What it is:
Active management is an investment strategy that tries to create excess returns through the recognition, anticipation, and exploitation of short-term investment trends.
How it works (Example):
Active management is the opposite of passive management (also known as buy-and-hold investing). Instead of dismissing short-term trends and focusing on long-term profits, active managers believe short-term price movements are important and often predictable. In this vein, active managers often refer to statistical anomalies, recurring patterns, and other data that supports a correlation between certain information and stock prices.
For any given investment, the passive manager is likely to rely more on the fundamental analysis of the company behind the security, such as the company's long-term strategy, the quality of its products, or the company's relationships with management when deciding whether to buy or sell. This type of analysis is largely intended to evaluate the investment's long-term potential, which is the passive investor's typical investment horizon.
The active manager, however, seeks to detect and exploit short-term trends in a security. This often involves quantitative and technical analyses, including ratio analysis, stock chart analysis, and other mathematical measures that have less to do with the nature of the company and more to do with trading patterns, news, and other market factors. An active manager's investment horizon can be months, days, or even hours or minutes.
Active managers are more likely to use leverage than passive managers because they are as concerned with mitigating short-term risk as they are about exploiting short-term gains. This in turn introduces more risk into an active portfolio but may also provide higher returns.
Why it Matters:
In general, the constant analysis associated with active management involves more trading activity than passive management. Active trading thus also generally requires more time and education than passive management, and it is important to note that the higher trading commissions and capital gains taxes may translate to higher management fees and return requirements.
The idea of active management is not immune from controversy. Passive managers note that active managers frequently fail to match or beat their benchmarks, and they question the reliability of active managers' methods for recognizing and predicting trends. But the most notable areas of disagreement between active and passive managers are theoretical rather than mechanical.
Many passive managers espouse the efficient market hypothesis, which says that stock prices are random and already reflect all available information. A cousin of this hypothesis, the random walk theory also claims it is impossible to consistently outperform the market, particularly in the short term, because it is impossible to predict stock prices.
Regardless, active management enjoys a large and loyal following among investors, and many active managers have posted returns well above market benchmarks. However, consistently providing above-average returns remains a big challenge.
No matter where they rest on the issue, most analysts encourage even the most passive investor to learn about and understand active management methods, stay current on their investments, and know how to read stock charts.