Active management
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Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming a benchmark index.
Ideally, the manager exploits market inefficiencies by purchasing securities that are undervalued, and/or (less frequently), short selling securities that are overvalued. Depending on the goals of the specific investment portfolio or mutual fund, active management may also strive to achieve a goal of less volatility or risk than the benchmark index instead of, or in addition to, greater long-term return
Active management is the opposite of passive management, in which the manager does not seek to outperform the benchmark index.
Active portfolio managers may use a variety of factors and strategies to construct their portfolio. These include quantitative measures such as P/E ratios and PEG ratios, sector bets that attempt to anticipate long-term macroeconomic trends (such as a focus on energy or housing stocks), and purchasing stocks of companies that are temporarily out-of-favor or selling at a discount to their intrinsic value. Some actively managed funds also pursue strategies such as merger arbitrage, short positions, option writing, and asset allocation.
The effectiveness of an actively-managed investment portfolio obviously depends on the skill of the manager and research staff. In reality, the majority of actively managed collective investment schemes rarely outperform their index counterparts over long periods of time, assuming that they are benchmarked correctly. For example, the Standard & Poor's Index Versus Active (SPIVA) quarterly scorecards demonstrate that only a minority of actively managed mutual funds usually beat Standard & Poor's various index benchmarks. As the time period for comparison increases, this minority percentage tends to shrink even more. [1]
When all expenses are taken into account, one might actually see underperformance, even if the securities outperform the market. However, if not for active management, passive management would become a gamble, thus the incentives for active management will aways exist. In addition, many investors find active management an attractive strategy within market segments that are less likely to be fully efficient, such as investments in small cap stocks.
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[edit] Advantages of active management
The primary attraction of active management is that it allows selection of investments that do not echo those of the market as a whole. Investors may have a variety of motivations for following such a strategy:
- They may be skeptical of the efficient market theory, or believe that some market segments are less efficient than others.
- They may want to manage volatility by investing in less-risky, high-quality companies rather than in the market as a whole, even at the cost of slightly lower returns.
- Conversely, some investors may want to take on additional risk for the chance of higher-than-market returns.
- Investments that are not highly correlated to the market are useful as a portfolio diversifier.
- Some investors may wish to follow a strategy that avoids or underweights certain industries compared to the market as a whole, and may find an actively-managed fund more in line with their particular investment goals. (For instance, an employee of a high-technology growth company who receives company stock or stock options as a benefit might prefer not to tie up their other assets in the same industry.)
Several of the actively-managed mutual funds with strong long-term records invest in value stocks. Passively-managed funds that track broad market indices such as the S&P 500 have money invested in both growth and value stocks.
The use of managed funds in certain emerging markets has been recommended by Burton Malkiel, a proponent of the efficient market theory who normally considers index funds to be superior to active management in developed markets.[1]
[edit] Disadvantages of active management
The most obvious disadvantage of active management is that the fund manager may make bad investment choices or follow an unsound theory in managing the portfolio. The fees associated with active management are also higher than those associated with passive management, even if frequent trading is not present. Those who are considering investing in an actively-managed mutual fund should evaluate the fund's prospectus carefully. The majority of actively managed large- and mid-cap stock funds in United States fail to outperform a passive stock index in recent decades.[2]
Active fund management strategies that involve frequent trading generate higher transaction costs which cut into the fund's return. In addition, the short-term capital gains resulting from frequent trades have an unfavorable tax treatment when such funds are held in a taxable account.
When the asset base of an actively-managed fund becomes too large, it begins to take on index-like characteristics because it must invest in an increasingly diverse set of investments instead of only those which represent the fund manager's best ideas. Many mutual fund companies close their funds before they reach this point, but there is potential for conflict of interest between the fund manager and shareholders because of the additional management fees that can be collected by keeping the fund open.
[edit] Real active management
Equity fund managers usually do not have board members at the firms in which they have an equity stake, and they do virtually nothing about the future performance of the firm. So buying and selling equity is not active management of the companies; it is just an active transaction of equity in the fund.
Real active management is done by the people that work at the company, every employee and manager. Private-equity is often real active management since a privately owned company have a small number of owners and usually have just one owner that make strategy decisions at the board level.
[edit] See also
[edit] References
- ^ Burton Malkiel. Investment Opportunities in China. July 16, 2007. (46:28 mark)
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This article does not cite any references or sources. (September 2007) Please help improve this article by adding citations to reliable sources. Unverifiable material may be challenged and removed. |
Books explaining why active management is very difficult:
- Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2
- John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
- Mark T. Hebner, Index Funds: The 12-Step Program for Active Investors, IFA Publishing, 2007, ISBN 0-976-80230-9
[edit] External links
- A system to rank and discover the best active fund managers
- Article: Do Active Mutual Fund Managers Have An Inherent Conflict of Interest?
- The Arithmetic of Active Management, where William F. Sharpe demonstrates that passive management will always outperform active management on average.
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