Application of Investment Strategies - Research Paper Example

Application of investment strategies Table of Contents Introduction 3 2. Scope 5 3. Research aims and objectives 6 4. Literature Review 6 5. Data and Methodology 10 5.1. Data Collection 10 5.2. Data Analysis instrument 10 5.3. Research philosophy adopted 11 5.4. Research approach adopted 11 5.5. Significance of qualitative data analysis 12 6. Discussion and Analysis 13 6.1. Passive strategy is highly effective in inefficient markets 13 6.2. Factors to be considered while implementing passive strategy 14 6.3. Why does indexing work? 15 6.4. Effect of different indexing techniques 15 7. Conclusion 16 Reference List 17 1. Introduction The term investment strategy has got several definitions stated within numerous literatures published by empirical research scholars over last two or three decades. Despite being defined in several ways, the meaning conveyed by academic scholars has stayed the same. In simple words, investment strategy refers to an investor’s plan of approach towards directing their investment choices on the basis of an individual’s objectives that is meant to be achieved. The investment strategies adopted by investors also take into consideration factors such as, risk tolerance level and further requirements for capital. The primary constituents of investment strategies include risk guidelines, asset allocation and purchase and sell directives. Investment strategies can vary significantly depending upon nature of the investors and objectives that they want to achieve. Strategies adopted by investors who focus on capital enhancement will always be different from one who applies a safety strategy directed towards protection of wealth. The most crucial aspect of an investment strategy is that it is formulated in accordance with an individual’s objectives and thus, the strategy is followed very closely by an investor (Howard, 2010). Selecting the most rewarding stock is a very common activity among investors and other equity fund managers. This conclusion can be seen in majority of academic researches done in the field of investment and portfolio management over last two decades. An extensive review of the literatures has enabled the researcher to understand that investors and investment managers resort to not only one, but several alternative investment strategies, in order to fetch maximum benefit for their client. Various investment strategies have been discussed in detail in empirical researches, but one strategy that has been implemented by majority of individual investors and investment management professionals is creation of portfolio (Ślepaczuk, Zakrzewski and Sakowski, 2012). Portfolio is a financial expression that denotes a compilation of investments done to acquire financial assets such as, bonds, stocks or cash equivalents, alongside their counterparts. Portfolios are either directly managed by investors or by investment professionals. The primary strategy of investors and investment professionals is to construct the portfolio by taking investing objective and level of risk tolerance into consideration. Investors acquire a variety of financial assets within their portfolio in order to diversify their investments so that even if their investments strategy fails in case of one financial asset, then they might be able to recover by gaining from another financial asset. Moreover, components of a portfolio also depend on nature of the investor. For example, a risk-averse investor will always take possessions of large cap value stocks, investment grade bonds and highly liquid assets; whereas a risk loving investor will include small cap value stocks and riskier assets such as, real estate, that yield higher return within the portfolio. The practice of managing the combination of components within a portfolio is termed as portfolio management (Berk and DeMarzo, 2011). Portfolio investor aims towards achieving a higher portfolio risk adjusted return, instead of investing in a single asset. Including multiple assets within a portfolio enables the investor to spread the risk as well as acquire a great5er return compared to the return generated by making investment in a single asset. Given the fact that financial markets go through different phases of ups and downs, investors realize both gains and losses in their respective portfolios, if it is not managed with respect to investors’ predictions about future developments in the market. As far as long-term investments like, pension funds, are concerned, incurring short-term losses does not impact overall investment as the stretched time frame allows the investor to recover from such losses by realizing positive returns in the future. Nevertheless, adopting the same strategy is not appropriate for certain investors as they are restricted due to liabilities and consumptions. Consequently, investors have to liquidate a part of their investments so as to fulfil financial obligations and needs. In other words, an investor’s choice to buy and sell stock depends upon his/her confidence that abnormal returns can be obtained out of the investment. On the other hand, efficient market hypothesis stated by Fama (1970) concerns a different perspective indicating that market prices incorporate available information immediately, thereby discarding any possibility for the investor to accrue abnormal returns. Should the efficient market hypothesis be taken into consideration, then it leaves the investor with only one possibility and that is to make portfolio investments and thereafter, hold the same for a predefined timeframe. In order to achieve maximum benefits out of an investment, investors adopt multiple strategies. One of the most commonly used concepts is active portfolio management technique, which allows investors to evaluate performance of their portfolio with respect to performance of the market of a standard portfolio. This enables the investor to establish whether the portfolio has yielded expected return or not. Dow Jones Index and S&P 500 are the most commonly used benchmarks in active portfolio management techniques. In addition, opportunities for investment are normally restricted to underlying stocks of the benchmark that is used. This approach is advantageous for investors as underlying indices of the benchmark are likely to follow a similar pattern of return to that of the overall market. This enables the investor to consider market return as the expected return, which is thereafter used as the benchmark return expected from the portfolio investment. Therefore, it can be said that investment strategies are formulated and implemented on the basis of various factors. Similarly, there are various investment strategies that are appropriate to a particular market type, market situation and components that are included within a portfolio. This research paper will cater to identify some of the relevant investment strategies that can be adopted by investors in order to maximise the return from their portfolio. An extensive literature review will be done in order to establish a solid foundation over which discussion regarding the alternative investments strategies can be done. 2. Scope While selecting an investment portfolio, it is very crucial for an investor to follow definite investment strategies by taking into consideration different investment principles, rule and behaviour (Petajisto and Anthonio, 2011). The underlying rationale behind this fact is that such strategies enable investors to keep themselves up-to-date with current market trends. By doing so, investors are able to predict future behaviour of the market, which is important factor ensuring value maximization from an investment portfolio. As far as this module project is concerned, the researcher has been assigned with the responsibility to suggest a new client with a suitable investment strategy to invest in a portfolio. The most critical factor in this case is that the client is new to portfolio investment and thus, has mixed feelings of both expectations and doubts. The scope of investment strategy to be suggested to the client will be based around the mixed feelings. The investment strategy will be formulated in such a way that its suits expectations of a novice investor, which in turn will enable the researcher to provide assurance to the investor regarding the fact that the investment strategy is directed towards maximising return and minimizing risk. In such a context, two fundamental types of investment strategies have been identified; active management and passive management. According to Petajisto and Anthonio (2011), an investor implementing an active strategy aims towards outperforming the investment benchmark index; whereas a passive strategy mainly involves minimizing transaction cost and forecasting the future precisely (Tergesen and Young, 2004). Given the fact that the client is new to investment portfolio, emphasis will be primarily laid on passive strategies as it will not be appropriate to recommend an aggressive strategy that will expose the client to market wide risk. 3. Research aims and objectives The primary aim of this study is to identify an appropriate investment strategy for a client who is relatively new to investment portfolio. In order to be able to do so, the following objectives have to be fulfilled: To explain the rationale behind considering passive strategies as an appropriate strategy for a new investor. To outline the key factors that should be considered in implementation of passive strategies. To analyse the advantages and disadvantages associated with use of index fund as a form of passive strategy. To understand effect of the three major indexing methods, those are available for the client. These methods are namely traditional indexing, synthetic indexing and enhanced indexing. 4. Literature Review Despite a number of studies on this particular topic, debate concerning efficacy of both passive and active investment strategies, in terms of maximising return for the investors, has been witnessed very frequently. In essence, there is no way that one can pick a side and give biased opinions over a particular strategy, since adoption of these strategies in order to invest in a portfolio is not a reciprocally exclusive decision and in some cases, it might even be appropriate to adopt both the strategies. Experienced investors who build their portfolio on the basis of strategic asset allocation to more than one classes of asset realize that each and every investment management professional has attributes that may either hinder or favour them during diverse market situations and among different classes of assets that have been included within the portfolio. In addition, regardless of their styles, an investment manager’s biggest strength may at times prove to be their biggest weakness. However, this fact entirely depends on the market environment. Investors following a passive strategy make no attempt to outperform an investment benchmark index. Rather, they try and reproduce the returns generated by the index. This type of investment is largely based on the belief that a market is efficient as suggested by Fama (1970) stating the efficient market hypothesis. In an efficient market, investors do not get the scope of gaining abnormal returns through extra effort and expense of active management. The major factors that are to be considered while implementing a passive strategy are the costs and risks associated with portfolio investment (Fleiner and Verling, 2013). On the other hand, active investment managers focus on outperforming the returns generated by a benchmarking index. The investment management professional attempts to do so by purchasing those securities, which they perceive to be undervalued in the market and selling those that they believe are being traded at their maximum value. This strategy is based upon the professional’s belief that markets can often be inefficient, which provides them with a great opportunity to exploit undervalued or overvalued securities, thereby outperforming the index. Unsurprisingly, not every investment manager has the same skills. They require huge amount of knowledge, experience and resources that enable them to predict behaviour of the market. Even so, at times, even the best of managers cannot get their predictions right leading their client to be exposed to a great deal of risk (Fleiner and Verling, 2013). Funds that are managed using passive strategies have lower cost compared to those managed using active strategies. In addition, using exchange traded fund, products may also provide the taxable investors with tax saving options by utilizing the benefit of redemption-in-kind tax strategies and evading pass-through costs. As far as empirical literatures are concerned, indexing is considered as one of the most efficient ways of investing in the market. Given the fact that very scant information is available to investors, collaboration of all choices made by all the investors in a market will give rise to a perfectly structured efficient portfolio. This is the concept of market efficiency. Even though by implementing passive investment strategies, an investor may be successful in avoiding the risk of an investment manager committing costly mistakes, yet the investor may also lose opportunity of taking defensive or offensive action while responding to market wide circumstances (Arnerich Massena & Associates, 2007). Active strategy management, on the other hand, provides the investor with an added benefit of expert analysis, which is based upon detailed research as well as prior experience. This suggests that the expense ratio is usually greater than passive strategy management, which in turns affects the net income (Hilsted, 2012). Nonetheless, it also suggests that there is a probability for the investor to generate significantly high net return and thus, outperform the market. A simple question of what passive and active management offer to the investor is regrettably as far as investment consultants will go in explaining the difference to their clients. It is believed that ways in which passive and active funds behave in the market is very pivotal in understanding the potential of passive and active strategies so as to maximize the return of ones investment portfolio (Arnerich Massena & Associates, 2007). As mentioned above in this section, cost and risk are two crucial factors that are to be considered while implementing passive investment strategies. According to Fleiner and Verling (2013), cost factors can be broadly classified into two categories. The first is operating cost of the funds. In essence, these are expenses that are inherent to the fund. The second one is tax costs. These expenses are inherent to the investor. Operating Costs: Identifying securities, which have potential to maximize value for the investor, is a difficult task. An investment that is managed on the basis of active strategies will always involve a team of professionals who are highly skilled as well as actively engaged in research works. They will have to conduct trading and management activities efficiently in order to be able to generate added value and consequently, outperform the index returns. This is precisely the reason behind the fact that managing funds by implementing active strategies cost more to investors compared to managing funds through passive strategies (Fleiner and Verling, 2013). In addition, managers implementing an active strategy tend to conduce trading on a frequent basis as compared to those who follow a passive strategy. As a consequence the transaction cost incurred by active investment managers tend to be higher than that of passive managers. Taxes: Passive strategy is considered to be a highly tax-efficient when compared to active strategy. The underlying rationale that justifies the above mentioned fact is that sale of securities is a taxable event. So, a manager who trades actively (in this case, an active manager) will always give rise to more taxable events, which in turn would increase tax expense of the investor. Inherently, active managers are frequent traders; if they make the right decisions, then they will be able to generate capital gains that are taxable. Hence, in this context as well, implementing a passive strategy proves to be less costly than that of active strategies (Fleiner and Verling, 2013). Risk factor: As far as the risk factor is concerned, consideration of several market wide risk factors is far from being absolute. There is no clear definition or formula that suggests the ways to consider risk. This is completely based on the investors perception about the market (Silva, Lee and Pornrojnangkool, 2009). Based upon consideration of various factors associated with the cost and risk of an investment, investors, investment managers as well as academic researchers consider indexing or investment funds to be the most favoured strategy, as far as implementing passive strategy is concerned. Indexing can be referred to as an investment plan, that aims towards tracking a particular market index as precisely as possible, after taking into account all expenses that are to be incurred while implementing a particular strategy. This objective is strikingly dissimilar from those pursued by conventional investment management professionals, which is to outperform the target market index, even after considering every possible expense associated with the investment (Philips, et al., 2014). Since introduction of this strategy during the 1970s, an unprecedented growth has been witnessed in implementation of indexing as an investment strategy. An indexed investment strategy via exchange traded fund or mutual fund aims to reflect the returns generated by a particular market, which has an investment in the same group of securities. Indexing strategy involves implementation of quantitative risk management and control techniques in order to track the return generated by a particular market and thereafter, aims to reproduce return generated by the benchmark index with negligible anticipated deviations (Philips, et al., 2014). This research study will involve a thorough explanation of the importance of passive investment strategies, thereby taking into consideration factors that are to be considered while implementing such a strategy. The researcher will also discuss and analyse indexing methods that are applied in the contemporary business environment with the sole motive of explaining an investor (client), who is relatively new to the field of portfolio investment and management, the appropriateness of implementing a passive investment strategy. 5. Data and Methodology 5.1. Data Collection Collecting extensive data is a very crucial aspect of a thoroughly successful research study. A critical analysis of the collected data enables researcher to enhance readability of a research study. Besides that, the research by means of a thorough evaluation of the extracted information (whether acquired through primary or secondary source) is able to uphold its validity, reliability and appropriateness. In this research study, the researcher will only be analysing secondary information that are obtained from authentic secondary sources such as, printed and electronic books, peer-reviewed journals, authentic websites and several other reliable online databases. Given the fact this research paper only involves analysis of secondary data and does not include any primary data analysis, the secondary information will be cross-referenced with information provided in empirical literatures and other authentic sources so as to maintain precision of the analysis. By implementing this methodology, the researcher will be able to develop a broad understanding about the issue that is being explored within the research. Apart from that, the researcher will also be able to establish synchronization between the obtained data and the ideas set forth in empirical literatures by assessing the issue conveniently throughout the research (QAA, 2012). 5.2. Data Analysis instrument Provided the fact that this research study will be conducted primarily on the basis of a case study approach without including any primary data analysis, the major data analysis tool is secondary in nature. In order to be able to complete this study in an appropriate manner, various passive strategies will be discussed on grounds of ideas set forth in existing literatures. Four major academic sources have been chosen to discuss various investment strategies. The basic rationale behind the selection of these sources is the fact that they provide researcher with substantial information, which is available in this field of research. As a consequence, the researcher is able to gain valuable insight regarding the same. This is precisely the reason behind adoption of a case study approach, which will facilitate a detailed analysis of pertinent information available regarding the subject matter. 5.3. Research philosophy adopted Given the fact that this particular research involves an in-depth assessment of qualitative data gathered from secondary information sources related to field of the subject matter, interpretive research philosophy has been deemed appropriate. According to Mukherji and Albon (2009), the underlying rationale behind application of this research philosophy is that this will allow the researcher to develop an in-depth understanding of reality by the help of a subjective interpretation of the same. Moreover, Somekh and Lewin (2004) stated that another motive behind implementation of interpretive philosophy is the fact that this philosophy facilitates a critical assessment of secondary information, which encompasses several details regarding the research issue that is being addressed. In addition, provided that this research study is micro-sociological in type, adopting interpretive philosophy will serve as a more effective foundation (Plummer, 1983). 5.4. Research approach adopted In order for the researcher to be successful in conducting this research study in an apt manner, inductive research has been regarded as the best fit approach. Blaxter, Hughes and Tight (2006) suggests that the underlying reason behind implementation of an inductive approach is that this study caters to explain a generalized issue initially and thereafter, emphasis will be laid upon studying more precise aspects of the present research issue. In addition to that, Saunders, Lewis and Thornhill (2009) stated that adopting of inductive approach will prove to be beneficial for the individual conducting the research, as far as interpolating the results and translating the same into strong conclusions are concerned. Provided that fundamental requisite of this research study is to prudently observe, evaluate and develop an understanding of the importance of investment strategies, with the underlying aim of suggesting an appropriate investment strategy for a relatively new investor, implementing an inductive research approach will enable the researcher to complete the research successfully and conveniently. The details that have been set forth in this section justify the adoption of inductive research approach. 5.5. Significance of qualitative data analysis Mentioning the phrase, ‘qualitative research and evaluation data’ in academic research grounds normally provides a description of explanatory and unrefined data related to the observation of general population regarding a particular issue, service or product. Besides that, there is another explanation of qualitative research method, which involves a detailed analysis and assessment of empirical literatures and secondary information related to a particular issue extracted from relevant data sources. This provides the researcher with enough opportunity to conduct a comparative analysis and thereafter establish a robust evidence dependent analysis. Several data collection strategies have been put into practice by empirical research scholars. However, strategies that were most commonly adopted are open-ended interviews, written documents, questionnaire survey and direct observation. An alternative information collection strategy that has been witnessed very frequently in experiential researches is a case study mythology. Data obtained from case studies, observations interviews as well as document reviews are classified as case examples and themes. In the genre of qualitative research, consistent comparative analysis has been the most adopted methodology. Alongside strategies that have been discussed above, there are numerous alternative data collection strategies that can be adopted depending on type and nature of the research. A number of alternative methods of reporting have been noticed in experiential literatures, where most favoured approach is the sense of story method. This method is aimed towards developing qualitative assessment respondent by using expressive glossary, direct quotes collected through interviews conducted with individuals as well as organizations and lastly, by focusing on intricate details. The elementary motive behind application of qualitative research methodology is that it enables the researcher to evaluate specific subjects, events and cases in great depth and detail. The extent to which information can be collected is not restricted to predetermined type of analysis. Qualitative research approach also serves as an effective assistance tool, as far as large scale verification and measurement of ideas, beliefs and attitudes are concerned. In addition to that, qualitative research methods also provide the researcher with detailed information that is applicable to pre-determined number of company cases and people, thereby facilitating a deeper insight into the research topic that is being explored. 6. Discussion and Analysis 6.1. Passive strategy is highly effective in inefficient markets Apart from beneficial in the efficient markets, passive strategy will also prove to be a winning strategy in inefficient markets. The underlying reason behind this fact is that wining strategy must always follow a zero sum game as depicted in figure 1. Figure 1: Distribution of returns (Source: Malkiel, 2003) According to Malkiel (2003), every stock has to be acquired by someone and in cases where a group of investors is generating above average returns, it suggests that another group of investor is exhibiting a below par performance. It is quite obvious that all investors cannot achieve above average returns. Figure 2 reveals that after taking into consideration all additional expenses associated with active management, majority of investors are likely to be unable to outperform the market average. The exhibit takes into account a 10% return generated by the market and added expenses of 120 basis points that are associated with active management. Figure 1: Distribution of returns after expenses (Source: Malkiel, 2003) The expenses that have been mentioned above include professionals fees, which are relatively higher for funds that are actively managed. For example, in the USA, an equity mutual fund that is actively managed realizes an expense ratio, that is more than 140 basis points. On the other hand, cheaper index funds are available in the market at an expense ratio, which stays between 10 and 20 basis points. Researchers have concluded that it is an additional 120 basis points, which results in underperformance of equity that are actively managed compared to its benchmark index. There are several other reasons that justify implementation of passive strategy while investing in a portfolio. For an investor who is taxable, implementing a passive strategy will minimize turnover as well as tax (Malkiel, 2003). 6.2. Factors to be considered while implementing passive strategy Cost factors favouring passive strategy: Funds are normally held in an account, where capital gains are taxable. In addition, the funds include securities in an asset class, where information is instantly accessible (Fleiner and Verling, 2013). Risk conditions that favour passive management: Investors who have invested in passive funds can anticipate their funds in order to keep track of the associated index precisely by considering that the difference in return from that of the index is basically the fee paid to investment manager. Index funds are more often than not completely invested; so, investors who hold onto securities during the period of a market downturn will participate wholly when the market recovers. Constructing a well diversified portfolio using passive strategy and rebalancing it on a regular basis will minimize overall volatility of the portfolio (Fleiner and Verling, 2013). 6.3. Why does indexing work? Indexing is a prudent strategy, particularly because security markets more often than not seem to be outstandingly efficient in incorporating and adapting to newly available information. In situations where information related to a particular stock or about the entire market is revealed, then that information is reflected in the prices without any delay. Although it is a fact that researchers have identified several anomalies and that predictable pattern of market behaviour apparently exists, none of these facts are evidential and conclusive enough to abandon the efficient market hypothesis. Incongruity is commonly minor in nature when compared to transaction costs that is required to take advantage of them. Although predictable market behavioural pattern does exist in some way or the other, majority of these patterns diminish as soon as they are identified. These facts suggest that indexing as a passive strategy is the most appropriate one to be implemented in such an efficient market (Malkiel, 2003). 6.4. Effect of different indexing techniques The fundamental rationale behind application of traditional indexing technique is to reduce the risk of market underperformance, by closely monitoring bond and stock indices that have the lowest cost. Implementation of a traditional indexing technique mainly lowers the turnover of a portfolio that contains index components. In addition, given the fact that the market determines weight of each component, probability of committing an error while judging the components is reduced to a great extent (Nasdaq, 2009). Synthetic indexing technique applied to a particular portfolio involves the concept of mimicking behaviour of a market benchmark index, which is associated with components that are included within an investors portfolio. In majority of the cases, synthetic indexing does a more precise tracking of the indexes. Many critics have been noted saying that the technique of synthetic indexing is exposed to counterparty risk and that it is not transparent, which may eventually misguide investors. Enhanced indexing is another variant of a passive investment strategy whose effect lies in enhancing the returns generated by an index fund or an underlying portfolio. This indexing technique also minimizes the effects of error that is committed while tracking the market. In many cases, enhanced indexing is considered as a combination of active and passive management, which can be implemented so as to outperform a benchmark index (JP Morgan, 2010). 7. Conclusion Building an investment portfolio on the basis of passive strategy management is an appropriate strategy. However, appropriateness of the strategy depends on tax status of the individual investor, time horizon as well as level of risk tolerance. On the other hand, a portfolio that is constructed on the basis of active strategy management may yield better result by potentially offering the investor with an enhanced downside protection and enabling managers to retain their ability of responding to varying market situations and circumstances. Nonetheless, some might even consider an amalgamation of both active and passive investment management strategies as the most optimal strategy. The main fact that can be understood from this research is that the extent to which a portfolio construction will involve implementation of a particular strategy depends largely on the specific sensitivities of a client as well as the individuals definitions associated with risks. In addition to that, implementation of a certain strategy will also rely upon the way in which a client perceives added value. Even so, provided the fact that implementation of passive strategy incurs relatively lesser cost for an investor compared to that of active strategy and that passive strategy shields an investors portfolio from several market wide risk exposures, it is the most appropriate strategy for an individual who is new to the field of portfolio management. Reference List Arnerich Massena & Associates, 2007. Active versus Passive Investment Management: Putting the debate into perspective. [pdf] Arnerich Massena & Associates. Available at: [Accessed 5 May 2014]. Berk, J. and DeMarzo, P., 2011. Corporate Finance. New Jersey: Prentice Hall. Blaxter, L., Hughes, C. and Tight, M., 2006. How to Research. 3rd ed. New York: McGraw-Hill International. Fama, E., 1970. Efficient Capital Markets: A Review of Theory and Empirical Work. 25(2), The Journal of Finance, pp. 282-417. Fleiner, M. and Verling, E., 2013. Exploring the benefits of using both active and passive investment strategies. 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