Active portfolio management aims to outperform the market, often compared to benchmark like the Standard & Poor's 500 Index. Performance evaluation involves metrics like Active Share and comparing portfolio holdings with the benchmark.
One of the most common strategies that investors and mutual fund managers use in the financial markets is active portfolio management. It is a dynamic investment strategy that aims to generate returns that exceed those of a specific benchmark market index.
In this article, we are going to explore the meaning of active portfolio management, deconstruct the various intricacies of this investment approach, and gain insights into the various advantages and disadvantages that it offers.
What is active portfolio management?
Active portfolio management can be defined as a hands-on investment approach where investors or mutual fund managers actively make investment decisions depending on the prevailing market conditions to ensure that the returns from the investment portfolio outperform a market index such as the Nifty 50 or the Sensex.
The strategy involves thorough research and analysis, precise selection and allocation of assets, the implementation of a range of strategies, and frequent monitoring of market conditions and portfolio performance.
Example of active portfolio management
Now that you are aware of the meaning of active portfolio management, let us take up a hypothetical example to help you understand the concept better.
Assume there is a mutual fund that invests in a diversified basket of equity stocks across multiple sectors, including retail and technology. The index that has been assigned as a benchmark is the Nifty 50.
The fund has a dedicated fund manager who is experienced in navigating the financial markets. The manager, after thorough market research and analysis, concludes that technology stocks are currently undervalued and that they are likely to grow at a fast pace shortly due to rapid innovation and increasing demand for tech solutions. The fund manager’s research also shines a light on the traditional retail sector and how it is likely to underperform due to declining sales and competition from e-commerce.
Based on the findings, the manager proceeds to include a set of fundamentally strong technology companies in the mutual fund’s portfolio, aiming to capitalise on their wealth-creation ability. Simultaneously, they also choose to divest their stake in stocks in the retail sector to prevent losses.
If the market moves according to the fund manager’s expectations, the mutual fund portfolio will generate returns that outperform the benchmark index, the Nifty 50. Such adjustments to the investment portfolio based on market conditions and economic forecasts are an example of active portfolio management.
Advantages of active portfolio management
Active portfolio management offers a plethora of different advantages. Let us look at some of the key benefits that this approach has to offer.
Potential for higher returns
Investors and fund managers who use active portfolio management constantly look out for market inefficiencies that can be exploited. For instance, skilled managers of mutual fund schemes often identify and invest in undervalued securities or emerging sectors in the hopes of creating wealth over the long run. If successful, the approach could potentially deliver returns far surpassing the overall market.
Tailored strategies
Another major advantage of active management is that investment strategies can be deeply personalised and tailored to investors’ objectives, risk tolerance levels and time horizons. Owing to such intricate levels of customisation, active portfolio management can cater to a wider range of investor’s needs and preferences compared to the one-size-fits-all approach of passive investment strategies.
Flexibility
Active portfolio management provides investors and fund managers with the freedom and flexibility to swiftly adapt to changing market conditions, economic indicators and geopolitical scenarios. Such high levels of agility can help them protect their portfolio from losing value due to market downturns. Additionally, it also enables them to capitalise on growth opportunities.
Risk management
Active portfolio management prioritises risk management. Investors and managers using this approach continuously monitor the various risks and implement various strategies, such as diversification, reallocation, and hedging, to protect their portfolios from downside risk due to adverse market conditions.
Tax considerations
Active management also involves implementing tax-efficient strategies. These include tax-loss harvesting, where the losses are offset with profits to minimise the impact of taxation on returns.
Techniques and strategies employed in active portfolio management
Investors and fund managers who opt for active portfolio management use a plethora of different techniques and strategies to outperform the market. Let us look at some of the most commonly used strategies.
- Asset allocation
Asset allocation involves earmarking and investing capital across various asset classes, such as stocks, debt securities or a combination of both. The ideal asset allocation mix is determined based on the goals and risk profile of the investor. - Security selection
Once the asset allocation mix is determined, the next step is to select individual securities that have the potential to outperform the market. When selecting securities, investors and fund managers use a mix of fundamental and technical analysis techniques to identify the right securities. - Risk management
Risk management involves implementing measures to protect the value of investments from declining due to adverse market movements. Some of the risk management techniques that are often used in active portfolio management include diversification, hedging and setting stop-loss orders. - Market timing
Market timing is a technique that involves purchasing and selling securities based on predictions of future market movements. Despite being challenging, timing the market can significantly enhance returns when done right. Investors and fund managers often use technical analysis to help time their investments. - Fundamental analysis
Fundamental analysis is a technique that involves identifying the true intrinsic worth of a security. It determines whether a particular security is overvalued or undervalued by examining the asset's financial health and other fundamental factors. - Technical analysis
Technical analysis is a technique that involves predicting the future movements of assets based on historical price and volume data. The method involves using charts, technical indicators and candlestick patterns to identify buy and sell signals.
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Market trends and conditions affecting active portfolio management
Several factors influence the effectiveness of active portfolio management. Understanding what they are can help in mitigating their effect on the strategy.
- Economic indicators
Key economic indicators such as Gross Domestic Product (GDP) and unemployment rates are all major factors that affect the financial market and the performance of an active portfolio management strategy. - Political and geopolitical events
Geopolitical tensions, unstable political scenarios and government policies can also influence investor sentiment and active portfolio management. - Industry trends and disruptors
Innovations and disruptions within specific industries can create new investment opportunities, risks or a combination of these two. For example, technological advancements and shifts in consumer behaviour often boost demand and enhance market performance, influencing active portfolio management. - Interest rate and inflation changes
Fluctuations in interest rates and inflation figures usually impact the performance of various financial securities. Investors and fund managers who actively manage their portfolios must look out for these changes and implement strategies accordingly. - Currency fluctuations
The exchange rate movements may also have a significant impact on active management strategies, especially if they involve investing in international securities or stocks that depend on foreign revenue. In such cases, it is important to employ hedging strategies to protect the investments from currency risk.
Also read ABOUT: What is portfolio composition
Best practices in active portfolio management
To be successful at active portfolio management, investors and fund managers must ensure that they employ the following good practices.
- Set investment objectives
Identifying investment goals that are measurable and realistic is important. This way, investors can ensure that they choose the right strategy, remain focused and refrain from making decisions that are impulsive or fueled by emotions. - Conduct regular reviews
Regularly reviewing and rebalancing the investment portfolio ensures that it aligns with the investment objectives and risk profile of the investor, which is a crucial factor for success. - Monitor and adjust strategies
Continuously monitoring market trends, economic indicators and the performance of individual securities can help investors and fund managers make informed and timely adjustments to their portfolios. - Stay informed of market trends and conditions
Investors can effectively navigate the complexities of the financial markets by keeping themselves updated on the various market developments, shifts in consumer behaviour, industry trends and global events. - Maintain a disciplined and consistent approach
Discipline, consistency and patience are the foundational stones for long-term success. Investors using an active portfolio management strategy must ensure that their approach to investing is disciplined and consistent. They must trust and adhere to the formulated strategies irrespective of market conditions and avoid making decisions fueled by emotions such as fear or greed.
Disadvantages of Active Portfolio Management
As an investor, merely being aware of the various advantages of this approach may not suffice. You must also get to know the various drawbacks as well. Here are some of the key disadvantages associated with active portfolio management.
- Higher costs
Many active portfolio management strategies involve frequent buying and selling of securities and constant monitoring of market movements. This inadvertently leads to higher expenses in the form of management fees and transaction costs, which can lower your returns. - Increased risks
Active management strategies focus on outperforming the market, even if it means taking on more risk. This makes the approach more suitable for investors with high-risk tolerance levels. Furthermore, there is also the risk of the portfolio not performing according to expectations, leading to less-than-ideal returns. - Complexity
Active portfolio management can be complex and time-consuming since it requires extensive research and analysis, the selection of stocks, the formulation and implementation of strategies, and constant monitoring.
Conclusion
Active portfolio management is an investment strategy that has the potential to deliver high returns compared to the market. However, despite its various benefits, the approach has a few drawbacks in the form of increased expenses and risk. As an investor, you must weigh the pros and cons associated with the strategy before opting for it.
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