Chapter 10
Active Portfolio Management
To whom men commit much, of him, they will demand the more.
—Luke 12:48, The New Testament
Portfolios can be managed passively or actively. Passive allocations are typically investments in an index fund. This management style is attractive because it minimizes trading costs and eliminates most management fees while earning the return on the index. The popularity of index funds has increased geometrically as evidenced by the staggering array of choices offered as retirement investment vehicles in various 401(k) and defined contribution plans. Active allocations, on the other hand, are made by managers who believe they can beat the index, presumably because they have superior information or skills, or both, relative to other market participants. Clients hire active managers and pay fees with the anticipation that the active manager will produce risk-adjusted returns above the index (the opportunity cost of funds) net of fees. These returns, referred to as alpha, are the returns to skill—stock selection, superior information, models, and so on—and are uncorrelated with the index return (and therefore beta). Active managers are alpha seekers who measure their performance relative to an agreed-upon benchmark.
Active management can be thought of as shorting the benchmark and going long the active portfolio. The active allocation therefore generates a return differential, relative to the benchmark, as well as a risk differential, referred to as ...
