What is Active Management?
Active management is the use of human capital to manage a portfolio of funds. Active managers rely on analytical research, personal judgment, and forecasts to make decisions on what securities to buy, hold, or sell.
How Does Active Management Work?
Investors who support active management don’t subscribe to the efficient market hypothesis. They are of the opinion that it’s possible to make profit from the stock market by using any number of trading strategies that intend to spot mispriced securities.
Fund sponsors and investment companies believe it is possible to perform better than the market and also employ professional investment managers who would manage one or more mutual funds of the company. An example of a prominent active fund manager is David Einhorn, Greenlight Capital’s founder and president.
Why Active Management?
Active management provides investors the opportunity to earn superior returns through astute selection of investments.
Active management also enables investors to customize portfolios. For example, active management can:
- Help an investor manage risk, by adjusting portfolio investments to reflect the investor’s risk tolerance.
- Focus on investments that generate dividend or interest income, if an investor seeks a steadier income flow.
- Support implementation of an investor’s tax plan.
- Identify investments that advance an investor’s mission-based goals. For example, an investor may wish to support companies that advance diversity in employment, even if investments in those companies are not the ones with the highest expected financial return in the short term.
On the other hand, compared to passive management, active management generally involves greater costs. Active managers must pay for the resources needed to identify investments through fundamental research, quantitative investing, or other active management approaches.
As a result, the fees charged by active managers are generally higher than those charged by passive managers. In addition, while active management has the potential to generate superior returns, it may not do so consistently. There is considerable debate about whether the results achieved by active management outweigh the higher costs involved.
However, recent research suggests that active management provides a reasonable combination of return and cost.
Objective of Active Management
Active management aims at producing better returns than the passively managed index funds. For instance, a large cap stock fund manager tries to outperform the 500 index of Standard & Poor. Unfortunately, for most of the active managers, it has been very difficult to achieve.
This event is nothing but a reflection of how difficult it is, irrespective of the manager’s talent to outperform the market. Funds that are actively managed usually have higher fees as against those that are passively managed.
Active Management Process
The active management process usually involves three steps:
The planning step involves identifying the investor’s objectives and constraints. It can involve risk and return expectations, liquidity needs, time horizon, tax issues, and legal and regulatory requirements. From these objectives and constraints, an investment policy statement (IPS) can be created. The IPS usually outlines the reporting requirements, rebalancing guidelines, investment communication, manager fees, and investment strategy and style.
Next, active managers need to form a capital market expectation and make forecasts for the risk-and-return profile of the securities to form the basis of the portfolio. Lastly, the strategic asset allocation should be determined with asset class weights.
The execution step involves the implementation of the portfolio with construction and revision. Active managers integrate their investment strategies with the capital market expectations to select specific securities for the overall portfolio. In doing this, active managers optimize the portfolio by combining assets efficiently to achieve certain return and risk objectives.
The feedback step involves managing exposures to investments. It is done by rebalancing the portfolio to ensure that the portfolio is still within the mandate of the IPS. Furthermore, the portfolio’s performance is periodically evaluated by investors to ensure that investment objectives are being met.
Active Management and Risk
By not being forced to follow certain benchmarks, risk can be managed more proficiently by active fund managers. For instance, a global banking exchange-traded fund (ETF) might be needed to hold a certain number of British banks; the fund might have experienced a significant value decrease following the 2016 shock Brexit result.
Alternatively, global banking fund that’s actively managed is capable of reducing or terminating exposure to British banks as a result of heightened risk levels. Active managers are also capable of reducing risk by utilizing different hedging strategies like short selling and utilizing derivatives for portfolio protection.
Advantages of Active Management
An advantage of active management is that a variety of investments and investment strategies can be selected. Some motivations for investors to lean towards active management are the following:
- Investors believe that actively managed funds can outperform the market.
- Investors believe they can pick the most skilled active managers.
- Investors may want to manage volatility differently than the overall market.
- Investors may want to follow a strategy that is in line with their personal investment goals.
- Investors can get exposure to alternative investments that are uncorrelated with the market.
Disadvantages of Active Management
Active management can be a disadvantage if the management makes bad investment choices. Even if active management performs well, it is well documented that most active managers underperform their passive management counterparts.
In addition, as an active management fund becomes very large, it begins to show index-like characteristics to diversify its investments. Lastly, active management requires an infrastructure of managers, analysts, and operations that require compensation, which makes active management more expensive than passive management.