying and selling allows managers to offset losers with winners.

Managing Risk

Active fund managers can manage risks more nimbly. A global banking exchange-traded fund (ETF) may be required to hold a specific number of British banks. That fund is likely to have dropped significantly following the shock Brexit vote in 2016. An actively managed global banking fund, meanwhile, might have reduced its exposure to British banks due to heightened levels of risk.

Active managers can also mitigate risk by using various hedging strategies such as short selling and using derivatives.

Active Management Performance 

There is plenty of controversy surrounding the performance of active managers. Their success or failure depends largely on which of the contradictory statistics is quoted.

Over the 10 years ended in 2017, active managers who invested in large-cap value stocks were most likely to beat the index, outperforming by 1.13% on average per year. A study showed that 84% of active managers in this category outperformed their benchmark index before fees were deducted.

But over the short term--three years--active managers underperformed the index by an average of 0.36%, and over five years they trailed it by 0.22%.

Another study showed that for the 30 years ended in 2016, actively managed funds returned 3.7% on average annually, compared to 10% for returns for passively managed funds.