The process of investment management can take various forms, with the more traditional type taking either an active or passive approach in an attempt to generating investment returns. The passive approach generally consists of the process of mirroring the constituents of a reference benchmark with equal weightings and asset holdings. A typical example of passive investment strategies include Index funds and Exchange Traded Funds (ETFs).
It comes as no surprise that most investors tend to have an inclination towards maximum yielding returns, and in fact, there exists a large number of funds which essentially take on active investment management strategies which essentially cater for such demands. Investment managers who are active in their day-to- day management styles, tend to seek to generate value added returns in excess to returns on a reference benchmark, a term better known as alpha.
Key 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 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 45% to a particular asset class, say equities for example, 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, i.e. allocating more than 45% of the fund’s total assets to equities. 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 German Bund or the US Treasury bill, for example) for a given unit of total portfolio risk. Reference to portfolio risk within this context is the degree of tendency of returns deviating from the historical mean returns of a portfolio.
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, and this has been statistically and historically proven time and time again, that 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, there exist inflation and GDP growth market factors which are non-diversifiable 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.