Absolute Returns and Relative Performance in Investment Management - Assignment Example

? Absolute Returns and Relative Performance in Investment Management Investment management refers to professional asset management aimed at meeting the specified investment goals. Establishment of the performance of investment can be challenging. The absolute return refers to the portfolio returned after sometime. Relative performance describes the difference between absolute return and the market performance. Relative performance enhances the measurement of performance of the actively managed funds with higher returns than the market (Brown & Kapadia 2007, p. 358). For the stock market perspective, the absolute investment returns are gaining more fame lately due to the start of mutual funds aiming at absolute return objectives. In contrast, traditional mutual fund aims at producing smart relative investment returns as compared to the suitable benchmark. Absolute returns facilitate profitability in most periods and acts over an extensive range of market conditions. Beta measure reduces the risks during the determination of return and risk on stocks and portfolios. Use of beta coefficient in stock selection requires comparison with the market. The investor, therefore, construct the portfolio by drawing the relationship between beta coefficient and the prevailing market prices. Betas carry with them high risks, and markets with negative betas may withstand the fluctuations in market prices. Despite betas helping in stock selection, its effectiveness assumes that movement in the market requires careful analysis of positive and negative directions. Also, beta approach assumes analysis of historical considerations for future prediction. As a result, when portfolio selection fails in accurate reading of the market movements, the resulting portfolio selection is incorrect. This method requires a high degree of precision. On the other hand, the alpha parameter indicates the return on security at zero market return. Positive alpha indicates bonus return while negative alpha indicates an undesirable penalty to the investor (Carter & Howard 1990, p. 81-85). Absolute return investing pursues the returns independent of the traditional benchmark and is unconstrained. This means that it uses the modern tools like the hedging strategies in reducing the investors’ risk. Absolute return acts as the modern strategy that pursues the target returns with reduced volatility than relative performances. This enhances the diversification of portfolios for all types of investors (Edwards & Alfons 2004, p. 143). Benchmark Indexes Investors establish a long term wealth in stocks due to historical tract record of their positive performance. Most traditional mutual funds constrain the manager to invest in domestic markets. However, the absolute return strategies are less constrained. The objective of absolute return removes constraints on managers and allow for the implementation of more strategies to address the market volatility. For instance, the relative performance may allow for investment in all sectors, but have a high likelihood of influence by benchmark index weightings of other sectors. This is because any divergent can result into risk. This compels the traditional funds take on a market exposure. On the other hand, the pursuit of absolute returns reduces the risks by managers when undertaking a full market exposure (Fornell 2006, p. 3). Traditional Benchmarks When compared to relative performances, absolute returns are independent of the traditional benchmarks. The measurement of funds in absolute returns does not involve the market indexes. Rather, their measurement takes place alongside their return goals. This enhances the removal of constraints on investment managers. The absolute return does not involve any incentive of making the funds appear similar to securities index. This provides greater incentive to prevent risk caused by negative returns (Fornell 2006, p. 4). Inflation The absolute return objective focuses on the elementary concerns of an investor to help achieve a positive return that enhances the purchasing power. This is advantageous due to long-term persistence of the inflation. Inflation undercuts return on all relative performances and this prevents its mandate from outperforming inflation. Outperformance of inflation by a margin irrespective of the market conditions enhances the attractiveness of absolute return strategies for diversifying the portfolio (Fornell 2006, p. 5). Market Risk Unlike traditional funds that compete on the basis of the relative performances instead of risk, the absolute returns apply asset allocation as the initial point. This allows the absolute return managers greater latitude of investing in wide area of securities, and frees of the fixed asset weightings of the traditional funds allocation approaches (Garashchenko 2004, p. 60). Flexibility Flexibility in investment provides investment tools that allow managers go beyond the traditional methods of getting exposure to the markets as well as seek the alpha opportunities. This results in additional returns to those generated by the market movements. The active use of tools that capture alpha may enhance the performance of an investment during negative market conditions. The relative performances apply similar tools, but their integral to strategy is minimal in case the fund fails in having a return goal like the absolute return target. Therefore, the absolute return enhances more flexibility in global investment across various sectors, and with modern tools that allow for the pursuit of consistent positive returns. This allows the money managers decide on areas with a high likelihood of appreciating. An absolute return manager can freely risk in investment with a high likelihood of generating positive returns and will be able to avoid the weak investments. With the increased evolution of the markets, the absolute return strategies may adapt to the changing market conditions. This makes the goal to be more resilient and versatile to the changing markets. The increased flexibility helps the absolute return strategies to overcome short-term volatility risks that affect the traditional funds strategies (Garashchenko 2004, p. 61). Diversification across Asset and Sectors Absolute return strategies allow for ownership of a wide range of investments and sectors that offer attractive opportunities. The absolute return strategy allows for greater flexibility than in the relative performances. This takes advantage of the increased diversification of the financial markets in the recent years. The combination of investments in securities with negative or low performance reduces the volatility of portfolios relative to returns (Garashchenko 2004, p. 64). Alternative Asset Classes The absolute return investing allows for alternative asset classes that involve investments beyond bonds and stocks. Adding the range of different investments to highly conventional investments diversifies the return sources that improve the performance relative to risk. This produces an efficient portfolio. The freedom to choose the investments enhances the performance of an investment in any market environment. This allows the manager determine the appropriate periods for diversifying across asset classes and selectively focus on various areas. The traditional funds can invest within the alternative asset classes but requires specialized funds to provide full exposure to the asset class. Contrary, absolute return strategy applies the positive return goals which can be excluded in case of expectation of negative returns (Garashchenko 2004, p. 66). Hedging Risk with the Modern Investment Tools This flexibility associates with absolute return strategies where they use the modern investment tools like derivatives and futures. This increases exposure to the specific markets and to fine-tune the investment strategies that mitigate the unwanted market risks. In contrast, the traditional investment strategies apply the hedging techniques, but the absolute return goals never guide them. This means that the traditional strategies hedging act as a blunt instrument of protecting performance in market decline but the absolute return strategy implements hedging to achieve the focused goals (Weller 2006, p. 531). Future, Forwards and Options Derivative refers to any investment whose value depends on performance of the other security. Forwards, futures and options form derivatives that give an indication on the market prices. These provide exposure to investment when prices move as expected. An absolute strategy offers attractiveness in future, forwards and options by reducing risks against the market declines. This allows the investor build a buffer against the declines in market. Derivatives enhance independent performance of the overall market direction and allow the investment managers implement their views on securities and sectors with a high likelihood of appreciating. This allows a comprehensive capturing of the overall investment view of a portfolio (Weller 2006, p. 535). From the above analysis, the absolute returns appear more important than relative performance in any investment since they focus on returns with less volatility. The absolute returns outperform even during negative market environments and offer the flexibility to invest with no constraints. Market Risk and Company Specific Risk in Share Valuation and Investment Management Share valuation refers to the calculation of theoretical values for the company stocks. This enhances the prediction of future market prices. Fundamentally, share valuation aims at giving estimates of the intrinsic value of the stock based on future profitability and cash flow prediction of the business. The share valuation process serves to facilitate the investment. This ensures liquidity in prices despite the underpinnings by illiquid investments like factories. On the other hand, investment management entails all the processes involved in management of a portfolio (Zeiler 2005, p. 52). The risks can be categorized as firm-specific that affects few or one company or market risk affecting most companies. The argument on market risks being less important than firm-specific risks is because firm-specific risks can be diversified within a portfolio. On the other hand, market risks persist even in diversified portfolios. Also, in conventional return and risk models, firm-specific risks do not affect the discount rates and expected returns but the market risks do. Risk forms an inherent component in any investment, and it relates to loss of capital, delay in capital repayment and variability of the returns. The risk in investments depends on maturity period, investments and repayment capacity. Market risk results from variability in returns due to fluctuations within the overall market. This includes factors that are exogenous to securities and which result in structural changes within the economy (Zeiler 2005, p. 52). Company-specific risk refers to the changes taking place within an industry and the resulting environment exposes the company to risks of earning operational revenue. This leads to failure of the company to earn through the operations carried out as a result of changes in business situations causing erosion of capital. The market risk reflects the losses in the trading book due to changes in the equity prices. Investment in stocks is a risky venture due to uncertainty of returns due to volatility in market prices. The increased volatility results from the varying market decisions and specific individual firms. The control of market risk is quite problematic. The events unique to each firm forms the primary causes of volatility in the individual returns of the firm. The volatility returns resulting from firm-specific events result in firm-specific risks. The stock returns of a firm can also be affected by the marketwide events, and the resulting volatility is market risk. Investors manage risks when choosing the risk they desire to incur. Some of the investors may be willing to engage in investments with relatively high risk level. However, most investors seek for the investments with relatively high risk since the risk is directly proportional to returns (Zeiler 2005, p. 53). Successful management of risks involves independent management of both market ad firm-specific risks. The management of firm-specific risks involves holding of diversified stocks portfolio. The diversification process can reduce risks since the events of an individual firm different to those of the other firms. Contrary, market risks can be managed through adjusting the shares of stock within the portfolio and selling the stocks with high risk and buying those with low risk. This is usually inconsistent and costly in relation to the desired investment strategies. Adjustment of portfolio shares is inconsistent with the strategy used in most executives trade the market portfolio so as to adjust the exposure to the market risks, but they remain subjects to firm-specific risks. Normally, the firm-specific risks are rampant in the stock markets due to the increased listings by the riskier companies. Research indicates that the profit margins, industry composition, profit margin and firm size results from an increase in firm-specific risks. According to the traditional asset pricing theory, the firm-specific risks can be diversified as opposed to the market risks, and hence, not priced as a risk factor (Zimmermann 2002, p. 147). On the other hand, market risks management requires employment of highly sophisticated statistical and mathematical techniques, such as Value-at-Risk (VAR). The VAR demands are extensive and depends on multi-asset options, correlation trading and power-reverse dual currency swaps. Keeping up with VAR tools is challenging. As a result, the valuation models have increased in complexity. This makes most banks desire to integrate new analytics of testing stress with anticipation of broad spectrum of the macroeconomic changes. This renders VAR and other models for risk management ineffective. These perceived limitations expose the organization under severe scrutiny. The recent recession and economic down turns led to the reliance of VAR on the normal distribution markets and the fundamental assumptions can be liquidated easily. Despite of regulators attempting to compensate for the limitations, the market risk framework requires upgrading. Some of the new elements like the requirement for calculating VAR increase the risk-weighted assets and boost the capital requirements through the introduction of the credit-valuation adjustment (Zimmermann 2002, p. 148). This imposition of high capital requirements may enhance safety of the financial system, but at the same time modelling the framework is blunt. Ongoing refinements enhance complementation of the work on VAR, but the risk model requires more work. The high-quality data results to high uncertainties in distinguishing the acceptable and unacceptable quality levels. The complexity of the VAR model has increased over the years. Also, management of steering framework is quite challenging and hence contradicts the managers. Therefore, the management of firm-specific risks enhances better risk appetite in deriving the limit structure (Andersen 2008, p. 157). It is easier to deal with firm-specific risks since they affect the profitability and the value of a specific firm. Therefore, the measurement of risk exposure involves examining the past and determining how earnings and the value of the firm changes with time. The contention of a firm being cynical with economic down turn risk exposure, there should be a back-up of impacts of recessions. Valuation of firm-specific risks involves the collection of data about the value of the firm and macroeconomic variables that determine the sensitivity. The firm-specific risks allow for shareholders to diversify the capital market. This happens through holding the equity of firms with imperfectly correlated risks. Bearing the firm-specific risks allows the shareholders become the claimants on the firm surplus. Other stakeholders collect their outside option only. The diversification of firm-specific risks by shareholders on capital markets acts as an efficient social insurance method that mitigates risks of job loss as a result of globalization (Brinson 2005, p. 24). Market risk is normally specific to each sector or business. As a result, the diversification can be more challenging than for the firm-specific risk. For instance for the market risk, a fall or rise in stocks affects all the companies involved, and this is inappropriate when evaluating the performance of a firm. The firm-specific risks will relate the individual risk profile for each company within the sector. Therefore, companies facing market risks experience high costs in production than the companies facing the firm-specific risks (Andersen 2008, p. 155). Reference List Andersen, T. (2008). The Performance Relationship of Effective Risk Management: Exploring the Firm-Specific Investment Rationale. Long Range Planning 41(2), pp. 155-76. Brinson, G. (2005). The Future of Investment Management. Financial Analysts Journal 61(4), pp. 24-28. Brown, G., & Kapadia, N. (2007). Firm-specific Risk and Equity Market Development. Journal of Financial Economics 84(2), pp. 358-88. Carter, R., & Howard, E. (1990). Security Analysis and Portfolio Management. The Journal of Portfolio Management 16(3), pp. 81-85. Edwards, J., & Alfons, J. (2004). Ownership Concentration and Share Valuation. German Economic Review 5(2), pp. 143-71. Fornell, C. (2006). Customer Satisfaction and Stock Prices: High Returns, Low Risk. Journal of Marketing 70(1), pp. 3-14. Garashchenko, F. (2004). The Problem on Security Portfolio Selection and Analysis of Sensitivity in Static Problems of Investment Management. Journal of Automation and Information Sciences 36(8), pp. 60-6. Weller, C. (2006). Social Security Privatization and Market Risk. Review of Policy Research 23(2), pp. 531-48. Zeiler, L. (2005). Portfolio Management. CFA Digest 35(1), pp. 52-53. Zimmermann, H. (2002). Editorial. Financial Markets and Portfolio Management 16(2), pp. 147-48. Read More