Active management is an investment strategy in which portfolio managers select securities with the goal of beating a benchmark index. This page covers how active management works, how it compares to passive investing, its cost implications, and what the Series 65, Series 7, and SIE exams require candidates to know.
Definition and Philosophy
Active management is an investment approach in which a portfolio manager or management team makes deliberate decisions about which securities to buy, hold, or sell, with the explicit goal of generating returns that exceed a designated benchmark index. Unlike passive management, which seeks to replicate the composition and performance of an index, active management is built on the conviction that skilled analysis, timing, and security selection can consistently produce superior risk-adjusted returns compared to simply holding the market.
The philosophy underpinning active management rests on a rejection, at least in part, of the efficient market hypothesis in its strongest form. Active managers believe that securities are not always priced correctly by the market, that mispricings can be identified through research and analysis, and that acting on those insights before the broader market corrects them can generate alpha — the excess return above the benchmark. This belief drives an enormous global industry managing trillions of dollars across equity, fixed income, multi-asset, and alternative investment strategies.
How Active Management Differs from Passive Management
The contrast between active and passive management is one of the defining debates in modern finance. Passive management — most commonly implemented through index funds or exchange-traded funds — aims to mirror the holdings and weightings of a specific index such as the S&P 500, the FTSE 100, or the Bloomberg Aggregate Bond Index. The passive manager does not make independent judgements about individual securities. They simply replicate the index, which means the investor receives exactly the market return, minus a very small fee.
Active management takes the opposite position. The active manager builds a portfolio that deliberately deviates from the index — overweighting securities they believe will outperform and underweighting or avoiding those they expect to lag. This deviation is called active share, and higher active share generally indicates a manager with stronger conviction in their views. Active management typically involves higher fees to pay for the research, analysis, and portfolio management required to make these decisions.
The Core Tools of Active Managers
Active managers rely on several analytical disciplines to make investment decisions. Fundamental analysis involves a detailed examination of a company's financial statements, competitive position, management quality, industry dynamics, and valuation metrics to determine whether its shares are priced above or below their intrinsic value. Technical analysis examines historical price patterns and trading volumes to identify trends and signals about future price movement. Quantitative analysis applies mathematical models and statistical techniques to large datasets to identify pricing anomalies or predictive relationships across securities.
Many active managers combine these approaches. A fundamentally driven manager might use quantitative screens to narrow a universe of thousands of securities down to a manageable shortlist before applying detailed fundamental research to make final decisions.
Types of Active Management Strategies
Active management encompasses a wide range of strategies distinguished by their investment philosophy and the types of opportunities they seek. Growth investing focuses on companies expected to grow revenues and earnings at above-average rates, typically accepting higher valuations in exchange for the prospect of rapid compounding. Value investing targets companies whose shares appear underpriced relative to their intrinsic worth — typically identified through metrics such as low price-to-earnings ratios, low price-to-book ratios, or high dividend yields — with the expectation that the market will eventually recognise their true value.
Momentum investing takes a different view, buying securities that have performed well recently on the basis that strong trends tend to persist. Contrarian investing does the opposite — deliberately buying assets that are out of favour and selling those that are widely popular, on the basis that market sentiment often overshoots fundamentals in both directions. Sector rotation involves shifting portfolio weight between industry sectors in anticipation of how different parts of the economy will perform at different stages of the economic cycle.
The Role of the Portfolio Manager
The portfolio manager is central to active management. They are responsible for forming and communicating an investment thesis, selecting and sizing positions, managing risk, and maintaining portfolio discipline under market pressure. In large asset management firms, portfolio managers typically work alongside teams of research analysts — specialists in particular sectors or asset classes — who provide the detailed analysis on which investment decisions are based. In smaller boutique firms, the portfolio manager may conduct much of this research directly.
The quality, experience, and intellectual rigour of the portfolio manager is one of the most significant determinants of active management outcomes. Unlike passive funds, which are largely interchangeable if they track the same index, active funds differ enormously in their philosophy, process, and results. Selecting an active manager is therefore a substantial decision requiring careful due diligence.
Fees and Cost Implications
Active management is materially more expensive than passive management. Active funds typically charge annual management fees ranging from 0.50% to 1.50% or higher for equity strategies, with hedge funds and certain alternative strategies commanding performance fees of 20% of profits above a hurdle rate in addition to a base management fee. These fees compound over time. A fund charging 1.20% per year will, over 20 years, have consumed a significant portion of gross returns relative to a passive fund charging 0.05% to 0.20%.
This fee drag is one of the primary reasons that the majority of active funds underperform their benchmarks over long periods after costs. The higher the fee, the greater the outperformance required simply to match the index — a hurdle that most managers fail to consistently clear.
The Performance Debate: Does Active Management Add Value?
This is one of the most studied and contested questions in finance. The evidence is, on balance, sobering for active management. The SPIVA reports published by S&P Dow Jones Indices consistently show that over ten and fifteen year periods, the large majority of actively managed funds in most categories underperform their benchmark indices after fees. Academic research from Eugene Fama, William Sharpe, and others has built a substantial theoretical and empirical case that markets are sufficiently efficient to make consistent outperformance very difficult.
However, the debate is not fully resolved. Markets are not uniformly efficient across all segments. Less well-researched markets — small-cap equities, emerging markets, certain credit segments — may offer genuine opportunities for skilled managers to exploit pricing inefficiencies before the information is widely absorbed. There is also evidence that a small minority of managers demonstrate persistent skill over time, though identifying them in advance is extremely difficult.
When Active Management May Be Justified
Active management may be justified in several specific circumstances. In less liquid or less researched markets, skilled managers may have a genuine informational edge. Where an investor has specific tax requirements — such as harvesting losses or managing concentration risk in a single security — active management allows customisation that a passive index cannot provide. Where an investor has strong convictions about ESG criteria or other ethical constraints, active management allows precise control over holdings.
Active management also plays a role in downside protection. A passive fund must hold the full index regardless of valuation — during periods of extreme market overvaluation, an active manager can reduce risk by shifting to cash or underweighting the most expensive segments.
Active Management in Different Asset Classes
The relative merits of active and passive management vary considerably by asset class. In large-cap developed market equities — the most heavily researched and efficiently priced segment of global markets — the case for active management is weakest, and the evidence against consistent outperformance is strongest. In fixed income, active management has historically added more consistent value because bond markets are more heterogeneous, less transparent, and less efficiently priced than equity markets. In alternative assets — private equity, hedge funds, private credit, real assets — active management is inherent to the asset class and the question is not whether to be active but how to select the best managers.
Key Metrics for Evaluating Active Managers
Alpha measures the excess return generated above what the portfolio's market risk exposure would predict. A positive alpha suggests the manager has added value beyond simply taking on more risk. The Sharpe Ratio measures the return per unit of total risk, allowing comparison between managers on a risk-adjusted basis. The Information Ratio measures the consistency of active returns relative to the benchmark — a high information ratio indicates persistent rather than occasional outperformance. Tracking error measures the degree to which the portfolio deviates from the benchmark — a higher tracking error reflects higher active share and greater divergence from the index.
Examination Relevance and Key Takeaways
Active management is tested across the SIE, Series 65, and Series 7 examinations. Candidates should understand the distinction between active and passive management, the concept and calculation of alpha, the role of the efficient market hypothesis in framing the active versus passive debate, and the cost implications of each approach.
The core concepts to retain are these: active management involves deliberate security selection with the goal of outperforming a benchmark; it is more expensive than passive management and most active funds underperform over long periods after fees; skill-based outperformance — alpha — is possible but difficult to sustain; and the appropriate role for active management depends on the asset class, the investor's specific constraints, and the quality of the manager selected.
