Investment management can take an active or passive approach to generating investment returns. The latter, however, would generally consist of replicating a reference benchmark with equal weightings and asset holdings. Examples of passive investment strategies include Index funds and Exchange Traded Funds (ETFs).
Most investors tend to enjoy maximum yielding returns, and many funds take on active investment management strategies within a fund’s terms of operation to cater for such demands. Active investment management seeks to generate value-added returns in excess to returns on a reference benchmark, better known as alpha in technical terms.
Ratios that fund managers usually use in assessing the active value added risk in a portfolio include the Information ratio and the Sharpe ratio. The former measures the mean active risk-return per unit of active risk. To keep it simple, it measures the ability of a manager to beat the benchmark relative to volatility.
For example, assuming a benchmark portfolio gives a weighting of 10 % to an asset class, a fund manager believing the asset class has upside potential going forward, can replicate the positions in a benchmark but assign a higher weighting to such an asset class. This investment strategy would be called taking an overweight exposure to the asset class. The same concept applies to the opposite, whereby investment managers can take on underweight positions.
The Sharpe ratio, considered more popular, measures the excess return over the risk-free rate (usually the rate on a US Treasury bill) per unit of total portfolio risk. By total portfolio risk, I refer to the degree of tendency of returns being dispersed from the mean returns of a portfolio.
Besides the weightings attributed to respective asset classes and positions within a portfolio, investment managers assess the factor sensitivities on the underlying constituents through the use of multi-factor models. Factor sensitivities constitute mainly of systematic (market) risk factors, that is, the risk factors in a portfolio that cannot be eliminated through added diversification of investment holdings.
A key in any portfolio is to have a well-diversified investment strategy. The larger the number of holdings in a portfolio, the greater the chance of eliminating asset specific risk factors and remaining with what is called systematic risk, given correlation is low amongst the selected positions. Multi-factor models assess all factors affecting the potential returns on an underlying holding. For example, inflation and GDP growth are non-diversifiable market factors that would largely affect cyclical stocks and high-yield holdings in a portfolio. These holdings would as a result be given a higher sensitivity factor by management in analysing the expected returns on the underlying constituents.
The above is an apercu of part of the analysis put forward by investment management teams in generating returns.
Disclaimer:
This article was issued by Mathieu Ganado, Junior Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.