What Is an Active Strategy in Investing?

Investors looking to outperform the market often turn to active strategies, which involve frequent buying and selling of securities based on research and forecasts. Unlike passive investing, which seeks to match market returns, active approaches aim to generate higher returns through strategic decision-making.

Successfully implementing an active strategy requires careful consideration of costs, stock selection methods, taxes, portfolio turnover, and performance measurement.

Cost Components in Active Approaches

Active investing comes with expenses that can significantly impact returns. Trading commissions, though eliminated by many brokerage platforms for retail investors, can still apply to institutional traders and those dealing in options or less common securities. Even without commissions, bid-ask spreads remain an unavoidable cost, particularly in less liquid markets, where wider spreads increase costs for frequent traders.

Beyond transaction-related expenses, management fees are another major factor. Actively managed mutual funds often have expense ratios exceeding 1%, while hedge funds typically charge a “2 and 20” fee structure—2% of assets under management plus 20% of profits. Separately managed accounts (SMAs) and private wealth management services also impose advisory fees, which can range from 0.25% to over 1% annually. These fees can erode returns, especially in years of underperformance.

Market impact costs are often overlooked but can be significant. Large trades, particularly in less liquid stocks, can move prices unfavorably before an order is fully executed. This slippage can be problematic for institutional investors managing substantial portfolios. High-frequency traders attempt to mitigate this by breaking orders into smaller transactions, but this approach can still lead to incremental losses.

Different Methods of Stock Selection

Active investors use various approaches to identify securities they believe will outperform the market. These methods differ in principles, data sources, and analytical techniques. Some focus on company fundamentals, while others emphasize price patterns, statistical models, or macroeconomic trends.

Fundamental

Fundamental analysis evaluates a company’s financial health, competitive position, and growth potential to determine whether its stock is undervalued or overvalued. Investors examine financial statements such as the income statement, balance sheet, and cash flow statement to assess profitability, debt levels, and cash generation. Key metrics include the price-to-earnings (P/E) ratio, return on equity (ROE), and free cash flow.

Beyond financials, fundamental analysts consider factors like management quality, industry trends, and competitive advantages. Warren Buffett’s investment philosophy, for example, emphasizes companies with strong economic moats—sustainable competitive advantages that protect profitability over time. Analysts also review regulatory filings, such as 10-K and 10-Q reports submitted to the SEC, to assess risks and future prospects.

Earnings reports and executive guidance play a key role. Companies consistently beating earnings expectations often see stock price appreciation, while disappointing results can lead to declines. Investors also monitor macroeconomic indicators such as interest rates and inflation, which influence corporate earnings and valuation multiples.

Technical

Technical analysis focuses on historical price movements and trading volume to predict future stock behavior. Instead of evaluating financials, technical traders study charts and patterns to identify trends, momentum, and potential reversals. Common tools include moving averages, relative strength index (RSI), and Bollinger Bands.

Trend analysis is widely used, with traders looking for upward or downward price movements. A stock trading above its 50-day and 200-day moving averages is often considered in an uptrend, while a break below these levels may signal weakness. Support and resistance levels—where stocks tend to stop falling or rising—help determine entry and exit points.

Candlestick patterns, such as the “hammer” or “head and shoulders,” provide insights into market sentiment. For example, a “bullish engulfing” pattern, where a stock’s price closes higher than the previous day’s high, may indicate an upward reversal. Technical traders also use volume analysis to confirm trends, as rising prices with increasing volume suggest strong buying interest.

Quantitative

Quantitative analysis relies on mathematical models and statistical techniques to identify investment opportunities. This approach analyzes large datasets to uncover patterns, correlations, and inefficiencies. Hedge funds and institutional investors often use quantitative strategies, employing algorithms to execute trades based on predefined criteria.

Factor investing is a common quantitative method, selecting stocks based on characteristics such as value, momentum, or volatility. For example, value-focused models screen for stocks with low price-to-book (P/B) ratios, while momentum strategies favor stocks with strong recent performance. Machine learning and artificial intelligence have further enhanced quantitative investing by identifying complex relationships that traditional models might overlook.

Backtesting is crucial, allowing investors to evaluate how a strategy would have performed using historical data. However, overfitting—designing a model that performs well on past data but fails in real-world conditions—is a risk. To mitigate this, investors use out-of-sample and stress testing to assess a model’s robustness under different market conditions.

Macro-Driven

Macro-driven investing focuses on broad economic trends, government policies, and global events to guide stock selection. Investors analyze factors such as GDP growth, inflation, interest rates, and fiscal policies to anticipate market movements. Central bank decisions, such as changes in the Federal Reserve’s benchmark interest rate, can significantly impact stock prices, particularly in interest-sensitive sectors like banking and real estate.

Geopolitical events, such as trade agreements, sanctions, or conflicts, also influence macro-driven strategies. Tariffs on imported goods can affect corporate earnings, while supply chain disruptions may impact production costs. Investors monitor economic indicators, such as the Consumer Price Index (CPI) and employment reports, to gauge economic health and adjust portfolios accordingly.

Sector rotation is a common macro-driven strategy, where investors shift capital between industries based on economic cycles. During economic expansion, cyclical sectors like technology and consumer discretionary tend to perform well, while defensive sectors like utilities and healthcare may be favored during downturns.

Tax Implications

Active strategies often lead to higher tax liabilities due to frequent transactions and the resulting capital gains. The tax treatment of these gains depends on the holding period. Stocks held for more than a year qualify for long-term capital gains tax rates, which in 2024 range from 0% to 20%, depending on taxable income. In contrast, short-term gains—profits from assets sold within a year—are taxed as ordinary income, with rates reaching up to 37% for high earners.

Dividend income also affects tax burdens. Qualified dividends, typically paid by U.S. corporations and some foreign companies in countries with tax treaties, are taxed at the lower long-term capital gains rates. Nonqualified dividends, including those from real estate investment trusts (REITs) and master limited partnerships (MLPs), are taxed at ordinary income rates.

Tax-loss harvesting can help offset gains by selling underperforming securities to generate capital losses. These losses offset capital gains dollar for dollar, and if losses exceed gains, up to $3,000 can be deducted against ordinary income annually, with excess losses carried forward. However, the IRS’s wash-sale rule prevents investors from claiming a loss if they repurchase the same or a substantially identical security within 30 days before or after the sale.

Role of Portfolio Turnover

Portfolio turnover—the frequency of buying and selling securities—affects both risk exposure and investment efficiency. High-turnover strategies capitalize on short-term opportunities but also increase the likelihood of misjudgments, as frequent trading exposes investors to liquidity shifts, price volatility, and execution risks.

Turnover also affects portfolio composition. Strategies with high turnover may experience style drift, where the portfolio gradually deviates from its original investment thesis. Additionally, the need to frequently reinvest proceeds can lead to suboptimal capital deployment if attractive opportunities are not immediately available, potentially resulting in a cash drag that dampens overall performance.

Performance Benchmarks

Evaluating an active strategy requires comparing performance against appropriate benchmarks. For equity portfolios, common benchmarks include the S&P 500 for large-cap U.S. stocks, the Russell 2000 for small-cap equities, and the MSCI EAFE for international developed markets. Fixed-income portfolios often compare against the Bloomberg U.S. Aggregate Bond Index.

Beyond absolute returns, investors analyze risk-adjusted performance using metrics such as alpha, the information ratio, and tracking error. If an active strategy consistently fails to generate positive alpha, it suggests that a passive approach may have been the better choice.