Active management traditionally means a mutual fund’s goal is to outperform an investment index, such as the S&P 500. Funds that do not attempt to beat a benchmark are passively managed. Passive funds closely mimic an index’s return and risk characteristics while performing slightly below the index due to a low management fee. Active managers believe that markets are inefficient and therefore can be exploited by investing in undervalued securities, shorting overvalued securities, or a combination of both.
Not all active management funds are created equal. All mutual funds are bound by their prospectus. Within the prospectus, the scope of a fund’s active management will be explained. Some funds are required to remain invested in the markets while others are allowed greater autonomy, for instance, being allowed to fully move to cash. Whether the scope of an actively managed fund is large or small, there are pros and cons to investing in actively managed funds as a whole.
The main benefit of active management is that it allows selective investment rather than investing like a benchmark. There are many reasons why investors may wish to invest in active funds. For example, with the recent stock market volatility, many investors choose to invest in less risky higher- quality dividend paying multi-national equities in order to reduce volatility even though they may be foregoing greater returns when compared to the broader market. As another example, investors may have more conviction about potential returns in certain sectors over others and therefore seek to invest in a fund that shares their perspective.
The primary disadvantage to actively managed funds is that the fund invests in the wrong investments and underperforms the benchmark. Fees are also typically higher when compared to passive investments. Additionally, actively managed mutual funds tend to create tax inefficiencies in taxable accounts since asset sales within the account cannot take a fund holder’s specific tax situations into account.
** The information provided should not be interpreted as a recommendation, no aspects of your individual financial situation were considered. Always consult a financial professional before implementing any strategies derived from the information above.
Something to consider is that if a fund is actively managed, there should be a track record against a comparable benchmark index that will show you returns versus the benchmark on a pre and after tax basis. This can help you weed out funds that might be better suited for tax deferred investing but also show you which sorts of actively managed funds might rack up higher internal trading costs that can possibly hinder your overall total return.
That there is an individual, team of analysts, or computer program that are making proactive (and sometimes reactive) trades to your underlying fun investments rather than just tracking and index, such as the S&P 500, which would be considered a passive approach.
Said slightly differently, active management is when a individual or team is attempting to "Select against" an Index - like Carolyn pointed out. A passive approach is to accept the returns of that Index (minus fees)
Carolyn hit the nail on the head with this one. I would only add one comment with regards to "active" vs. "passive". Generally speaking you are going to have a higher internal cost with active managers. Passive management tends be cheaper.
Carolyn gave a good answer. There are a lot of people that have been convinced that passive/index investing is superior to active management. I believe that's based on the large number of active funds that do not beat their benchmarks net of fees. Let's be honest though that there are a lot of bad funds our there or overly expensive funds. There are some good funds and good fund managers that do have a good history of beating their benchmarks. More importantly, not every portfolio manager manages a mutual fund where his/her performance is widely know. There are many good private managers that work with high net investors or other entities.
In general, passive/index investing works well in some areas and not as well in others. Domestic large cap is a good area for passive because the stocks are widely covered by analyst. Small cap stocks are less well covered and have a higher potential for a good analyst to have an informational advantage. Foreign investing has many variables that make the ability to deviate from a benchmark desirable. There are good bond fund managers, like Jeff Gundlach, who have a great record of beating their benchmark through duration management, credit quality management, geographic management, and other factors.
I am in favor of having a hybrid approach with both passive and active. I believe advisors who stick to just one method (usually passive) will suffer more in major market declines due to the lack of flexibility passive funds have.
The premise of active management is an underlying belief by the fund manager that value (i.e. increased performance, decreased risk, etc.) can be added through his/her investment process to the management of a mutual fund, versus just a passive stance of investing in an index and accepting the inherent risk and whatever performance level that is achieved in that given index.
Just remember as Carolyn said not all active managers are created equal. An investor should always understand the risks involved with either strategy. A good Financial Services pro can help you pick the best of the best, you can also use tools like Morningstar to narrow the field.