Risk and return strategies

Portfolio management is principally about risk and return strategies.

Introduction

Portfolio management is principally about risk and return strategies. Portfolio management is concerned with the construction and management of investment assets. There are two principal school of portfolio management: passive and active. A passive and active term refers to the method by which the assets are selected for inclusion into the portfolio. A passive portfolio includes the market portfolio; consist of shares in all companies quoted on the stock exchange, or a selection of group of stock e.g. all technology stocks. Passive portfolio therefore does not make any attempt to research each stock and decide if it should be included or excluded from the portfolio. There is no technical or fundamental analysis carried out in order to beat the market portfolio. Passive equity portfolio management is all about long-term buy and hold strategy, usually tracking an index over time. This is designed to match the market portfolio performance.

Active portfolio management on the other hand uses research, analysis (both fundamental and technical), economic factors and also an element of subjective judgement in selecting stock into the portfolio. It is believed that the stocks are undervalued and will out perform the market portfolio in the future.

Planning

The planning stage of portfolio management involves a written investment policy statement. A clearly defined investment policy that includes the preferred management technique, hence, active or passive indexed portfolio management. It also outlines the portfolio goals; level of returns and defined risk tolerances for the portfolio. The planning also involves rebalancing strategies and means of effective internal and external communication of those goals.

Asset Analysis

Aside from inside knowledge asset selection advice is based on two principal types of investment analysis: technical analysis and fundamental analysis. Technical analysis is based on studying past trends in share prices in the belief that patterns can be discerned in their movements which can be used to predict future movements. This uses graphs of historical share price variations and it is often referred to as “chartists” analysis.

Fundamental analysis concentrates on the study of the underlying position of the company. Such details as its strengths and weaknesses and future opportunities and threats, also uses ratio analysis in evaluating a particular stock.

Asset Selection and Combination

Stock selection as part of Active portfolio management has very limited impact on the return investors earn, as a result of stock markets being efficient. The efficient markets hypothesis (EMH) holds that a stock market is efficient if the market price of a company’s share quickly and correctly reflects all relevant information as it becomes available (Lumby, S., Jones, C., (2004)). In asset selection and combination we need to remember that investors are risk-adverse and select their portfolios by the mean/variance criteria (i.e. they are markowitz efficient investors). However, asset combination does result in an increase portfolio returns as a result of how the investment are combined and allocated within the available asset classes. The combination of stocks vs. bonds vs. cash, large companies very smaller ones, UK companies vs. overseas stocks and value companies vs. growth companies.

Evaluation of Performance

Portfolio performance evaluation involves return measurement (weight average return) over several periods. Performance measures such as market timing and security analysis. Style analysis is used to describe a portfolio by evaluating how its returns act, rather than by using a simplistic concept of what the portfolio included. Its objective is also to provide a superior mean of performance measurement for stocks and also the skills of the fund manager. Style analysis uses an asset class factor model:

Ri = bi1Fi1+bi2Fi2+ … + binFin+ei

Where Fi1 … Fin are return factors and bi1 …  bni are sensitivities to the factors.

All factors are return factors to the portfolio. The factors used in the portfolio are stock index, bonds, value stock, growth stock etc. There are many ways to evaluate the performance of a portfolio, style analysis is one of the newest techniques and it allows us to explain how portfolio returns behave. It is also a useful mean of stock selection for the portfolio. 

Re Balancing

Rebalancing the portfolio is critical for the financial future. Rebalancing involves buying low and selling high. This process ensures that the portfolio is in line with the initial portfolio asset allocation plan. As the economic conditions change some assets within the portfolio will appreciate faster then others and their weighting within the portfolio will change from the initial allocation plan. This will result in an out of balance portfolio and will need rebalancing by selling high performing stock and buying low performing ones.

Indexing – Advantages and Disadvantages

As the stock markets are efficient there are various advantages in index funds over actively managed funds as a portfolio management method. EMH theory states that security markets are extremely efficient in processing individual stock information; so undervalued shares are difficult to consistently identify and purchase. Another advantage is the lower expenses in managing an index fund over an active fund. Also lower trading costs versus actively managed funds where stocks are typically traded more frequently and finally, lower capital gains taxes resulting from shares being sold less often. Disadvantages of indexing are in terms of tracking error suffered as a result of changing economic climax where certain stock will out perform expectations. This could result in the portfolio becoming out of balance and rebalancing results in transaction costs and subsequent errors in tracking the underlying index.

Active Portfolio Management

An Active investor is one that is not passive. Active portfolio manager’s portfolio will differ from that of a passive manager. This is due to that fact that active managers will act on perception of mispricing in stock market, and as such perceptions change frequently, such managers tend to trade frequently, hence, the term ‘active’.

Efficient Market Hypothesis would disagree that such mispricing exist in the market and that the stock market is efficient. Therefore, active portfolio manager’s returns are lower then that of passive managers, due to the increase cost of actively managing the portfolio. If the markets are semi-strong or strong form efficient then active portfolio management in terms of fundamental or technical analysis are waste of time as they will not provide a potential gains in discovering the undervalued stocks. Only if the market were weak form efficient than it would permit fundamental analysis to uncover potential gains. Therefore, active portfolio management is an unrewarding exercise and can lead to waste of both effort and money.

Passive vs. Active

There are various advantages of passive portfolio management over that of active. We have already discussed the EMH and how that would suggest that active management has very little value in terms of portfolio selection in a semi-strong form of market efficiency.  So passive portfolio management costs much less than active management. This give passive investors an increase net returns as the management costs are lower. Passive portfolios are also more tax efficient with their ‘buy and hold forever’ approach result in low income tax costs. Active portfolio often attracts capital gains tax from sell of short-term appreciated gains in stocks. Passive mutual funds have a inherently low turnover of securities and thus are exposed to fewer realised capital gains.

Passive portfolios have predictable styles. A passive investor knows exactly what types of securities he or she is invested in. Active managers, on the other hand, can vary the composition of their portfolios significantly over time – a problem known as “style drift”.

Conclusion

Actively managed portfolio will try to deliver excess returns over the passive portfolio by actively forecasting future returns on individual stocks. However, in reality they do not obtain significant excess return of the market portfolio, which is the primary indexing for the passive portfolio management.   This is in accordance with the efficient market hypothesis that states that stock markets are semi-strong or strong form efficient, with stocks being priced correctly. 

Index funds are arguable more successful portfolio management method on the believe that markets are significantly efficient and active manager will not be able to gain excess returns, after taking into account the excessive costs involved in active management. Passive management seeks to deliver the return and risks associated with the chosen index.

Evaluation of index funds performance is in terms of how closing the portfolio tracks the underlying index in terms of returns. The costs associated with index funds are in rebalancing the portfolio. It assumes that when the economic condition changes and the assets weight within the portfolio can be redefined automatically. However, in rebalancing the portfolio involves physical selling of high stocks and selling low stocks, which involve transaction costs. This result in tracking errors driven by transaction costs, funds cash flows un-invested, treatment of dividend by the index and index composition changes. Finally, the liquidity of the underlying index stocks can have an impact on transaction costs and subsequently the tracking error encountered by the portfolio.

References & Bibliography

Lumby, S., Jones, C., (2004), Corporate Finance – theory and practice 7th edition, Thomson

ACCA Paper 3.7 (2001) Strategic Financial Management, The Financial Training Company