How many investment decisions do you think your investment adviser makes when he or she advises you to buy shares in, say, BP plc?
Just one, you might think. In fact, he has made quite a number!
Buying shares in BP can be described as an investment (a) in ordinary shares, (b) in a UK-based company with international business interests, (c) with the relevant currency exposure, (d) principally involved in the oil sector, and (e) in a particular company called BP plc. At the very least, therefore, five decisions have been made.
The five main decisions involve a number of decisions or considerations.
Before choosing shares as the preferred security, the adviser would have considered your (i.e. the client's) investment objectives, your attitude towards risk, the potential performance of shares compared with that of bonds, bank deposits and other investment vehicles, and a number of other factors. Since the investment adviser is here choosing between different securities, this is the investment asset decision.
Again, the investment adviser's recommendation to invest in a company with substantial UK interests must have been based on an opinion as to the likely performance of the UK economy versus other economies.
The fact that BP is based in the UK also goes to show the adviser's opinion about the sort of environment which the UK provides international business. This may be called the market decision, involving both economic and business environment decision.
By choosing the market, the adviser is also making a decision on currency. BP has assets and liabilities around the world, but its main currency exposure is to the sterling and the dollar. Currency exposure is hedged but currency movements always have an impact on performance, or, at least, its measurement.
The shares trade in pounds and, therefore, the nominal value of your holdings would be expressed in sterling. This may impact on your portfolio's performance if it is expressed in Maltese liri. The currency factor is linked to the market decision but investment managers and advisers often decouple the two factors by hedging currency risk separately.
Investing in the oil sector, the business sector decision must have been preceded by an assessment of the growth potential of the different sectors (eg. brewery, construction, electronics, banking). Economic expansion is rarely, if ever, evenly spread: certain sectors usually lead others and grow at a faster rate.
The decision to invest in BP and not, say, ExxonMobil, should be based on the analysis of the different oil companies under consideration and their likely future performance. This can be called the investment unit decision.
These factors, and others, underpin the five main decisions - namely, the investment asset decision, the market decision, the currency exposure decision, the sector decision and the investment unit decision. As the investment adviser follows the markets and deals in different securities in various sectors, he forms opinions as to their potential.
While trying to minimise risk, the investment adviser tries to get the best performance. The recommendation to buy BP shares, therefore, is not as simple as it looks!
Investment management aims to increase the value of the portfolio being managed consistent with the investor's risk preference and investment objectives. This increase in value can be either in the form of income (eg. dividends) or capital appreciation (eg. increases in the price of the securities making up the portfolio).
An elderly client might wish to have high income to supplement his pension while a younger man might want to increase the capital value of his portfolio and, for tax purposes, minimise income.
Having ascertained an investor's risk preference and investment objectives, the investment adviser must decide how best to maximise performance within the constraints imposed.
As generally referred to, decisions on investment strategy concentrate on the investment asset decision, the market decision and currency exposure while tactical investment decision making is concerned with the sector decision and the investment unit decision.
The investment adviser must first make strategic decisions:
¤ What type of investment asset should the investor acquire?
¤ In which market should the investor invest? and
¤ What currency exposure should be contracted?
The adviser should first decide whether to recommend shares, bonds, bank deposits, options, futures, convertible preference shares or some other investment asset.
Second, the investment manager should choose a market. There are various ways in which a market can be defined but let us, for our purposes here, to keep things simple and clear, choose to define the market by the country in which the investment takes place.
Thirdly, there is the currency. Sometimes, the adviser or manager is asked to use the home currency as benchmark. At other times, another currency might be adopted.
Once the adviser decides on the strategy, he or she can either find the appropriate instrument, for example a UK index fund, investing in ordinary shares across the UK, or go further and make tactical decisions.
Wearing this new hat he must make two decisions. First, the tactical investment manager should decide which sector in the market chosen is likely to grow the fastest. Second, the investment manager should decide which unit, eg. company, within that sector is likely to outperform the others.
The tactical manager will ask questions such as "Should I buy BP shares or Shell shares?".
The strategic manager would be saying "Never mind BP or Shell - should I be in shares at all and, if so, should I be in the UK share market or somewhere else? Or is it better if I buy US treasury bills? Should I use the Maltese lira as benchmark?"
Sometimes, the strategic manager and the tactical manager are different individuals, even different committees. The strategic manager takes a wide view of all the different investment assets and markets available without bothering too much about the different sectors and companies within a particular market.
The tactical manager, on the other hand, is often an expert on a much narrower range of investments, for example UK shares, or even UK bank and financial shares.
As business globalised, many investment advisers and analysts have opted to look at particular industries on a worldwide basis. This is especially so for commodities which are traded internationally. Rather than studying UK oils or European aircraft manufacturers, they look at oil companies and aircraft manufacturers across the world.
For decision making purposes, the market decision becomes one with business sector decision and both the strategist and the tactician have to adjust their thinking accordingly. Of course, the strategy/tactics decision is not a neat one, and there are various overlaps.
It is important for an investor to know whether the investment adviser he or she has selected emphasises strategy, tactics, or both. The performance of tactical managers is often no better than the average performance of the markets within which they operate.
Strategic managers often leave the sector decision and the investment unit decision to tactical managers located in the market the strategic managers have chosen, often investing in investment funds specialising in that country.
Strategic decisions are critical and often account for most of the of the total variation in portfolio returns.
Mr Azzopardi is managing director of Azzopardi Investment Management Limited (www.azzopardi.com) which is licensed by the MFSA to provide investment services, including stockbroking. This article is only meant to provide information, which the writer believes to be accurate at the time of writing, and is not intended to give investment advice and its contents should not be construed as such. The value of securities, and the currencies in which they are denominated, may go down as well as up. Mr Azzopardi and/or the company may have an interest in securities mentioned. Readers are requested to seek professional financial advice tailored to their own personal circumstances.