Active management

Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index or target return. In passive management, investors expect a return that closely replicates the investment weighting and returns of a benchmark index and will often invest in an index fund. Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index or target return. In passive management, investors expect a return that closely replicates the investment weighting and returns of a benchmark index and will often invest in an index fund. Ideally, the active manager exploits market inefficiencies by purchasing securities (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 ratios 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 risk arbitrage, short positions, option writing, and asset allocation. Using the concept of asset allocation, researchers divide active management into two parts; one part is selecting securities within an asset class, while the other part is selecting between asset classes (often called tactical asset allocation). For example, a large-cap U.S. stock fund might decide which large-cap U.S. stocks to include in the fund. Then those stocks will do better or worse than the class in general. Another fund may choose to move money between bonds and stocks, or some country versus a different one, et cetera. Then one class will do worse or better than the other class. The case where a fund changes its class of assets is called style drift. An example would be where a fund that normally invests in government bonds switches into stocks of small companies in emerging markets. Although this gives the most discretion to the manager, it also makes it difficult for the investor (portfolio manager) if he also has a target of asset allocation. The effectiveness of an actively managed investment portfolio 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 or R-squared to determine correlations) 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 out-performers and under-performers, but this group that outperforms is also the same group that outperforms passively managed portfolios over long periods of time.