The use of human capital to manage a portfolio of funds
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Active management is the use of human capital to manage a portfolio of funds. Active managers rely on analytical research, personal judgment, and forecasts to make decisions on what securities to buy, hold, or sell.
Theory of Active Management
Investors who do not follow the Efficient Markets Hypothesis believe in active management. They hold the belief that there are some inefficiencies in the market that allow for market prices to be incorrect. Therefore, it is possible to profit in the stock market by identifying mispriced securities and employing a strategy to take advantage of the price correction.
Such an investment strategy can involve purchasing securities that are undervalued or short-selling securities that are overvalued. In addition, active management is used to modify risk and create less volatility than the benchmark.
Active management aims to generate better returns than a benchmark, usually some sort of a market index. Unfortunately, a majority of active managers are unable able to consistently outperform passively managed funds. In addition, actively managed funds charge higher fees than passively managed funds.
Active Management Process
The active management process usually involves three steps:
The planning step involves identifying the investor’s objectives and constraints. It can involve risk and return expectations, liquidity needs, time horizon, tax issues, and legal and regulatory requirements. From these objectives and constraints, an investment policy statement (IPS) can be created. The IPS usually outlines the reporting requirements, rebalancing guidelines, investment communication, manager fees, and investment strategy and style.
Next, active managers need to form a capital market expectation and make forecasts for the risk-and-return profile of the securities to form the basis of the portfolio. Lastly, the strategic asset allocation should be determined with asset class weights.
The execution step involves the implementation of the portfolio with construction and revision. Active managers integrate their investment strategies with the capital market expectations to select specific securities for the overall portfolio. In doing this, active managers optimize the portfolio by combining assets efficiently to achieve certain return and risk objectives.
The feedback step involves managing exposures to investments. It is done by rebalancing the portfolio to ensure that the portfolio is still within the mandate of the IPS. Furthermore, the portfolio’s performance is periodically evaluated by investors to ensure that investment objectives are being met.
Active vs. Passive Management
Active managers are expected to respond to changing capital market expectations. It is in contrast with passive management, where a portfolio is tied to an index and does not react to changes in capital market expectations.
In portfolio management, an investment policy statement should be created; the policy outlines the concrete investment strategy for an investment fund. In a broad sense, investment strategies can be one of the following:
1. Passive strategy
A passive investment strategy involves not reacting to changing capital market expectations. For example, a portfolio tied to the S&P500 Index, an index representing the United States equity markets, may add or drop holdings in response to changes in the underlying index composition, but will not respond to changes in capital market expectations of an individual security’s investment value.
Indexing is a common passive approach to investing in which a portfolio of securities replicates the returns of a specified index.
2. Active strategy
Active investment strategy involves management responding to changing capital market expectations. Active management of a portfolio means that the holding weights differ from the portfolio’s benchmark (comparison portfolio), in an attempt to produce excess risk-adjusted returns, also known as alpha. The different holding weights reflect management’s differing expectations to the overall market.
3. Semi-active strategy
A semi-active investment strategy involves an enhanced index approach where alpha is sought after while emphasizing risk relative to the benchmark.
Advantages of Active Management
An advantage of active management is that a variety of investments and investment strategies can be selected. Some motivations for investors to lean towards active management are the following:
Investors believe that actively managed funds can outperform the market.
Investors believe they can pick the most skilled active managers.
Investors may want to manage volatility differently than the overall market.
Investors may want to follow a strategy that is in line with their personal investment goals.
Investors can get exposure to alternative investments that are uncorrelated with the market.
Disadvantages of Active Management
Active management can be a disadvantage if the management makes bad investment choices. Even if active management performs well, it is well documented that most active managers underperform their passive management counterparts.
In addition, as an active management fund becomes very large, it begins to show index-like characteristics to diversify its investments. Lastly, active management requires an infrastructure of managers, analysts, and operations that require compensation, which makes active management more expensive than passive management.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
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