Active Management

Trying to beat the market through stock picking and timing

Understanding active management and whether professional fund managers can consistently outperform
Modified

September 7, 2025

Category: Investment Strategy
Difficulty: Beginner

Definition

Investment approach where fund managers actively buy and sell stocks trying to beat market performance, as opposed to simply matching market returns.

What Active Managers Do

The Basic Idea

Active managers believe they can:

  • Pick better stocks than what’s in market indexes
  • Time the market by buying and selling at the right moments
  • Beat the market by earning higher returns than just buying an index fund
  • Add value through research and expertise

How They Try to Beat the Market

Stock Research - Study company financial reports - Meet with company management - Analyze industry trends - Compare companies to find the best ones

Market Timing - Buy more stocks when markets look cheap - Sell stocks when markets look expensive - Move money between different types of investments - Adjust portfolio based on economic conditions

The Big Question: Does It Work?

The Challenge

To justify their higher fees, active managers need to:

  • Beat the market by enough to cover their extra costs
  • Do it consistently over many years
  • Do it across different market conditions

What the Evidence Shows

Mixed Results: - Some managers beat the market some years - Very few beat it consistently over 10+ years - Most underperform after accounting for fees - Past performance doesn’t predict future results

Why It’s Hard: - Markets are pretty efficient at pricing stocks - Other smart professionals are trying to do the same thing - Higher fees create a handicap to overcome - Emotions and biases affect decision-making

Costs of Active Management

Higher Fees

  • Management fees: Usually 0.5% to 2% per year
  • Performance fees: Sometimes 10-20% of profits
  • Trading costs: Buying and selling stocks costs money
  • Tax costs: More trading often means more taxes

Example

If an index fund charges 0.1% and an active fund charges 1.0%, the active fund needs to beat the market by at least 0.9% just to break even.

When Active Management Might Make Sense

Potential Benefits

  • Downside protection: May lose less in bad markets
  • Specialized expertise: Access to professional research
  • Flexibility: Can adapt to changing market conditions
  • Concentrated bets: Can make larger bets on best ideas

Good Candidates for Active Management

  • Smaller markets: Less efficient markets with more opportunities
  • Specialized strategies: Unique approaches not available in index funds
  • Risk management: When you need specific risk controls
  • Tax management: When tax efficiency is crucial

Red Flags to Watch For

Warning Signs

  • Closet indexing: Manager mostly copies the index but charges high fees
  • Style drift: Manager changes strategy frequently
  • High turnover: Excessive trading that generates costs
  • Short track record: Manager hasn’t proven themselves over time

Questions to Ask

  • How different is this portfolio from the index?
  • What specific edge does this manager have?
  • How consistent has performance been?
  • Are fees reasonable for the strategy?

Simple Guidelines

For Most Investors

  • Start with index funds for core holdings
  • Consider active funds for smaller portions of portfolio
  • Focus on low-cost options when choosing active funds
  • Don’t chase last year’s hot performer

If You Choose Active Funds

  • Look for managers with 5+ year track records
  • Understand exactly what strategy they use
  • Make sure fees are reasonable
  • Don’t expect miracles - good active management is rare

External Resources