What Is Active Investment Management?
Understand how active management differs from buy-and-hold, why predefined rules remove emotional bias, and how a systematic daily evaluation may improve a portfolio's risk/reward relationship.
To better understand how active management may benefit a portfolio, it is important to understand how it differs from the commonly accepted practice of buy and hold.
Active Management versus Buy and Hold
"Active investment management is taking an active role in the ongoing process of investment selection and risk management with the objective of improving a portfolio's risk/reward relationship."
Another definition would be "the science of determining which asset class has statistically the best chance of providing positive returns as determined on a daily basis."
To clarify how it differs from traditional investment disciplines, such as "buy and hold," it is necessary to explain those further. Buy and hold is a discipline, when coupled with Modern Portfolio Theory (MPT), that constructs an investment portfolio considering the risk and time horizon of the individual investor. The end result is typically comprised of several (if not all) asset classes — stocks, bonds, and cash. Some also include real estate and precious metals. The more sophisticated portfolios will contain different classes of stocks (large, mid, and small cap, growth and value) and bonds (government, corporate, and municipal, investment grade and high-yield) to provide a fine-tuning of the risk/reward parameters. Typically this is the method used by the average investor. Recent research has introduced probability testing based on history of varying market performances.
The Challenges of Buy and Hold
Buy and hold is simply that — hold on to the investments no matter what the market is doing. This means that if the market goes up, your portfolio should go up and vice versa. It's the vice versa that is the problem. As investors have clearly experienced in significant market downturns, this approach provides considerable exposure to loss during declining markets.
Key Limitations of Buy and Hold
- Diversification has limits. MPT taught us to diversify. While in minor market corrections this mitigates the potential for loss, it cannot remove it completely. It was designed to take advantage of the history of the various markets to not all move in the same direction at the same time. However, there is no provision that allows for making money (or at least breaking even) when either or both are falling.
- Reliance on subjective research. Both approaches rely mostly on traditional fundamental research to select investments. Whether buying mutual funds or individual stocks, more often than not these are based on the recommendations of individuals who have looked "at the numbers," economic forecasts, government statistics, and any and all subjective factors.
- Probability testing has blind spots. Probability testing was borne out of Monte Carlo simulations — they take all the yearly performances of an index, randomize the order, and test the portfolio over different time periods thousands of times. The result shows the probability of providing a positive return over 1, 2, 5, or 10 year periods. The problem is that those years when the market does poorly still exist. They haven't been addressed in such a way that considers how a positive result can come from a negative time period.
How Active Investment Management Differs
Active investment management differs in a number of important ways:
Selective Exposure
Depending on the active manager's system, this could involve market segment, time period, and amount of portfolio invested. A given manager may specialize in an index and on a regular basis determine when and how much of the portfolio should be exposed — including the possibility of being positioned to benefit if the index falls.
Objective Process
The process is objective — without emotional input. Most, if not all, active managers employ models based on strict mathematical rules that have been tested continuously and rigorously over long periods. Unlike fundamental research, in a quantitative approach, the formulae make the decision.
Dual Risk Management
Risk management can be twofold: controlling dollars invested at any given time, and determining when to be exposed to the market, either up or down. Having the ability to be invested (up or down) or to be 100% in money market is not possible or practical with traditional investment disciplines.
Improved Risk/Reward
All of these lead to the goal of improving the risk/reward relationship. If risk can be objectively and statistically managed then the reward should increase. Active managers base their theories on varying levels of risk exposure with respect to the expected reward.
The Power of Daily Evaluation
All mutual funds have some degree of active management in that securities are added or removed on a regular basis. Perhaps the investment professional reviews accounts on a weekly or monthly basis. The active manager typically decides on a daily basis how money should be invested for the next day. Not next week, or next month, but the next day and only the next day.
Recent markets have shown us that trying to predict where the markets will be in the next month or year is less accurate than predicting the weather a week in advance. However, while not always correct, predicting the weather for the next day is much easier. It is not that easy with the market, but if wrong, the active manager won't be wrong for the whole year.
Addressing the Market Timing Question
This may all sound like active managers are trying to time the market and in fact, that is largely true. Most investors have been conditioned that timing the market doesn't work — that if you miss the 10 best days your return would be significantly less. What they don't tell you is that if you missed the 10 worst days, your return would be significantly more. And in this case, the gain from missing the worst days exceeds the loss from missing the best days.
Historical Context
For the period 1980 through July 2016, there were 9,233 trading days for the S&P 500 index — 4,909 were up, 4,341 were down, and 1 was unchanged. That equates to about 53% up and 47% down. The S&P 500 index went from 105 to 2,182 during that period. But it wasn't straight up. There were losses lasting anywhere from a few months to about 3 years totaling -42%, -49%, and -55%.
It is important to understand that hundreds of investment firms were built around the theory of buy and hold, with billions both invested and under management based on this theory. Buy and hold is a viable investment strategy if the time horizon is long term — meaning 20 to 30 years. However, the success of the buy and hold theory is based on being invested long enough to weather the up and down cycles of the markets, and that eventually a profit will be realized. The obvious flaw is that it depends a great deal on when an investor starts and when they need to access the money.
A Simpler, More Structured Approach
It is a much easier task to look at the markets on a daily basis and make an intelligent assessment as to what will likely happen the next day. It is a simple concept, one that everyone can appreciate and grasp. There is no guarantee that such a prediction will be correct, but the probability that the decision will be correct is higher than the probability of predicting where the markets will be in 10 years.
This is not like flipping a coin. On any given day, the odds that the market will be up or down are not necessarily 50-50. Each coin flip is an independent event; the markets are influenced by many events on a daily basis.
Active management has several advantages over buy and hold with the ability to still diversify over several market sectors. The practice has been in use and refined for over three decades. Considering the ability of active managers to be fully invested in such a way as to make money in an up or a down market or be completely risk free (in money market) on any given day is a feature that traditional mutual funds or investment managers do not offer.
Disclosure: This article is educational in nature and does not constitute investment advice, a recommendation, or an offer to buy or sell any security. All investing involves risk, including the possible loss of principal. Past performance does not guarantee future results. The AIM framework is a rules-based methodology designed to guide exposure decisions. Suitability depends on individual circumstances. Consult a qualified financial professional before making investment decisions.
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