Active management is a central concept in portfolio management and investment strategy. For financial advisors, this offers the potential to add value for your clients, especially in complex or volatile markets.
In this article, Wealth Professional Canada will highlight what active management is and how it works in practice. We’ll also talk about how it compares to passive management, and the pros and cons you should consider when advising your clients.
Active management refers to the hands-on approach of making investment decisions in a portfolio. Instead of following a fixed set of rules or mirroring a market index, an active manager or team continually monitors the portfolio. They make decisions based on research, analysis, and experience.
Active managers aim to outperform a designated benchmark, such as the S&P/TSX Composite Index or the FTSE Canada Universe Bond Index. They might also focus on additional goals, such as:
The process involves analyzing market trends and company financials. It also involves looking at economic indicators as well as meeting with company executives and evaluating business models.
Active management can take many forms. Some managers use quantitative models and algorithms, while others rely on discretionary judgment or a combination of both. The key feature is the ongoing, proactive effort to select investments and adjust the portfolio to achieve better results than a passive strategy.
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There are some investment vehicles, like mutual funds and hedge funds, that often employ active management to seek higher returns through market timing and security selection.
Active management involves:
Active management is common in mutual funds and is often used for fixed income and balanced portfolios. It is especially relevant for clients who want to pursue higher returns and manage risk more actively.
Active management is best illustrated through real-world examples. Consider a Canadian mutual fund managed by a team of professionals. The team tracks the performance of the portfolio daily. They also research potential investments. Then, they decide which assets to buy, hold, or sell. Check out these other sample scenarios:
Suppose you manage a Canadian core fixed income fund. Your benchmark is the FTSE Canada Universe Bond Index. Instead of simply buying all the bonds in the index, you and your team analyze the market and assess credit quality. Then, you identify opportunities to add value.
You might notice that certain corporate bonds are undervalued due to recent market volatility. After thorough research and credit analysis, you decide to increase the fund’s allocation to these bonds. At the same time, you reduce exposure to sectors or issuers that appear riskier based on your analysis.
This approach allows you to take advantage of market inefficiencies and adjust to changing economic conditions. You can also have the potential to outperform the benchmark. Over time, your active decisions can lead to higher returns, better risk management, or both.
During periods of market stress, such as the 2008 financial crisis or the COVID-19 pandemic, active managers can quickly shift portfolios to reduce risk. For instance, you might move assets from riskier sectors to safer ones.
You might also increase the allocation to government bonds or hold more cash. This flexibility can help protect your clients’ portfolios from large losses when markets decline.
The Canadian bond market has grown more complex over the years, with more issuers, sectors, and individual securities. As an active manager, you can use sector rotation strategies and in-depth credit research to identify mispriced securities and adjust the portfolio accordingly.
This expertise can add value, especially in markets with wide return dispersion and high kurtosis, where the probability of extreme outcomes is greater.
The debate between active and passive management is ongoing, and there is no one-size-fits-all answer. Both approaches have strengths and limitations, and the best choice depends on your clients’ risk tolerance and investment preferences. Let's discuss them below for further comparison:
Active management seeks to outperform the market by making smarter decisions about which assets to buy or sell. Active managers use research and judgment to identify opportunities and manage risk. They can adjust portfolios in response to market changes or new information.
Supporters of active management point to the potential for higher returns and better risk management. The same is true regarding the ability to pursue specific goals such as ESG investing or downside protection. Active management can be especially valuable in markets with greater complexity, volatility, or inefficiency.
Passive management, also known as indexing, involves building a portfolio that mirrors a specific market index. The goal is to match, not beat, the performance of the index. Passive funds usually have lower fees and greater transparency. They also have less turnover than actively managed funds.
Advocates of passive management argue that markets are efficient and that it is difficult for active managers to consistently outperform benchmarks after fees. Passive strategies are popular for their simplicity and cost-effectiveness. These techniques can also provide broad market exposure.
Watch this video to learn more about active versus passive management:
Even in real estate investment trusts (REITs), there’s still a debate for active versus passive management.
Active management offers several advantages, but it also comes with challenges and potential drawbacks. As a financial advisor, you need to weigh these factors when recommending strategies to your clients:
Check out some of active management’s benefits:
Active managers aim to beat their benchmarks by identifying undervalued securities and exploiting market inefficiencies. They also adjust portfolios as conditions change. In fixed income markets, active managers have consistently delivered higher returns than passive benchmarks, especially in recent years.
Active managers can respond quickly to market volatility and economic shifts. They can reduce exposure to risky assets and increase allocations to safer investments. Another upside is using hedging strategies to protect portfolios during downturns.
Active management allows for greater flexibility in portfolio construction. Managers can select securities based on research and adjust sector allocations. They can also pursue opportunities that are not available in passive funds.
Active managers can manage tax consequences by realizing losses to offset gains or timing trades to minimize tax impacts. This flexibility can be valuable for clients with specific tax considerations.
Active management can be designed to meet your clients’ unique goals, such as ESG investing and income generation. It can also be tailored for capital preservation. Managers can align portfolios with specific preferences or constraints.
Below are some concerns that your clients should be aware of:
Actively managed funds typically have higher management fees than passive funds. These fees pay for the expertise and ongoing efforts of investment professionals. Higher fees can reduce net returns, especially if the manager does not outperform the benchmark.
Active trading can result in higher turnover and more taxable events, making actively managed funds less tax-efficient than passive funds.
Not all active managers outperform their benchmarks. Success depends on the manager’s skill and research capabilities. Market conditions can also have an impact. As such, some active funds might underperform after fees.
Active management requires ongoing research and analysis plus decision-making. This complexity can make it harder for your clients to understand how their portfolios are managed.
Active management relies on the judgment and experience of managers. This can introduce biases or mistakes. Poor decisions can then lead to underperformance or increased risk.
One of the strongest arguments for active management is its ability to provide downside protection during periods of market volatility. When markets are turbulent, passive funds simply follow the index, which can lead to significant losses.
On the other hand, active managers can take defensive actions, such as:
For example, during the 2008 financial crisis and other periods of market stress, active managers were able to reduce exposure to riskier sectors and protect their clients’ portfolios from larger losses. This proactive approach can help your clients stay invested and avoid making impulsive decisions during downturns.
When deciding whether to recommend active management to your clients, consider the following factors:
Active management is not the right choice for every client or every market. However, in certain asset classes and market conditions, it can offer meaningful benefits, including higher returns and better risk management. It can also provide greater flexibility.
Since the 2008 financial crisis, active fixed income managers in Canada have consistently outperformed passive benchmarks. This outperformance is linked to the wider distribution of returns and increased sector diversification. It is also related to the ability to identify mispriced securities.
Active managers can also navigate periods of lower market liquidity and regulatory changes, taking advantage of opportunities that passive strategies might miss.
Active management offers the potential to outperform benchmarks and manage risk proactively. It can also enable you to adjust portfolios based on your clients’ unique needs. While active management comes with higher fees and greater complexity, its advantages can have an impact, especially in markets where opportunities for value-added strategies exist.
As you guide your clients through changing market conditions, consider how active management can complement other investment approaches and help achieve long-term goals. Evaluate the skills and track record of active managers and make sure that the strategy aligns with your clients’ objectives and risk tolerance.
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