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Active management (also called active investing) is an approach to investing. In an actively managed portfolio of investments, the investor selects the investments that make up the portfolio. Active management is often compared to passive management or index investing.

Approach

Active investors aim to generate additional returns by buying and selling investments advantageously. They look for investments where the market price differs from the underlying value and will buy investments when the market price is too low and sell investments when the market price is too high.[1]

Active investors use various techniques to identify mispriced investments. Two common techniques are:

Active management may be used in all aspects of investing. It can be used for:

Active investors have many goals. Many active investors are seeking a higher return. Other goals of active management can be managing risk, minimizing taxes, increasing dividend or interest income, or achieving non-financial goals, such as advancing social or environmental causes.[3]

Theory

Active investors seek to profit from market inefficiencies by purchasing investments that are undervalued or by selling securities that are overvalued.

Therefore, active investors do not agree with the strong and semi-strong forms of the efficient-market hypothesis (EMH). In the stronger forms of the EMH, all public information has been incorporated into stock prices, which makes it impossible to outperform.

Active management is consistent with the weak form of the EMH, which argues that prices reflect all information related to price changes in the past. Under the weak form the EMH, fundamental analysis can be profitable, though technical analysis cannot be profitable.[4]

There are two well-known theories that the balance between active management and passive management:

With regard to empirical support for both theories, a 2021 paper finds that "the research findings seem to accord more with a Grossman and Stiglitz equilibrium than Sharpe's proposition." The paper also notes that "the underlying logic [of Sharpe's proposition] is not as water-tight as it may seem."[7]

Performance

Many writers on finance argue that actively managed funds consistently underperform, and, as a result, they recommend investing in index funds.[8][9] This negative assessment is controversial and has been challenged.[10]

There are two reports that regularly evaluate the performance of actively managed funds. The first is the SPIVA report (Standard & Poors Index Versus Active), which compares actively managed funds to an index.[11] The second is the Morningstar Active-Passive Barometer, which compares actively managed funds to passively managed funds.[12] Both reports are published semi-annually and use a similar approach, namely:

These reports have often concluded that the performance of actively-managed funds is disappointing. For example, the SPIVA U.S. Year-End 2021 report finds that "79.6% of domestic equity funds lagged the S&P Composite 1500 in 2021."[13] Results vary by category, with some categories experiencing a higher percentage of outperformance.

One analysis of the methodology in these reports concludes that it results in an overly negative assessment of active managers' skill, especially over longer periods.[14]

SPIVA publishes two additional reports comparing the performance of actively managed funds to a passive benchmark: a risk-adjusted performance analysis[15] and a performance "persistence" analysis. The persistence analysis calculates the percentage of actively managed funds that have outperformed a passive benchmark in consecutive periods.[16]

The persistence report is controversial. One critic has called persistence "overrated" and a "red herring".[17]

Many academic studies have concluded that actively managed US equity funds underperform after fees. Well known studies include Jensen (1968),[18] Malkiel (1995),[19] Elton, Gruber, and Blake (1996),[20] and Fama and French (2010).[21] However, Berk and van Binsbergen (2015) find that dollar-weighted returns are consistent with the Grossman-Stiglitz equilibrium.[22]

Advantages of active management

Active management provides investors with the potential to earn higher returns. Active investors can have expertise that enables them to select investments that do better than the market as a whole.

Active management is more flexible than passive management. This flexibility has multiple benefits for investors:

Disadvantages of active management

The most obvious disadvantage of active management is that investment returns may be lower rather than higher.

In addition, active management is generally more expensive than passive management. The higher costs are a result of the resources needed to evaluate investments and determine whether they should be bought or sold.

Finally, active management is often less tax-efficient than passive management, because it may buy and sell investments more frequently and generate capital gains as a result.[24][25] However, active managers can be tax-efficient.[26]

Use of active management

Active management is the most common investment approach. For example, at the end of 2020, $14.8 trillion of U.S. mutual fund assets were actively managed, while only $4.8 trillion were passively managed.[27]

However, active management does not dominate in every category. For example, at the end of 2020, only $0.2 trillion of the $5.3 trillion in assets in 1940 Act exchange-traded funds were actively managed.[27]

Active Management and the Markets

Active management plays an important role in maintaining market efficiency. Through the buying and selling of investments, active managers establish the market prices for securities. Therefore, an increase in the amount of active management will lead to greater market efficiency.[28] Market efficiency is beneficial because it encourages broad investor participation in the market, it makes it easier for investors to diversity risk, and it encourages capital formation.[29]

Active management also plays an important role in capital formation, because actively-managed portfolios are the buyers of initial public offerings of securities.[29]

See also

References

  1. ^ a b "Active Management Definition". Investopedia. Retrieved 2022-02-28.
  2. ^ Pozen, Robert C. (2015). The fund industry : how your money is managed. Theresa Hamacher (2nd ed.). Hoboken. p. 14141. ISBN 978-1-118-92996-4. OCLC 890793124.((cite book)): CS1 maint: location missing publisher (link)
  3. ^ "What is Active Management? - Investment Adviser Association". 2022-02-03. Retrieved 2022-02-28.
  4. ^ Malkiel, Burton (2012). "4: The Efficient-Market Hypothesis and the Financial Crisis" (PDF). In Blinder, Alan S.; Lo, Andrew W.; Solow, Robert M. (eds.). Rethinking the Financial Crisis. Russell Sage Foundation. pp. 75–98.
  5. ^ Grossman, Sanford J.; Stiglitz, Joseph E. (1980). "On the Impossibility of Informationally Efficient Markets". The American Economic Review. 70 (3): 393–408. ISSN 0002-8282. JSTOR 1805228.
  6. ^ Sharpe, William F. (1991). "The Arithmetic of Active Management". Financial Analysts Journal. 47 (1): 7–9. doi:10.2469/faj.v47.n1.7. ISSN 0015-198X. JSTOR 4479386. S2CID 55933931.
  7. ^ Warren, Geoff (2020-01-02). "Is Active Investing Doomed as a Negative Sum Game? A Critical Review". Alpha Architect. Retrieved 2023-01-25.
  8. ^ "Mutual Funds That Consistently Beat the Market? Not One of 2,132". New York Times. 2022-12-02. Retrieved 2023-08-21.
  9. ^ Choi, James J. (2022). "Popular Personal Financial Advice versus the Professors". Journal of Economic Perspectives. 36 (4): 167–192. doi:10.1257/jep.36.4.167. ISSN 0895-3309.
  10. ^ Cremers, K.J. Martijn; Fulkerson, Jon A.; Riley, Timothy B. (2019-10-02). "Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds". Financial Analysts Journal. 75 (4): 8–35. doi:10.1080/0015198X.2019.1628555. ISSN 0015-198X.
  11. ^ "SPIVA | S&P Dow Jones Indices". www.spglobal.com. Retrieved 2022-03-25.
  12. ^ "Download Morningstar's Active/Passive Barometer | Morningstar". Morningstar, Inc. Retrieved 2022-03-25.
  13. ^ "SPIVA U.S. Year-End 2021 - SPIVA | S&P Dow Jones Indices". www.spglobal.com. Retrieved 2022-03-25.
  14. ^ Rethinking Survivorship Bias in Active/Passive Comparisons (PDF). Active Managers Council. 2020.
  15. ^ "Risk-Adjusted SPIVA® Scorecard: Year-End 2020 - SPIVA | S&P Dow Jones Indices". www.spglobal.com. Retrieved 2022-03-25.
  16. ^ "U.S. Persistence Scorecard Mid-Year 2021 - SPIVA | S&P Dow Jones Indices". www.spglobal.com. Retrieved 2022-03-25.
  17. ^ "Quit Chasing Unicorns: Consistent Fund Performance Is Overrated". Morningstar, Inc. 2018-12-18. Retrieved 2022-03-25.
  18. ^ Jensen, Michael C. (May 1968). "The Performance of Mutual Funds in the Period 1945-1964". The Journal of Finance. 23 (2): 389–416. doi:10.1111/j.1540-6261.1968.tb00815.x. ISSN 0022-1082.
  19. ^ Malkiel, Burton G. (June 1995). "Returns from Investing in Equity Mutual Funds 1971 to 1991". The Journal of Finance. 50 (2): 549–572. doi:10.1111/j.1540-6261.1995.tb04795.x. ISSN 0022-1082.
  20. ^ Elton, Edwin J.; Gruber, Martin J.; Blake, Christopher R. (January 1996). "The Persistence of Risk-Adjusted Mutual Fund Performance". The Journal of Business. 69 (2): 133. doi:10.1086/209685. ISSN 0021-9398. S2CID 154218629.
  21. ^ Fama, Eugene F.; French, Kenneth R. (2010-09-21). "Luck versus Skill in the Cross-Section of Mutual Fund Returns". The Journal of Finance. 65 (5): 1915–1947. doi:10.1111/j.1540-6261.2010.01598.x. ISSN 0022-1082. S2CID 14275087.
  22. ^ Berk, Jonathan B.; van Binsbergen, Jules H. (2015-10-01). "Measuring skill in the mutual fund industry". Journal of Financial Economics. 118 (1): 1–20. doi:10.1016/j.jfineco.2015.05.002. ISSN 0304-405X.
  23. ^ "What is Active Management? - Investment Adviser Association". 2022-02-03. Retrieved 2022-02-28.
  24. ^ Saunders, Laura (October 21, 2016). "How Passive Funds Trim Your Tax Bill". The Wall Street Journal. Retrieved September 5, 2023.
  25. ^ Arnott, Robert D.; Berkin, Andrew L.; Ye, Jia (2000-07-31). "How Well Have Taxable Investors Been Served in the 1980s and 1990s?". The Journal of Portfolio Management. 26 (4): 84–93. doi:10.3905/jpm.2000.319766. ISSN 0095-4918. S2CID 155080167.
  26. ^ "Mythbusted: Active ETFs can be as tax efficient as passive ETFs". Capital Group. March 3, 2023.
  27. ^ a b "2021 Investment Company Fact Book". www.icifactbook.org. Retrieved 2021-12-31.
  28. ^ Wermers, Russ (2021). "Active Investing and the Efficiency of Security Markets". Journal of Investment Management. 19 (1).
  29. ^ a b "Active Management and Market Efficiency: A Summary of the Academic Literature" (PDF). Archived (PDF) from the original on 2020-10-05.

Further reading