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If you’re looking for an investment strategy that may beat the market, active management may be worth considering. The goal of active management is to outperform a specific market index or, in a market downturn, to book losses that are less severe than a specific market index suffers. However, active management has fallen out of favor with many investors who find that its outcomes are less consistent than passive management strategies. So is active management right for your portfolio?

What is Active Management?

Active management is an investment strategy in which an investor or an outside manager or managers actively manage a portfolio. Fund managers use fundamental analysis, technical analysis, forecasting and their knowledge and experience to make investment decisions. Investment decisions include which securities to buy and when to buy and sell those securities.

Unlike the passive management strategy, active management doesn’t follow the efficient market hypothesis. Instead, active managers believe they can profit from using other strategies that identify undervalued investments. Some investment firms believe it’s possible to beat the market by hiring investment managers to manage their mutual funds.

The goal of active management is to outperform passively managed index funds. An example of one of these actively managed funds is a larger-cap fund that tries to beat the Standard & Poor’s 500 index.

Advantages of Active Management

A fund manager’s skill set, expertise, experience and judgments are exercised when managing funds. For instance, a fund manager may have extensive experience in the technology industry. Therefore, they can use the knowledge and expertise to potentially surpass benchmark returns. They may do this by investing in technology stocks that the fund manager considers undervalued.

Additionally, fund managers can be opportunistic when it comes to selecting assets in their funds. They can use a variety of strategies that potentially minimize their losses in a down market or when the manager observes risk.

Another advantage is that active managers can sometimes capitalize on the benefits of tax management within the fund. Since they can buy and sell when they deem necessary, they can offset losing investments with investments that are doing well.

Disadvantages of Active Management

Actively managed funds tend to have higher fees than passively managed funds. This is because research and transactional fees tend to be costly. If an actively managed fund charges 3% and the benchmark index earns 10% then the actively managed fund must earn 13% just to match the index. If you invest in a hedge fund, you may have to pay a management fee regardless of the performance of the fund. Sometimes, active managers even charge a performance fee as well that can be as much as 20% profit of the returns.

Additionally, there is controversy around the performance of active managers and if they produce superior returns. In fact, over the past 15 years, 92.43% of large-cap managers, 95.13% of mid-cap managers, 97.70 of small-cap managers failed to surpass their benchmark index. Also, over three years, active managers underperformed the market by 0.36%.

How to Pick Actively Managed Funds

If you think active fund management is the right investment strategy for you, look for actively managed funds that have a defined investment goal. You’ll want to ensure that the goals of the fund are aligned with your investment objectives. You’ll also want to evaluate the tenure of the fund managers. It’s wise to work with a fund manager who has the experience, knowledge and analysis tools to achieve a strong long-term performance.

Additionally, review the fund’s track record. Observe how the fund performed in up and down markets. And, lastly, make sure to review the fee structure. Since active funds require a lot of research and analysis, it’s important to select a fund that doesn’t have astronomical fees.

Active Management vs. Passive Management

Active investing and passive investing are opposites. While passive investors ride the market for years at a time, active investors are constantly trading with the trends of the market. There is no perfect answer to which investment strategy is better because each investor’s financial circumstances and goals will determine which strategy is more beneficial.

The decision essentially comes down to the investor’s risk tolerance. An investor’s risk tolerance is the ability to handle the volatility of the market to gain higher returns. Passive investing is a good fit for those who don’t want to take on too much risk due to the safe nature of ETFs, index funds and mutual funds. Conversely, if risky investing is up your alley, you may want to choose active investing.

Another factor when determining which investment strategy is right for you is what your investment goals are. For instance, let’s say you’re 25 years old and want to purchase a home in the next few years and your best friend is 30 but wants to save for retirement. The investments that each of you select may be drastically different. This is because your time horizon is a lot shorter, meaning you may be willing to take on more risk — that is, opt for active management — to potentially cover the cost of the home. On the other hand, your friend may want to use a less risky investment strategy — that is, opt for passive management — due to a longer time horizon.

The Bottom Line

Picking investing strategies is not an either-or matter. Retail investors can combine active and passive strategies by having some of their assets actively managed and others passively managed. Because active investing requires a higher exposure to risk, it’s best for those who can stomach market volatility, have a shorter time horizon and — if they themselves are the ones actively managing their own assets — pay close, consistent attention to the market.

One consideration is whether the assets being managed are in a taxable or a tax-deferred account. While active management can sometimes create occasional tax advantages, in general, passive investments, followed consistently, are often more tax friendly. That’s because passive investment entails less frequent transactions and therefore fewer capital gains distributions, which are taxable.

Tips

  • If you’re not a fan of DIY investing, you may want aid from someone more knowledgeable. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to find a match among your local advisors who will help you achieve your financial goals, get started now.
  • For those who have less money to invest, robo-advisors are a great alternative to more expensive financial advisors. In fact, many robos already incorporate plenty of index funds, ETFs and mutual funds in their portfolios. As a result, passive investing is a major centerpiece in the robo-advisor community.

Photo credit: ©iStock.com/mihailomilovanovic, ©iStock.com/Oleksii Yeremieiev, ©iStock.com/AscentXmedia

Ashley Chorpenning Ashley Chorpenning is an experienced financial writer currently serving as an investment and insurance expert at SmartAsset. In addition to being a contributing writer at SmartAsset, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.
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