Active Investing

Active investing—or active portfolio management—is an approach to managing a portfolio of financial assets that entails trading those assets for the purpose of enhancing returns. Trading decisions may be made by an individual, committee or computer algorithm in various ways, but all boil down to one of two approaches:

• fundamental analysis,
• technical analysis.

Actively managed institutional portfolios are typically benchmarked—managed relative to some basket of securities, such as the stocks in the S&P 500. The goal of benchmarking is to achieve returns that exceed those of the benchmark while incurring risk comparable to that of the benchmark. At any point in time, differences between the composition of the portfolio and its benchmark are called active bets. For example, if the portfolio is invested 3% in IBM stock while the benchmark is invested 1% in IBM, this would represent an active bet on IBM equal to 2% of the portfolio’s value.

Active investing can be restricted to a specific asset class or to a fixed asset allocation, such as 60% in equities and 40% in fixed income. In this case, active bets relate only to the specific instruments held. On the other hand, asset allocation can also be active, in which case active bets relate to both specific instruments as well as the asset classes.

Traditionally, there was no name for active investing without a benchmark. Such behavior is typical of retail investors who may buy and sell securities without the means or knowledge to rigorously assess performance against a benchmark. In the early 2000s, the expanding hedge fund industry encouraged institutional investors to similarly not benchmark their portfolios. They called this absolute return investing, suggesting that hedge funds should not be tied to benchmarks that rise or fall when their strategy was to achieve high absolute returns in all market conditions.[2] The goal of this dubious marketing may have been to remove the spotlight of benchmarking from hedge fund returns, which were increasingly disappointing relative to benchmarks.

Costs associated with active investing include management fees and transaction costs, both of which can be substantial. If a portfolio is taxable, there is an additional tax cost due to the portfolio continually trading and realizing capital gains. According to the efficient market hypothesis, active investing cannot compensate for these costs, which is why many investors prefer inexpensive passive investing strategies. Indeed, repeated studies of mutual fund performance indicate that actively managed funds tend to underperform similar passively managed funds. This is true both before management fees and after management fees.[1]

While active investing is expensive for investors, it is an enormous source of revenue for the financial services industry, which earns investment management fees, brokerage commissions and other forms of revenue from clients’ active investing. The industry’s considerable marketing muscle feeds a stream of advertisements, articles, commentary and news reporting premised on an assumption that portfolios should be actively managed.