Understanding investment strategies - Active Management
Unlike pre-programmed passive portfolios which slavishly mirror the performance of a particular index, such as the MSCI Europe, actively managed funds are overseen by a professional manager who invests in what they believe have the best investment potential.
While the objective of a passive portfolio or tracker fund is to simply match an index’s performance, the goal of an active manager is to outperform their chosen market.
Fundamentally active managers believe that markets are inefficient; that many securities, such as stocks and bonds, are often mispriced and by trading in these mispriced assets they believe they can achieve excess returns.
How active fund managers operate
To deliver market beating returns active managers need to not only carefully pick their stocks but also keep an eye on their asset allocation i.e. how they diversify investors’ cash across holdings and different industries. By having a decent spread of different investments, it can dilute the potential for losses but at the same time no matter how well-diversified a fund is, it could still lose money.
A fund manager usually decides on how to manage their portfolio’s asset allocation according to the vehicle’s risk level and objectives - for example, a fund with a higher risk profile might have a more concentrated spread of investments than a more lower risk vehicle.
When it comes to choosing which holdings to buy and sell, an active fund manager will populate the portfolio in line with their investment strategy. For instance, an equity income fund manager is likely to focus on dividend paying stocks.
To achieve their goal of delivering over and above the market, active managers will keep a close eye on market and economic trends as well as company announcements, all of which can have an impact on a fund’s performance. They will move in and out of stocks and/or sectors depending on their outlook and the news flow.
The advantages and disadvantages of active investing
The primary advantage of investing with an active fund manager is the potential to enjoy market-beating returns. Of course this is not guaranteed.
But when you invest with an active fund manager, your money is put in the hands of a professional who makes informed investment decisions, based on their experience, judgment and prevailing market trends in terms of what securities to buy and sell. This means active investment managers can take swift action and alter their asset allocation and holdings in an attempt to protect investors’ cash if they believe the market is looks like it is set to endure a period of volatility. But again, even if a manager takes defensive action, it is not guaranteed that they will be able to shield investor’s cash from a downturn.
In terms of disadvantages, active funds carry higher annual fees than passively run portfolios. Depending on the fund, investors could be charged maybe around 1% a year for an actively managed fund, while some passive portfolios levy costs closer to 0.1%. Of course there is always the risk that an active manager will make mistakes and as a result underperform the market they are trying to beat. In addition, style issues may interfere with performance. At any given time, a manager's style – for example value, income or growth - may be out of favour with the market, which in turn could their reduce returns. But even if your manager’s investment style is in favour, they could still underperform.
The bottom line
Active investment managers attempt to take advantage of market inefficiencies, such as under-priced securities, in a bid to achieve market beating long-term returns. They essentially do three core things - asset allocation, security selection and market analysis. The main advantages of active investing include expert analysis, the potential for a manager to take defensive measures if necessary - and the possibility of higher than average returns.
However investors need to bear in mind that active funds carry higher fees than passive portfolios and in addition, an active fund manager may underperform the wider market.
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