Basic Investment Strategies an Investment Manager Can Follow - Essay Example

There are two basic investment strategies an investment manager can follow. Active fund managers try to perform better than the stock market average, while a fund manager who follows the passive strategy does not even try to out-perform the market average. Introduction When making an investment decision, a manager is expected to be rational and select the most efficient strategy that can improve returns to the business. There are two investment strategies to choose from, and they include active and passive management funds (Hebner, 2005). Many people argue about the investment strategies and the most effective strategy to use. However, with the increasing traded funds, managers can access passive funds effectively. The purpose of this paper is to discuss active and passive funds and their differences and propose the most effective funds. Active funds Active funds are the funds that are managed and run by professionals (Berezin, 2005). The fund managers or the financial management team make investment decisions after conducting an effective business appraisal and determine the most effective businesses (Alexander & Sheedy, 2005). Competent and skilled managers conduct an extensive research study in the market, they have exclusive access to various financial sectors, and then they discuss with managers of different companies and analyze the success of the business before making a decision (Avkiran, 2011). It is important to note that active funds focus on creating value for the investment that is higher than the prevailing market conditions or earn returns more conservative with the aim of protecting the capital from losing its value (Berezin, 2005). Therefore, one can note that active funds aim to provide higher returns from the investment (Alexander & Sheedy, 2005). However, the managers must have the right skills to actively manage the resources to achieve the desired outcome (Hebner, 2005). The managers controlling active funds must monitor the progress of the sector always with the aim of evaluating the dynamics in the business environment, and when they detect that the value of the investment is declining, they can move the funds to a sector that is growing and can provide value (Avkiran, 2011). It means that the managers can do all they can to protect the value of the money and avoid losses. Rationale for active funds The first rationale of using active funds is that the managers invest in the business with the aim of outdoing the competitors in the market (Alexander & Sheedy, 2005). Consequently, excess return on capital can generate substantial outcomes because of the concept of compounding excess returns (Hebner, 2005). Using active funds is more flexible to both the investor and the manager (Avkiran, 2011). It is because active funds are raised from a large pool of investment as compared to passively managed funds that are limited to a specific benchmark (Berezin, 2005). Individuals managing active funds have the opportunity to weigh and shift the sector of investment meaning that are flexible thus minimizing the risk of investment. The managers make informed decisions based on past experience regarding the investment decisions (Berezin, 2005). This is because they are not restricted on the particular index (Avkiran, 2011). As such, the investments managers can take identify possible risks and take appropriate measures to achieve a desired outcome (Richard, 2011). However, the active managers do not meet their needs and expectation. Research conducted in the UK shows that only 24% of actively managed funds manage to outdo the benchmark target (Michael, 2014). It means that active funds might not generate desired revenue. Passive funds Passive funds are the funds that managers invest in the business and attempt to outdo the market by using strategies (Richard, 2011). The managers who use passive investment strategy believe that the market hypothesis is efficient meaning that the market players reflect information available in the market and make concrete decisions that can improve the performance of their investment (Baity et al, 2014). Investing in passive funds is crucial because it helps to enhance diversification as well as reducing the turnover and this is significant in keeping internal transaction costs low (Clyde, 2006). Traditionally, investors can access passive funds in the equity market but the changing business environment has created diversity hence they can access the funds in various markets (Roca, 2012). Rationale for passive funds The first rationale behind the use of passive funds is that individuals will have average cost performance at the end when compared to market prevailing market conditions (Eccles, 2012). It is this reason that individuals who invest in passive funds benefit better because the concept reduces the cost of investment (Richard, 2011). However, the principal has the right to monitor the performance of the manager to ensure good returns on investment (Roca, 2012). Individuals invest in passive funds because of the lower operational costs thus increasing the capital returns. Difference between active and passive funds One can differentiate active and passive funds. The first difference is that managers track active funds and conduct market research before making an investment decision (Richard, 2011). It means that they make decisions based on the findings of the market research (Roca, 2012). On the contrary, decisions made regarding passive decisions are based on market track, and in other words the cost charged is less as compared to active funds (Preko, 2012). For instance, computers run the funds, and investors get returns based on the prevailing market performance so that they make decisions based on the market returns (James, 2002). Another difference is that passive managers replicate on the template that already exists in the market and does not try to add value to the investment portfolios (James, 2002). On the contrary, active funds are costly because the managers have to research and analyze the market findings for efficient decision-making (James, 2002). This makes active funds expensive as compared to passive funds. Similarity Despite these differences, active and passive funds have similarity in that they focus on competition styles with the aim of making effective investment decisions (Norreklit, 2000). The funds are used by different investors who want to create a value of their investment (James, 2002). However, the assumption is that the managers in both active and passive funds are rational and they make the best decisions to achieve a high return on investments, and they work towards avoiding making losses (Preko, 2012). Pros and cons of active funds The first advantage of active funds is that it is simple to make the investment decisions. It is because it is not a must for managers to own shares of a particular company. As a result, the managers make decisions based on the expected performance of the sector (Hebner, 2005). It means that they do not make decisions based on the list of companies in the market but general performance, and this makes the process of investment simple. Active funds are managed with the aim of outperforming the conditions in the market. It is because they do not depend on the specific index but managers focus on the best strategies to enhance the return on assets (Norreklit, 2000). In this way, the managers have the responsibility of deciding the investment techniques to employ to create investment value to improve its returns. Besides, active funds are essential to investors because it provides a large pool of investment options. It is because the managers can make decisions and take various shares in different companies (Ananth, 2004). In the process, they get more revenue from diversified sources as compared to investors who invest in passive funds (Ananth, 2004). The most important thing is that it is easy to administer active funds because managers can make changes depending on the changes in the market (Preko, 2012). Active funds have disadvantages that scare away investors. The first disadvantage is that it is costly to implement because the cost of operation is high (Tracy, 2012). For instance, the managers have to conduct market feasibility to determine the best performing companies to invest (Stickney, 2009). Therefore, most investors want to put their resources where the cost of operation is low to increase the output (Tracy, 2012). These funds are concentrated in nature, and this makes its operations very difficult (Stickney, 2009). For instance, the managers are rational and must make rational decisions to achieve the desired outcome (Tracy, 2012). To achieve this, the investors have to adjust their strategies regularly to suit the market conditions (Weistroffer, 2010). As a result, it is difficult to operate active funds since the market conditions keep changing from time to time (Hebner, 2005). Transparency is a key issue in administering, and this affects the privacy of companies when making investment strategies (Weistroffer, 2010). Pros and cons Passive funds The first advantage of passive funds is that it has a low operational risk (Ananth, 2004). The risk of investing passive funds is low because it designed for long-term development (Ananth, 2004). The investments are diversified hence the investors can make viable decisions regarding the best way to earn their money (Weistroffer, 2010). Besides, the investors make a decision on the prevailing market conditions, and they do not have to select specific companies to invest. Its diversity protects individuals from making losses thus assuring investors good returns on their investments (Norreklit, 2000). The cost of investing in passive funds is low as compared to non-index investments (Norreklit, 2000). It implies that they perform better by a particular margin and this helps to cater for transaction fees (William, 2010). Very few transactions are available during the investment process, and this reduces the transaction fees generating a high return on capital invested (Richard, 2011). Simplicity is another advantage of passive funds. The process is simple because the investors understand the prevailing index in the market and this improves their confidence. They know their expectation from the prevailing market conditions (Ittelson, 2009). Moreover, the manager makes a decision based on market track (Richard, 2011). For instance, the process of making a decision is simple because businesses make investment decisions according to market conditions and not specific performance of the company that might take time and consume resources (William, 2010). However, the biggest risk facing passive funds is concentration (William, 2010). It is a problem that many investors tend to ignore, but it affects the performance of the investments (William, 2010). The investors have various options to make because of many companies in the market, but they concentrate on biggest firms (Richard, 2011). Because of this issue, investors concentrate on some sectors ignoring opportunities in developing sectors (Hřebíček, 2014). Concentration increases the risks of losses (Frame, 2013). The other factor to take into account regarding passive funds is that they are not sensitive to valuation (Frame, 2013). In this regard, more passive money in the market increases the anomalies for the active fund managers to exploit (Richard, 2011). Because of this fact, the managers fail to identify this opportunity hence they fail to manage the high fees (Frame, 2013). Recommendation Considering the above analysis, the most effective investment decision to make is using passive funds. It is because the procedure of making an investment is simple as well as the cost of transactions (Frame, 2013). For instance, the managers make decisions based on the existing information about the market conditions so that they do not have to research about the performance of each company (Richard, 2011). It is worth to note that the diversity of passive funds reduces the risks of losing the investment value, and this makes it the best investment decision as compared to active fund (Frame, 2013). However, investors should consider taking both active and passive funds to generate more income. Conclusion Making an investment strategic decision is a crucial part that influences the return on capital invested. The managers have the responsibility of analyzing the market and prevailing market conditions to determine the best investment decision. In this regard, two investment decisions are active funds and passive funds. Regarding active funds, the managers conduct market analysis to understand the dynamics of the business environment and make an appropriate decision. On the contrary, managers make passive funds decisions based on the existing market conditions. In this regard, the most effective investment decision is taking passive funds as an investment because it has more advantages. 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