Active Investing

In this article, Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022) elaborates on the concept of active investing, which is a core investment strategy that relies heavily on market timing and stock picking as the two main drivers of financial performance.

This article is structured as follows: we introduce the concept of active investing in asset management. Next, we present an overview of the academic literature regarding active investing. We finish by presenting some basic principles on active investing.

Introduction

Active investing is an approach for going beyond matching a benchmark’s performance and instead aiming to outperform it. Alpha may be calculated using the CAPM framework, by comparing the fund manager’s expected return with the expected market return (Jensen, 1968). The search for alpha is done through two very different types of investment approaches: stock picking and market timing.

Stock picking

Stock picking is a method used by active managers to select assets based on a variety of variables such as their intrinsic value, the growth rate of dividends, and so on. Active managers use the fundamental analysis approach, which is based on the dissection of economic and financial data that may impact the asset price in the market.

Market timing

Market timing is a trading approach that involves entering and exiting the market at the right time. In other words, when rising outlooks are expected, investors will enter the market, and when downward outlooks are expected, investors will exit. For instance, technical analysis, which examines price and volume of transactions over time to forecast short-term future evolution, and fundamental analysis, which examines the macroeconomic and microeconomic data to forecast future asset prices, are the two techniques on which active managers base their decisions.

Review of academic literature on active investing

As fund managers tried strategies to beat the market, financial literature delved deeper into the mechanism to achieve this purpose. Jensen’s groundbreaking work in the early ’70s gave rise to the concept of alpha in the tracking of a fund’s performance to distinguish between the fund’s manager’s ability to generate abnormal returns and the part of the returns due to luck (Jensen, 1968).

Jensen develops a risk-adjusted measure of portfolio performance that quantifies the contribution of a manager’s forecasting ability to the fund’s returns. He used the measure to quantify the predictive ability of 115 mutual fund managers from 1945 to 1964—that is, their ability to produce returns above those expected given the risk level of each portfolio.

Not only does the evidence on mutual fund performance indicate that these 115 funds on average were unable to forecast security prices accurately enough to outperform a buy-and-hold strategy, but there is also very little evidence that any individual fund performed significantly better than what we would expect from mutual random chance. Additionally, it is critical to highlight that these conclusions hold even when fund returns are measured net of management expenses (that is assume their bookkeeping, research, and other expenses except brokerage commissions were obtained free). Thus, on average, the funds did not appear to be profitable enough in their trading activity to cover even their brokerage expenses.

Core principles of active investing

First principle: market efficiency varies between asset classes.

Investment information is not always readily available in all markets. For less efficient asset classes, an “active” management strategy offers a larger possibility to outperform the market, whereas a “passive” investment strategy may be more appropriate for highly efficient asset classes. In other words, there are compelling advantages for incorporating both active and passive techniques into an overall portfolio.

For example, Wall Street analysts cover a huge portion of US large size shares, making it harder to locate cheap companies. For this highly efficient asset class, a passive investment strategy may be more cost-effective in some cases. On the other side, emerging market equities are sometimes under-researched and difficult to appraise, providing an active manager with additional opportunities to identify mispriced companies. The critical point here is to notice the distinctions and then make the appropriate decisions.

Second principle: market efficiency varies across asset classes.

Within practically every asset class, active and passive management strategies can alternate as winners periodically. Even the most efficient asset classes can occasionally benefit from active management over passive. The reason is substantially distinct from the one stated in Principle One. Principle Two is related to the “Grossman-Stiglitz Paradox”: If markets are fully efficient, there is no reason to investigate them; yet markets can only be perfectly efficient for as long as they are regularly investigated. When investors run out of patience researching stocks in a highly efficient market, passive investment becomes appealing, reopening the door to opportunities for active research. This can result in an annual cycle of active/passive trends.

In some investing environments, active strategies have tended to benefit investors more, while passive strategies have tended to outperform in others. For instance, active managers may outperform more frequently than passive managers when the market is turbulent, or the economy is deteriorating. On the other way, when certain securities within the market move in lockstep or when stock valuations are more consistent, passive strategies may be preferable. Investors may gain from combining passive and active strategies in a way that exploits these insights, depending on the opportunity in various areas of the capital markets. Market conditions, on the other hand, vary constantly, and it frequently takes an intelligent eye to determine when and how much to skew toward passive rather than active investments (Morgan Stanley, 2021).

It’s worth noting that attaining consistently successful active management has historically been more challenging in some asset classes and segments of the market, such as large US company stocks. As a result, it may make sense to be more passive in certain areas and more active in asset classes and segments of the market where active investing has historically been more rewarding, such as overseas stocks in emerging markets and smaller U.S. corporations (Morgan Stanley, 2021).

Why should I be interested in this post?

If you are a business school or university undergraduate or graduate student, this content will help you in broadening your knowledge of finance.

Useful resources

Academic research

Grossman, S., Stiglitz, J., 1980. On the impossibility of Informationally efficient markets. The American Economic Review, 70(3), 393-408.

Lintner, J. 1965a. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics 47(1): 13-37.

Lintner, J. 1965b. Security Prices, Risk and Maximal Gains from Diversification. The Journal of Finance, 20(4): 587-615.

Mangram, M.E., 2013. A simplified perspective of the Markowitz Portfolio Theory. Global Journal of Business Research, 7(1): 59-70.

Markowitz, H., 1952. Portfolio Selection. The Journal of Finance, 7(1): 77-91.

Mossin, J. 1966. Equilibrium in a Capital Asset Market. Econometrica, 34(4): 768-783.

Sharpe, W.F. 1963. A Simplified Model for Portfolio Analysis. Management Science, 9(2): 277-293.

Sharpe, W.F. 1964. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19(3): 425-442.

Business analysis

Forbes, 2021. Active or Passive investing? Two principles provide the answer

JP Morgan Asset Management, 2021. Investing

Morgan Stanley, 2021. Active vs Passive management

About the author

The article was written in November 2021 by Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022).