Portfolio management - Essay Example

Portfolio management Introduction An investor may hold a collection of investments to derive future payments that will compensate the investor for the time the funds are committed, the expected rate of inflation, and the uncertainty of the future payments. The "investor" can be an individual, a government, a pension fund, or a corporation. The most vital decision regarding investing that an investor can make involves the amount of risk he or she is willing to bear. Most investors will want to obtain the highest return for the lowest amount of possible risk. However, there tends to be a trade-off between risk and return, whereby larger returns are generally associated with larger risk. Portfolio management helps to bring together various securities and other assets into portfolios that address investor needs, and then to manage those portfolios in order to achieve investment objectives. Effective asset management revolves around a portfolio manager's ability to assess and effectively manage risk. With the explosion of technology, access to information has increased dramatically at all levels of the investment cycle. It is the job of the portfolio manager to manage the vast array of available information and to transform it into successful investments for the portfolio for which he/she has the remit to manage. Portfolio management has faced lots of ups and downs due to the market turbulences caused by the global market credit crunch. In this following section, the functions and roles played by the portfolio managers are discussed upon. Portfolio management Portfolio management is principally about risk and return strategies. It is concerned with the construction and management of investment assets. There are two fundamental ways that a portfolio manager can add value which are follows ( Lumby, 1994): Strategic diversification- The portfolio manager generates value by effectively exploiting diversification opportunities between the assets in the portfolio. For instance, two stocks that are not well correlated can be combined so as to get more return relative to risk. Alpha return- The second way that fund managers add value is by generating returns that are in excess of what could be obtained by a reasonable combination of the asset classes in the fund. Alpha generation may be due to the relative weight given to each of a series of asset classes at any given time or it may be due to the specific stocks selected within an asset class-finding the best stocks in a sector. 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". The styles of portfolio management are discussed in the following section. Active portfolio manager An active portfolio manager is one who constantly makes decisions and appraises the value of investments within the portfolio by collecting information, using forecasting techniques, and predicting the future performance of the various asset classes, market sectors, individual equities or assets. His goal is to obtain better performance for the portfolio. He uses personal ability and judgment to select undervalued assets to attempt to outperform the market. The active managers adopt strategies, all involving detailed analysis, as given below (Brentani, C. 2004, p.93): i. Top-down approach- This approach involves assessing the prospects for particular market sectors or countries (depending on the index), following a detailed review of general economic, financial and political factors. Sector weightings may be changed by fund managers depending on their view of the prevailing economic cycle (known as sector rotation). If a recession is likely, shares in consumer sectors such as retailing, homebuilders and motor distributors will be sold and the proceeds reinvested in, say, the food manufacturing sector. A portfolio is then selected of individual shares in the favored sectors. ii. Bottom-up approach- The bottom-up approach involves the careful selection of individual shares that are assessed to be relatively undervalued and are subsequently sold once they have been re-rated. This involves detailed analysis of available information including: reports on the markets in which the company operates, its competitive position; quality of management; products and technology; customer base and sales potential, prospects for exports; capital expenditure requirements; cost structure and supplier base; and an assessment of the strength of the balance sheet, income and cash flow statements. This analysis will then be combined with judgment on its relative share price, price earnings ratio, dividend prospects and market sentiment. The process may necessitate company visits and meetings with industry analysts. Using all this information, suitable forecasts can be drawn up and the decision made whether or not to buy. Passive portfolio manager A passive manager is one who lays out an investment plan for the portfolio and this includes what asset classes to employ and what percentage of the money to allocate to each asset class (Herr, L., 2008). The portfolio manager holds a portfolio of assets for a long period of time (several years) with few changes over time, and entails little input from his side. This strategy does not require the fund manager to outperform an index or to try to select undervalued assets. The theory behind passive fund management implies that two conditions are being satisfied in the securities market; efficiency and homogeneity of 9expectations. The assumption is that if securities markets are efficient, securities will always be priced fairly and there will be no incentive to trade actively. Also, if securities markets are characterized by investors who have homogeneous expectations of risks and returns, then again there is no incentive to trade actively. If too few securities are held in the portfolio, however, diversifiable risk may remain. Thus, a larger number of securities must be held for proper diversification. Once a portfolio is fully built and all the asset classes are in balance, the passive manager does little else other than keep records and rebalances the portfolio when necessary. For the manager who feels they need to be a bit pro-active when it comes to portfolio management, one might add an individual stock from time to time. For the vast majority of investors, it is best to play the role of passive manager and let the markets do their work. Active portfolio manager vs. Passive portfolio manager The efficient market theory in its purest form strongly supports passive investing, as it dismisses the possibility for superior returns through investment selection. According to the Efficient Market Hypothesis, the market appears to adjust so quickly to the information about individual stocks and the economy as a whole that no technique of selecting a portfolio, neither technical nor fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified group of securities. 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 than 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. The other advantages of being a passive portfolio manager are as follows (Cypress Asset Management, 2007): Passive portfolios cost much less to manage than their actively managed alternative. The expenses of passive mutual funds are normally 50-80% less than an active fund in the same asset class. This often gives the passive investor an immediate advantage of 1% or more in net returns. Passive portfolios are more tax efficient. Taxable capital gains are generated any time appreciated securities are sold within a portfolio. Passive portfolios, with their "buy and hold forever" approach, seldom sell securities, resulting in very low income tax costs. 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". In reality, there are multiple market "anomalies" that do not support the efficient market theory, at least, not in its purest form. The advantages to active portfolio managers over the passive portfolio managers are as given below: 1. Psychological biases: Cause and effect mismatches- Many investors assume past results are representative of future results. In reality, past results are representative of past events and will not necessarily repeat in the future. Excessive buying of stocks with high past returns leads to over-valuation. Active managers that are aware of this bias could benefit by avoiding many over-valued situations. Conservatism bias- Once people have formed an opinion it is difficult to change it. They will be initially unwilling to accept the new evidence of improved or diminished prospects. Active managers who recognize this fact could obtain superior returns by more quickly recognizing the new economic realities of the companies they research. Narrow framing bias- Some long-term investors become obsessive about short-term price movements in a single stock or a narrowly-defined sector instead of focusing on changes in their total wealth. Narrowly-defined risk aversion leads to excessive under-valuation of certain stocks or sectors. The skilled, active managers who successfully recognize the narrow-framing bias could exploit excessive under-valuation. Ambiguity aversion- People are excessively fearful of situations of ambiguity. Waiting for perfect information causes investors to miss superior returns. The lack of direct familiarity also explains the home bias most investors have. The information disseminated through research by active managers leads to market efficiency. In a sense, passive investors are "free" riders, benefiting at no cost from the work of all active managers. However, the more investors select indexing, the less efficient the markets become due to decreased research coverage. Opportunistic, active managers could exploit increased inefficiencies and deliver market-beating returns. As a result, more investors would migrate to active styles in search of better returns. Research coverage, in turn, would increase, also increasing the efficiency of markets, therefore the relative attractiveness of passive management. Passive management could not exist without active managers keeping the markets efficient. This apparent paradox serves as a natural "check and balance" system in the markets. Unbiased investor advisors that correctly identify the advantages and disadvantages of both passive and active strategies can help their clients create investment portfolios that allow for the benefits of both worlds. Sometimes portfolio managers will combine elements of both passive and active fund management. This technique is known as portfolio tilting (Brentani, C. 2004, p.91). Here a fund manager might hold all the constituents of a particular index primarily in proportion to their market values within the index. However, a few constituents in, for example, the technology sector of the fund may be held in a proportion slightly higher than that in the index, and thus the portfolio is considered to be 'tilted' in the direction of technology stocks. One of the main difficulties in combining an active strategy with a passive strategy is in determining the degree to which the fund should be actively versus passively managed. Portfolio management during the global market crunch The credit crunch that set in from mid 2007 owes its origin to sub-prime mortgages offered to US borrowers who failed to meet standard bank lending criteria Soaring default rates on these non-prime mortgages have fed through into so-called 'structured products' that were mass manufactured to securitize those mortgages: collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), bank 'conduits' and special investment vehicles (SIVs). Structured products were sold worldwide, exporting US sub-prime mortgage default risk to foreign investors. This forced banks to raise loan interest rates and tighten lending criteria, triggering a credit crunch. The portfolio managers at financial institutions have traditionally been "buy and hold" investors, which meant making loans and holding them to maturity (Kerr, 2008). However, so-called active credit portfolio management is more about originating, managing and selling-on. The active portfolio managers have an advantage over their passive counterparts, during the global credit crunch due to the following reasons (Putyatin, V. and Bezooijen, J. 2008): Active managers can generate excess returns through tactical opportunities Structural opportunities in fixed-income markets create sources for added value (including the existence of liquidity, term, volatility and credit premiums) Diversification allows active managers to reduce risk. Passive fixed-income strategies have limitations and come with significant opportunity costs. The recent turmoil in global financial markets led to volatility in fixed-income markets as well. Overall, this has created more favorable conditions for active portfolio managers; these conditions include steeper yield curves, higher volatility and wider credit spreads. For instance, of the two U.S. equity managers in portfolio of Western Joint Pension Fund (Northwater and PanAgora), only PanAgora is an active manager (Belanger, 2008). As a passive manager, Northwater's role is to replicate the return of the S&P 500 Index and the S&P 400 MidCap Index, which they have done during the month of September. PanAgora manages a portfolio that invests in U.S. small cap companies. In this volatile market environment, they have kept their investment philosophy and model in place. That is, they seek to own quality companies that are attractive and have positive market sentiment. Going forward, it is their view that investors will be more risk averse and will seek to buy into quality (asset quality, earnings quality and loan quality) and financial strength (strong debt and interest rate coverage and low debt-to-assets). These factors are already incorporated into their model and should position them favorably. Nevertheless, they continue to improve their model by incorporating non-traditional signals. For example, they have incorporated credit default swap information into their model which assesses the likelihood of a company going into default. Translating this information into a quantitative signal allows them to better determine the return prospects of individual companies during this wide-spread credit crisis. Portfolio diversification is an important element of portfolio construction under normal market conditions (Rockefeller, A. 2007). Careful diversification, while important in normal markets, cannot be expected to work during crisis conditions. Investors should consider investing in areas of the market that are not aligned with the holdings of the liquidity-demanding entities that are de-stabilizing the markets. This position does not invalidate diversification, but rather points to the importance of independent research and proprietary information. It also underscores the need for market participants to assess capacity levels appropriately so that they do not hold a majority of positions that cannot be traded within a reasonable amount of time. 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.The tactical allocation decision ultimately influences the decision between active and passive management. Although passive strategies may have an edge in very efficient areas of the market, active strategies may have an edge in less efficient areas. The active portfolio management strategy has an advantage over the passive portfolio management strategy especially during the market turbulences caused by the credit market crunch. Both strategies will continue to co-exist in the industry because their relationship is symbiotic. Portfolio management will gain strength as an established means for managing investments, and is likely to continue as a way for savers to invest over the next decades. References 1. Brentani, C. (2004) Portfolio management in practice. Elsevier Butterworth-Heinemann Linacre House, Jordan Hill, Oxford, p.91. 2. Cypress Asset management (2007) Passive Portfolio Management [Internet]. Available from [Accessed on 28November 2008]. 3. Good Returns (2008) Riding the Global Credit Crunch and Commodities Boom [Internet]. Available from < http://www.goodreturns.co.nz> [Accessed on 27 November 2008]. 4. Herr, L. (2008) Active vs. Passive Portfolio Management. ITA Wealth Management [Internet]. Available from < http://www.lherr.org> [Accessed on 27 November 2008]. 5. Kerr, D. (2008) Credit portfolio investors unprepared for fresh crisis. [Internet]. Available from < http://www.wealth-bulletin.com> [Accessed on 28 November 2008]. 6. Lumby, S. (1994) Investment Appraisal and financial decisions. Fifth Edition. London: International Thomson Business Press. 7. Putyatin, V. and Bezooijen, J. (2008) PIMCO - In Focus LDI Active vs. Passive July 2008 [Internet]. Available from [Accessed on 28 November 2008]. 8. Rockefeller, A. (2007) Importance of Strategy Diversification in Changing Markets [Internet]. Available from < http://www.ssga.com> [Accessed on 28 November 2008]. Read More