Active management
Active management is an investment management approach in which a portfolio manager or investment team makes deliberate investment decisions with the objective of achieving returns different from, and typically higher than, those of a specified benchmark. Active management may involve security selection, asset allocation, sector allocation, market timing, or other investment decisions based on financial analysis, economic research, valuation models, and market expectations.
Active management is commonly used across asset classes, including equities, fixed-income securities, commodities, and alternative investments. It contrasts with Passive management, which generally seeks to replicate the performance of a market index or other benchmark rather than make investments primarily to outperform it.
The effectiveness of active management depends on the ability of portfolio managers to identify investment opportunities, manage risk, control costs, and make decisions that generate sufficient additional returns to justify the associated expenses.
Objectives
The principal objectives of active management are to:
- outperform a specified benchmark;
- identify undervalued or attractive investments;
- manage portfolio risk;
- exploit market inefficiencies;
- adjust portfolio exposure to changing market conditions;
- generate alpha.
The specific objectives depend on the investment mandate and strategy.
Methods
Active managers may use several investment techniques, including:
- Fundamental analysis;
- Technical analysis;
- Quantitative analysis;
- security selection;
- sector allocation;
- geographic allocation;
- market timing;
- factor-based strategies.
Managers may combine several approaches within a single portfolio.
Security selection
Security selection involves identifying individual securities that the portfolio manager believes offer attractive risk-adjusted return potential.
For example, an equity manager may evaluate a company's financial statements, competitive position, valuation, management quality, and growth prospects before deciding whether to purchase or sell its shares.
Asset allocation
Active management may involve changing allocations among asset classes in response to changes in economic conditions, valuations, interest rates, or market expectations.
A portfolio manager may increase exposure to equities during periods considered favorable for economic growth or reduce exposure when perceived risks increase.
Market timing
Market timing involves adjusting investment positions based on expectations regarding future market movements.
Active managers may increase or decrease exposure to particular securities, sectors, markets, or asset classes in an attempt to benefit from anticipated changes in prices.
Risk management
Risk management is an important component of active management.
Managers may control risk through:
- diversification;
- position limits;
- sector limits;
- hedging;
- asset allocation;
- cash management;
- portfolio monitoring.
Risk management seeks to limit losses while maintaining exposure to opportunities identified by the investment strategy.
Performance measurement
Active management is generally evaluated relative to an appropriate benchmark.
A common measure is alpha, which represents the portion of investment performance not explained by exposure to systematic market risk under a specified analytical model.
Other measures may include:
- Sharpe ratio;
- Information ratio;
- tracking error;
- maximum drawdown;
- benchmark-relative return.
Costs
Active management generally involves higher costs than passive management because of research, portfolio management, trading, analysis, and other operational activities.
Transaction costs, management fees, taxes, and market impact can reduce investment returns and therefore affect the ability of an active strategy to outperform its benchmark.
Relationship with portfolio management
Portfolio management provides the broader framework within which active management is implemented.
Active portfolio managers make decisions concerning security selection, asset allocation, risk management, and portfolio construction in accordance with a defined investment mandate.
Relationship with passive management
Passive management generally seeks to track a benchmark rather than systematically outperform it.
Active management differs by allowing the portfolio manager to deliberately deviate from the benchmark in pursuit of additional returns or other investment objectives.
Relationship with investment management
Active management is one of the principal approaches within Investment management.
It requires continuous analysis and decision-making regarding portfolio holdings, market conditions, risk exposures, and investment opportunities.
Example
Suppose an equity fund uses the S&P 500 as its benchmark.
If the portfolio manager believes that certain technology companies are undervalued, the manager may assign those companies a higher portfolio weight than their weights in the S&P 500.
The resulting portfolio therefore differs from the benchmark. If the selected investments perform sufficiently well, the portfolio may generate returns above the benchmark after accounting for costs.
Applications
Active management is widely used in:
- mutual funds;
- hedge funds;
- pension funds;
- institutional portfolios;
- private wealth management;
- equity portfolios;
- fixed-income portfolios;
- alternative investment strategies.
Advantages
Active management provides flexibility to respond to changing market conditions and allows managers to select securities, sectors, and asset classes based on investment research and expectations.
It may also provide opportunities to exploit market inefficiencies, manage downside risk, and pursue returns above a benchmark.
Limitations
Active management does not guarantee outperformance. Investment decisions may be incorrect, market conditions may change unexpectedly, and the additional costs associated with research and trading may reduce returns.
Persistent outperformance after fees can be difficult to achieve, particularly in highly competitive and liquid markets.
Importance
Active management is a fundamental investment approach in which portfolio managers use research, analysis, and discretionary investment decisions to seek returns different from or higher than those of a benchmark. It plays an important role in portfolio management by providing flexibility in security selection, asset allocation, and risk management, while also introducing additional costs and the risk of underperformance.