The Selection of Investment Strategy and Portfolio Management - Essay Example

Introduction: The selection of investment strategy is the key to evaluate the fund manager’s success. The fund’s success can be easily judged in terms of numbers i.e the return on the investment. The issue that needs to be considered in evaluating the performance of the investment management strategy is that the performance must be compared with the relevant benchmark (Gilles, Alexeeva, & Buxton, 2005). If the strategy outperforms the benchmark then it is considered to be profitable investment. In order to outperform the benchmark the manager needs to deviate the portfolio weightings from the benchmark. The deviation may lead to the management of the fund with in depth analysis regarding the price movements of the stocks or bonds, which are managed under fund (Swensen, 2009). There has been a long debate on the structuring and management of the fund. The fund can be either actively managed or passively managed. Some researchers argue that the active management is more suitable for the high risk investors. On the other hand, some argue that passive management is considered to be sustainable and reasonable investment. The base of such arguments moves around the concept and belief about the market efficiencies. The market efficiency is referred to as the concept that describes that if market prices of the securities move according to the publication of relevant information in the market (Damodaran, 2012). The time frame, which takes to reflect the information in the prices of the security defines the efficiency of the market. If the time frame is large then the market may be considered as inefficient market and it gives the opportunity to generate excessive returns as compared to that of the market. On the other hand, if the time frame is short to reflect the new information into the prices of the securities then the market is considered to be highly efficient. Therefore, it does not give any opportunity to active manager to generate excessive return and the passive management is better. Therefore, some people argue that markets are efficient and it is difficult and expensive to create excessive return. On the other hand, others argue that markets have inefficiencies and using the inefficiencies more effectively can generate excessive returns. Categories of Efficient Market Hypothesis: The Efficiency market hypothesis can be categorized into three main categories, which are as follows 1. Weak Form EMH: The weak form efficient market reflects all the market information. The market considered to be efficient based on the available market information. The assumption that is included in weak form efficient market hypothesis is that the market rate of return should be independent (Palan, 2004). In addition to this, the weak form efficient market hypothesis also assumes that the past returns have no effect on the future returns. 2. Semi Strong Form EMH: In semi strong form efficient market the market is efficient that reflects all publicly available information. The assumption, which is included in the semi strong form efficient market hypothesis is that stock adjust quickly to absorb or capture new information. In case of semi strong form efficient market the investor cannot get benefit by trading on new information (Lee & S.Y. Ho, 2003) 3. Strong Form EMH: It reflects all form public and private information. The strong form efficient market hypothesis incorporates both the weak form and semi strong form efficient market hypothesis. The assumption of strong form efficient market hypothesis is that the investor cannot generate the excessive returns from the market because of highly efficient market (Elton, Gruber, Brown, & Goetzman, 2009). The paper will examine the active and passive investment management strategy and assesses the two approaches to managing the assets. The paper examines the case based on the literature review and empirical evidence What is Active & Passive Management? Active strategies in investment is referred to as the fund management strategy, which deviates the weights of stocks or bonds from that of the index fund with the expectation to achieve higher return from the market (Chong, 2004). In other words, the active portfolio management is the portfolio management strategy with the goal of outperforming than that of the benchmark. The benchmark can be the index or more customized based on investment style of the portfolio manager (Vishwanath & Krishnamurti, 2009). In case of passive investment style the return generated from the portfolio is generally approximately replicates the benchmark return. The portfolio return and the benchmark return cannot be exactly matched because of the transaction cost involved in the portfolio management. The passive investment strategy replicates the investment strategy of the index and is suitable for the investors and portfolio managers who do not want to take higher risk and are satisfied from the market return (Widger & Crosby, 2014). Active management on the other hand generates higher expected return based on the expectations and judgement of the fund manager to deviate the portfolio weightings from that of the benchmark. The active management strategy is suitable for the investors who want to generate excessive return and have higher ability to tolerate risk (Litterman, 2004). The higher risk tolerance requirement, in case of active management, is because of the risk factor that the judgement or projection of the fund manager may be wrong and the loss may be much more than that of the benchmark (Voicu, 2007). The structure of active management can be explained with the help of example of portfolio based on stocks which is initially passively structured i.e all the stocks in the portfolio have the same weights as that in the index. Portfolio manager believes that particular stocks in the portfolio are undervalued and some stocks are overvalued based on fundamental analysis. The portfolio manager may make the judgement that the identified undervalued stocks will increase in value and the overvalued stocks will decrease in value to return to their intrinsic value. In case of active management it is assumed that the stocks are chronic in nature i.e the value will return to their intrinsic value in the future. Therefore, based on the judgement of the portfolio or fund manager, the weight of undervalued stocks will be increased and the weight of overvalued stocks will be decreased. If the stocks move towards their intrinsic value, the long position in more number of undervalued stocks than that of the benchmark will increase the portfolio value more than that the benchmark. Moreover, the short position in overvalued stocks will lead the portfolio to outperform the benchmark because holding the overvalued stocks in the benchmark portfolio will lead to the loss in the portfolio. Therefore, the active portfolio management is used to outperform the portfolio than that of the benchmark. Investment funds the active management always play one of the most important role to evaluate the portfolio performance, as well as, the performance of the fund manager. The identification of active management strategies is the key to the success of the manager. Theoretical Foundation of the Two Approaches: As discussed in the introduction section regarding efficient market hypothesis concept. The same concept is used to describe the theoretical underpinning of the two approaches of investment management i.e active versus passive management. The efficiency of the market defines the effective utilization of investment management approach. If the financial market is considered to be highly efficient i.e the investor is not able to generate excessive return because all the public and private information, it is reflected in the prices of the securities in no time then the active management strategy is considered to be of no use (Petersen, 2012).Even the use of active management strategy may lead to a loss because of higher management cost. On the other hand, the passive management strategy is proved to be more useful because of lower management cost and generate the return approximately equal to the market return. Moreover if the market efficiency moves away from strong form efficiency then the role of active management becomes more significant in terms of positive returns. (Grinold & Kahn, 1999) Empirical Evidence In Active Management: The empirical evidences, on active versus passive investment, show that the results in most of the cases may not be clear because of the factors such as charges of investment management and the market efficiency is not clear. One study proves that the active management fails to add value in case of unit trust and mutual fund performance (Jackson, 2004). In another study conducted by Frank J. Fabozi, CFA shows that most of the active managers provide more convincing cases to pursue passive management (1998). He showed in his book on “Active Equity Portfolio Management” that large number of studies performs and examines the active portfolio management but on average passive management outperforms the active management. In mutual fund industry the management fee is relatively higher and the claimed alpha returns, which are generated by active portfolio managers may lead to zero or even negative after fee returns (Ang, Goetzmann, & Schaefer, 2009). Therefore, the higher fee of active portfolio management leads the strategy to underperform.The same study was conducted by Chris Bryan and Graham Taylor and proves the same that the management cost reduces the active management return (2012). In addition to this, another study indicates the Mutual fund internationally underperforms the market (Ferreira, Keswani, Miguel, & Ramos, 2013). The reason may be the performance and management fee. The study also indicates that the relationship between mutual fund performance and financial development level of the country is positive. So it can be implied that the country’s own trading environment along with legal environment are considered to be more important in defining the cross country fund performance. Study on the period of 1998 to 2000, which was assumed to be good period to take higher risk was proved to underperform the S&P500 benchmark (Wermer, 2003). Role of Fundamental Analysis in Fund Management The fundamental analysis refers to the identification of the intrinsic or the true value of the portfolio. The intrinsic value is calculated using different methods. One of the most common methods of calculating the intrinsic value is the discounted cash flow method. There are number of other fundamental analysis that can be used to identify and calculate the true value of the portfolio. In other words, the fundamental analysis refers to the evaluation of the financial statements analysis of the actual worth of the firm and its management. In addition to this, the fundamental analysis refers to the evaluation of the company’s competitive advantage, company’s performance as compared to the performance of the competitors. Moreover, as compared the fundamentally calculated equity value of the company, which is calculated using the financial statements and detailed financial models, to the market value of the company it can be concluded whether security is over or undervalued (Thomset, 2006). In case of fund management, fundamental analysis can help the fund manager to identify that the stock of the company in the market is undervalued or overvalued. This analysis can help the fund manager to use active management strategy to increase value of the portfolio. The role of fundamental analysis can be explained with the help of the following example. The analyst in equity research department of Asset Management Company relies on the financial statement of the company to evaluate the company’s actual worth. The financial statements include Balance Sheet, Income Statement, Cash flows, Changes in Equity Statement. The net assets and liabilities is referred to as the equity of the firm. Role of Derivatives in Active Management: The derivative market is being widely used by more sophisticated international financial market. It requires specialised expertise to benefit from the derivative based strategies (Robert, 2007). The profits that can be derived from the derivative in the shape of 1. Changes in the discount rates 2. Changes in the equity markets 3. Shifts in the currency exchange rates 4. Changes or shift in the demand and supply of different commodities internationally The two most widely used benefits of derivative that define its role in active management are as follows 1. Price Discovery In the futures market, the underlying assets can be geographically scattered with different spot prices internationally. The underlying asset with the shortest time to expiration is used as a proxy for the price of the asset. The future contracts define the price of the underlying assets based on the judgement of the investors regarding the movement of the price (Chance & Brooks, 2012) 2. Risk management: Hedge using derivative based contracts such as Swaps can be most widely used to reduce the risk of unexpected price movement in the market. The hedging can be used to reduce the risk and improve the active management returns but may be less than the fully exposed active management strategies (Chance & Brooks, 2012) Trading Experience of Portfolio Management: This section of the report is based on the trading experience of managing a portfolio of £1,000,000 of an offshore fund located in island of hope. The designed portfolio is evaluated based on the historical returns and compare those returns with the historical returns of S&P 500. The purpose of selecting such strategy is that the actual consistency in the selected portfolio return can be seen i.e whether the portfolio returns are consistent over the period of previous six years or not. The selected portfolio is based on the combination of S&P500, S&P Growth Stock, S&P value stock. The strategy is quite much unique and less diversified because the portfolio is totally based on the index funds and some of them must be overlapping stocks within the fund but the performance of the portfolio along with its Sharpe ratio prove the performance is better than investing only in S&P 500. Lets first review the performance of S&P500 Year S&P500 2014* 2075.37 12.3% 2013 1848.36 29.6% 2012 1426.19 11.7% 2011 1277.06 1.5% 2010 1257.64 12.8% 2009 1115.1   Mean Return 13.58% Standard Deviation 10.09% 1 year Rf( US T-bill rate) 0.00% Sharpe Ratio 1.345 Source: www.stocktrak.com *2014 data is provisional The above performance of S&P500 is based on year end results of the index. The mean return over the period of 6 years is 13.58%. The risk free return is based on one year US treasury rate which is 0%. Therefore, the Sharpe ratio is 1.345. As can be seen in the table above the year end results, there is variability in the performance of the index. Therefore, the standard deviation of the index is higher i.e 10.09%. The portfolio performance over the period of last six years is discussed in the following part of the paper. As the portfolio is based on the combination of Growth & Value Stocks with different combinations, a brief discussion of value versus growth stock is mentioned as follows Growth Stock: Growth stock is referred to as the shares of the company whose earnings are expected to grow more than the average earnings growth rate. The dividend payment is not usually made in the growth stock. The reason may be that the growth oriented companies usually reinvest the earnings to expand the company. Therefore, the rapid expansion of the companies may lead to increase in the earnings of the companies significantly. The capital appreciation is relatively higher in growth oriented companies. In addition to this, the price multiples are higher in growth stocks. The dividend payout ratio is lower in case of growth stocks because of the reinvestment of the retained earning (Faerber, 2006) Value Stocks: The value stock is referred to as the price of the company, which is considered undervalued. In other words value stock trades at a price below where it should be traded. The judgement is made based on its financial and technical indicators. Unlike growth stocks, value stocks have higher dividend payout ratios and lower price multiple i.e. lower price to book and price to earning ratios (Esme, 2013). Let’s review the selected portfolio ` Source: www.stocktrak.com *2014 data is provisional As in the above table the allocation of the portfolio can be seen that equal investments in the entire three index. The return of the portfolio is relatively greater than the S&P500. This may show that the active management of deviating the portfolio from the benchmark increases the return. Historical movement of the portfolio shows that as compared to S&P500 the return shows variation i.e in 2010, the return of the portfolio was higher than that of S&P500 whereas in 2011 the return of the portfolio falls significantly and it is less than that of S&P500. The reason that can be observed is that the negative return in value stocks. The negative return in the value stock i.e -2.4% indicates that the prices of the value stocks may fall or increase less than the expectations. In addition to this, it may also be possible that the some value stocks may not be properly categorized. The wrong categorization may be created if the stock may show lower price multiple once in the lifetime of stock and based on that the stock may be categorized as value stock. This may also happen in case of growth stock. Evaluation of the portfolio based on Sharpe ratio The Sharpe ratio that measures the risk adjusted return over and above the risk free rate. The risk free rate, which is used in this case is the one year rate of US treasury bill i.e 0%. The Sharpe ratio of the portfolio is less than that of the S&P500. Therefore, the allocation is not suitable in accordance to the investment policy statement. Diversification Analysis The diversification can be analysed using the correlation of the portfolio. The portfolio has poor diversification benefits. This can be concluded from the correlation of the S&P500 with S&P Value Index and Growth Index. The correlation is significantly higher. The reason is that most of the stocks in the S&P value index and growth index may also be present in S&P 500. Therefore, the portfolio does not provide diversification benefit. Another weighting of the same portfolio gives much better results, which are as follows Source: www.stocktrak.com *2014 data is provisional In the table above it can be seen that now 80% of the portfolio is allocated to S&P Growth and remaining 20% to S&P500. The returns are greater than S&P500 but less than S&P Growth. The allocation gives better results as compared to the equal allocation among all the indices. Although the current allocation reduces the return as compared to that of the previous portfolio allocation but the Sharpe ratio has increased, which implies that the risk adjusted return has improved. The current allocation still does not give diversification benefit but the active allocation has improved. Discussion of Active Allocation The strategy selected in the portfolio is a good example of active allocation. The S&P500, S&P Value and S&P Growth indices include overlapping stocks. The result may not be properly diversified because of high correlation but the portfolio allocation strategy deviate the weights of the stocks from that of the benchmark to get excessive return. The deviation can be seen in a way that in the initial allocation the weights move more towards the value stocks, which shows negative returns and eventually the overall portfolio return, has reduced. In the second allocation where significant portion of the portfolio has been allocated to growth stocks, which results in better risk adjusted returns. In both cases the deviation from the benchmark results in higher returns. One major issue that needs to be considered while investing is the exchange rate and country risk must also be considered in case of offshore funds. Conclusion: The empirical evidence proves that the active investment management is not that much effective as assumed in theory considering the concept of efficient market hypothesis. Contrariwise trading experience shows that deviating the weights of securities in the portfolio from that of the benchmark may improve risk adjusted return. Despite of the high correlation, active investment management can give profitable results at a given level of risk. Different studies on the active versus passive investment management identifies that markets are highly efficient and it is difficult to generate higher alpha using active management strategies. Bibliography Ang, A., Goetzmann, W. N., & Schaefer, S. M. (2009). Evaluation of Active Management of the Norwegian Government Pension Fund. Bryant, C., & Taylor, G. (2012). Fund Management Charges, Investment Costs and Perdormance. Investment Management Associates. Chance, D., & Brooks, R. (2012). Introduction to Derivatives & Risk Management. 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