As someone interested in investing in the stock market, you may be wondering what active portfolio management is and how it works. Active portfolio management is a strategy that involves making decisions about individual investments to achieve a desired level of return. In this article, we will discuss what active portfolio management is.
This article will also explore the features of active portfolio management. By the end of this short read, you will understand what type of assets active portfolio managers invest in, its pros and cons, and if it is right for you.
What is active portfolio management?
Active portfolio management is a process of selecting, buying, and selling securities to outperform a specific benchmark or market index. Active portfolio managers’ main goal is to beat the market.
It can be contrasted with passive portfolio management, which involves investing in a diversified mix of assets that match the underlying benchmark. This type of management requires a higher level of involvement than passive portfolio management, which simply involves investing in a predetermined mix of assets and holding.
Active portfolio managers typically focus on specific sectors or types of assets, whereas passive managers will hold a more broadly diversified portfolio.
What are the main characteristics of active portfolio management?
Here are the key features of active portfolio management:
- Security selection
- Asset allocation
- Risk management
- Higher management fees
- Use of Leverage
Active portfolio managers make decisions about which individual securities to buy and sell. This process involves analyzing companies and industries to identify those that are undervalued or have growth potential.
To achieve optimal security selection, active portfolio managers will use a variety of tools, including financial statement analysis, economic analysis, and technical analysis. They may use trading tools such as stop-loss orders to limit downside risk.
Active portfolio managers also make decisions about how to allocate their assets among different asset classes. This process involves determining what percentage of their portfolio should be invested in stocks, bonds, cash, and other assets.
Active portfolio managers also make decisions about when to buy and sell securities. This process is based on the belief that security prices move in cycles and that it is possible to profit by predicting these movements.
An example of a market cycle would be the movement from an uptrend to a downtrend. To profit from this market cycle, an active manager would need to sell their holdings before the market trend reverses.
Active portfolio managers seek to minimize risk by diversifying their portfolios and actively monitoring their positions. They may also use hedging strategies to protect against losses in specific securities or sectors.
Hedging is when you take a position in an asset that is opposite of your current position. For example, if you are long (own) a stock, you would hedge your position by buying put options on that stock. If the stock price falls, the value of your put option will increase, offsetting some of the losses from your stock position.
Active portfolio managers will also have a clear understanding of the risk/reward profile of each security in their portfolios. This means that they are aware of the potential losses that could be incurred from holding particular security, as well as the expected return. They are also willing to hedge their portfolios heavily against tail risk.
Higher management fees
Active portfolio management generally requires higher management fees than passive portfolio management. This is because active managers must research and make decisions about individual securities, which takes time and money.
Management fees can range from 0.50% to over 2.0% of assets under management, depending on the firm and the type of account. This may not seem like a lot, but it can add up over time, especially if you have a large account. However, if their expertise can generate higher returns, then the fees may be worth it.
Use of Leverage
Active portfolio managers may use leverage, which is the borrowing of money to invest. This can magnify gains or losses. For example, if an active manager buys $100,000 worth of stock with leverage, and the stock goes up by 20%, then the value of their position will increase to $120,000.
They could then sell the original shares for a profit of $20,000. However, if the stock price falls by 20%, then the value of their position will decrease to $80,000. If it keeps decreasing they may experience a margin call.
This means that their broker will require them to deposit more money or sell some of their positions to cover the losses. Leverage can be a risky strategy, but if used correctly, it can help active portfolio managers achieve their investment objectives.
What type of assets do active portfolio managers invest in?
Active portfolio managers typically invest in stocks, but they may also hold other types of assets, such as bonds, real estate, and commodities. They may also use derivative instruments, such as options and futures contracts, to speculate on the direction of the market or to hedge their portfolios.
Active portfolio managers typically have a more aggressive investment style and are willing to take on more risk in pursuit of higher returns. For example, they may invest in small-cap stocks or junk bonds, which tend to be more volatile than blue-chip stocks or government bonds.
Overall, the exact allocation of assets that they will own depends on the market condition and their conviction in the underlying security. If they believe that a particular stock is undervalued, they may have a larger position in it.
If they believe that the stock market is about to crash, they may increase their cash holdings. If you aren't sure about which assets to invest in, an active portfolio manager may be helpful for you.
Active portfolio management examples
An example of active portfolio management would be a portfolio manager who buys and sells stocks based on their own research and analysis. They would make decisions about which companies to invest in and when to buy or sell their shares.
An active portfolio manager would typically have a more hands-on approach to investing than a passive portfolio manager.
For example, they may spend hours researching a particular company before making an investment decision.
Some of the most famous active portfolio managers include:
George Soros Example
Here is an example story of what a meeting with an active portfolio manager might look like:
You sit down with your financial advisor, who tells you that he thinks it might be time to start actively managing your portfolio.
He says that the market has been doing well recently, but he thinks it might be due for a correction. He recommends that you sell some of your stocks and buy some bonds instead. You're not sure if you want to do this, so you ask him to explain how active portfolio management works.
He tells you that active portfolio managers make decisions about which stocks to buy and sell based on their expert analysis. They also have a more opportunistic and risk-adjusted investment strategy, which can provide you with higher returns.
You're not sure if you want to take on more risk, so you ask him to give you an example of how active portfolio management might work. He tells you the story of George Soros, who is one of the most famous active portfolio managers.
In 1992, Soros bet against the British pound and made around $1 billion in profits. He did this by selling pounds and buying other currencies. This story makes you feel more comfortable about taking on more risks. You decide to go ahead and start actively managing your portfolio with the help of your financial advisor.
However, right before you sign on the dotted line, you notice the management fee is quite high. You ask your financial advisor about this concern. He tells you that active portfolio management comes with higher fees because it requires more work than traditional, passive investing.
You think about it for a moment and decide that you're still interested in actively managing your portfolio, even though it will cost you more. You sign the paperwork and begin working with your new active portfolio manager.
What strategy do active portfolio managers use?
When it comes to active portfolio management, there are two main strategies that managers use to achieve their investment objectives. The first strategy is known as top-down investing, and it involves starting with an analysis of the overall economy before moving on to individual sectors and then to specific companies.
For example, a manager who uses this strategy might begin by looking at factors such as GDP growth, inflation, and interest rates. They would then look at how different sectors are performing, and finally, they would select individual companies to invest in. This is what is known as top-down investing.
The second strategy is known as bottom-up investing, and it involves starting with an analysis of individual companies before moving on to sectors and then the overall economy. To do this, managers might look at factors such as a company's financial statements, competitive advantage, and management team.
The majority of active portfolio managers use a combination of both top-down and bottom-up investing to make the most informed investment decisions possible.
Do you need an active portfolio manager?
The answer to this question depends on your investment objectives and risk tolerance. If you're someone who is looking to generate high returns and are comfortable with taking on more risk, then actively managed portfolios might be a good fit for you.
On the other hand, if you're someone who is risk-averse and is looking for stability, then a passive portfolio might be a better option.
If you answer "Yes" to the following questions, then actively managed portfolios might be a good fit for you.
- Are you comfortable with volatility?
- Are you looking to generate high returns?
- Do you have a long-term investment horizon?
- Are you comfortable with paying higher fees?
- Do you want someone else to control your investment outcome?
At the end of the day, you don't need an active portfolio manager. However, it can be a good decision for some people. It all depends on the manager and your investment goals.
How to choose an active portfolio manager?
When it comes to choosing an active portfolio manager, there are a few things you should keep in mind. First, make sure to interview several managers to find one that you're comfortable with. Second, be sure to ask about their investment strategy and philosophy.
Finally, make sure to ask about their fees. While there is no one perfect way to choose an active portfolio manager, these tips should help you narrow down your options and find a manager that's a good fit for you.
If you are looking for someone to manage your portfolio, you may want to consider an active portfolio manager. While they generally have higher management fees, they may also be able to generate higher returns.
Although this is not always the case. Some research suggests that, over time, passive investing outperforms active investing. So you will want to weigh your options and decide what is best for you and your financial goals.