Market insights and analysis

By Jerry Wagner

Investors often ask me, “What is active management?”

Many confuse the phrase “active management” with the simple act of running a mutual fund populated with stock picks within the strict guidelines of a prospectus, as opposed to running an index fund, where the manager simply buys and holds the shares making up a particular stock or bond index.

While many valid definitions exist, I prefer to look at active management as a way to add more “dimension” to an investing approach.

Investing “dimensions”

Zero dimension: Buy and hold. We are often told to “be a buy-and-hold investor.” Yet, while the phrase “buy and hold” is two words linked together by a connector, that single conjunction “and” does not give the approach any “dimension.”

“Buy and hold,” in its purest form, has zero dimensionality—you buy. “Holding” is not a word of action. Following this approach is passive investing in its purest form.

Graphically, zero dimensionality is a dot. It has no length, width, or height—it’s only a dot, just like the period at the end of this sentence. Like the period, it can appear at any place on a page—high or low. Like the return from a buy-and-hold investment, it just is. It’s the return of the underlying index, and that’s all there is. When the S&P is up, the dot is higher. When it’s down, that’s all she wrote—you get what you see.

One dimension: Buy and sell. Most investors are one-dimensional investors. They buy and … they sell. Both verbs denote activity—buying and selling. That makes most investors active investors.

While passive investors often focus on only the state of the investment itself without dimension (i.e., the factors about the investment that caused them to buy in the first place), active investors view investing in at least a one-dimensional state. No longer just a “dot,” a one-dimensional line consists of at least two dots. They focus on both buy and sell factors.

Still, they differ further. Some buy and then sell after a long time, while others buy and then, within a fairly short time, they sell. One-dimensional investing, then, is like a line. And that line can be long or short.

Two dimensions: Considering market direction. To graduate to two-dimensional investing, as one would in drawing, where length and height are combined to form a square, one must add another component and look at direction.

A two-dimensional investor, then, considers market direction, or the prevailing direction of prices of the individual securities, in making his or her buy and sell decisions. The market environment can actually alter the length of time that one holds the investment, whether you buy or sell at all, or even whether you reverse the process and sell short to benefit from a current or impending downturn.

Three dimensions: Dynamic risk management. Dynamic, risk-managed investing is like a cube. It’s three-dimensional. It has width, length, and height.

Dynamic, risk-managed investing is many steps beyond the simple act of buying and selling. A lot more is going on.

One-dimensional active managers have factors that influence when to buy—just like the buy-and-hold investor—but add in a process for determining when to sell. Both the buy and the sell factors are quantitative (solely based on numbers): no emotion, no subjectivity—just disciplined, mathematical investing.

Intermediate-level, or two-dimensional, active managers add in the directional dimension—price momentum, the potential downside, the price movement of one investment as it relates to another—all coming together to determine the position to take in an investment. Strategies that are based on following the trend, doing the opposite (mean reversion), or simply following price patterns that have historical persistency in terms of follow-through can be employed.

Dynamic, risk-managed investors add in yet another dimension—the risk-management dimension. Its three-dimensional practitioners incorporate advanced investment ingredients: the active reallocation of the position size in any investments to as small as zero, hedging, the use or avoidance of leverage, shifts to cash and bonds determined by volatility, tactical timing measures, and stop-loss signals.

The result is a complete investment strategy, a strategy based on dynamic, risk-managed investing that considers not just getting invested, or just buying and selling, or even determining whether the market is moving up or down. Instead, it considers all of these elements plus the tools to actively preserve the investment in case bad luck or a bad strategy results in unintended losses.

Taking three-dimensional investing even further with dynamic risk management

Finally, think of each of those dynamic, risk-managed investing strategies as bricks. Combine them and you have the foundation of an investment portfolio designed to weather the fourth dimension—time, and all of the financial storms that come with it.

Only dynamic risk management, not the passive holding of investments, is multi-dimensional. Investors have to ask themselves, “What’s better: standing on a dot on the sidewalk out in front of my future home or moving into the multi-dimensional space inside?”