Active management

Active management, in the traditional sense, is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund's portfolio. Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell. The opposite of active management is passive management, better known as "indexing.”

Another type of active management is quantitative investing, where instead of picking individual stocks or bonds for a portfolio one at a time based on in-depth research, the manager uses data and computer models to select groups of securities with certain desired characteristics. An example of this would be factor investing. Other ways to label these two end-member approaches to active management are 'discretionary' versus 'systematic'.

Active management's results
Canadian mutual funds with active management have a hard time beating their benchmarks over five years, as shown by the following table:

Percentage of funds outperforming the index over five years, as of June 30, 2020; June 30, 2015; and June 30, 2010

The ten year numbers are typically worse, with for example only 5% of actively managed funds beating their benchmark in the US equity category.

Actively managed fixed income mutual funds do not have a good record of beating their benchmarks in Canada either. Over ten years as December 31, 2014, one study found that 0% of short term bond funds funds beat their benchmarks, whereas 4% of medium term bond funds did. Over five years, the figures were 2% and 4%.

Causes of active management underperformance
The basic explanation of why active managers underperform their benchmarks on the aggregate is the fees: "the aggregate portfolio of actively managed U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors". This was first stated by Sharpe in a paper called "The arithmetic of active management".

Selecting active managers
Some active managers may beat their benchmarks in particular years, or even consistently over a series of years. Nevertheless the retail investor still has the problem of discerning how much of the outperformance was due to skill rather than luck, and which managers will do well in the future. In a paper on US mutual funds called "Luck versus skill in the cross-Section of mutual fund returns", Fama & French state that "few funds produce benchmark-adjusted expected returns sufficient to cover their costs". In other words, there is some evidence of skill before fees, but not so much after fees.

As the saying goes, "past performance is not indicative of future results". Star managers can leave their funds, or their outperformance suddenly vanish. A commonly cited US example is Peter Lynch's Magellan fund, which did have benchmark-beating performance over many years, even when analyzed through the lens of a three-factor model. Unfortunately the fund managers that succeeded Lynch did not have any statistically significant 'alpha' (outperformance).

S&P found that "(...) of the Canadian Equity funds that finished in the top quartile in terms of cumulative returns for the period from June 2010 to June 2015, only 8.3% finished in the top quartile for the period from June 2015 to June 2020. In fact, it was more likely for a top-quartile fund to close its doors or change style (25% combined) than to remain in the top quartile."

Why does it persist?
If there is little evidence of manager skill after fees in equity mutual funds, why does active management persist, especially the high-fee type marketed to retail investors? There are several possible explanations.
 * A behavioral explanation is that individual investors using actively managed funds may be subject to overconfidence or optimism bias, i.e. they hope to beat the market and they perhaps erroneously believe that they will be able to select an outperforming manager, and then exit the fund before outperformance vanishes.
 * Some investors might find it difficult to believe that investing is one of rare areas in life where hard work (trying to beat the market with active management) is unlikely to produce better results than percieved 'laziness' (passive management).
 * Another explanation is that investors are responding to "external influences such as marketing efforts or the recommendations of advisers".
 * Finally, there may be non-financial benefits to picking active managers. For example, if an investor picks an active manager that ends up outperforming before fees (although probably not after fees), that investor might still feel smarter than average and brag about returns (before fees).