Finance:Active management

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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.

Approach

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:

  • Fundamental analysis. This approach analyzes the characteristics of individual investments to evaluate their risk and potential return.
  • Quantitative analysis. This approach establishes a systematic process for buying and selling investments using data about individual investments.[2]

Active management may be used in all aspects of investing. It can be used for:

  • Security selection. Choosing individual stocks, bonds, or other investments.
  • Asset allocation. Determining the allocation of investment among asset classes, such as stocks, bonds, and cash.
  • Sustainable investing. Analyzing the impact of environmental, social, and governance (ESG) factors on investments.

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]

Theory

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:

  • Grossman-Stiglitz (1980).[5] In the Grossman-Stiglitz equilibrium, active investors benefit from researching potential investments by earning a higher return; however, these higher returns only offset the costs of performing the research. Grossman-Stiglitz explains why both active and passive investing would exist in equilibrium.
  • Sharpe (1991).[6] Sharpe's proposition argues that, before costs, the average active manager must earn the market return; therefore, after costs, the average active manager will earn less than the market. As a result, according to Sharpe, active investing is a zero sum game before costs and a negative sum game after costs.

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]

Performance

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:

  • They group funds into categories based on investment type (e.g., emerging market stocks, municipal bonds).
  • For various periods (ranging from 1 year to 20 years), they compare the performance of the funds in the category to the performance of a relevant index (in the SPIVA report) or of passively managed funds in that category (in the Morningstar Barometer).
  • They calculate the percentage of funds in the category that outperform the passive alternative and the percent that underperform. (SPIVA reports the percent that underperform, while Morningstar reports the percent that outperform.)

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]

Advantages of active management

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:

  • Active investors can tailor the risk of their investments to match their risk tolerance. For example, more conservative investors may want to adjust their portfolios to emphasize blue-chip investment. or they may plan to adjust the risk of their investments as their personal circumstances change.
  • Investors can adjust exposures to reflect existing exposures. For example, employees of high-tech companies might wish to limit exposure to the stocks of high-tech companies in their investment portfolios.
  • Similarly, active investors can emphasize income generation (from dividends or coupon payments) over capital appreciation.
  • Active investors have the ability to time the sale of investments with capital gains for tax-planning purposes.
  • Active investment enables investors to align their portfolios with their mission-based goals. For example, investors may want to emphasize companies with a lower carbon footprint or that follow certain practices with regard to diversity, equity, and inclusion.[23][1]

Disadvantages of active management

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]

Use of active management

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 and the Markets

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]

See also

References

  1. ↑ 1.0 1.1 "Active Management Definition" (in en). https://www.investopedia.com/terms/a/activemanagement.asp. 
  2. ↑ Pozen, Robert C. (2015). The fund industry : how your money is managed. Theresa Hamacher (2nd ed.). Hoboken. pp. 14141. ISBN 978-1-118-92996-4. OCLC 890793124. https://www.worldcat.org/oclc/890793124. 
  3. ↑ "What is Active Management? - Investment Adviser Association" (in en-US). 2022-02-03. https://investmentadviser.org/active-managers-council/what-is-active-management/. 
  4. ↑ Malkiel, Burton (2012). "4: The Efficient-Market Hypothesis and the Financial Crisis". in Blinder, Alan S.; Lo, Andrew W.; Solow, Robert M.. Rethinking the Financial Crisis. Russell Sage Foundation. pp. 75–98. https://www.russellsage.org/sites/all/files/Rethinking-Finance/Malkiel.%20The%20Efficient-Market%20Hypothesis%20and%20the%20Financial%20Crisis%20102611.pdf. 
  5. ↑ Grossman, Sanford J.; Stiglitz, Joseph E. (1980). "On the Impossibility of Informationally Efficient Markets". The American Economic Review 70 (3): 393–408. ISSN 0002-8282. https://www.jstor.org/stable/1805228. 
  6. ↑ Sharpe, William F. (1991). "The Arithmetic of Active Management". Financial Analysts Journal 47 (1): 7–9. doi:10.2469/faj.v47.n1.7. ISSN 0015-198X. https://www.jstor.org/stable/4479386. 
  7. ↑ Warren, Geoff (2020-01-02). "Is Active Investing Doomed as a Negative Sum Game? A Critical Review." (in en-US). https://alphaarchitect.com/2020/01/is-active-investing-doomed-as-a-negative-sum-game-a-critical-review/. 
  8. ↑ "Mutual Funds That Consistently Beat the Market? Not One of 2,132." (in en). New York Times. 2022-12-02. https://www.nytimes.com/2022/12/02/business/stock-market-index-funds.html. 
  9. ↑ Choi, James J. (2022). "Popular Personal Financial Advice versus the Professors" (in en). Journal of Economic Perspectives 36 (4): 167–192. doi:10.1257/jep.36.4.167. ISSN 0895-3309. 
  10. ↑ Cremers, K.J. Martijn; Fulkerson, Jon A.; Riley, Timothy B. (2019-10-02). "Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds" (in en). Financial Analysts Journal 75 (4): 8–35. doi:10.1080/0015198X.2019.1628555. ISSN 0015-198X. 
  11. ↑ "SPIVA | S&P Dow Jones Indices". https://www.spglobal.com/spdji/en/research-insights/spiva/. 
  12. ↑ "Download Morningstar's Active/Passive Barometer | Morningstar" (in en). https://www.morningstar.com/lp/active-passive-barometer. 
  13. ↑ "SPIVA U.S. Year-End 2021 - SPIVA | S&P Dow Jones Indices". https://www.spglobal.com/spdji/en/spiva/article/spiva-us/. 
  14. ↑ Rethinking Survivorship Bias in Active/Passive Comparisons. Active Managers Council. 2020. https://investmentadviser.org/wp-content/uploads/2021/12/WP_Rethinking_Survivorship_v2.pdf?t=61ba488b2f944. 
  15. ↑ "Risk-Adjusted SPIVA® Scorecard: Year-End 2020 - SPIVA | S&P Dow Jones Indices". https://www.spglobal.com/spdji/en/spiva/article/risk-adjusted-spiva-scorecard/. 
  16. ↑ "U.S. Persistence Scorecard Mid-Year 2021 - SPIVA | S&P Dow Jones Indices". https://www.spglobal.com/spdji/en/spiva/article/us-persistence-scorecard/. 
  17. ↑ "Quit Chasing Unicorns: Consistent Fund Performance Is Overrated" (in en). 2018-12-18. https://www.morningstar.com/articles/905261/quit-chasing-unicorns-consistent-fund-performance-is-overrated. 
  18. ↑ Jensen, Michael C. (May 1968). "The Performance of Mutual Funds in the Period 1945-1964". The Journal of Finance 23 (2): 389–416. doi:10.1111/j.1540-6261.1968.tb00815.x. ISSN 0022-1082. 
  19. ↑ Malkiel, Burton G. (June 1995). "Returns from Investing in Equity Mutual Funds 1971 to 1991". The Journal of Finance 50 (2): 549–572. doi:10.1111/j.1540-6261.1995.tb04795.x. ISSN 0022-1082. http://dx.doi.org/10.1111/j.1540-6261.1995.tb04795.x. 
  20. ↑ Elton, Edwin J.; Gruber, Martin J.; Blake, Christopher R. (January 1996). "The Persistence of Risk-Adjusted Mutual Fund Performance". The Journal of Business 69 (2): 133. doi:10.1086/209685. ISSN 0021-9398. http://dx.doi.org/10.1086/209685. 
  21. ↑ Fama, Eugene F.; French, Kenneth R. (2010-09-21). "Luck versus Skill in the Cross-Section of Mutual Fund Returns". The Journal of Finance 65 (5): 1915–1947. doi:10.1111/j.1540-6261.2010.01598.x. ISSN 0022-1082. http://dx.doi.org/10.1111/j.1540-6261.2010.01598.x. 
  22. ↑ Berk, Jonathan B.; van Binsbergen, Jules H. (2015-10-01). "Measuring skill in the mutual fund industry". Journal of Financial Economics 118 (1): 1–20. doi:10.1016/j.jfineco.2015.05.002. ISSN 0304-405X. 
  23. ↑ "What is Active Management? - Investment Adviser Association" (in en-US). 2022-02-03. https://investmentadviser.org/active-managers-council/what-is-active-management/. 
  24. ↑ Saunders, Laura (October 21, 2016). "How Passive Funds Trim Your Tax Bill". The Wall Street Journal. https://www.wsj.com/articles/how-passive-funds-trim-your-tax-bill-1476968401. 
  25. ↑ Arnott, Robert D.; Berkin, Andrew L.; Ye, Jia (2000-07-31). "How Well Have Taxable Investors Been Served in the 1980s and 1990s?" (in en). The Journal of Portfolio Management 26 (4): 84–93. doi:10.3905/jpm.2000.319766. ISSN 0095-4918. http://pm-research.com/lookup/doi/10.3905/jpm.2000.319766. 
  26. ↑ "Mythbusted: Active ETFs can be as tax efficient as passive ETFs". March 3, 2023. https://www.capitalgroup.com/advisor/investments/exchange-traded-funds/resources/mythbusted-CG-capital-gains.html. 
  27. ↑ 27.0 27.1 "2021 Investment Company Fact Book". https://www.icifactbook.org/. 
  28. ↑ Wermers, Russ (2021). "Active Investing and the Efficiency of Security Markets". Journal of Investment Management 19 (1). 
  29. ↑ 29.0 29.1 "Active Management and Market Efficiency: A Summary of the Academic Literature". https://higherlogicdownload.s3.amazonaws.com/INVESTMENTADVISER/4d240ae3-bc9b-4155-8bd1-14cbac904146/UploadedImages/amc/docs/WP-AMC-Market-Efficiency_v0719.pdf. 

Further reading

  • 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:0-9768023-0-9

External links



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