Active Investing

Active portfolio management—or active investing—is an approach to managing a portfolio of financial assets that entails trading those assets for the purpose of enhancing returns. Trading decisions may be made by an inpidual, a group of inpiduals, or some computer algorithm. Generally, the portfolio is managed relative to some benchmark or basket of securities, such as the stocks in the S&P 500. The goal is then to achieve returns that exceed those of the benchmark. At any point in time, differences between the composition of the portfolio and its benchmark are called active bets. For example, if the portfolio is invested 3% in IBM stock while the benchmark is invested 1% in IBM, this would repsent an active bet on IBM equal to 2% of the portfolio's value.

Actively managed portfolios can be restricted to a specific asset class or to a fixed asset allocation, such as 60% in equities and 40% in fixed income. In this case, active bets relate only to the specific instruments held. On the other hand, asset allocation can also be active, in which case active bets relate to both specific instruments as well as the asset classes.

The turnover of a portfolio is the fraction of the portfolio's holdings that are sold and replaced each year. Because trading generates transaction costs, turnover is a drag on a portfolio's performance. For active portfolios, turnover of between 50% and 150% is common. Turnover for hedge funds is routinely several hundred percent.

The opposite of active portfolio management is passive portfolio management—or passive investing, With this approach, the portfolio—called a passive portfolio—is invested to mirror a specific benchmark, with all holdings proportional to those of the benchmark. There is no trading for the purpose of enhancing returns. The portfolio earns the same returns as the benchmark, less expenses. Another way to think of passive management is that it is active management with no active bets allowed. This doesn't mean there is no trading. New investments to the portfolio or the reinvestment of income may prompt the purchase of additional holdings, but these will be in proportion to the holdings of the benchmark. Withdrawals from the portfolio will similarly prompt a proportional sale of holdings.

In the context of passive investing, the benchmark is sometimes called an index. With this terminology, a passively managed mutual fund is called an index fund, and passive investing is called indexing.

Trading may also be prompted by changes in the benchmark. For example, many passive portfolios are invested in the stocks of the S&P 500. The composition of the S&P 500 is occasionally updated. Each time that happens, there is a spurt of trading as all the S&P 500 index funds liquidate positions in stocks removed from the index and purchase positions in stocks added to the index.

In this way, passive management differs from a related technique called buy-and-hold investing. With buy-and-hold, there is no benchmark. A portfolio of instruments is merely purchased and held for the long-term. Income, new investments or withdrawals may necessitate the purchase or sale of additional holdings, but these do not have to be in proportion to some benchmark's holdings. In this way, buy-and-hold affords some active investment decisions at the time of initial investment or when there are cash flows to or from the portfolio. Because there is no benchmark, changes in a benchmark cannot prompt trading, as is the case with passive investing.

Management fees and transaction costs for active management tend to be substantial, which is the primary reason investors opt for passive or buy-and-hold investing. According to the efficient market hypothesis, active investors cannot expect to be rewarded for incurring those additional costs. Indeed, repeated studies of mutual fund performance indicate that actively managed funds tend to underperform similar passively managed funds. This is true both before management fees and after management fees.

For taxable equity portfolios, passive or buy-and-hold management have the advantage of deferring capital gains taxes. Over a decade or more, the advantage can be substantial, if turnover is kept at essentially 0%. The magnitude of the benefit also depends on the applicable capital gains tax rate.