What is active management?
Active management is an investment approach in which a person or team continually monitors a portfolio and makes explicit buy, hold, and sell decisions to try to achieve objectives that go beyond simply tracking a market benchmark. Typical goals include outperforming a chosen benchmark index, controlling portfolio risk, managing tax outcomes, or meeting nonfinancial constraints such as environmental, social, and governance (ESG) standards.
Key definitions
– Active management: Ongoing, discretionary or model-driven decision-making about portfolio holdings intended to meet specific objectives (outperformance, risk control, tax management, ESG, etc.).
– Benchmark: A market index or sector measure used to judge a portfolio’s performance (for example, the Russell 1000 Growth Index).
– Passive management (indexing): An approach that seeks to replicate the holdings and weightings of an index rather than depart from it.
– Excess return (active return): The difference between the portfolio’s return and the benchmark’s return. Formula: Excess return = Portfolio return − Benchmark return.
– Active Share: A holdings-based metric that measures how much a portfolio’s holdings differ from its benchmark (expressed as a percentage). It is not the same as excess return.
How active managers work (brief)
– Research and selection: Managers use fundamental analysis (company financials, industry studies), quantitative models, technical signals, or some combination to pick securities.
– Position sizing and allocation: Managers choose how much to allocate to each holding and to different asset classes or sectors.
– Tactical changes and risk management: Managers can change exposures quickly, use hedges (derivatives, short selling), or shift allocations to reduce downside risk.
– Tax and operational tactics: Managers can harvest losses or time trades to limit tax liabilities, and can exercise discretion on turnover.
Advantages of active management
– Flexibility: Managers can change exposures and deviate from index weights when they see risk or opportunity.
– Custom goals possible: Active funds can pursue tax objectives, ESG constraints, income needs, or short-term risk management.
– Potential to exploit inefficiencies: Active managers aim to find mispriced securities or sectors that they expect to outperform.
Disadvantages of active management
– Higher costs: Active funds typically charge higher fees, which reduce net returns to investors.
– Tax inefficiency: Greater turnover can trigger more taxable events for investors in taxable accounts.
– Mixed outcomes: Many active managers fail to outperform their benchmarks net of fees over long periods; outcomes vary by market segment and time frame.
How performance is measured
– Compare the portfolio’s return to the chosen benchmark over consistent time periods.
– Calculate excess return: Portfolio return − Benchmark return. Include gross and net-of-fees returns when evaluating managers.
– Consider risk-adjusted metrics (not covered in detail here) and holdings-based measures like Active Share to understand how different the portfolio is from its benchmark.
Worked numeric example (from the example data)
A mutual fund returned 17.35% over five years while its benchmark, the Russell 1000 Growth Index, returned 15.89% over the same period.
– Excess return = 17.35% − 15.89% = 1.46 percentage points.
That 1.46% is the fund’s outperformance (excess return) over that period. Note: this number is not the fund’s Active Share; Active Share is calculated from holdings differences, not return differences.
Checklist for evaluating an active manager
1. Define objectives: Are you looking for absolute return, benchmark outperformance, income, tax management, or ESG compliance?
2. Identify the benchmark: Is the chosen benchmark appropriate for the strategy and asset mix?
3. Compare net returns: Look at returns after fees (expense ratio, performance fees) against the benchmark for multiple rolling periods (1, 3, 5, 10 years).
4. Check fees and turnover: Know the expense ratio and typical portfolio turnover—higher turnover often raises tax bills and trading costs.
5. Examine risk management: Ask how the manager controls downside risk (hedging, stop-losses, position limits).
6. Review manager experience and process: How repeatable and documented is the investment process? Is it discretionary or rules-based?
7. Measure active exposures: Look at Active Share, sector and factor bets, and concentration (number of holdings).
8. Tax considerations: For taxable investors, ask how trades are managed for tax efficiency.
9. Transparency and reporting: Does the fund provide timely holdings, rationale for decisions, and performance attribution?
10. Look at survivorship bias and fees-adjusted statistics: Ensure performance comparisons account for funds that closed or merged and include fees.
Practical note on fees
Active strategies often charge materially more than passive index funds. Because excess return must first cover fees, always compare net performance (after fees) with the benchmark to judge manager value.
Managing risk with active management
Active managers can reduce exposures to regions, sectors, or single issuers more quickly than index funds, and can use hedges such as derivatives or short positions. That flexibility can help in volatile or event-driven situations (for example, materially reducing exposure to a country or sector after a political shock).
A few points about the evidence
Empirical studies and industry reviews reach different conclusions depending on the asset class, time period, and specific managers studied. Some categories and periods show a high share of active managers beating their benchmark before fees; after fees and across long horizons, outperformance is less consistent.
Reputable sources for further reading
– Investopedia — “Active Management”: https://www.investopedia.com/terms/a/activemanagement.asp
– Fidelity — Fidelity Blue Chip Growth Fund information: https://fundresearch.fidelity.com/mutual-funds/summary/31607R105
– U.S. Securities and Exchange Commission (SEC) — investor guides on mutual funds and ETFs: https://www.sec.gov/investor
Educational disclaimer
This explainer is for educational purposes only and does not constitute personalized investment advice or a recommendation to buy or sell any security or fund. Investors should perform their own research or consult a licensed financial professional before making investment decisions.