29.2. Active Vs. Passive Portfolio Management Strategies

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1 NPTEL Course Course Title: Security Analysis and Portfolio Management Course Coordinator: Dr. Jitendra Mahakud Module-15 Session-29 Equity Portfolio Management Strategies Equity Portfolio Management Strategies The equity portfolio return profiles can be modified by the use of different investment management strategies. To achieve the desired investment objective a portfolio manager has to take necessary steps with respect to his decision on asset allocation, risk diversification, benchmarking, monitoring, forecasting the future economic performance as well as the market movement, investors risk tolerance assessment and finally the return generation with respect to the appropriate investment risk undertaken. Broadly the equity portfolio management strategy can be categorised as passive and active investment management strategies. In a more generalised sense the popular financial advisors approach is to follow financial strategies that are scientific, well diversified, savings focused, risk controlled, low cost, and tax efficient In a theoretical sense the appropriate one among the two is still a ongoing debatable issue and some suggest for the hybrid active/passive portfolio management strategy by combining the benefits of both the approaches. However, the appropriate choice must be made with respect to the investment objective and the risk tolerance level. In this session we will concentrate on the passive investment management strategy and in the next session we will elaborate upon the active portfolio management strategy Active Vs. Passive Portfolio Management Strategies Passive Strategy: Strategy of holding a portfolio of securities without attempting to outperform other investors through superior market forecasting. A passive investment strategy involves the selection of diversified securities in a portfolio that will not change over a long period of time. Passive investment strategies are achieved through buy-and-hold investing and stock are purchased in such a way that portfolio s returns will track those of an index over time. This approach to investing also referred as indexing. This investment strategy invest in broad sectors of the market, called asset 1

2 classes or indexes and makes no attempt to distinguish between attractive/unattractive securities, or forecast securities prices, or time markets and industries. The performance of such strategy is judged by the consistent tracking of the benchmark index performance with low level of deviation between portfolio and index return. More often, those who argue for passive investment strategy argue that on average the lower implementation costs of passive investment strategies will increase net investment returns. Active Strategy: Attempts to outperform a passive benchmark portfolio on a riskadjusted basis. An active investment strategy involves active trading of securities in a portfolio in an attempt to produce superior risk-adjusted returns to that of the market. Active strategy believes timing the market accurately and thus always will produce superior returns. It believes in buying and selling securities over short periods of time based on prices (patterns) and value. While deciding whether to follow an active or passive strategy (or some combination of the two), an investor takes in to account the trade-off between the low cost but less exciting alternative of indexing versus the higher cost but potentially more lucrative alternative of active management. With respect to the their different approaches the passive investment strategies are more generalisation on the assumptions of efficient market and the active management strategies are more generalisation on the belief of inefficient markets. Investment Philosophy for Equity Investment 1. Passive Management Strategies 2. Active Management Strategies Efficient Market Hypothesis Inefficient Market Buy and hold: Long term Fundamental Analysis Indexing Top-down (e.g., asset class rotation, sector Low cost and minimal alteration rotation) Bottom-up (e.g.,stock undervaluation/overvaluation) Technical Analysis Contrarian (e.g., overreaction) Continuation (e.g., price momentum) Full replication Sampling Quadratic optimization or programming. Anomalies and Attributes Calendar effects (e.g. weekend, January) Security characteristics (e.g., P/E, P/B, earnings momentum, firm size) Investment style (e.g., value, growth) Short term and frequent alteration Betting against markets 2

3 29.2. Basic Premises of Passive Portfolio Management Strategies In the investment industry, a distinction is often made between the passive investment strategy or holding securities for a longer period of time with small and infrequent changes and low cost with that of active management strategy. Passive strategists believe as if the security markets are relatively efficient. The portfolios they hold may be surrogates for the market portfolio that are known as index funds, or they may be portfolios that are tailored to suit clients with preferences and circum stances that differ from those of the average investors. In either case, passive portfolio managers do not try to out perform their designated benchmarks. (Alexander, J.G. et al., 2007) Let s consider a passive portfolio manager who investment in the appropriate mix of Treasury bill and an index fund designed to match the return on a selected market index, such as CNX Nifty. The best mixture would depend on the shape and location of the client s indifference curves. In Figure 29.1 point f plots the risk free return offered by 91 days Treasury bills and point M plots the risk and expected return of the market index such as CNX Nifty, using consensus forecasts. Mixtures of the two investments plot along line fm. The client s attitude toward risk and return is shown by the set of indifference curves, and the optimal mixture of f and M lies at the point O*. Where the indifference curve is tangent to line fm. In this example the best mixture uses both Treasury bills and the index fund. In other situations the index fund might be levered up by borrowing. When management is passive, the optimal mixture is altered only when: the client s preference change, the risk free rate changes, the consensus forecast about the risk and expected return of the bench mark portfolio. Passive Portfolio Management Strategies Figure 29.1 Source: Alexander, J.G. et al, Fundamentals of investments, Third Edition, Prentice hall,

4 29.3. Tracking Error and Passive Investment Management Strategy Tracking error can be defined as the extent to which return fluctuations in the managed portfolios are not correlated with return fluctuations in the benchmark. The basic objective of a passive portfolio formation is to replicate the essence of a particular equity index and to generate return that closely matched with the benchmark index return. Goal of the portfolio manager is to reduce the tracking error or to minimise the portfolio s return volatility relative to the benchmark. The period t return to managed portfolio can be given as: R N = wr (29.1) pt i it i= 1 Where, N = number of assets in the managed portfolio, Wi = investment weight of asset i in the managed portfolio, Rit = return to asset i in period t. Then the specification for the Period t return differential between the managed portfolio and the benchmark portfolio can be given as: N = wr R = R R t i it bt pt bt i= 1 (29.2) Where, Rbt = return to the benchmark portfolio in period. It is important to mention here that with respect to the N assets in the managed portfolio and the bench mark portfolio, is a function of investment weights that the manager selects and that not all t of the assets in the benchmark need be included in the managed portfolio and the w =o may exist for some assets. For a sample of T return observations, the variance of can be calculated as follows: T 2 t= 1 σ = ( ) t ( T 1) 2..(29.3) The standard deviation of return differential is: σ = σ 2 = periodic tracking error. The annualised tracking error (TE) can be calculated as: TE = σ p. Where, p is the number of return periods in a year. For example p=12 for monthly returns, P=252 for daily returns. 4

5 29.4. Types of Passive Portfolios Index Funds: It attempts to design a portfolio to replicate the performance of a specific index i.e. benchmark index. The difference arises between benchmark index and portfolio because of cash flow, company mergers and bankruptcies. Customized Funds: In this case the benchmark index is a customized rather than a published index. This has been made because of two reasons: constraints on allowable securities and to provide adequate diversification Factor/Style Funds: This type of fund replicates a benchmark geared to mimic the performance of a given stock factor such as growth, small capitalization or high yield. It can also be specialized or titled towards specific sector or industries such as the energy sector Index Portfolio Strategy Construction Techniques It basically follows three types of techniques: full replication, sampling, quadratic optimization or programming. Full replication: with this technique all the securities in the index are purchased in proportion to their weights in the index. Advantages: all the securities in the index are purchased in proportion to their weights in the index, it helps to ensure close tracking. Disadvantages: more transaction cost, high commission for reinvestment in dividend Quadratic optimization: with this technique historical information on price changes and correlations between securities are input to a computer program that determines the composition of a portfolio that will minimize tracking error with the benchmark (Reilly and Brown,2003). Advantages: historical Information on price changes and correlation between securities are input into a computer that determines the composition of a portfolio that will minimize tracking error with the benchmark. Disadvantages: based on historical data which will lead to failure to track the index. Sampling: With sampling, a portfolio manager would only need to buy a representative sample of stocks that comprise the benchmark index. Advantages: 5

6 buys a representative sample of stocks in the benchmark index according to their weights in the index, lower commission, reinvestment of dividends is less difficult. Disadvantages: more tracking error Choosing the Right Index In selecting the right index for bench marking following points need attention: Small market indexes are liquid but under diversified Larger market indexes are illiquid but diversified. So the benchmark index should be the right mix of both and must follow the characteristics of a good index such as: representative of market, well diversified, highly liquid, professionally managed Additional Readings: Alexander, Gordon, J., Sharpe, William, F. and Bailey, Jeffery, V., Fundamentals of Investment, 3 rd Edition, Pearson Education. Bodie, Z., Kane, A, Marcus,A.J., and Mohanty, P. Investments, 6 th Edition, Tata McGraw-Hill. Fisher D.E. and Jordan R.J., Security Analysis and Portfolio Management, 4th Edition., Prentice-Hall. Jones, Charles, P., Investment Analysis and Management, 9 th Edition, John Wiley and Sons. Prasanna, C., Investment Analysis and Portfolio Management, 3rd Edition, Tata McGraw-Hill. Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management, 7th Edition, Thomson Soth-Western. Additional Questions with Answers Session 29: Equity Portfolio Management Strategies 1. What are the different types of Equity Portfolio Management Strategies? Ans. I. Passive Strategy: Strategy of holding a portfolio of securities without attempting to outperform other investors through superior market forecasting Long-term buy-and-hold strategy Usually track an index over time Designed to match market performance Manager is judged on how well they track the target index Replicate the performance of an index May slightly underperform the target index due to fees and commissions Many different market indexes are used for tracking portfolios 6

7 II. Active Strategy: Attempts to outperform a passive benchmark portfolio on a riskadjusted basis Attempts to outperform a passive benchmark portfolio on a risk-adjusted basis Goal is to earn a portfolio return that exceeds the return of a passive benchmark portfolio, net of transaction costs, on a risk-adjusted basis Practical difficulties of active manager Transactions costs must be offset Risk can exceed passive benchmark Screening can be based on various stock characteristics: Value, Growth, P/E, Capitalization 2. Write short note on Quadratic Optimization. Quadratic Optimization: Rather than obtaining a sample based on industry or security characteristics, quadratic optimization or programming techniques can be used to construct a passive portfolio. With quadratic programming, historical information on price changes and correlations between securities are input to a computer program that determines the composition of a portfolio that will minimize tracking error with the benchmark. Advantages: Historical Information on price changes and correlation between securities are input into a computer that determines the composition of a portfolio that will minimize tracking error with the benchmark. Disadvantages: Based on historical data which will lead to failure to track the index 3. What are the suggestive ways towards Passive Equity Portfolio Management? Ans: Passive Equity Portfolio Management: Strategy of holding a portfolio of securities without attempting to outperform other investors through superior market forecasting Long-term buy-and-hold strategy and uusually track an index over time Designed to match market performance Manager is judged on how well they track the target index and able to rreplicate the performance of an index May slightly underperform the target index due to fees and commissions Many different market indexes are used for tracking portfolios Types of Passive Portfolios: Index Funds: It attempts to design a portfolio to replicate the performance of a specific index i.e. benchmark index. The difference arises between benchmark index and portfolio because of cash flow, company mergers and bankruptcies 7

8 Customized Funds: In this case the benchmark index is a customized rather than a published index. This has been made because of two reasons i.e. constraints on allowable securities and to provide adequate diversification Factor/Style Funds: This type of fund replicates a benchmark geared to mimic the performance of a given stock factor such as growth, small capitalization or high yield. It can also be specialized or titled towards specific sector or industries such as the energy sector. 4. What are the different Index Portfolio Strategy Construction Techniques? Index Portfolio Strategy Construction Techniques: I. Full Replication or Full Sampling: All securities in the index are purchased in proportion to their weights in the index. Advantages: All the securities in the index are purchased in proportion to their weights in the index, It helps to ensure close tracking Disadvantages: More transaction cost, High commission for reinvestment in dividend II. Sampling: Only a representative sample of the stocks that make up the index are purchased. Advantages: Buys a representative sample of stocks in the benchmark index according to their weights in the index, Lower commission, Reinvestment of dividends is less difficult Disadvantages: More tracking error III. Quadratic Optimization or Programming Advantages: Historical Information on price changes and correlation between securities are input into a computer that determines the composition of a portfolio that will minimize tracking error with the benchmark. Disadvantages: Based on historical data which will lead to failure to track the index Choosing the Right Index Involves following considerations: Small market indexes are liquid but under diversified Larger market indexes are illiquid but diversified So the benchmark index should be the right mix of both Good Index characters are: Representative of market, Well diversified,highly liquid, Professionally managed 8