The objective of the equity selection process is to create a portfolio of individual equity issues having the common theme among them of Growth at a Reasonable Price, with the focus on the long term. Growth is measured as superior, sustainable growth in future earnings, cash flow and dividends in relation to the stock market, in general, as well as the sector within which the company competes. A Reasonable Price is one that provides the investor with a reasonable basis for expecting the elements of growth to flow through to an effective future total return on investment.
Traditional valuation tools including absolute and relative price earnings and cash flow ratios, dividend yields and dividend growth, are first measured for each stock relative to their respective historic ranges. These valuation levels are then also analyzed in terms of prospective changes in the rates of growth and profitability relative to the industry peer group and the market in general. (http://www. jamisonfirst. com/process-equity-portfolio-management. htm) Equity Portfolio Management Strategies 2 What are the techniques for constructing a passive index portfolio?
Passive management (also called passive investing) is a financial strategy in which a fund manager makes as few portfolio decisions as possible, in order to minimize transaction costs, including the incidence of capital gains tax. One popular method is to mimic the performance of an externally specified index—called ‘index funds’. There are four reasons behind this indexing. Firstly, the average investor will have an average before-costs performance equal to the market average in the long term. Therefore the investor will benefit more from reducing investment costs than from trying to beat the average.
Secondly, it is efficient in terms of markets hypothesis, which postulates that equilibrium market prices fully reflect all available information. Thirdly, indexing aids investors in monitoring the investment manager’s performance. Lastly, the investors will hold a mixture of the market portfolio and thus a fund indexed to “the market” is the only fund investors need. Therefore the technique for constructing a passive index portfolio is to purchase securities in the same proportion as in the stock market index. Investment funds are then run by investment managers who do not actively manage the funds but furtively mirror the index. http://en. wikipedia. org/wiki/Passive_management)
Equity Portfolio Management Strategies 3 What are the goals for a passive equity portfolio manager and for active managers? Are they the same? In general, the investor would expect the portfolio manager to construct a portfolio with the highest possible rate of return. In the case of active managers, the task at hand is quite straight forward if the client’s risk level is neutral. Nevertheless when the client is risk averse, the answer is more difficult. The active managers will have to do a risk assessment in order to ascertain that the average return commensurate with risk. Bodie, Kane & Marcus, 2002 pp 918) Passive managers however aim only at establishing a well diversified portfolio securities without attempting to find under- or overvalued stocks. Passive management is usually characterized by a buy-and-hold strategy (Sinquefield, 1995). Because the efficient market theory indicates that stock prices are at fair levels, given all available information, it makes no sense to buy and sell securities frequently, which generates large brokerage fees without increasing expected performance. (pp 349 – 350)
In essence, the similarities in the goals for a passive equity portfolio manager and for active managers lie in their effort in maximizing the client’s returns. Where active managers aim to perform the task by risk assessment of investments, passive managers do so by simply referring the investor to a diverse choice of investments. Equity Portfolio Management Strategies 4 What is the difference between an index mutual fund and an exchange-traded fund? Mutual funds are the common name for an open end investment companies. An index fund tries to match the performance of a broad market index.
The fund buys shares in securities included in a particular index in proportion to each security’s representation in that index. Investment in an index fund is a low-cost way for small investors to pursue a passive investment strategy – that is, to invest without engaging in security analysis. (Bodie, Kane & Marcus, 2002, pp 109) Exchange-traded funds (ETFs) however, are offshoots of mutual funds that allow investors to trade index portfolios just as they do shares of stock. This is why ETFs offer several advantages over conventional mutual funds.
A mutual fund’s net asset value is quoted and therefore, investors can buy or sell their shares in the fund for only once a day. In contrast, ETFs trade continuously. Moreover ETFs can be sold short or purchased at a margin. ETFs are also cheaper than usual mutual funds. Investors who buy ETFs do so through brokers rather than buying directly from the fund. Therefore, the fund saves the cost marketing itself directly to small investors. This reduction in expenses translates into lower management fee. (pp 116 – 117)
Equity Portfolio Management Strategies 5. What techniques are used by active managers in an attempt to outperform their benchmark? In many cases, an active investment manager’s performance is assessed in terms of the manager’s ability to “beat a benchmark”. Return-based style analysis provides a way of identifying the asset mix of the fund manager and comparing it with the asset mix of the performance benchmark. This enables the plan sponsor or an individual investor with valuable insights regarding the extent to which the bets cancel or reinforce each other. (Coggin & Fabozzi, 2003, pp 2)
The technique incorporated in return-based analysis style is by means of Sharpe’s Measure as the criterion for all overall portfolios. The popularity of the concept was aided by a well-known study that 91. 5% of the variation in returns of 82 mutual funds could be explained by the fund’s asset allocation to bills, bonds, and stocks. Later studies that considered asset allocation across a broader range of asset classes found that as much as 97% of fund return can be explained by asset allocation alone. This technique considers 12 styles of portfolios. The idea was to obtain fund returns on indexes representing a range of asset classes.
The regression coefficient on each index would then measure the implicit allocation to that “style”. (Bodie, Kane & Marcus, 2002, pp 831) Equity Portfolio Management Strategies 6 Definition of Fund-of Fund and Hedge Fund A fund of funds (FoF) is an investment fund that uses an investment strategy of holding a portfolio of other investment funds rather than investing directly in shares, bonds or other securities. This type of investing is often referred to as multi-manager investment. Investing in a collective investment scheme will increase diversity compared to a small investor holding a range of securities directly.
Investing in a fund of funds arrangement will achieve even greater diversification. (http://en. wikipedia. org/wiki/Fund_of_Funds) A hedge fund is a private investment fund charging a performance fee and typically opens only to a limited number of investors. Hedge funds are largely open to accredited investors only. They have grown in the public securities and private investment markets. Hedge funds are limited only by the terms of the contracts governing the particular fund. Hedge funds may either be long or short assets and may enter into futures, swaps and other derivative contracts.
Due to the substantial risks involved in unregulated, complex, and leveraged investments, hedge funds are normally open only to professional, institutional or otherwise accredited investors. (http://en. wikipedia. org/wiki/Hedge_funds) Equity Portfolio Management Strategies 7 Are they classified as active or passive? Fund of funds is classified as a passive equity management as it involves presenting a diversified selection in one portfolio for the investor to invest in. Hedge fund however is classified as an active equity management as the process involves substantial risk assessment.