Active management

Definition

Active management is an investment strategy where a portfolio manager makes specific investment decisions with the aim of outperforming a benchmark index through ongoing buying and selling of assets. This approach contrasts with passive management, where the goal is to mirror the performance of a specific index. Active management involves in-depth research, market analysis, and adjustments to the portfolio based on market conditions.

5 Must Know Facts For Your Next Test

1. Active management aims to generate alpha, which is the excess return of an investment relative to the return of a benchmark index.
2. Portfolio managers who engage in active management typically analyze various factors such as economic trends, company fundamentals, and market sentiment to make informed decisions.
3. This strategy often incurs higher fees due to frequent trading and extensive research compared to passive strategies that simply track an index.
4. Active management can lead to higher potential returns but also comes with increased risks and volatility due to market timing and stock selection.
5. Performance measures like the Sharpe Ratio are used to evaluate the effectiveness of active management by comparing returns against risk taken.

Review Questions

• How does active management differ from passive management in terms of investment strategy and objectives?
  • Active management differs from passive management primarily in its approach to investment strategy. Active managers seek to outperform a benchmark index through strategic buying and selling of assets based on in-depth market research and analysis. In contrast, passive management aims to replicate the performance of a specific index without attempting to beat it, resulting in generally lower costs and less frequent trading.
• Discuss the role of performance measures such as the Sharpe Ratio in evaluating active management strategies.
  • Performance measures like the Sharpe Ratio play a crucial role in evaluating active management strategies by providing insights into risk-adjusted returns. The Sharpe Ratio compares the excess return of an investment relative to its volatility, helping investors determine whether an active manager is generating returns that justify the risks taken. A higher Sharpe Ratio indicates better performance when adjusting for risk, making it a valuable tool for assessing the effectiveness of active management.
• Evaluate the implications of high fees associated with active management on investor returns compared to passive strategies over time.
  • The high fees associated with active management can significantly impact investor returns over time, particularly when considering compounding effects. While active managers may strive to generate higher returns than their benchmarks, these returns can be eroded by fees that are typically much higher than those for passive strategies. As a result, even if an active manager achieves outperformance, net returns for investors may not substantially exceed those from lower-cost passive investments, leading many investors to reconsider their preferences between these two approaches.

Related terms

Benchmark Index: A standard against which the performance of an investment manager or portfolio can be measured, often representing a specific market segment.

Portfolio Manager: A financial professional responsible for making investment decisions and managing a portfolio of assets to achieve specific financial goals.

Sharpe Ratio: A measure used to assess the risk-adjusted return of an investment, indicating how much excess return is received for the extra volatility endured.