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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.
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]
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]
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]
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:
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]
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 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]
Passive management is an investing strategy that tracks a market-weighted index or portfolio. Passive management is most common on the equity market, where index funds track a stock market index, but it is becoming more common in other investment types, including bonds, commodities and hedge funds.
An index fund is a mutual fund or exchange-traded fund (ETF) designed to follow certain preset rules so that it can replicate the performance ("track") of a specified basket of underlying investments. While index providers often emphasize that they are for-profit organizations, index providers have the ability to act as "reluctant regulators" when determining which companies are suitable for an index. Those rules may include tracking prominent indexes like the S&P 500 or the Dow Jones Industrial Average or implementation rules, such as tax-management, tracking error minimization, large block trading or patient/flexible trading strategies that allow for greater tracking error but lower market impact costs. Index funds may also have rules that screen for social and sustainable criteria.
The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.
An exchange-traded fund (ETF) is a type of investment fund that is also an exchange-traded product, i.e., it is traded on stock exchanges. ETFs own financial assets such as stocks, bonds, currencies, debts, futures contracts, and/or commodities such as gold bars. The list of assets that each ETF owns, as well as their weightings, is posted on the website of the issuer daily, or quarterly in the case of active non-transparent ETFs. Many ETFs provide some level of diversification compared to owning an individual stock.
The Vanguard Group, Inc., is an American registered investment advisor based in Malvern, Pennsylvania, with about $7.7 trillion in global assets under management, as of April 2023. It is the largest provider of mutual funds and the second-largest provider of exchange-traded funds (ETFs) in the world after BlackRock's iShares. In addition to mutual funds and ETFs, Vanguard offers brokerage services, educational account services, financial planning, asset management, and trust services. Several mutual funds managed by Vanguard are ranked at the top of the list of US mutual funds by assets under management. Along with BlackRock and State Street, Vanguard is considered to be one of the Big Three index fund managers that play a dominant role in corporate America.
Burton Gordon Malkiel is an American economist, financial executive, and writer most noted for his classic finance book A Random Walk Down Wall Street.
Market timing is the strategy of making buying or selling decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the outlook for an aggregate market rather than for a particular financial asset.
Investment management is the professional asset management of various securities, including shareholdings, bonds, and other assets, such as real estate, to meet specified investment goals for the benefit of investors. Investors may be institutions, such as insurance companies, pension funds, corporations, charities, educational establishments, or private investors, either directly via investment contracts/mandates or via collective investment schemes like mutual funds, exchange-traded funds, or REITs.
Alpha is a measure of the active return on an investment, the performance of that investment compared with a suitable market index. An alpha of 1% means the investment's return on investment over a selected period of time was 1% better than the market during that same period; a negative alpha means the investment underperformed the market. Alpha, along with beta, is one of two key coefficients in the capital asset pricing model used in modern portfolio theory and is closely related to other important quantities such as standard deviation, R-squared and the Sharpe ratio.
Buy and hold, also called position trading, is an investment strategy whereby an investor buys financial assets or non-financial assets such as real estate, to hold them long term, with the goal of realizing price appreciation, despite volatility.
Capital Group is an American financial services company. It ranks among the world's oldest and largest investment management organizations, with over $2.6 trillion in assets under management. Founded in Los Angeles, California in 1931, it is privately held and has offices around the globe in the Americas, Asia, Australia and Europe.
Core & Satellite Portfolio Management is an investment strategy that incorporates traditional fixed-income and equity-based securities, known as the "core" portion of the portfolio, with a percentage of selected individual securities in the fixed-income and equity-based side of the port folio known as the "satellite" portion.
A Random Walk Down Wall Street, written by Burton Gordon Malkiel, a Princeton University economist, is a book on the subject of stock markets which popularized the random walk hypothesis. Malkiel argues that asset prices typically exhibit signs of a random walk, and thus one cannot consistently outperform market averages. The book is frequently cited by those in favor of the efficient-market hypothesis. As of 2023, there have been 13 editions. After the 12th edition, over 1.5 million copies had been sold A practical popularization is The Random Walk Guide to Investing: Ten Rules for Financial Success.
Tactical asset allocation (TAA) is a dynamic investment strategy that actively adjusts a portfolio's asset allocation. The goal of a TAA strategy is to improve the risk-adjusted returns of passive management investing.
Relative return is a measure of the return of an investment portfolio relative to a theoretical passive reference portfolio or benchmark.
A portfolio manager (PM) is a professional responsible for making investment decisions and carrying out investment activities on behalf of vested individuals or institutions. Clients invest their money into the PM's investment policy for future growth, such as a retirement fund, endowment fund, or education fund. PMs work with a team of analysts and researchers and are responsible for establishing an investment strategy, selecting appropriate investments, and allocating each investment properly towards an investment fund or asset management vehicle.
In finance, a stock index, or stock market index, is an index that measures the performance of a stock market, or of a subset of a stock market. It helps investors compare current stock price levels with past prices to calculate market performance.
An investment fund is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group such as reducing the risks of the investment by a significant percentage. These advantages include an ability to:
Index Fund Advisors (IFA) is a registered investment advisor (RIA) headquartered in Irvine, California, with representatives in several locations across the United States. The company was founded on March 5, 1999, by Mark T. Hebner, former president of nuclear pharmacy company Syncor International, with the goal of providing online automated investment adviser services, with a personal touch as needed, while also providing educational material regarding investing to the general public through the website IFA.com.
Style drift occurs when a mutual fund's actual and declared investment style differs. A mutual fund’s declared investment style can be found in the fund prospectus which investors commonly rely upon to aid their investment decisions. For most investors, they assumed that mutual fund managers will invest according to the advertised guidelines, this is however, not the case for a fund with style drift. Style drift is commonplace in today’s mutual fund industry, making no distinction between developed and developing markets according to studies in the United States by Brown and Goetzmann (1997) and in China as reported in Sina Finance.
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