If you’re visiting a financial planner or trustee, they’ll likely ask if you’re interested in active management. What is active management? At its simplest level, this means having someone follow your portfolio, buy, sell, and rebalance to maximize investment returns. The theory is that with active management, your portfolio will return above and beyond the market average.
Active management is a sensitive subject in the investment world. Many fund managers make their living by beating the stock market, justifying the concept of active management. However, even prolific investors, such as Warren Buffett, warn that active management is not necessary. It can be difficult to decide if active management is right for you or if you prefer long-term indexing. What is the good answer ?
The objective of active management
The goal of a fund manager or portfolio manager is simple: to outperform the market. If the market returns 12% this year, an active manager must match or rather beat it. The idea is that you’ll pay an investment expert a premium to beat the market, and your portfolio’s superior performance is enough to cover those costs (and more). So, if the market returns 12% and the portfolio manager charges 2% of the assets under management, your portfolio should generate at least 14% return.
Active management can happen at any scale. This could mean handing over your entire portfolio to a trustee to manage. Or, it can mean investing in an ETF or actively managed mutual fund. It may even mean relying on AI and machine learning to rebalance your portfolio in response to the market. This type of management is active, which is opposed to passive managementâalso called indexing.
The advantages of active management
The biggest advantage of active management is that you trust someone to manage your investments for you. If you’re risk averse, impulsive, or lack the self-confidence to invest, this is where the management fees pay off.
The biggest theoretical the advantage of active management is a better return on investments. This is, of course, if the person or company who manages your assets is able to consistently outperform the market during the life of your investment. Remember after-tax real rate of return account when considering the success of a portfolio or fund manager.
Beyond simply generating higher returns, active management is also about actively mitigating risk. The idea is that if (when) the market goes through a rough patch, the manager will rebalance quickly to hedge against volatility. Or, if a certain security in your portfolio is underperforming, they will have the means to remove it. In addition, they will reinvest in performing securities.
The disadvantages of active management
Active management comes with its fair share of criticisms, but there are also some real downsides to be aware of. The costs associated with active management are at the fore. As a general rule of thumb, any amount above 1-1.5% management fee will reduce your return on investment. It also means that the manager will have to do much better than the market, to justify a real after-tax rate of return that beats the market.
The other major problem with active management is that you are handing over control of your investments to someone else. This implies that this person will act in your best interest and make decisions that will benefit you. But that doesn’t always mean they’ll do what you would. If a portfolio manager’s decision doesn’t go well for some reason, it’s a decision you have to live with.
Finally, active management can mean compromising the diversity of your portfolio. In an effort to easily beat the market, many managers pursue more aggressive strategies. In the event of market downturn or volatility, your portfolio may suffer more than the market or diversified investors.
Warren Buffett’s famous hedge fund bet
The most succinct and poignant argument against active management comes from none other than Warren Buffett. In 2007, he bet $ 500,000 against any hedge fund that claimed to be able to outperform index funds over a decade. Only one firm took the gamble: ProtÃ©gÃ© Partners. A decade passed, and in 2017 Buffet became the winner of a landslide victory. In fact, he invested the $ 500,000 that we wagered and, in 2017, at the end of the wager, he pledged to donate the (then) $ 2.2 million to charity (Girls, Inc.).
The bet, although it is a great headline, shows the power of index investing, which any investor can understand. Additionally, Buffett says his returns have also been largely fueled by the lack of active management fees. This is a word of caution for any investor who thinks they are smart enough to beat the market. Buffett concedes that a lucky few will always beat the market, but that they will always be in the minority.
Is management right for you?
If you don’t know what to do with your investment portfolio, ask yourself a simple question. What is active management? It’s letting someone with more experience and skills make decisions about your investments, for a fee. If you’re willing to pay for expertise and peace of mind, active management can be a comfort. If you believe in the markets and settle for indexing, you may not need to pay a portfolio manager.
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There are clear advantages and disadvantages to active management. Historical evidence does not exactly support active fund management. But, then again, there is a reason why virtually all high net worth people trust someone to manage their investments. Ask yourself if active management is part of your long-term investment strategy, or if you just define it and forget it.