Active Management

Definition

Active management is an investment strategy where a portfolio manager makes specific investment decisions to outperform a benchmark index. This approach involves ongoing analysis and adjustment of the investment portfolio based on market trends, economic forecasts, and individual security performance. Active management contrasts with passive management, which aims to replicate the performance of a specific index without trying to outperform it.

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, trading, and portfolio adjustments.
2. Investment managers who practice active management rely on fundamental analysis, technical analysis, or a combination of both to identify opportunities for generating alpha, which is excess return above the benchmark.
3. Despite its potential for higher returns, studies have shown that not all active managers consistently outperform their benchmarks over time.
4. Active management strategies can include various asset classes such as equities, fixed income, and alternative investments, allowing for a broad range of investment opportunities.
5. One key risk in active management is that it can lead to higher portfolio turnover, which may incur additional transaction costs and tax implications for investors.

Review Questions

• How does active management differ from passive management in terms of strategy and objectives?
  • Active management differs from passive management primarily in its approach to investing. While active management seeks to outperform a benchmark index through specific investment decisions made by a portfolio manager, passive management aims to replicate the performance of an index by holding a fixed set of securities. The objective of active management is to generate alpha by leveraging market insights and research, whereas passive management accepts market returns without attempting to exceed them.
• Evaluate the effectiveness of active management strategies compared to passive strategies in generating returns for investors.
  • The effectiveness of active management strategies compared to passive strategies has been widely debated. While some active managers have succeeded in outperforming their benchmarks during certain periods, many fail to do so consistently over the long term due to factors such as market efficiency and high fees. Studies show that over extended time frames, a significant percentage of actively managed funds underperform their benchmarks, leading many investors to favor passive strategies for cost-effectiveness and consistent returns.
• Assess the implications of high fees associated with active management on investor returns and decision-making.
  • High fees associated with active management can significantly impact investor returns over time by eroding potential profits. These fees cover research, trading costs, and compensation for portfolio managers, which can add up quickly. When investors consider these costs against the backdrop of historical performance data showing that many active managers underperform their benchmarks, it raises critical questions about the value proposition of active management. Investors must weigh the potential for higher returns against these fees, ultimately influencing their decision-making regarding whether to pursue an active or passive investment strategy.

Related terms

Passive Management: An investment strategy that seeks to replicate the performance of a specific index by holding the same securities in the same proportions, without active decision-making.

Portfolio Diversification: The practice of spreading investments across various assets to reduce risk and volatility, often utilized in both active and passive management strategies.

Benchmark Index: A standard against which the performance of an investment portfolio can be measured, often used in evaluating the success of active management strategies.