Active management

Active management is an investment strategy in which portfolio managers make deliberate decisions about which securities to buy, hold or sell with the goal of outperforming a benchmark index or achieving specific investment objectives ^[1]. Unlike passive management which seeks to replicate index performance, active managers apply research, analysis and judgment to identify opportunities for generating excess returns known as alpha. The approach requires ongoing monitoring of markets and frequent portfolio adjustments in response to changing conditions.

Historical development

Active investment management has roots extending back to the earliest organized securities markets. When stock exchanges emerged in the seventeenth and eighteenth centuries, investors and advisors sought ways to identify undervalued securities and profit from market movements ^[2]. These early practitioners developed analytical techniques that evolved into modern security analysis and portfolio management.

The formalization of investment analysis accelerated in the early twentieth century. Benjamin Graham and David Dodd's 1934 book Security Analysis established fundamental analysis as a systematic approach to stock selection based on examination of financial statements and business economics. Graham's subsequent work on value investing influenced generations of active managers and demonstrated that rigorous analysis could identify mispriced securities.

Modern portfolio theory developed by Harry Markowitz in the 1950s provided mathematical frameworks for understanding risk and return. The Capital Asset Pricing Model introduced concepts of market risk and beta that helped define what active managers were attempting to achieve. These theoretical advances enabled more precise measurement of manager performance and contributed to the debate over whether active management could consistently add value.

The growth of mutual funds and institutional investors in the latter half of the twentieth century expanded the active management industry enormously. Professional portfolio managers competed to attract assets based on their ability to generate superior returns. Performance measurement and attribution techniques improved allowing investors to evaluate manager skill more rigorously.

The emergence of index funds beginning in the 1970s provided a passive alternative that challenged the value proposition of active management. Academic research documenting that most active managers failed to beat benchmarks over time intensified scrutiny of the industry. Despite these challenges active management remains a significant portion of the investment industry.

Objectives and alpha generation

The primary objective of active management is to generate alpha which represents the excess return above what could be achieved by simply holding the benchmark index ^[3]. A portfolio with positive alpha has outperformed its benchmark while negative alpha indicates underperformance.

Alpha reflects the value added by manager skill after accounting for market exposure and other risk factors. If a portfolio returns twelve percent while its benchmark returns ten percent the portfolio has generated two percentage points of excess return. However determining true alpha requires adjusting for risk differences between the portfolio and benchmark.

Modern research has decomposed what was traditionally called alpha into multiple components. Some apparent alpha represents exposure to systematic risk factors such as value, size or momentum that can be captured through rules-based strategies at lower cost. Managers claiming alpha must demonstrate returns beyond what these factor exposures would generate. This more demanding definition has reduced measured alpha across the industry.

Active managers pursue alpha through various approaches including identifying undervalued securities, timing market movements, exploiting temporary mispricings and accessing superior information. The efficiency of modern markets makes consistent alpha generation challenging as prices quickly incorporate publicly available information.

Investment approaches

Active managers employ several distinct methodologies for making investment decisions ^[4].

Fundamental analysis

Fundamental analysis evaluates the intrinsic value of securities by examining underlying business and economic factors. For equity investments this includes analyzing financial statements, assessing competitive position, evaluating management quality and projecting future earnings. The goal is to identify securities trading at prices that differ from their intrinsic values.

Bottom-up fundamental analysis focuses on individual company characteristics with limited attention to macroeconomic factors. Top-down approaches begin with economic and sector analysis before selecting specific securities. Many managers combine elements of both approaches.

Fixed income fundamental analysis examines issuer creditworthiness, interest rate sensitivity and structural features of bonds. Credit analysis assesses the probability of default and expected recovery in default scenarios. Interest rate forecasting influences duration positioning.

Quantitative analysis

Quantitative approaches use systematic rules and statistical models to guide investment decisions. Factors associated with excess returns such as value, momentum, quality and low volatility are identified through historical analysis and used to construct portfolios. Computer algorithms may execute trades based on signals generated by models.

Quantitative strategies offer consistency and the ability to process large amounts of data. However they depend on historical patterns continuing and may be vulnerable when market dynamics change. Many active managers combine quantitative tools with qualitative judgment.

Technical analysis

Technical analysis uses price and volume data to identify patterns and trends that may predict future movements. Technical indicators, chart patterns and momentum measures guide trading decisions. While controversial among academics technical analysis remains popular among some active traders.

Process and execution

Active management involves ongoing processes for research, portfolio construction and trading ^[5].

Research and idea generation

Analysts and portfolio managers conduct research to identify investment opportunities. This may include meeting with company management, analyzing industry trends, building financial models and evaluating competitive dynamics. Research teams develop investment theses that explain why particular securities are expected to generate excess returns.

The research process must generate ideas faster than the market incorporates relevant information into prices. Managers invest in proprietary data sources, specialized expertise and analytical infrastructure to gain informational advantages. Timely access to management and industry contacts can provide insights before they become widely known.

Portfolio construction

Portfolio construction translates investment ideas into actual positions considering objectives, constraints and risk management. Decisions include how much to allocate to each position, how to diversify across sectors and factors, and how much to deviate from benchmark weights.

Risk management monitors portfolio exposures and ensures they remain within acceptable bounds. Stress testing evaluates potential losses under adverse scenarios. Managers balance conviction in their best ideas against the need for diversification.

Trading and implementation

Executing trades without adversely affecting prices requires skill especially for larger portfolios. Market impact occurs when trading activity moves prices against the trader. Algorithms and careful order management minimize implementation costs.

Transaction costs including commissions, bid-ask spreads and market impact reduce returns. Active strategies with high turnover face larger cumulative costs. Managers must generate sufficient gross returns to cover these costs and still deliver net alpha.

Active versus passive management

The debate between active and passive management has intensified as evidence accumulates about relative performance ^[6].

Performance evidence

Research consistently shows that most actively managed funds underperform their benchmark indices over extended periods. Studies indicate that roughly eighty to ninety percent of active managers fail to beat their benchmarks over ten to fifteen year horizons. Large capitalization domestic equity funds have particularly poor records due to the efficiency of this market segment.

The minority of managers who outperform in one period often fail to repeat in subsequent periods. Persistence of outperformance is limited suggesting that identifying skilled managers in advance is difficult. Some outperformance may reflect luck rather than skill.

Fee considerations

Active management costs significantly more than passive alternatives. Active fund fees typically range from 0.5 to 1.5 percent annually compared to less than 0.2 percent for many index funds. Higher fees create a performance hurdle that active managers must overcome to match net returns of passive alternatives.

The fee disadvantage compounds over time. Even modest annual fee differences amount to substantial wealth differences over decades. Investors increasingly recognize that low cost passive strategies capture most market returns.

Where active may add value

Despite overall underperformance, active management may provide value in specific circumstances. Less efficient market segments such as small capitalization stocks, emerging markets and certain fixed income sectors offer greater opportunity for skilled managers to identify mispricings. Managers with genuine skill can add value if investors can identify them.

Active management enables customization of portfolios to reflect specific stakeholder preferences, risk tolerances and constraints that index replication cannot accommodate. Tax management, responsible investing considerations and liability matching may require active approaches.

Advantages of active management

Active management offers potential benefits in appropriate circumstances ^[7]:

• Opportunity to generate returns above benchmark performance
• Flexibility to respond to changing market conditions
• Ability to avoid securities perceived as overvalued or risky
• Customization to meet specific investor objectives and constraints
• Potential for risk management through tactical adjustments
• Access to less efficient market segments
• Incorporation of environmental, social and governance considerations

Limitations of active management

Significant challenges constrain the value of active management ^[8]:

• Most active managers underperform benchmarks over time
• Higher fees reduce net returns to investors
• Trading costs erode performance especially for high turnover strategies
• Difficulty identifying skilled managers in advance
• Market efficiency limits opportunities for excess returns
• Tax inefficiency from frequent trading in taxable accounts
• Manager risk if key personnel depart or judgment deteriorates
• Past performance does not reliably predict future results

Active management — recommended articles

Strategy — Risk management — Decision making — Financial management — Planning — Management — Efficiency — Stakeholder — Organization

References

• Grinold R.C., Kahn R.N. (2000), Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk, McGraw-Hill, 2nd edition.
• Sharpe W.F. (1991), The Arithmetic of Active Management, Financial Analysts Journal, Vol. 47, No. 1.
• Ellis C.D. (2017), Winning the Loser's Game: Timeless Strategies for Successful Investing, McGraw-Hill, 7th edition.
• S&P Global (2024), SPIVA U.S. Scorecard.
• CFA Institute (2022), Standards of Practice Handbook.

Footnotes

1. Grinold R.C., Kahn R.N. (2000), p. 13
2. Ellis C.D. (2017), pp. 1-15
3. Grinold R.C., Kahn R.N. (2000), pp. 107-125
4. CFA Institute (2022), pp. 185-200
5. Grinold R.C., Kahn R.N. (2000), pp. 315-345
6. Sharpe W.F. (1991), pp. 7-9
7. Ellis C.D. (2017), pp. 25-35
8. S&P Global (2024), pp. 2-8

Author: Sławomir Wawak