Active management

Active management refers to the strategy of actively selecting investments, as opposed to passively investing in a market index. Active managers make decisions based on research and analysis in an attempt to outperform the market. This is in contrast to passive management, which involves investing in a diversified portfolio that tracks the performance of a market index. Active management can be more expensive than passive management due to the additional research and analysis required.

Active management applications

Active management can be useful in certain situations, such as:

• When an investor has a high-conviction view on a particular security or market: Active managers may be able to capitalize on this conviction by overweighting or underweighting that security or market.
• When an investor has a specific investment objective that cannot be met through passive investment: For example, an investor with a specific sector or geographic focus may be better served by an actively managed fund that has a similar focus.
• When market conditions are favorable for active management: Active managers may be able to outperform passive managers during certain market conditions, such as when markets are inefficient or have high volatility.

It's important to keep in mind that active management does not always outperform passive management and the extra cost associated with active management may not justify the potential gain. It's also worth noting that a well-diversified portfolio of passive investment can be a good strategy for long-term investors.

Advantages of active management

Active management can provide several advantages over passive management, including:

• The potential for outperformance: Active managers may be able to outperform the market by making investment decisions based on in-depth research and analysis.
• Flexibility: Active managers can make decisions based on their own views and convictions, rather than being constrained by a market index.
• Active risk management: Active managers can make adjustments to a portfolio in response to changing market conditions, which can help to mitigate risk.
• Tax management: Active managers can make investment decisions with the goal of minimizing taxes.
• Tailored investment strategies: Active management can be used to implement specialized investment strategies, such as focused on a particular sector, geographic region or other specific criteria.

It's important to note that while active management has these advantages it's not guaranteed to outperform passive management and the additional costs associated with active management may not justify the potential gain.

Limitations of active management

Active management can have several limitations, including:

• Higher costs: Active management typically involves higher expenses, such as research and analysis, trading costs, and management fees. These costs can eat into returns, making it more difficult for an active manager to outperform a passively managed fund.
• Difficulty in outperforming the market: Active managers often struggle to consistently outperform the market, particularly after accounting for their higher expenses. Research has shown that a significant proportion of active managers underperform their benchmark indices over the long-term.
• Lack of transparency: Active managers may not disclose their investment strategies or positions, making it difficult for investors to understand the underlying holdings of the fund.
• Short-term focus: Active managers may focus on short-term performance, which can lead to higher turnover and increased trading costs.
• Lack of diversification: Active managers may concentrate their portfolios in a small number of securities, increasing the risk of underperformance if those securities do not perform as expected.
• Emotions and biases: Active managers may make decisions based on emotions or biases, which can lead to suboptimal investment decisions.

It's important to consider these limitations when deciding whether or not to invest in an actively managed fund, and to weigh the potential benefits against the potential drawbacks.

Active management — recommended articles

Portfolio construction — Passive management — Long term investment plans — Diversifiable risk — Managed forex accounts — Fiduciary Call — Investment horizon — Risk-return tradeoff — Risk-free return — Hazard assessment

References

• Wermers, R. (2020). Active investing and the efficiency of security markets. The Journal of Investment Management.
• Pástor, L., & Stambaugh, R. F. (2012). On the size of the active management industry. Journal of Political Economy, 120(4), 740-781.
• Foster, F. D., & Warren, G. J. (2015). Why might investors choose active management?. Journal of Behavioral Finance, 16(1), 20-39.