Active Management

Active management is an approach to running money in which a manager or team decides which securities to hold, in what amounts and when to trade, with the aim of producing a better result than a chosen benchmark or of meeting a specific goal such as income or lower risk. It is used by most hedge funds, many mutual funds, a growing number of actively managed exchange-traded funds and by private wealth managers.

Its opposite is passive management, which aims to match an index at low cost rather than beat it. The two sit at either end of a spectrum: many portfolios mix an indexed core with active "satellites", and "smart beta" funds follow rules but deviate from market weights. Active managers are part of the wider business of investment management and, in most countries, must be registered with a securities regulator such as the Securities and Exchange Commission in the United States.

Think of two ways to plan a road trip. One traveller follows the main motorway the whole way, accepting whatever traffic everyone else gets. The other studies the map, listens to the radio and takes side roads whenever they look quicker. The second driver may arrive earlier, but may also get lost, and the extra effort has a price.

An active manager is the second driver. They spend time and money researching companies, economies and prices, and they move money around in the hope of finishing ahead of the crowd. Investors pay for that effort through higher fees, so the manager has to beat the plain route by more than the extra cost before the investor is actually better off.

Active managers use several broad methods, often in combination:

• Security selection. Analysts study company accounts, management and industries to find shares or bonds that they believe are mispriced, the core of value investing and growth investing.
• Asset allocation and timing. Managers shift money between shares, bonds, cash and other assets as their view of the economy changes; pure attempts to forecast short-term moves are known as market timing.
• Quantitative strategies. Computer models rank securities on measurable factors such as price momentum, valuation or quality and trade on the signals.
• Engagement. Some managers buy stakes in order to push company boards for change, an approach called activist investing.

Performance is usually judged against a benchmark index. The excess return over that index is called alpha, while sensitivity to the market as a whole is measured by beta. Because higher returns can simply come from taking more risk, analysts also look at risk-adjusted measures such as the Sharpe ratio.

Active funds charge more than index funds because research staff, data and trading cost money. Charges appear as a management fee inside the fund's expense ratio, and frequent trading adds hidden costs that show up in a high turnover ratio. According to the Investment Company Institute, the average index equity mutual fund in the United States charged about 0.05 percent a year in 2024, a small fraction of what typical actively managed equity funds charge.

The Nobel laureate William Sharpe set out a simple piece of logic in 1991: before costs, the average actively managed dollar must earn the market return, because active and passive investors together hold the whole market. After costs, the average active dollar must therefore earn less. This does not mean no manager can win, only that winners are offset by losers and that fees widen the gap.

The evidence broadly matches that logic. S&P Dow Jones Indices' SPIVA scorecards have repeatedly found that most actively managed US large-company equity funds trailed the S&P 500 over 10- and 15-year periods, and that funds which beat their benchmark in one period seldom keep doing so. Results are less one-sided in some less-researched markets and in parts of fixed income, which is one reason active management keeps a large share of assets.

Supporters argue that active managers make markets work. Their research and trading push prices towards fair value, a role that the efficient market hypothesis assumes someone performs. Active managers can avoid overpriced bubbles that an index must hold, manage risk in falling markets, apply ESG or religious screens, and vote shares with care through stewardship work.

Critics point to the cost data and the difficulty of identifying skilled managers in advance. They also note conflicts of interest: managers are paid on assets under management rather than results, a version of the principal-agent problem, and some "closet trackers" charge active fees while holding portfolios close to the index. Findings from behavioral economics suggest that investors themselves often chase past winners, buying active funds after strong runs and selling after weak ones.

Money has moved steadily from active to index strategies. Morningstar data showed that passive US mutual funds and ETFs overtook active ones by assets at the end of 2023, and the gap widened in 2024. Active management still dominates private equity, private credit, hedge funds and much of the bond market, and active ETFs have been one of the fastest-growing product types since the US Securities and Exchange Commission adopted its ETF rule in 2019.

• S&P Dow Jones Indices: SPIVA research
• Investor.gov: Mutual Funds and ETFs