Active management

Definition

Active management is an investment strategy where a portfolio manager or team makes specific investment decisions in an attempt to outperform a benchmark index. This approach contrasts with passive management, which seeks to replicate the performance of a market index. Active management involves research, analysis, and judgment to select securities that are expected to deliver higher returns than the overall market.

5 Must Know Facts For Your Next Test

1. Active management typically involves higher fees compared to passive management due to the costs associated with research and trading.
2. Success in active management depends heavily on the skills and expertise of the portfolio managers, as well as their ability to anticipate market trends.
3. Studies show that a majority of active managers fail to consistently outperform their benchmarks over long periods.
4. Active management strategies can include fundamental analysis, technical analysis, and macroeconomic analysis to make informed investment decisions.
5. While active management aims for higher returns, it also comes with increased risk and volatility compared to passive strategies.

Review Questions

• How does active management differ from passive management in terms of strategy and execution?
  • Active management differs from passive management mainly in its approach to investment strategy. Active managers engage in research and decision-making to select securities they believe will outperform a benchmark index. In contrast, passive managers seek to match the performance of an index by holding the same securities in the same proportions without making frequent changes. This fundamental difference affects how each strategy performs during different market conditions.
• Discuss the role of performance measurement in evaluating the effectiveness of active management strategies.
  • Performance measurement is crucial for evaluating active management because it determines whether the strategy has successfully achieved its goal of outperforming a benchmark index. Key metrics such as alpha, which measures excess return above the benchmark, and tracking error, which assesses the volatility of returns relative to the benchmark, provide insight into how well an active manager is performing. An effective evaluation process allows investors to assess if their active management fees are justified by consistent outperformance.
• Evaluate the implications of recent studies showing that most active managers underperform their benchmarks over time, considering investor behavior and market efficiency.
  • The implications of studies indicating that most active managers underperform their benchmarks challenge the traditional belief in the value of active management. This trend suggests that many investors may reconsider their allocation towards actively managed funds, particularly when factoring in higher fees. Additionally, these findings highlight questions about market efficiency; if markets are efficient, it becomes increasingly difficult for managers to consistently achieve superior returns. Understanding this context can influence investor behavior, leading them towards passive investment strategies as a more cost-effective and reliable alternative.

Related terms

Benchmark Index: A standard against which the performance of a security, mutual fund, or investment portfolio can be measured.

Passive Management:

An investment strategy that aims to replicate the performance of a specific index or benchmark, minimizing buying and selling activity.

Portfolio Diversification: The practice of spreading investments across various financial instruments, industries, and other categories to reduce risk.