The pursuit of alpha, or the quest for investment returns that exceed the market's average, is a fundamental goal for many investors. This ambition often leads them to consider the role of active managers – investment professionals who aim to outperform the market through their skill, research and strategic decisions. Unlike passive strategies that replicate market indices, active management involves a hands-on approach, with decisions about buying, selling and holding assets based on market analysis, economic forecasts and company performance.
UNDERSTANDING ACTIVE MANAGEMENT
Active management is predicated on the belief that skilled managers can exploit market inefficiencies to generate superior returns. These managers use a variety of strategies, including fundamental analysis, technical analysis and macroeconomic research, to identify undervalued stocks or sectors poised for growth. The active approach can be applied across asset classes, including equities, fixed income and alternative investments, offering a broad arena for managers to seek alpha.
The success of active management is measured not just by absolute returns, but by performance relative to a benchmark index. Achieving alpha requires not only selecting the right investments but also timing the market effectively – a challenge even for seasoned professionals.
THE CASE FOR ACTIVE MANAGEMENT
Expertise and research: Active managers claim to bring a wealth of expertise and resources to the table. Their access to comprehensive market data, research reports and industry contacts can provide insights that individual investors might not possess. This information advantage allows them to make informed decisions and potentially spot opportunities where others see none.
Flexibility and responsiveness: Market conditions can change rapidly and active managers have the flexibility to adjust their portfolios in response. Whether it's shifting asset allocation, taking defensive positions in downturns or capitalising on short-term trends, active management can navigate the ebbs and flows of the market more dynamically than passive strategies.
Potential for outperformance: The primary allure of active management is the potential to outperform the market. In certain market environments, especially during periods of volatility or when certain sectors or styles are in favour, active managers can leverage their skills to generate significant excess returns.
THE RISKS AND CHALLENGES
Cost: Active management typically comes with higher fees than passive investing. These fees can erode returns, especially if the manager does not consistently deliver alpha. Investors must weigh the potential for higher returns against the certainty of higher costs.
Risk of underperformance: The quest for alpha is fraught with the risk of underperformance. Various studies have shown that a significant number of active funds fail to beat their benchmark indices over the long term. The challenge of overcoming the headwind of higher fees and the difficulty of consistently making correct market predictions contribute to this risk.
Market efficiency: The efficient market hypothesis posits that it's impossible to consistently achieve higher returns than the average market performance through stock selection or market timing, as all available information is already reflected in stock prices. While not universally accepted, this theory underscores the challenge facing active managers in finding and exploiting market inefficiencies.
CHOOSING AN ACTIVE MANAGER
When considering active management, investors should conduct thorough due diligence. This includes reviewing the manager's track record, investment philosophy and performance relative to their benchmark and peers. It's also important to understand the manager's approach to risk management and how they have performed in different market conditions.
Investors should also consider their own investment goals, time horizon and risk tolerance. Active management may be more suitable for those with a higher risk tolerance and a longer time horizon, allowing them to weather potential periods of underperformance in pursuit of superior long-term returns.
Chasing alpha with active managers offers the potential for higher returns but comes with its own set of challenges and risks. While the expertise and strategies employed by active managers can add value, the higher costs and risks of underperformance are significant considerations. Investors who choose this path should be prepared for the possibility of volatility in their pursuit of superior returns and conduct careful research when selecting an active manager.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.