Active management


Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index or target return. In passive management, investors expect a return that closely replicates the investment weighting and returns of a benchmark index and will often invest in an index fund.

Concept

Ideally, the active manager exploits market inefficiencies by purchasing securities that are undervalued or by short selling securities that are overvalued. Either of these methods may be used alone or in combination. Depending on the goals of the specific investment portfolio, hedge fund or mutual fund, active management may also serve to create less volatility than the benchmark index. The reduction of risk may be instead of, or in addition to, the goal of creating an investment return greater than the benchmark.
Active portfolio managers may use a variety of factors and strategies to construct their portfolio. These include quantitative measures such as price–earnings ratios and PEG ratios, sector investments that attempt to anticipate long-term macroeconomic trends, and purchasing stocks of companies that are temporarily out-of-favor or selling at a discount to their intrinsic value. Some actively managed funds also pursue strategies such as risk arbitrage, short positions, option writing, and asset allocation.

Asset allocation

Using the concept of asset allocation, researchers divide active management into two parts; one part is selecting securities within an asset class, while the other part is selecting between asset classes. For example, a large-cap U.S. stock fund might decide which large-cap U.S. stocks to include in the fund. Then those stocks will do better or worse than the class in general. Another fund may choose to move money between bonds and stocks, or some country versus a different one, et cetera. Then one class will do worse or better than the other class.
The case where a fund changes its class of assets is called style drift. An example would be where a fund that normally invests in government bonds switches into stocks of small companies in emerging markets. Although this gives the most discretion to the manager, it also makes it difficult for the investor if he also has a target of asset allocation.

Performance

The effectiveness of an actively managed investment portfolio depends on the skill of the manager and research staff but also on how the term active is defined. Many mutual funds purported to be actively managed stay fully invested regardless of market conditions, with only minor allocation adjustments over time. Other managers will retreat fully to cash, or use hedging strategies during prolonged market declines. These two groups of active managers will often have very different performance characteristics.
The Standard & Poor's Index Versus Active quarterly scorecards demonstrate that only a minority of actively managed mutual funds have gains better than the Standard & Poor's index benchmark. As the time period for comparison increases, the percentage of actively managed funds whose gains exceed the S&P benchmark declines further. This may be due to the preponderance of closet-index funds in the study.
Only about 30% of mutual funds are active enough that the manager has the latitude to move completely out of an asset class in decline, which is what many investors expect from active management. Of these 30% of funds there are out-performers and under-performers, but this group that outperforms is also the same group that outperforms passively managed portfolios over long periods of time.
Due to mutual fund fees and/or expenses, it is possible that an active or passively managed mutual fund could under-perform compared to the benchmark index, even though the securities that comprise the mutual fund are outperforming the benchmark.
In addition, many investors find active management an attractive investment strategy in volatile or declining markets or when investing in market segments that are less likely to be profitable when considered as a whole. These kinds of sectors might include a sector such as small cap stocks.

Active share and closet indexers

Active funds which differ from their benchmark indexes are described as having higher "active share". Funds which have low active share are described as "closet indexers". "Focus funds" such as activist investors which invest relatively few stocks, typically have high active share. Tracking error also measures divergence from the benchmark index. Research suggests that managers with high active share are better able to outperform their benchmark.
Approximately 20% of all mutual funds are pure index funds. The balance are actively managed in some respect. In reality, a large percentage of actively managed mutual funds rarely outperform their index counterparts over an extended period of time because 45% of all mutual funds are "closet indexers" — funds whose portfolios look like indexes and whose performance is very closely correlated to an index but call themselves active to justify higher management fees. Prospectuses of closet indexers will often include language such as "80% of holdings will be large cap growth stocks within the S&P 500" causing the majority of their performance to be directly dependent upon the performance of the growth stock index they are benchmarking, less the larger fees.

Advantages of active management

The primary attraction of active management is that it allows selection of a variety of investments instead of investing in the market as a whole. Investors may have a variety of motivations for following such a strategy:
Several of the actively managed mutual funds with strong long-term records invest in value stocks. Passively managed funds that track broad market indices such as the S&P 500 have money invested in all the securities in that index i.e. both growth and value stocks.
The use of managed funds in certain emerging markets has been recommended by Burton Malkiel, a proponent of the efficient market theory who normally considers index funds to be superior to active management in developed markets.

Disadvantages of active management

The most obvious disadvantage of active management is that the fund manager may make bad investment choices or follow an unsound theory in managing the portfolio. Unless active management is performed by a robo-advisor the fees associated with active management are generally also higher than those associated with passive management, even if frequent trading is not present, reflecting in part the additional research costs associated with active investing. Those who are considering investing in an actively managed mutual fund should evaluate the fund's prospectus carefully. Data from recent decades demonstrates that the majority of actively managed large and mid-cap stock funds in United States fail to outperform their passive stock index counterparts.
Active fund management strategies that involve frequent trading generate higher transaction costs which diminish the fund's return. In addition, the short-term capital gains resulting from frequent trades often have an unfavorable income tax impact when such funds are held in a taxable account.
When the asset base of an actively managed fund becomes too large, it begins to take on index-like characteristics because it must invest in an increasingly diverse set of investments instead of those limited to the fund manager's best ideas. Many mutual fund companies close their funds before they reach this point, but there is potential for a conflict of interest between mutual fund management and shareholders because closing the fund will result in a loss of income for the mutual fund company.

Real active management

Most mutual funds do not have board members and directors with an equity stake in the mutual fund that their manager are administrating. In other words, the directors and board members don't directly impact the future performance of the fund. Real active management, then, is when every manager and director has a vested interest in the success of the fund. Private equity is often real active management since a privately owned company usually has just one owner that make strategy decisions at the board level.

Industry

In the United States, as of 2019, the top 5 asset managers accounted for 55% of the 19.3 trillion in mutual fund and ETF investments. However, for active management, the top 5 account for 22% of the market, with the top 10 accounting for 30% and the top 25 accounting for 39%. BlackRock and Vanguard are the top two when including passive investments.
The top 5 active management companies in 2018 were Capital Group Companies, Fidelity Investments, Vanguard, T. Rowe Price, and Dimensional Fund Advisors; in 2008, the list included PIMCO and Franklin Templeton. Of these, Fidelity and Vanguard also focus on passive investing. Other notable companies include Legg Mason, Eaton Vance, Invesco, AllianceBernstein, Natixis Investment Managers, and Aegon.
In 2019, the head of Invesco predicted that up to a third of the asset management firms could disappear.
While passive investment has taken share from actively-managed mutual funds, as of 2019 in the United States passive management accounted for about $4.271 trillion in US investment compared to $35.6 trillion in total publicly-traded equity shares, with a broader array of active managers such as hedge funds and pensions accounting for the difference. In addition, fixed income is more often actively-managed.