Disadvantages of Active management

Active management issues –

Active management is simply an attempt to "beat the market" as measured by a particular benchmark or index. For example, an investor might buy or sell certain stocks to try to get better returns than one of the stock market indexes such as the S&P 500 Index or the S&P/TSX Index. 

The aim of active fund management is to outperform the benchmark index for a particular fund, after fees are paid.  Prevailing market trends, the economy, political and other current events, and company-specific factors can all affect an active manager's decisions. So the most obvious disadvantage of active management is that the fund manager may make bad investment choices or follow an unsound theory in managing the portfolio.

 

In reality, a large percentage of actively managed mutual funds rarely outperform their index counterparts over an extended period of time, (although some managers do outperform passively managed portfolios over long periods of time).  

The reason most active mutual funds underperform market indexes are because they are "closet indexers" — funds whose portfolios look like indexes and whose performance is very closely correlated to an index.  These mutual funds are only marketing themselves as “active managers” to justify higher management fees and management of these funds believe that if they only trail market returns by a few percentage points, the clients won’t leave, however if they underperformed the market significantly clients would leave. 

    

Active fund management strategies that involve frequent trading generate higher transaction costs which diminish the fund's return.  In addition, the short-term capital gains resulting from frequent trades often have an unfavorables income tax impact when such funds are held in a taxable account. 

As an individual investor, keep in mind that both active and passive managers are selecting investments from the same pool of equities. Active management should have a place in most investor portfolios but it is important to keep in determine:

Does the manager have a track record of outperforming market benchmarks over extended periods of time?

Is the manager a closet indexer, calling themselves active managers to justify higher investment management fees?

Is my active manager involved in frequent trading, which generates higher transaction cost and additional capital gains taxes?

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kevin@scoutinvestment.ca                www.scoutinvestments.ca                              1-800-795-6701