Active return is the percentage gain or loss of an investment relative to the investment's benchmark. A benchmark might be market comprehensive, such as the Standard and Poor's 500 Index (S&P 500), or sector specific, such as the Dow Jones U.S. Financials Index. An active return is a difference between the benchmark and the actual return. It can be positive or negative and is typically used to assess performance. Companies that seek active returns are known as “active fund managers” and are usually asset management firms or hedge funds.
Breaking Down Active Return
A portfolio that outperforms the market has a positive active return, assuming that the market as a whole is the benchmark. For example, if the benchmark return is 5% and the actual return is 8%, the active return would then be 3% (8% - 5% = 3%).
If the same portfolio returned only 4%, it would have a negative active return of -1% (4% - 5% = -1%).
If the benchmark is a specific segment of the market, the same portfolio could hypothetically underperform the broader market and still have a positive active return relative to the chosen benchmark. This is why it is crucial for investors to know the benchmark a fund uses and why. (For further reading, see: How to Use a Benchmark to Evaluate a Portfolio.)
Chasing Active Returns
Legendary investor Warren Buffet believes most investors would achieve better returns by investing in an index fund as opposed to trying to beat the market. He believes that any active returns fund managers make get eroded by fees. Research from S&P and Dow Jones indices supports Buffet’s thinking. Data revealed that active fund managers who outperform against a benchmark over a one-year period have a less than 50% chance of outperforming it again by the same rate in the second year. The study also found that, even if fund managers had a successful three-year record of generating active returns, they underperformed the benchmark in the following three years.
Many fund managers combine active and passive management to create a core and satellite strategy that maintains core holdings in a diversified index fund to minimize risk while also actively managing a satellite component of the portfolio to try to outperform a benchmark.
Active Return Strategies
Fund managers who are seeking active returns try to detect and exploit short-term price movements by using fundamental and technical analysis. For example, a manager may create a portfolio that consists of stocks that have a low debt-to-equity ratio and pay a dividend yield above 3%. Another manager may buy stocks that have formed an inverse head and shoulders reversal chart pattern. Fund managers also closely follow trading patterns, news, and order flow in their endeavor to achieve active returns.