The process of investment management can either take an active or else passive approach to generating investment returns. The passive approach generally consists of the process of replicating the constituents of a reference benchmark with equal weightings and asset holdings.
Examples of passive investment strategies include Index Funds and Exchange Traded Funds (ETFs).
It is no surprise that most investors tend to enjoy maximum yielding returns, and in fact, there exists a large number of funds which essentially take on active investment management strategies within a fund’s terms of operation to cater for such demands. Investment managers who are active in their day-to-day, seek to generate value added returns in excess to returns on a reference benchmark, better known as alpha in more technical jargon.
Key ratios that fund managers usually use in assessing the active value added risk in a portfolio include the Sharpe Ratio and the Information Ratio. The Information Ratio is a means of assessing the mean active risk return per unit of active risk. Put simply, it measures the ability of a manager to beat the benchmark relative to volatility.
For instance, let us assume a benchmark portfolio gives a weighting of 25% to an asset class, with the underlying 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. The way the manager would go about beating the benchmark is by taking an overweight exposure to the asset class. The same concept applies to the opposite, whereby investment managers can take underweight positions, or as we say, go short (exposure) to the benchmark.
The Sharpe ratio is one of the more popular and widely used ratios, which measures the excess return over the risk free rate (usually the rate on a US Treasury bill or the German Bund, for example) per unit of total portfolio risk. Reference to portfolio risk is the degree of tendency of returns being deviating from the mean returns of a portfolio.
Besides the weightings attributed to respective asset classes and positions within a portfolio, investment managers also assess the factor sensitivities on the underlying constituents through the use of multi-factor models. Primarily, factor sensitivities constitute mainly of systemic (market) risk factors. Systemic risk is the type of risk within a portfolio that cannot be eliminated through added diversification of investment holdings.
It is of paramount importance for a portfolio 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.
However, there reaches a point where the added value of having more securities within a portfolio diminishes. Nevertheless, multi-factor models exist, which assess all factors affecting the potential returns on an underlying holding. For instance, GDP growth and inflation market factors which are non-diversifiable and which however largely affect cyclical stocks and high yield holdings in a portfolio. These holdings, as a result, would be given a higher sensitivity factor by management in analysing the expected returns on the underlying constituents.
Disclaimer:
This article was issued by Mark Vella, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are 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.