For those individuals whose bread and butter are within the investment world, are dependent on returns from investments or either take an interest in investment are inevitably and undoubtedly swamped with information about investment products, primarily investments in bonds and/or equities, either directly or indirectly. However, it is important for the novice as well as seasoned investor to familiarise him/herself with the investment processes and varying management styles portfolio managers use to generate performance.
Put simply, the investment process can either take varying degrees of participation (or level of activity), categorised across two different styles; active or passive approaches to generating investment returns. Passive investing generally consists of the process of replicating the constituents of a reference benchmark which closely mimics the weightings and asset holdings of that benchmark. Typical examples of such products/instruments would be Index funds and Exchange Traded Funds (ETFs).
Let’s face it – any investor who invests their hard earned money to work, does so to enjoy maximum yielding returns, and there exists a large number of funds (Collective Investment Schemes) which essentially take on active investment management strategies within a fund’s terms of lifespan which in fact cater for such demands. Active Investment managers seek to generate value added returns in excess to returns on a reference benchmark, what in more technical jargon is known as alpha.
In addition to that, there are also key performance and portfolio analytical ratios that fund managers generally use in assessing risk adjusted-return in a portfolio, including the Sharpe ratio and the information ratio.
The information ratio assesses the average active risk return per unit of active risk. Put simply, it measures the ability of a manager to beat the benchmark with respect to how volatile the market was during that period.
As an example, say a benchmark portfolio has a weighting of 25% to an asset class, with the fund manager having a conviction that the asset class has upside potential; the portfolio manager can seek to beat the benchmark by replicating the positions in a benchmark but assigning a higher weighting to such an asset class. In doing so, the manager would go about exceeding the performance of the benchmark by taking an overweight exposure to the said asset class. The same concept applies on the contrary; investment managers can take underweight positions to the benchmark if they are of the opinion that a particular asset class is expected to come under pressure.
On the other hand, the Sharpe ratio, is one of the more popular and widely used ratios; it is a ratio which measures the excess return over the risk free rate for every unit of total portfolio risk. Reference to portfolio risk is the degree of tendency of returns deviating from the historical mean returns of a portfolio.
Apart from assessing and altering the weightings attributed to respective asset classes and positions within a portfolio, portfolio managers also assess the factor sensitivities on the underlying constituents through the use of multi factor models. Systematic risk is the type of risk within a portfolio that cannot be eliminated through added diversification of investment holdings, and managers strive to manage this risk through strategic asset allocation.
It is hence critical 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 the fact that correlation is low amongst the selected positions. However, there reaches a point where the added value of having more securities within a portfolio diminishes. Never the less, multi factor models exist which assess all factors affecting the potential returns on an underlying holding and how this can contribute to portfolio performance.
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