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.
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.
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.
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.
There are two well-known theories that the balance between active management and passive management:
Grossman-Stiglitz (1980). 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). 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."
Performance
Many writers on finance argue that actively managed funds consistently underperform, and, as a result, they recommend investing in index funds. This negative assessment is controversial and has been challenged.
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. The second is the Morningstar Active-Passive Barometer, which compares actively managed funds to passively managed funds. 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.)