Active Fund Management: Meaning, How It Works, Advantages and Disadvantages

Imagine you are a new chef in a hotel, assigned a task to prepare a dish. Now, you have two approaches to designing a dish. In the first approach, you can simply follow the pre-determined recipe the hotel uses to prepare the same dish, step by step, without adding your culinary expertise. Thus strictly adhering to the recipe. In the second approach, you can prepare the dish from scratch using your experience in selecting vegetables, spices, seasonings, etc. Both approaches focus on designing a dish, but the process is different. 

In the investment world, the first approach is referred to as a passive approach. Under this approach, you aim to build a portfolio by replicating a pre-determined market index without actively picking stocks. Here, you desire to match the return of a market index simply. These indexes can be Nifty 50, Sensex, Nifty 500 or any other market index. Remember what we learned about index funds in the mutual fund classification module? They strictly follow the same passive approach of building a portfolio. 

In the example above, the second approach actively builds a portfolio. Here, you aim to beat the benchmark and generate alpha, i.e. excess returns over and above the market index. Therefore, you use your expertise and research and put time and effort into handpicking potential stocks that can beat the benchmark. Thus, active management uses human capital to manage a portfolio. Active managers or investors rely on analytical research, their judgment, and forecasts to make decisions on what securities to buy, sell, or hold. 

Remember in the earlier chapters, we studied the efficient market hypothesis? Active Investors do not believe in the Efficient Markets Hypothesis. Rather, they believe that inefficiencies in the market allow market prices to be incorrectly priced. Thus, an investor can profit in the stock market by identifying mispriced securities and following a strategy to take advantage of this. 

What Are the Objectives of Active funds?

Mutual funds that follow an active approach to building a portfolio are called active funds. As discussed above, the main objective of active funds is to beat the benchmark index and generate alpha. Apart from this, other objectives of active funds include:

• Preservation of capital: By managing risk and actively picking stocks, active fund managers aim to protect the capital downside by avoiding significant losses. This can be done by timely cutting off the losers as and when the fundamentals of a stock deteriorate. 
• Adaptability: As the fund managers can deviate from the market index, they can adjust their portfolio per the market conditions by actively making decisions as and when the situation demands. This also helps them take advantage of emerging market opportunities. 
• Value creation: Some active funds follow a value investing style where they invest in undervalued stocks while short-selling overvalued stocks. This leads to value creation for investors of the active fund. 

How Do Active Funds Work?

As the aim is to beat the benchmark, active funds usually follow a set process. Active funds have a team of portfolio managers, qualified research analysts, and other key people who study listed companies, understand their financials, analyse market trends, consider macroeconomic trends, and then make investment decisions. The steps included in this process are:

1. Planning

This step involves identifying investors' investment objectives and constraints. These are generally the target group of investors from whom the fund aims to attract investments. This can include an analysis of investors:

• Risk and return expectations
• Time horizon
• Liquidity needs
• Legal and regulatory requirements, and Tax Issues

After considering the above factors, an investment policy statement (IPS) is created for an investor. This statement usually notes the reporting requirements, investment communication, rebalancing guidelines, investment strategy and style, manager fees, etc. 

2. Securities selection and portfolio construction

After identifying the fund’s objective and constraints, active managers hunt for securities that are a potential fit for their portfolio. This involves the process of in-depth research and analysis of the companies. After identifying the appropriate securities, fund managers start the portfolio construction using active investment strategies, thus deploying the investor's resources. Allocation and securities weights depend on various factors like risk and reward of the securities, market conditions, fund’s objective, legal constraints, etc. This step makes active funds different from passive funds. Here, as clearly understood, the fund manager is involved in each and every step and takes decisions in the best interest of investors. 

3. Monitoring and evaluation

The Active fund management team regularly monitors the portfolio’s performance and makes informed decisions accordingly. This involves:

• Measuring the past performance of the portfolio
• Regularly monitoring the portfolio companies 
• Active tracking of portfolio companies as well as potential entrants in the portfolio 
• Regular communication with company management, attending conference calls and investor presentations
• Exiting securities if fundamentals change or in any other adverse situation
• Fresh investments in new securities 
• Portfolio rebalancing and bringing the weights of the securities to predetermined weights. This can include selling the overweight or overvalued securities and buying the underweight or undervalued securities. 

The step involves managing exposures to investments made in a portfolio. It ensures that the portfolio is still within the fund’s investment objective.

Advantages of Active Management

The principal advantage of active investing is the flexibility of the fund manager to make use of various investment choices and strategies. This gives investors of an active fund the following advantages:

• Potential to outperform the market and earn alpha. Thus, it generates returns better than passive investing. 
• Investors can follow a strategy that aligns with their personal investment goals.
• Ability to adjust to market conditions and exploit opportunities on time. This helps in making informed decisions. 

Disadvantages of Active Management

We have looked at all the positives of active investing. However, it doesn’t mean active investing doesn’t have disadvantages. Active funds come with their own set of problems, some of them being:

• There are chances that the fund manager's investment decisions might turn out to be unfavourable. This can lead to bad investment choices. 
• Active selection of securities doesn’t guarantee outperformance. There are chances of active funds underperforming the benchmark index, resulting in negative alpha.
• When an actively managed fund becomes popular due to its past returns, it might attract colossal investment flows from investors. This can lead to funds becoming very large in terms of asset pool. This can lead to funds having index-like characteristics due to over-diversification. Also, suppose the fund’s asset pools become very large. In that case, it also becomes difficult for the fund manager to deploy funds, and thus, it might result in investing in companies with huge market capitalisation to ensure liquidity for investors. This ultimately leads to deviating from the investment objective of the fund. 
• Past returns of active funds don’t guarantee future returns. Outperformance in one year might be followed by years of underperformance. 

Why Active Funds Are Expensive?

Another disadvantage of active funds is that these funds are expensive. What do we mean by expensive? This means the expense ratio of these funds is usually higher than that of passively managed funds. To recap, the expense ratio is the annual maintenance fees and charges levied by the mutual fund to fund its expenses. This leads to a higher cost burden for the investors of active funds. There are various reasons why active funds have a high expense ratio:

• As you understand now, active funds involve continuous research and in-depth analysis, unlike passive funds. This involves hiring market research professionals and investing in information systems, data, and other resources. This all comes at a high cost for the fund. 
• On top of the research and analysis cost, the compensation to professional fund managers is even higher, as they spend their significant time and efforts managing active funds, continuously aiming to outperform the market. 
• As active funds frequently buy and sell securities as per the fund manager’s discretion to respond to changing market conditions, they involve high transaction costs in the form of brokerages and bid-ask spreads. Passive funds are rebalanced only when the index tracks rebalances. 
• Apart from research and construction of the portfolio, a high cost is involved in the constant monitoring of the fund. The fund managers must ensure that the portfolio aligns with the fund's investment objective. 
• It might be possible that many active fund managers are compensated in the form of incentives if their fund performs well. This acts as a reward to motivate the fund managers to maintain the same level of performance in the future. However, This leads to additional costs for the fund investors. 

Apart from the above costs, there are other generic costs like marketing and distribution expenses, custodial and administrative expenses, etc. All the factors combined result in active funds having higher fees than passively managed funds. 

An active management style requires a huge infrastructure of analysts, managers, and operations. This requires high compensation, ultimately making an actively managed fund more expensive than a passive fund. 

How Many Active Funds Surpass the Benchmark?

The main objective of the active fund is to generate alpha, i.e. excess returns over a market index. However, after meeting all the expenses, additional costs, etc., can active funds beat the benchmark? Let’s talk about some data here. 

There is a report named ‘S&P Indices Versus Active Funds’ [SPIVA], which is published by S&P Global every six months. As a part of that report, The SPIVA India Scorecard compares the performance of actively managed Indian equity and bond mutual funds with their respective benchmark indices over 1-, 3-, 5- and 10-year investment horizons.

Here is the conclusion from the report fund-wise:

Indian Equity Large-Cap Funds

• The S&P BSE 100 gained 7.1% in 1st half of 2023, and 58.1% of active fund managers underperformed the benchmark over the same period.
• The underperformance rates remained high over three- and five-year periods, at 86.2% and 92.9%, respectively.
• Active fund managers produced comparatively better returns over the 10 years, with the underperformance rate dropping to 61.2%.

Indian Equity Linked Savings Scheme [ELSS] Funds

• The S&P BSE 200 was up 6.2% in the first half of 2023, and 17.5% of Indian ELSS funds underperformed the index during the same period.
• Over the longer term, the underperformance rate rose, with 66.7% of funds underperforming the benchmark over the 10-year period.
• Indian ELSS funds achieved the second-highest long-term survival rate across all categories in the SPIVA India Scorecard, with 75.0% still surviving after 10 years.

Indian Government Bond Funds 

• The benchmark for Indian Equity Mid-/Small-Cap funds, the S&P BSE 400 MidSmallCap Index, rose 12.4% in H1 2023, and 45.3% of active managers underperformed the index. 
• Among all the SPIVA India Scorecard categories, Indian Equity Mid-/SmallCap funds fared the best over a five-year horizon, with only 38.1% underperforming the S&P BSE 400 MidSmallCap Index.

Indian Equity Mid-/Small-Cap Funds 

The S&P BSE India Government Bond Index increased 4.7% in the first half of 2023. Fewer than one-sixth of active managers beat the benchmark over the period, with an underperformance rate of 85.2%. 
Fewer funds underperformed as time horizons extended, with underperformance rates over the three- and five-year periods falling to 75.0% and 66.7%, respectively.

Here is a tabular representation of the above findings:

Thus, the above data analysis tells you that it has become difficult for active fund managers to beat the benchmark, especially over a longer term. Over the longer term, there is some scope for outperformance in the mid and small-cap categories. However, the fund’s selection and holding on to it becomes challenging for the investor. 

What Should Investors Consider before Choosing an Actively Managed Fund over a Passive One?

We have understood most of the details about the active funds. However, the final question arises: what should investors consider before choosing an actively managed fund over a passive one? Well, there are several factors, and let’s discuss them in detail:

• Investment strategy and goal 

Active funds are suitable if the investor aims to earn potential excess returns by taking on more risk. Passive funds simply replicate the benchmark index and thus are as risky as a benchmark. However, active funds involve active decision-making and selecting securities, which have a high probability of unfavourable outcomes. However, if you, as an investor, are okay with the risk component and chances of higher volatility in your portfolio, you can choose active funds over passive funds. 

• Fees and costs

We have seen earlier that active funds are more expensive than passive funds for various reasons. If higher costs justify the outperformance in the market, you can choose an active fund over a passive one. However, the difference between the index and net returns generated by an active fund after meeting all the expenses is insignificant. In that case, you might choose a passive fund over an active fund. 

• Performance consistency

Investors should look into the manager’s consistency in generating excess returns. As mentioned in the risk section, past performance doesn’t guarantee future performance; therefore, earlier years of outperformance hold no guarantee of repeating the same performance in the future. Thus, if you as an investor believe the fund managers are capable, believe in the investment ability to make informed decisions and can generate alpha, you can choose an active fund over a passive fund. 

Thus, if you have a higher risk appetite and are comfortable with longer periods of volatility and fund underperformance but at the same time believe in the fund manager's capability, you can choose active funds over passive. 

What Are the Funds Considered in Active Fund Management? 

Active funds can spread across multiple categories across debt and equity classifications discussed earlier in the mutual fund's classification chapter. Therefore, active funds are present in every category with their investment focus and strategy. These types are

• Equity funds

1. Large-cap 
2. Mid-cap 
3. Small cap 
4. Sectoral or thematic funds 

• Debt funds

1. Government bond funds 
2. Corporate bond funds 

• Balanced or hybrid funds 

1. Global and international funds
2. Commodities fund
3. Multi-asset funds 

These are the broad categories that have active funds. You must carefully assess the fund strategy, investment objective, historical performance, fee structure, fund manager, etc., before choosing a fund in a particular category. Also, select a fund that matches your risk and return expectations. Apart from the funds mentioned above, there are other categories of funds, but the ones mentioned above are the most prominent and widely used. To understand the meaning of each category in detail, please refer to the mutual funds classification chapter. 

How To Invest in Mutual Funds on Angel One?

1. Open the Angel One app. On the Home page, go to ‘Mutual Funds’.
2. Choose the Mutual Fund that you want to invest in from the various lists provided on the Mutual Fund portal.
3. Choose whether you want to invest via lump sum or SIP mode.
4. Enter the amount that you want to invest.
5. Click on the payment button to complete the payment and start your investment.

To conclude this chapter on active funds, these funds offer you the potential to earn superior returns but at higher costs.  These funds also come with their continuous challenge to beat the market consistently. Therefore, you should weigh these factors carefully, considering your financial objectives, risk tolerance, and the insights from reports. Ultimately, deciding between active and passive investing should align with an investor's unique financial journey and goals.