Active Investing - Explained
What is Active Investing?
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Table of ContentsWhat is Active Investing?How Does Active Investing Work?Limitations of Active InvestingAcademic Research on Active Investing
What is Active Investing?
Active investing is an investment technique which involves the investor engaging in ongoing buying and selling. Active investors buy investments and constantly monitor their activity to capitalize on profitable conditions.
How Does Active Investing Work?
Active investing is greatly involved. Unlike passive investors that invest in stock once they believe in its long-term appreciation potential, active investors usually check their stocks' price movements many times each day. Typically, active investors want short-term profits. Smart beta exchange-traded funds are an economical way for investors to capitalize on active investing by thinking of other factors instead of just tracking a benchmark index, like choosing a portfolio solely because of company earnings or some other fundamental approach. Risk management: active investing makes it possible for money managers to modify the portfolios of investors to match the predominant market conditions. For instance, during the 2008 financial crisis peak, investment managers could've improved portfolio exposure to the financial sector in order to reduce the risk of their clients in the market. Short-term opportunities: active investing can be utilized by investors to capitalize on short-term trading opportunities. Traders can utilize swing trading strategies for trading market ranges or for capitalizing on momentum. In swing trading, positions are usually held between 2 and 6 days but might span for up to two weeks. Most times, stock prices oscillate, thus creating various short-term trading opportunities. Outcomes: active investing makes it possible for money managers to meet their clients' specific needs, like providing retirement income, diversification, or a targeted investment return. For example, a hedge fund manager may utilize an active long or short strategy in a bid to deliver an absolute return which isn't comparable to a benchmark or other measure. (For more details, check out the Q&A: What is the difference between relative and absolute return?)
Limitations of Active Investing
Cost: due to the possibility of many transactions, active investing can be expensive. If an investor continuously buys and sells stocks, then commissions may have a major impact on the overall investment return. Investors who decide to invest sigh an active investment manager, like a hedge fund, must pay a management fee, irrespective of how successful the fund is in its performance. Active management fees can have a 0.10%-2% range of assets under management (AUM). Active money managers might also charge a 10%-20% performance fee of the profit they generate. Minimum investment amounts: often times, active funds set minimum investment thresholds for prospective investors. For instance, a hedge fund may need new investors to have a $250,000 starting investment.
Academic Research on Active Investing
- Presidential address: The cost of active investing, French, K. R. (2008). Presidential address: The cost of active investing. The Journal of Finance, 63(4), 1537-1573. I compare the fees, expenses, and trading costs society pays to invest in the U.S. stock market with an estimate of what would be paid if everyone invested passively. Averaging over 19802006, I find investors spend 0.67% of the aggregate value of the market each year searching for superior returns. Society's capitalized cost of price discovery is at least 10% of the current market cap. Under reasonable assumptions, the typical investor would increase his average annual return by 67 basis points over the 19802006 period if he switched to a passive market portfolio.
- Facebook finance: How social interaction propagates active investing, Heimer, R. Z., & Simon, D. (2012, February). Facebook finance: How social interaction propagates active investing. In AFA 2013 San Diego Meetings. This research presents empirical evidence of the propagation of active investing strategies within a network of retail traders. We provide support for a model by Hirshleifer (2010) which demonstrates that social interactions contribute to the growth of active strategies. Using new proprietary data compiled through a social network for foreign exchange traders, we verify key assumptions of the model that the willingness of traders to contact other traders is increasing in their short-term returns while trading intensity is increasing in the performance of those from whom they receive communications.
- Self-enhancing transmission bias and active investing, Han, B., & Hirshleifer, D. A. (2015). Self-enhancing transmission bias and active investing. Individual investors often invest actively and lose thereby. Social interaction seems to exacerbate this tendency. In the model here, senders' propensity to discuss their strategies' returns, and receivers' propensity to be converted, are increasing in sender return. The rate of conversion of investors to active investing is convex in sender return. Unconditionally, active strategies (high variance, skewness, and personal involvement) dominate the population unless the mean return penalty to active investing is too large. Thus, the model can explain overvaluation of 'active' asset characteristics even when investors have no inherent preference over them.
- Self-enhancing transmission bias and active investing, Han, B., & Hirshleifer, D. (2012). Self-enhancing transmission bias and active investing. Available at SSRN, 2032697.
- The value of active investing: can active institutional investors remove excess comovement of stock returns?, Ye, P. (2012). The value of active investing: can active institutional investors remove excess comovement of stock returns?. Journal of Financial and Quantitative Analysis, 47(3), 667-688. This study uses Cremers and Petajistos (2009) method to separate active institutional investors from passive ones and shows that active investors can alleviate the anomalous comovement of stock returns. Focusing on 2 events linked to the excess comovement anomaly, Standard & Poors 500 Index additions and stock splits, I find that if an event stock has more active institutional investors trading in the post-event period, the anomalous comovement effect disappears. In contrast, if an event stock experiences a massive exit of active investors, this anomaly persists. The exit of active institutional investors also results in a strong price synchronicity effect.
- Active risk-based investing, Jurczenko, E., & Teiletche, J. (2015). Active risk-based investing. Available at SSRN 2592904. Risk-based investment solutions are seen as incorporating no views. In this article, we propose an analytical framework that allows the introduction of explicit active views on expected asset returns in risk-based solutions. Starting from a Black-Litterman approach, we derive closed-form formulas for the weights of the active risk-based portfolio, and identify their main determinants. We discuss implementation aspects and show how our framework is related to other popular active investing methodologies. We illustrate the methodology with a multi-asset portfolio allocation problem using views based on macroeconomic regimes over the period 1974-2013.