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IOSR Journal of Business and Management (IOSR-JBM)
e-ISSN: 2278-487X, p-ISSN: 2319-7668. Volume 16, Issue 8. Ver. II (Aug. 2014), PP 01-05
www.iosrjournals.org
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The Validity of Active Investment Fund Management
Onyeka Uche Ofili
Abstract: This paper considers basically the validity of active investment fund management especially as it
concerns generating more profit for an investor. The paper recognises that in other to fully appreciate the
validity of active investment fund management it should be compared with passively managed funds. Both forms
of fund management have their merits and demerits. The paper therefore, goes into detail in comparing and
contrasting the advantages and disadvantages of both forms of funds management. The paper concludes by
noting that actively managed funds have a higher potential of yielding better returns in an inefficient market. It
further recognises that it may be better to adopt passive management strategy in a highly efficient market.
However, the final choice of which among these two strategies to adopt rests with the investor’ expectations and
what he intends to make out of his investment.
Keywords: investment, management, funds, active, passive
I. Introduction
Active investment fund management is the use of specialized means to manage a fund‟s portfolio with
the aim of outperforming the market. Active investment managers basically aim to take advantage of
inefficiencies in the market by buying securities that are undervalued and in cases of overvalued securities they
adopt short-selling option. Active investment management could be achieved by employing the services of a
single manager or a group of managers who will use their experience, analytical research, forecast and
experiential knowledge and acquired skills to make intelligent market decisions. They decide when and what
securities to buy, hold or sell. Some of the methods used by active investment managers include quantitative
measures such as price/earnings ratio, deep understanding of the market dynamics for example focusing mainly
on banking stock/bonds during a given period as a result of the prevailing economic situation at the time. By
reason of this strong understanding of the market they are able to fish out companies that may be having some
problems and selling their stocks and may be bonds at a discounted value in desperation to raise more capital.
This expertise analysis and research effort put in by active managers cost money. This cost is transferred to the
investors by way of fees paid to the active managers for their services. This ends up impacting on the
investments net return. However, if all goes well the fund manager may still be able to outperform the market
after deducting all costs giving more returns to the investor (Arnerich, T. et al 2007).
Active managers may use the above strategies independent of one another or use them in combination.
Active managers aside from generating returns that exceed the benchmark index may also strive to maintain
portfolios that are less volatile than the benchmark. Investors who follow the principles of active investment
management believe it is generally possible to identify and exploit mispriced securities. In essence these
investors do not believe in the efficient market hypothesis. The underlying reason investors embark on active
management is to generate better returns relative to passively managed index funds. Nonetheless, some
investors recognise that active investment is quite demanding in terms of skills and time and may therefore opt
to go with passive investment, which does not require sophisticated skills. The investors simply buy and hold
the security with the intention that the security will closely follow a specified index.
Passively managed funds typically have lower cost than actively managed funds. In an efficient market
where there is free flow of information (and investors have knowledge of what is going on in the market)
passive investment is a good strategy to adopt. By adopting the passive investment option an investor can avoid
the risk of an active manager investing wrongly and causing the investor huge loss. Earlier studies dating back
to Treynor & Mazuy (1966) and Henriksson & Merton (1981), as well as recent studies such as Becker, Ferson,
Myers, & Schill (1999) and Jiang (2003), all find that the average market timing performance of mutual funds is
insignificant and sometimes even negative. However, a passively managed fund cannot take advantage of
opportunities that may come about in the market as a result of say stock mispricing as mispricing opportunities
in the market can only be better understood through thorough investigation (Arnerich et al 2007).
The rest of the paper is organized as follows; the next section considers the attributes of a good
investment manager. This is followed by an attempt to answer the question “is active investment management
better than passive investment management”? And finally the paper reaches a conclusion.
The Validity Of Active Investment Fund Management
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WHO IS A GOOD INVESTMENT MANAGER?
The success of actively managed funds is a function of the skills and expertise of the investment
managers behind the management of the funds. It is therefore, important to understand those characteristics that
make a good investment manager. A good investment manager is one who is able to react quickly to changes in
the market. He is able to understand and follow the market momentum (the measure of the rate of rise and fall in
stock price) (Mulvey & Kim 2008). Good managers learn to follow and take advantage of momentum effect,
since it is reported by Grinblatt, Titman, & Wermers (1995) that about three-quarters of equity funds track
momentum.
In selecting a good investment manager investors may want to consider the past performance of the
manager. For this reason and to readily convince potential clients managers maintain a composite; a compilation
of all the portfolios they managed in the past. The composite presentation gives potential investors a fair idea of
the manager‟s past strategies and how well those strategies were implemented. Composite performance can be
presented in a lot of ways but the main standard is the Global Investment Performance Standard (Alliso 2010).
The composite format should at least reveal the followings: Gross-of-Fee and Net-of-Fee Total Returns, indicate
investment benchmark total returns for all periods, total number of portfolios and total composite assets, and the
variability of the returns on the various portfolios.
Choosing a good manager involves analysing his historical performance and taking a close look at the
strategies and plans he has for the future, (Schmidt 2010). It is not enough to choose an investment manager
simply on accounts of his previous performance. The consistency of his past performance has to be taken into
consideration. This can be achieved by comparing the manager‟s performance over the last say ten years with
the performance of other managers. Comparison should also be made between the manager‟s investment
portfolio absolute return with indexes and portfolios with similar characteristics (such as comparing a growth
stock with other growth stocks or value stocks with other value stocks). This could also mean for example
comparing a typical US large cap stock with the S&P benchmarks. It should be investigated to determine how
well the manger followed his initial strategy and plan. A manager consistently outperforming his benchmark
may sound like a good thing but it may not necessarily be. The reasons for achieving a low correlation between
the actual returns and the expected returns may be as a result of the fund manager possessing strong market
timing skills and good sense of picking the right stock. Alternatively it could be that the manager is not in
control of what he is doing and was merely lucky or simply just following the trend. Some investors may prefer
to go with managers who consistently follow set plans while others may not care as long as the fund manager
generates returns that are better than the benchmark (Schmidt 2010).
Knowing how fund managers perform during various market cycles is very important. This helps to
reveal whether the fund manager shows varying levels of performance during market downturns and market
upturns or whether he is consistent irrespective of the market cycles. It could reveal whether a manager
performed relatively well during both cycles compared to other fund managers. Finally it is important to know
how committed and confident the fund manager is to his fund. An investment manager that does not invest in
his own fund obviously does not trust his ability to make reasonable returns. This is a very important criterion
and should not be taken for granted. A fund manager who has faith in his ability and skill will be more than
willing to invest in his own funds.
IS ACTIVE MANAGEMENT BETTER THAN PASSIVE MANAGEMENT?
Portfolio investment managers carry out due diligence on a particular security before taking a decision
whether to invest in the security. Before buying a particular stock or bond they consider issues such as the
quality and value of the company, its past and future potentials, the industry and country in which the company
is situated and other factors and its credit rating. They basically ensure that capital is judiciously and prudently
allocated among securities. Because active management entails prudent allocation of capital between the
securities that are traded in the secondary market through due diligence many argue the process guarantees
reliability and trustworthiness of the security market (Adkins, 2007). In choosing a fund manager to a large
extent the investor trusts that the manager will invest the money wisely. The investor trusts that the manager‟s
investment discretion will yield good returns. This however, may not always be the case. The manager may
make bad decisions or adopt strategies that are counterproductive (Boyle 2008).
The behaviour of security market is influenced by a couple of factors including inflation, interest rates,
domestic unrest, oil price fluctuations, terrorism and even earnings. These factors interact with each other and
consequently affect the dynamism of the market causing the market to behave in unpredictable ways. The
market behaviour or movement can also be influenced by a phenomenon referred to as „herding‟. This is a
situation where there is unsupported rallied or sell-offs in the market. Herd behaviour is said to occur when
individuals mimic the behaviour of a larger group irrespective of whether the decision to follow the larger group
is the right decision or not. This can be attributed to social pressure to conform to what may be considered as a
norm or the right thing at the time (Phung 2010). The complex and unpredictable nature of the market make
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investors seek ways of avoiding the volatility of the market and ways via which they can outperform the market.
Even though there may be no clear cut formula for beating the market investors believe that active management
can be used to overcome the threat of market volatility. Investors believe that active managers have the requisite
skills and better understanding of the behaviour of the security market. Investment managers are assumed to
have the time and tools to adequately analyze and predict the market. They are believed to have the correct
software applications to carry out this analysis and that they can also predict and time the market by reason of
the experience they have acquired over time on the job. Active investment managers could work individually or
as a team to fulfil their client‟s investment objectives. This could be with the aim of outperforming a given
benchmark or by tracking a specific yardstick set by the investor. This yardstick may not track any known
benchmark (Brown 2010). It is also argued that the activities of active investment managers in the overall help
to make the market more efficient as it helps improve the accuracy of financial prices and provides room for
efficient capital allocation (Swedroe 2009).
It is common for the performance of an actively managed investment portfolio to be compared to a
given benchmark index, this technique was originally developed by Jensen (1968). However, the methods
adopted in the past for the measurement of the performance of securities assume that the risk level of the
portfolios remain constant throughout the period of the evaluation. It also takes for granted the fact that the
expected rate of return of the portfolios may vary with the economic climate (Lee 1999). According to Lee
(1999) many of the challenges seen in previous performance studies echo the inability of traditional measures to
properly take into consideration the unstable pattern of security returns. In other to eliminate these shortcomings
in future measurement techniques Ferson and Schadt (1996) and later Lee (1999) suggested an approach called
conditional performance evaluation, which adds market indicators. With this performance evaluation approach
it was discovered that the average fund performance show significant improvement when compared with
previous traditional methods of funds performance analysis.
Many authors have argued against the ability of fund managers to accurately anticipate the behaviour
of the market (Knigge et al. 2004) and Fung et al. (2002)). Also the work by Roy and Deb (2004) found that
there does not exist significant market timing coefficients. Following the findings by Roy and Deb (2004) one
may then argue that fund managers do not bring any significant value and their funds management ability can
therefore be said to be inefficient. Furthermore other studies such as Becker, Ferson, Myers, and Schill (1999)
and Jiang (2003) including earlier studies by Treynor and Mazuy (1966) and Henriksson and Merton (1981) all
suggest that market timing performance of mutual funds is insignificant and sometimes return as negative. They
suggest that there is no clear cut formula for predicting the market. The reasoning is that if there is any such
formula everybody will adopt the formula and sooner than later the formula will become common knowledge
and give no investor/manager any edge. However some other authors such as Jiang et al. (2005) and Lee (1999)
argue that it is possible for fund managers to possess accurate timing ability. Jian et al., (2005) propose in their
paper new measures of market timing based on mutual fund holdings thereby eliminating the possibility of
artificial timing biases.
Malkiel (2003) in his paper argues that passive management is a better strategy to adopt rather than
active management irrespective of whether the market is efficient or not, domestic or international market, and
small capitalisation stocks or large capitalisation equities. The paper demonstrated that passive management is
more profitable due to the high cost of running an active portfolio. These costs include management fee which is
significantly higher for actively managed funds. Also for taxable investors passive management has higher
tendency to minimise taxes and reduce turnover. Reduction in turnover means reduction in brokerage costs and
also reduction in the spread between bid and asked prices and the negative market impact that emanates from
selling blocks of securities. This is in consonant with the findings of Wermers (2000) and Kaushik and Barnhart
(2008). These authors carried out investigation on actively managed mutual fund performance and reported that
an average well diversified mutual fund tends to under-perform passive market benchmarks after adjusting for
transactions cost, risk and other trading expenses.
The cost of active investment management is seen to erode the gains achieved by investing actively as
against investing passively. Various authors including Fandetti (2010) and Pittman, Kirk, and Dillon (2009), all
argue that active investment fees are high enough to significantly reduce the extra profitability of using fund
manager. Furthermore if the manager engages in frequent trading this will generate huge transaction cost and
further reduce the returns. Worst still if such finds are held in taxable accounts the returns will further be
reduced. In the research carried out by Pittman, S., Kirk, M., and Dillon, B. (2009) in which 3, 5 and 10 year
sample periods were examined it was discovered that the average returns generated by active managers did not
outperform the S&P IFCI Emerging Markets index after costs. Instead the findings revealed that the average
manager‟s performance before cost was similar to the index and after cost was deducted from the returns it was
found to perform less than the index. These findings are in line with Sharpe‟s assertion (Sharpe 1991).
It is also worth pointing out that as actively managed portfolio attends success and grows it tends to
begin to behave more like an index as the asset base becomes more diversified. Furthermore this success may
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lead to laxity and lack of focus on the part of the managers. Another problem active investment companies and
invariably actively managed portfolios face is that key managers within the investment company may leave for
greener pasture by joining other organisations or simply starting their own business. These companies may
begin to lose focus due to overconfidence and may generally become sloppy and pay little attention to the
changing dynamics of the business environment (Voicu 2010).
IMPLICATION
Active investment is a strategy that can be used to outperform the market. However, in an efficient
market this becomes more difficult as there is better flow of information and this information is readily available
to all. Whether it is taking advantage of mispricing opportunities within an efficient market or taking advantage
of the broader opportunity base in an inefficient market it requires a reasonable level of expertise. To optimally
take advantage of the opportunities that may come up in the security market an investor may be better off
employing the services of an investment manager.
Active investment managers can choose to invest in less risky, high quality companies instead of
investing randomly in selected stocks. By so doing the manager is able to control volatility of the fund. Take the
fall of the tech sector in 1999 and the banking sector in 2008 which comprised over 20 percent of the FTSE 100
index. It is only with active investment that an investor can avoid such risks in certain stocks especially decline
in the market that affects specific stocks that hold a huge percentage of the index. If say during the recent
decline in BP‟s share value as a result of the oil spill in the Gulf of Mexico, Shell and HSBC also had problems
that resulted in there share values dropping that will mean a huge drop in the value of the FTSE 100 index. This
will be particularly so since these three companies alone hold over 20 percent of the index. This sort of risk can
only be avoided through active investing (Kearney 2010). Alternatively the manager may choose to invest in
stocks with higher risk with the aim of obtaining higher returns. He may choose to combine these various stocks
with the aim of diversifying the portfolio (having investments that are not highly correlated with the market) and
possibly reducing the portfolio volatility. Active managers can help an investor generally meet his investment
objectives. These objectives could mean investing in specific industries, specific categories of stocks or even in
emerging markets with significant level of market inefficiency (Malkiel 2007).
For an active investment management company to be successful it must be ready to engage in
continuous research, be extremely disciplined and must always follow simple and well defined processes. It
must not incur huge expenses as this will end up impacting on the overall returns to the investor. Lastly it must
have real passion for investing. For an investment company the managers must share common objectives of
maximising shareholders interest and at the same time ensuring that investors get expected returns on their
investment (Voicu 2010). The management team must work together, share market information freely and be
committed to ensuring that right investment decisions are made at all times.
The final choice of whether to invest actively or passively lies with the investor. It is all dependent on
what the investor wants to get out of his investment and the level of risk he wants to take.
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AUTHOR’S BIOGRAPHY
My name is Onyeka Uche Ofili. I am the Chairman/CEO of UCS Nigeria Limited. I hold a first degree
in Electrical Engineering (University of Lagos) and an MBA (University of Liverpool) and a Master Degree
(LLM) in Innovation, Technology and the Law (University of Edinburgh). I just recently concluded a Doctorate
in Business Administration and I am currently pursuing my PhD at the International School of Management,
Paris. My email address is ucheofili@gmail.com and ucheofili@ucs.com.ng
