Active Management (Investing) - Explained
What is Active Management?
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Table of ContentsWhat is Active Management?How Does Active Management Work?Objective of Active ManagementAdvantages of Active ManagementActive Management and RiskActive Management and PerformanceAcademic Research on Active Management
What is Active Management?
Active management refers to using a human element, like a single manager, co-managers, or even a team of managers, to actively manage the portfolio of a fund. Active managers depend on forecasts, analytical research, and their personal experience and judgement when making investment decisions on what securities to purchase, hold, and those to sell. Passive management or indexing is the opposite of active management.
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.
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.
Advantages of Active Management
The experience, expertise, judgment, and skill of a fund manager are used when investing in a fund that's actively managed. For instance, a fund manager might be able to outperform benchmark returns simply by having investments in a select group of car-related stocks which the manager considers to be undervalued. Flexibility is one core aspect of active fund managers. In the process of stock selection, there is freedom as performance isn't tracked to an index. Allowance is granted by actively managed funds for benefits in the management of tax. Buying and selling when it's necessary makes it possible to compensate for losing investments with winning ones.
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.
Active Management and Performance
Controversy surrounds active managers' performance. Whether investors would benefit superior results via an actively managed fund as against an ETF that's mechanically traded dependent on the individual managing both the time period and the fund. Over the ten years completed in 2017, active managers that invested in large-cap value stocks had the greatest chance of beating the index, performing better with 1.13% on average each year. Based on a study, 84% of active managers in this group performed better than their benchmark index gross-of-fees. Over the short-term, precisely three years, active managers underperformed the index by a 0.36% average, and over 5 years, they trailed it by 0.22%. An entirely different study showed that for the thirty years completed in 2016, the actively managed fund returned approximately 3.7% annually, as against 10% for passively managed fund returns.
Academic Research on Active Management
- The arithmetic of active management, Sharpe, W. F. (1991). The arithmetic of active management. Financial Analysts Journal, 47(1), 7-9.
- Scale and skill in active management, Pstor, ., Stambaugh, R. F., & Taylor, L. A. (2015). Scale and skill in active management. Journal of Financial Economics, 116(1), 23-45. We empirically analyze the nature of returns to scale in active mutual fund management. We find strong evidence of decreasing returns at the industry level. As the size of the active mutual fund industry increases, a funds ability to outperform passive benchmarks declines. At the fund level, all methods considered indicate decreasing returns, though estimates that avoid econometric biases are insignificant. We also find that the active management industry has become more skilled over time. This upward trend in skill coincides with industry growth, which precludes the skill improvement from boosting fund performance. Finally, we find that performance deteriorates over a typical funds lifetime. This result can also be explained by industry-level decreasing returns to scale.
- Portfolio constraints and the fundamental law of active management, Clarke, R., De Silva, H., & Thorley, S. (2002). Portfolio constraints and the fundamental law of active management. Financial Analysts Journal, 58(5), 48-66.
- On the size of the active management industry, Pstor, L., & Stambaugh, R. F. (2012). On the size of the active management industry. Journal of Political Economy, 120(4), 740-781. We argue that active managements popularity is not puzzling despite the industrys poor track record. Our explanation features decreasing returns to scale: As the industrys size increases, every managers ability to outperform passive benchmarks declines. The poor track record occurred before the growth of indexing modestly reduced the share of active management to its current size. At this size, better performance is expected by investors who believe in decreasing returns to scale. Such beliefs persist because persistence in industry size causes learning about returns to scale to be slow. The industry should shrink only moderately if its underperformance continues.
- Return dispersion and active management, De Silva, H., Sapra, S., & Thorley, S. (2001). Return dispersion and active management. Financial Analysts Journal, 57(5), 29-42
- Active management in mostly efficient markets, Jones, R. C., & Wermers, R. (2011). Active management in mostly efficient markets. Financial Analysts Journal, 67(6), 29-45. This survey of the literature on the value of active management shows that the average active manager does not outperform but that a significant minority of active managers do add value. Further, studies suggest that investors may be able to identify superior active managers (SAMs) in advance by using public information. Investors who can identify SAMs should be able to improve their overall Sharpe ratio by including a meaningful exposure to active strategies.