Active Management: Pros & Cons

Active management in the financial world involves an approach where investment managers actively make buy, hold, and sell decisions to outperform a specific benchmark. This strategy stands in contrast to passive management, which aims to replicate the performance of a market index. But is trying to beat the market always the right strategy?

Pros of Active Management

1. Potential for Higher ReturnsActive managers have the potential to earn returns that exceed the market average. For instance, studies have shown that some active managers in the small-cap sector have outperformed their benchmarks over the long term. According to recent data, approximately 35% of active small-cap managers have outperformed their benchmarks over a 10-year period.
2. Risk ManagementActive managers can adjust their portfolios to protect against market volatility. By continuously monitoring the market and making strategic decisions, they can mitigate risks and potentially avoid significant losses.
3. Personalized Investment StrategiesActive managers can tailor investment strategies to meet specific client objectives and risk tolerance levels. This personalized approach allows for more flexibility in managing portfolios, which can be particularly beneficial for investors with unique financial situations.
4. Adapting to Changing Market ConditionsActive managers can adjust their investment portfolios based on current economic trends and market opportunities. This adaptability is crucial in dynamic markets where conditions can change rapidly.
5. Tax ManagementThe flexibility in buying and selling securities allows active managers to offset losers with winners, potentially reducing tax liabilities. This tax management strategy can be particularly beneficial for investors in high-tax brackets.

Cons of Active Management

While the potential for higher returns and tailored strategies can be enticing, active management is not without its downsides. Investors need to carefully consider the following drawbacks:

1. Higher FeesActive management typically incurs higher fees due to research, trading, and management costs. These fees can significantly reduce overall investment returns, making it challenging for active managers to consistently outperform the market.
2. Increased RiskActive management involves the frequent buying and selling of securities, which results in higher levels of volatility and risk in the portfolio. This increased risk can lead to significant losses if the manager's decisions are incorrect.
3. Potential for UnderperformanceDespite the goal of outperforming the market, active managers may only sometimes be successful in generating higher returns than the market average. In fact, historical data shows that a majority of active managers fail to outperform their benchmarks over the long term. According to the S&P Indices Versus Active (SPIVA) Scorecard, approximately 75% of active large-cap managers underperformed the S&P 500 over a 10-year period.
4. Behavioral BiasesInvestors often choose active management due to behavioral biases such as overconfidence and familiarity. However, these biases can lead to poor investment decisions and a higher likelihood of underperformance.

Conclusion

Active management offers several potential benefits, including the possibility of higher returns, active risk management, personalized investment strategies, adaptability to changing market conditions, and tax management. However, it also comes with significant drawbacks such as higher fees, increased risk, and the potential for underperformance.