How Active Return Works

The part of an investment portfolio's returns (profit or loss) that you can specifically trace to the portfolio manager's active management decisions is an active return. Managers of active mutual funds are responsible for pursuing active returns or attempting to "beat the market." The opposite of an active return is a passive return. If you decide to invest in actively managed funds, you assume that the fund can outdo a passively managed one if a talented manager handles it.

You can calculate an active return by subtracting the investment return from the benchmark because of overall market movements. If the real return exceeds the market index, the fund has received a positive active return. Similarly, if the fund's earnings fall short of the market index, the market automatically has a negative active return and will be deemed to have underperformed. The return that an investor will gain by using a passive investing strategy is the benchmark.

Using technical analysis, portfolio managers seeking active returns try to take advantage of undervalued stocks and short-term price fluctuations. The manager might, for example, build a portfolio of overvalued securities to short sell for a profit. The manager tries to minimize risk compared to a benchmark index, depending on the fund's objectives and will use asset allocation, risk arbitrage, and short positions when putting together an investment portfolio. The portfolio manager and research team's abilities determine the actively managed fund's performance.

Example of Active Return

For example, if you choose to invest in active return, you have to get the service of a portfolio manager. Now, if you eventually invest and the market itself is the benchmark, in that case, a portfolio that surpasses the market offers you a positive active return. Assuming the benchmark return is 6% and the actual return is 9%, the active return would be 3% (9% - 6% = 3%).

The same portfolio will give you a negative active return of -1 percent if only returned 5% (5% - 6% = -1 percent). Considering your investment objective, the portfolio manager will attempt to reduce risk compared to the market itself (the benchmark). If the benchmark is a particular market segment, the same portfolio could theoretically underperform the broader market while still generating a positive active return relative to the chosen benchmark. This is why investors need to understand why a fund uses a particular benchmark.

Whatever outcome you get is a result of the portfolio manager's active asset management.

Active Vs. Passive Return

The two primary investment methods for generating returns on investments are active and passive asset management. Active asset management is a portfolio management practice in which the portfolio manager decides how to invest funds. Through buying and selling securities such as bonds, futures contracts, and options contracts on public exchange markets, the manager seeks to outperform the benchmark index, like the S&P 500.

The managers put their plans into action to outperform fund managers who duplicate an index's security holdings. There is no active asset management to make decisions in passive asset management. Instead, it concentrates on simulating the asset holdings of a particular stock index. It creates an investment that is equal to the particular index and uses the same weighting to produce outcomes comparable to the index.

Because of the low turnover ratio and the absence of an active management team that would otherwise be compensated by management fees, passively managed funds have lower costs than actively managed funds.