Actively Managed Funds: What Does Outperforming the Market Mean?

Actively managed funds aim to deliver investment returns that surpass a passive, market-tracking approach. Investors select these funds expecting professional managers to identify opportunities for superior performance. Understanding what “outperforming the market” truly means is important for anyone considering such an investment.

What is an Actively Managed Fund?

An actively managed fund involves professional managers making deliberate investment decisions to achieve specific objectives. These managers conduct research and analyze market trends to select assets they believe will generate favorable returns. They frequently adjust the portfolio based on changing market conditions or economic indicators.

This approach differs from passive investing, where funds aim to mirror the composition and performance of a particular market index. In actively managed funds, the expertise and judgment of the fund manager are central to the investment strategy. The manager has flexibility in selecting investments, unlike index funds which must closely match a specific benchmark.

Defining Outperformance: Beating the Benchmark

For an actively managed fund, outperforming the market means generating a higher total return than a specific, relevant market index or benchmark over a given period. The “market” is not a single entity; it is represented by a benchmark index that serves as a standard for comparison. These benchmarks reflect the performance of a market segment, such as the S&P 500 for large-cap U.S. equities or the Russell 2000 for small-cap stocks.

Benchmarks are selected to align with a fund’s investment strategy, ensuring a fair comparison. For example, a fund investing in large U.S. companies would use a large-cap U.S. equity index as its benchmark. This allows investors to evaluate how well a fund performs relative to its intended market segment.

Active managers attempt to exceed benchmark returns through various investment decisions. These may include strategic stock selection, allocating assets to specific sectors, or timing market movements. Their focus is demonstrating superior returns compared to the established market standard.

Calculating and Reporting Outperformance

Outperformance is measured based on a fund’s total return, which includes both price appreciation and any dividends or interest received. Outperformance is typically measured net of all fund expenses and fees. This means management fees, administrative costs, and trading expenses are deducted before calculating the reported return.

Measuring performance net of fees is important because these costs directly reduce an investor’s actual returns. A fund might achieve strong gross returns, but high fees can result in a net return lower than the benchmark. Regulations, such as the SEC Marketing Rule, emphasize that net performance must be presented with equal prominence to gross performance.

Performance is evaluated over various time horizons, such as 1-year, 3-year, 5-year, and 10-year periods. Short-term fluctuations can be misleading, so longer periods offer a more stable assessment of a fund’s ability to consistently outperform. Fund performance is reported by directly comparing the fund’s net return against its chosen benchmark’s return for these periods.

The Rationale Behind the Goal

Actively managed funds set outperformance as their primary objective to justify the higher fees they typically charge. These funds usually have higher expense ratios compared to passive funds, often ranging from 0.8% to over 1% annually. Outperformance is presented as the value proposition for these increased costs, compensating for the expertise of the fund managers.

Investors choose actively managed funds expecting better returns than they could attain by simply tracking a market index. The competitive landscape within the investment management industry also plays a role. Funds strive to attract and retain capital by demonstrating superior performance, which serves as a key differentiator.