Active Portfolio Management: Meaning, Strategies

Active portfolio management is an investment strategy in which professional managers purchase and sell securities on behalf of investors to meet specific goals. Let’s learn more about this below. 

What is Active Portfolio Management?

Active portfolio management is a more hands-on investment strategy in which professional managers buy and sell securities, such as bonds and stocks, with the objective of outperforming specific market benchmark indexes. The approach itself depends on extensive research and market analysis, along with continuous portfolio management and adjustments. 

Of course, while there are potentially higher returns, the fees are also higher than those of passive investing. Company news, economic data, and fundamental and technical analysis are used to determine strategies, such as sector rotation, stock picking, leveraging inefficiencies in the market, and market timing.

The approach also carries higher risks due to its dependence on the manager's skills, while also incurring higher trading costs and management fees. In this case, passive portfolio management only aims to match the market by tracking an index.

However, active portfolio management aims to beat the market through skilled managerial decisions. Managers may actively buy stocks they feel are undervalued and sell them after price rises, while even short-selling overvalued stocks to make profits from dips in prices. They may also adjust holdings in response to political developments or economic forecasts. 

Example of Active Portfolio Management

There are several examples of actively managed portfolios -  

• Suppose the portfolio manager sees huge innovation and demand in the technology sector, with potential for future growth, while noting falling sales and competition in the e-commerce or retail sector. In this case, the manager decides to scale up fund allocation to tech entities that are fundamentally strong (digital services, software companies, etc.). 
• Simultaneously, the manager also exits or reduces positions in retail stocks that are struggling in order to prevent losses. In this case, the goal may be to achieve optimised returns above the market average or to outperform the benchmark, such as the Sensex or Nifty 50. 
• Managers may also adjust equity/debt exposure depending on market forecasts and conditions. So, let’s say there is a strong market rally. In this case, the manager may move to an 80:20 (equity-to-debt) ratio rather than 60:40 or 70:30 to make the most of the favourable growth environment.

Advantages of Active Portfolio Management

There are several advantages of active portfolio management, including the following: 

Potential for Higher Returns 

One of the benefits of active investment management is the potential to earn higher returns. This is because the experienced portfolio manager will have a primary goal of generating alpha or returns surpassing the benchmark index. The portfolio manager will keep identifying and leveraging mispriced securities (overvalued or undervalued) that are often missed by passive strategies. Active managers also invest in several high-growth segments or new opportunities, enabling possible outperformance across diverse market conditions. 

Tailored Strategies

There are tailored or personalised active portfolio management strategies that align with investors' goals, desired time horizon, and risk appetite. Unlike passive funds that mirror entire indexes, active management builds focused, thematic portfolios tailored to clients' needs and objectives. 

Flexibility 

Active portfolio management helps managers respond swiftly to market fluctuations, economic shifts, and major geopolitical developments. Managers are not required to hold particular underperforming stocks, with full freedom to switch asset allocation to minimise losses. They can actively rotate across multiple economic sectors while leveraging market cycles to achieve higher returns.

Risk Management 

Active managers can smartly manage risk by adopting defensive positions during market downturns, shifting to stable assets, and increasing cash holdings. They also use strategies such as derivatives, short selling, and stop-loss orders to minimise losses. This is not possible with buy-and-hold strategies followed in passive portfolio management. 

Tax Considerations 

Managers can also strategically sell underperforming securities to generate losses, offsetting capital gains and lowering overall tax liabilities. They can also better manage the timing of taxable events. 

If you were looking at the active vs passive portfolio management debate, the above-mentioned pointers will give you an idea.

Techniques and Strategies Employed in Active Portfolio Management

Several strategies and techniques are employed in active portfolio management. Some of them include: 

• Fundamental Analysis

This involves analysing the intrinsic value of a security alongside economic trends, financial health, and other industry factors. The aim here is to identify undervalued assets. 

• Technical Analysis

Some key aspects here include using patterns, charts, and trading volumes to forecast future price movements and time market trades. 

• Market Timing

This is an attempt to forecast shifts in the market for buying low and selling high, using technical indicators for validation. 

• Stock Picking

Managers actively choose individual stocks, believing in their future growth potential or undervalued nature. 

• Asset Allocation

They determine the asset-class mix (bonds, stocks, cash, etc.) and adjust it based on market conditions and the overall outlook. 

• Sectoral Rotation

Investments are shifted between sectors such as energy and technology in response to changing economic conditions. 

• Diversification

This involves spreading investments across multiple assets, geographies, and industries to reduce risk. 

• Hedging

Leveraging financial instruments, such as futures and options, to offset possible losses. 

• Stop-Loss Orders

This means automatically selling securities when they fall to predetermined prices to limit losses. 

• Rebalancing Portfolios

The strategy involves periodic portfolio adjustments back to the target asset allocation levels. 

• Regular Portfolio Reviews

Market conditions are continuously tracked, along with portfolio performance and other economic indicators. 

There is a goal-based approach at work, in which managers define clients' financial goals based on their risk appetite and investment duration. Thereafter, they choose financial instruments and build the portfolio to implement their investment decisions (based on strategy and research). They regularly evaluate performance against specific benchmarks and objectives thereafter. 

Market Trends and Conditions Affecting Active Portfolio Management

Active portfolio management is often affected by multiple market conditions and trends. Some of them include: 

• Economic Indicators

These include unemployment rates, GDP growth, and inflation. They directly impact securities and market sentiments, thereby necessitating active management and continuous tracking. 

• Geopolitical Events

Key geopolitical developments, such as global tensions, trade policies, and political instability, which may lead to volatility and affect investments. 

• Inflation and Interest Rates

Market fluctuations may affect returns across multiple asset classes, prompting managers to adjust strategies for risk mitigation and to discover new opportunities. 

• Industry Trends

These include shifts in consumer behaviour, thematic investing cycles, and disruptive technologies. The goal for managers in this case is to leverage particular sectors. 

• Technological Advancements

New-age tech innovations like AI and others may create new investment risks and themes. This needs active management to identify undervalued technologies or sectors, and to adapt swiftly to changes. 

There are other market conditions that affect strategies, including the following: 

• Range-Bound or Sideways Markets

Intelligent stock choices and cost control are vital in flat markets. 

• Uncertain Conditions and Volatility

Lower liquidity and high volatility often create a conducive environment for active management. Managers can swiftly identify mispriced stocks and manage risk more effectively than passive investment strategies. 

• Market Breadth

When more stocks participate in market rallies, active managers usually outperform their benchmarks, according to historical trends. 

Best Practices in Active Portfolio Management

Some of the best practices in active portfolio management include: 

• Defining the financial goals and strategies to achieve them, keeping risk tolerance and time horizon in mind
• Sticking to the strategy/plan, while bypassing emotional impulses or reactions to market fluctuations 
• Ensuring all the investments strategically support the strategic objectives and diversifying investments throughout multiple asset classes to lower risks 
• Combining multiple assets with specific allocation ratios as per the client’s risk profile
• Conducting thorough research on investments and staying informed on the market trends and other economic indicators 
• Regular portfolio monitoring and rebalancing periodically to maintain the target risk levels and allocation 
• Minimising costs in terms of active management fees and trading costs, since they eat into the net returns significantly 
• Using data for insights and forecasts, while understanding and mitigating biases 
• Swiftly adapting strategies to technological changes, market shifts, and evolving needs 
• Focusing on identifying and investing in areas with high potential 

Disadvantages of Active Portfolio Management

Here are some of the potential disadvantages of active portfolio management: 

• It requires higher management fees and brokerage commissions, along with costs for frequent transactions, which may impact the overall returns
• There are risks of underperformance, where many active funds do not outperform their benchmarks after taking their fees and charges into account 
• The success of the fund depends on the skill, experience, stock selection, strategies, and market timing of the manager
• Frequent buying and selling of securities may result in short-term capital gains, which are taxed at higher rates than long-term gains. It may lower the overall net returns
• Decisions may be prone to human errors, biases, and emotional judgments, thereby affecting the portfolio adversely at times 

Conclusion

As you can see, active portfolio management comes with its own set of benefits, including personalised portfolios, active risk management, potentially higher returns, and data-driven decision-making. At the same time, there are risks, including dependence on the manager's skills and high fees and charges that may erode the final net returns. It works if you are confident in the manager’s abilities and want research-based, goal-driven investments tailored to your particular needs.