Active management
Encyclopedia
Active management refers to a portfolio management
strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index. Investors or mutual funds that do not aspire to create a return in excess of a benchmark index will often invest in an index fund
that replicates as closely as possible the investment weighting and returns of that index; this is called passive management. Active management is the opposite of passive management
, because in passive management the manager does not seek to outperform the benchmark index.
(stocks etc.) 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 (or risk) 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(s). These include quantitative measures such as price/earnings ratio P/E ratio
s and PEG ratios, sector investments that attempt to anticipate long-term macroeconomic trends (such as a focus on energy or housing stocks), 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 merger arbitrage, short positions, option
writing, and asset allocation
.
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 (See the term R2
or R-squared to determine correlation
s) 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.
The Standard & Poor's Index Versus Active (SPIVA) quarterly scorecards demonstrate that only a minority of actively managed mutual funds have gains better than the Standard & Poor's (S&P) 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 outperformers and underperformers, but this group that outperforms is also the same group that outperforms passively managed portfoloios 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 underperform compared to the benchmark index, even though the securities that comprise the mutual fund are outperforming the benchmark, because indexes themselves have no expenses whatsoever. However, since many investors are not satisfied with a benchmark return a demand for actively-managed continues to exist. 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 whole. These kinds of sectors might include a sector such as small cap
stocks.
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 market
s.
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 (management fees) for the mutual fund company.
However, the problem with this business model where the manager's money is invested plus he receives a fee dependent on the performance of the managed vehicle was observed in 2008. It was heralded as the perfect solution as it combines the interest of the client with the ones of the manager. Many money managers who had their own money invested in these vehicles saw their income being reduced to pure management fees rather than performance fees. In some cases the losses incurred by their funds had been so big that it was almost impossible to recoup these losses over the next couple of years. Hence they decided to close their funds. By doing that they robbed the investors of the chance that their investments recover.
Investment management
Investment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index. Investors or mutual funds that do not aspire to create a return in excess of a benchmark index will often invest in an index fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
that replicates as closely as possible the investment weighting and returns of that index; this is called passive management. Active management is the opposite of passive management
Passive management
Passive management is a financial strategy in which an investor invests in accordance with a pre-determined strategy that doesn't entail any forecasting...
, because in passive management the manager does not seek to outperform the benchmark index.
Concept
Ideally, the active manager exploits market inefficiencies by purchasing securitiesSecurity (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
(stocks etc.) that are undervalued or by short selling
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
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 (or risk) 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(s). These include quantitative measures such as price/earnings ratio P/E ratio
P/E ratio
The P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...
s and PEG ratios, sector investments that attempt to anticipate long-term macroeconomic trends (such as a focus on energy or housing stocks), 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 merger arbitrage, short positions, option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
writing, and asset allocation
Asset allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
.
Performance
The effectiveness of an actively-managed investment portfolio obviously 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.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 (See the term R2
Coefficient of determination
In statistics, the coefficient of determination R2 is used in the context of statistical models whose main purpose is the prediction of future outcomes on the basis of other related information. It is the proportion of variability in a data set that is accounted for by the statistical model...
or R-squared to determine correlation
Correlation
In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....
s) 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.
The Standard & Poor's Index Versus Active (SPIVA) quarterly scorecards demonstrate that only a minority of actively managed mutual funds have gains better than the Standard & Poor's (S&P) 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 outperformers and underperformers, but this group that outperforms is also the same group that outperforms passively managed portfoloios 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 underperform compared to the benchmark index, even though the securities that comprise the mutual fund are outperforming the benchmark, because indexes themselves have no expenses whatsoever. However, since many investors are not satisfied with a benchmark return a demand for actively-managed continues to exist. 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 whole. These kinds of sectors might include a sector such as small cap
Market capitalization
Market capitalization is a measurement of the value of the ownership interest that shareholders hold in a business enterprise. It is equal to the share price times the number of shares outstanding of a publicly traded company...
stocks.
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:- They may be skeptical of the efficient-market hypothesis, or believe that some market segments are less efficient in creating profits than others.
- They may want to manage volatility by investing in less-risky, high-quality companies rather than in the market as a whole, even at the cost of slightly lower returns.
- Conversely, some investors may want to take on additional risk in exchange for the opportunity of obtaining higher-than-market returns.
- Investments that are not highly correlated to the market are useful as a portfolio diversifier and may reduce overall portfolio volatility.
- Some investors may wish to follow a strategy that avoids or underweights certain industries compared to the market as a whole, and may find an actively-managed fund more in line with their particular investment goals. (For instance, an employee of a high-technology growth company who receives company stock or stock options as a benefit might prefer not to have additional funds invested in the same industry.)
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
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
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
Emerging markets
Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. Based on data from 2006, there are around 28 emerging markets in the world . The economies of China and India are considered to be the largest...
has been recommended by Burton Malkiel
Burton Malkiel
Burton Gordon Malkiel is an American economist and writer, most famous for his classic finance book A Random Walk Down Wall Street...
, a proponent of the efficient market theory who normally considers index funds to be superior to active management in developed market
Developed market
In investing, developed markets are those countries that are thought to be the most developed and therefore less risky.-FTSE Group's list:FTSE Group, a provider of economic and financial data, assigns the market status of countries as Developed, Advanced Emerging, Secondary Emerging or Frontier on...
s.
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. The fees associated with active management are also higher than those associated with passive management, even if frequent trading is not present. Those who are considering investing in an actively-managed mutual fund should evaluate the fund's prospectusProspectus (finance)
In finance, a prospectus is a document that describes a financial security for potential buyers. A prospectus commonly provides investors with material information about mutual funds, stocks, bonds and other investments, such as a description of the company's business, financial statements,...
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 (management fees) 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(s) 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.However, the problem with this business model where the manager's money is invested plus he receives a fee dependent on the performance of the managed vehicle was observed in 2008. It was heralded as the perfect solution as it combines the interest of the client with the ones of the manager. Many money managers who had their own money invested in these vehicles saw their income being reduced to pure management fees rather than performance fees. In some cases the losses incurred by their funds had been so big that it was almost impossible to recoup these losses over the next couple of years. Hence they decided to close their funds. By doing that they robbed the investors of the chance that their investments recover.
Books explaining why active management is very difficult
- Burton G. Malkiel, A Random Walk Down Wall StreetA Random Walk Down Wall StreetA Random Walk Down Wall Street, written by Burton Malkiel, a Princeton economist, is an influential book on the subject of stock markets which introduced the random walk hypothesis. Malkiel argues that asset prices typically exhibit signs of random walk and that one cannot consistently outperform...
, W. W. Norton, 1996, ISBN 0-393-03888-2 - John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
- Mark T. Hebner, Index Funds: The 12-Step Program for Active Investors, IFA Publishing, 2007, ISBN 0-9768023-0-9
External links
- Article: Do Active Mutual Fund Managers Have An Inherent Conflict of Interest?
- The Arithmetic of Active Management, where William F. Sharpe demonstrates that passive management will always outperform active management on average.
- National Association of Active Investment Managers
- A Sanity-Saving Retirement Stock Portfolio