Ideally, the active manager exploits market inefficiencies by purchasing securities (stocks etc.) that are undervalued or by short selling securities that are overvalued. Either of these methods may be used alone or in combination. Depending on the goals of the specific investment portfolio, hedge fund or mutual fund, active management may also serve to create less volatility (or risk) than the benchmark index. The reduction of risk may be instead of, or in addition to, the goal of creating an investment return greater than the benchmark.
Active portfolio managers may use a variety of factors and strategies to construct their portfolio(s). These include quantitative measures such as price/earnings ratio P/E ratios and PEG ratios, sector investments that attempt to anticipate long-term macroeconomic trends (such as a focus on energy or housing stocks), and purchasing stocks of companies that are temporarily out-of-favor or selling at a discount to their intrinsic value. Some actively managed funds also pursue strategies such as merger arbitrage, short positions, option writing, and asset allocation.
The effectiveness of an actively-managed investment portfolio obviously depends on the skill of the manager and research staff. In reality, the majority of actively managed collective investment schemes rarely outperform their index counterparts over an extended period of time, assuming that they are benchmarked correctly. For example, the Standard & Poor's Index Versus Active (SPIVA) quarterly scorecards demonstrate that only a minority of actively managed mutual funds have gains better than the Standard & Poor's (S&P) index benchmark. As the time period for comparison increases, the percentage of actively-managed funds whose gains exceed the S&P benchmark declines further.
Due to mutual fund fees and/or expenses, it is possible that an active or passively managed mutual fund could underperform compared to the benchmark index, even though the securities that comprise the mutual fund are outperforming the benchmark. However, since many investors are not satisfied with a benchmark return a demand for actively-managed continues to exist. In addition, many investors find active management an attractive investment strategy when investing in market segments that are less likely to be profitable when considered as whole. These kinds of sectors might include a sector such as small cap stocks.
Several of the actively-managed mutual funds with strong long-term records invest in value stocks. Passively-managed funds that track broad market indices such as the S&P 500 have money invested in all the securities in that index ie. both growth and value stocks.
The use of managed funds in certain emerging markets has been recommended by Burton Malkiel, a proponent of the efficient market theory who normally considers index funds to be superior to active management in developed markets.
The most obvious disadvantage of active management is that the fund manager may make bad investment choices or follow an unsound theory in managing the portfolio. The fees associated with active management are also higher than those associated with passive management, even if frequent trading is not present. Those who are considering investing in an actively-managed mutual fund should evaluate the fund's prospectus carefully. Data from recent decades demonstrates that the majority of actively-managed large and mid-cap stock funds in United States fail to outperform their passive stock index counterparts.
Active fund management strategies that involve frequent trading generate higher transaction costs which diminish the fund's return. In addition, the short-term capital gains resulting from frequent trades often have an unfavorable income tax impact when such funds are held in a taxable account.
When the asset base of an actively-managed fund becomes too large, it begins to take on index-like characteristics because it must invest in an increasingly diverse set of investments instead of those limited to the fund manager's best ideas. Many mutual fund companies close their funds before they reach this point, but there is potential for a conflict of interest between mutal fund management and shareholders because closing the fund will result in a loss of income (management fees) for the mutual fund company.
Most mutual funds do not have board members and directors with an equity stake in the mutual fund that their manager(s) are administrating. In other words, the directors and board members don't directly impact the future performance of the fund. Real active management then, is when every manager and director has a vested interest in the success of the fund. Private-equity is often real active management since a privately owned company usually has just one owner that make strategy decisions at the board level.