What is Active Management?
If you visit with a financial planner or a fiduciary, they’re likely to ask if you’re interested in active management. What is active management? At its simplest level, it means someone is tracking your portfolio, buying, selling and rebalancing to optimize investment performance. The theory is that through active management, your portfolio will return above and beyond the market average.
Active management is a sensitive subject in the investment world. Many fund managers make a living beating the stock market, justifying the concept of active management. However, even prolific investors—such as Warren Buffett—caution that active management isn’t necessary. It can be difficult to decide whether active management is for you, or if you’re better off indexing for the long-haul. What’s the right answer?
The Goal of Active Management
The goal of a fund manager or portfolio manager is simple: outperform the market. If the market returns 12% this year, an active manager needs to match it—or rather, beat it. The idea is that you’ll pay an investment expert a premium to beat the market, and that your portfolio’s superior performance is enough to cover that fee (and more). So, if the market returns 12% and the portfolio manager charges 2% of asset under management, your portfolio needs to generate at least 14% in returns.
Active management can occur at any scale. It might mean entrusting your entire portfolio to a fiduciary to manage. Or, it might mean investing in an actively managed ETF or mutual fund. It can even mean relying on AI and machine learning to rebalance your portfolio in reaction to the market. This type of management is active, which is opposite passive management—also called indexing.
The Pros of Active Management
The biggest positive surrounding active management is that you’re trusting someone to manage your investments for you. If you’re risk-averse, impulsive or lack investing confidence, this is where the management fee pays for itself.
The biggest theoretical benefit of active management is better investment performance. This is, of course, if the person or firm managing your assets is able to consistently outperform the market over the life of your investment. Remember to account for the after-tax real rate of return when considering the success of a portfolio or fund manager.
Beyond simply generating higher returns, active management is also about active risk mitigation. The idea is that if (when) the market hits a rough patch, the manager will quickly rebalance to hedge against volatility. Or, if a certain stock in your portfolio is underperforming, they’ll have the wherewithal to cull it. Moreover, they’ll reinvest in high-performing securities.
The Cons of Active Management
Active management comes with its fair share of criticism, but there are also real drawbacks to consider as well. The costs associated with active management are front and center. As a general rule of thumb, anything higher than 1-1.5% in management fees will take a bite out of your ROI. This also means the manager will need to perform that much better than the market, to justify an after-tax real rate of return that beats the market.
The other chief issue with active management is that you’re relinquishing control over your investments to someone else. It’s implied that this person will act in your best interests and make decisions that benefit you. But this doesn’t always mean they’ll do what you would do. If a portfolio manager’s decision doesn’t pan out favorably for some reason, it’s a decision you need to live with.
Finally, active management may mean compromising the diversity of your portfolio. In an effort to handily beat the market, many managers pursue more aggressive strategies. In the event of market downturn or volatility, your portfolio may suffer more than the market or diversified investors.
Warren Buffett’s Famous Hedge Fund Bet
The most succinct and poignant argument against active management comes from none other than Warren Buffett. In 2007, he wagered $500,000 against any hedge fund that claimed it could outperform index funds over a decade. Only one firm took the bet: Protégé Partners. A decade passed and, in 2017, Buffet became the winner in a landslide victory. In fact, he invested the $500,000 we wagered and, in 2017 when the bet ended, pledged to donate the (then) $2.2 million to charity (Girls, Inc.).
The bet—while a great headline—shows the power of index investing, which is something any investor can understand. Moreover, Buffett claims that his returns were also largely fueled by the lack of an active management fee. It’s a cautionary tale for any investor who thinks they’re smart enough to beat the market. Buffett concedes that a lucky few will always beat the market, but that they’ll forever be in the minority.
Is Management Right for You?
If you’re uncertain about what to do with your investment portfolio, ask yourself a simple question. What is active management? It’s letting someone with more experience and skill make decisions about your investments—for a fee. If you’re willing to pay for expertise and peace of mind, active management can be a comfort. If you believe in markets and are content with indexing, you might not need to pay a portfolio manager.
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There are clear pros and cons to active management. Historical evidence isn’t exactly in favor of active fund management. But, then again, there’s a reason that virtually every high-net-worth individual trusts someone to manage their investments. Ask yourself if active management is part of your long-term investment strategy, or if you’re content to set it and forget it.