What is Active Management
Active management is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund's portfolio. Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell. The opposite of active management is passive management, better known as "indexing.”
BREAKING DOWN Active Management
Investors who believe in active management do not follow the efficient market hypothesis. They believe it is possible to profit from the stock market through any number of strategies that aim to identify mispriced securities. Investment companies and fund sponsors believe it's possible to outperform the market and employ professional investment managers to manage one or more of the company's mutual funds. David Einhorn, founder and president of Greenlight Capital, is an example of a well-known active fund manager.
Objective of Active Management
Active management seeks to produce better returns than those of passively managed index funds. For example, a large cap stock fund manager attempts to beat the performance of the Standard & Poor's 500 index. Unfortunately, for a large majority of active managers, this has been difficult to achieve. This phenomenon is simply a reflection of how hard it is, no matter how talented the manager, to beat the market. Actively managed funds typically have higher fees than passively managed funds.
Advantages of Active Management
A fund manager’s expertise, experience, skill and judgment is being utilized when investing in an actively managed fund. For example, a fund manager may have extensive experience in the automotive industry, so as a result, the fund may be able to beat benchmark returns by investing in a select group of car-related stocks that the manager believes are undervalued. Active fund managers have flexibility. There is typically freedom in the stock selection process as performance is not tracked to an index. Actively managed funds allow for benefits in tax management. The ability to buy and sell when deemed necessary makes it possible to offset losing investments with wining investments.
Active Management and Risk
By not being compelled to follow specific benchmarks, active fund managers can manage risk more proficiently. For example, a global banking exchange-traded fund (ETF) may be required to hold a specific number of British banks; the fund is likely to have significantly decreased in value following the shock Brexit result in 2016. Alternatively, an actively managed global banking fund has the ability to reduce or terminate 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 to protect portfolios.
Active Management and Performance
Controversy surrounds the performance of active managers. Whether investors will enjoy superior results through an actively managed fund as opposed to a mechanically traded ETF depends on the person managing the fund and the time period. Over the 10 years ended in 2017, active managers who invest 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 gross-of-fees. 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. (For related reading, see "Passive vs. Active Portfolio Management: What's the Difference?")