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Portfolio Management in a local context

  • Financial Analyst
  • Blog post submitted on 19th June 2019
06744 CC Trader Talk V2

In the portfolio management space, there are essentially two schools of thought. The first is the belief that markets are inherently inefficient in translating new information into market prices. In doing so, savvy investors can make additional profits over and above the expected return from the assets being bought via active management (also called alpha).

On the flip side, there are those who believe that markets are highly efficient, and by inference, don’t believe that there is any added value by actively managing a portfolio over the long run, especially when adjusting for fees. Actively managing a portfolio involves taking on positions in your investment portfolio which differ in weighting to the benchmark against which the portfolio’s performance is being evaluated. Taking a simple example, if a portfolio’s mandate is to invest in equities listed on the Malta Stock Exchange, then an appropriate performance benchmark would likely be the MSE Equity Total Return Index.

There are those who argue that active management, although proven historically to yield marginal additional returns over the long run, involves several other costs which are difficult to quantify, and remain unaccounted for. These include illiquidity premiums on certain assets, the time involved in keeping oneself updated with current events and doing due research on subject companies, and the mental discipline and opportunity costs related to entering and exiting positions frequently.

The move towards passive investing has been championed by Index investing, whereby investors buy instruments which closely tracks a benchmark, which is typically an Index. The proliferation of exchange traded funds (ETFs) offering all kinds of Index investing opportunities in multi-asset classes has been the driving force behind the significant growth in assets under management. Passively managed funds hold a rising share of total financial assets, with as much as fourteen percent of U.S. stocks held in passive mutual funds and ETFs, up from less than four percent in 2005 according to Morningstar, Inc.

Unfortunately, due to the inherent size and liquidity of the companies listed on the Malta Stock Exchange, an ETF which tracks the MSE index is currently unavailable. Investors looking to invest in local companies’ securities would need to do so directly in individual company shares and bonds, or via a mutual fund such as Calamatta Cuschieri’s Malta Balanced Income Fund, offering an optimised exposure to both bonds and equities listed on the Malta Stock Exchange.

For passive investors looking to strictly replicate an Index, they are faced with two practical choices. They may either invest in all the securities forming part of the index, weighted in the manner in which the index is being calculated; known as full replication. In the case of the MSE Equity Price Index, which an example of a capitalisation weighted index, the proportion of shares is determined based on the relevant companies’ share of total capitalisation of the index.

Due to costs and practical implementation issues, largely being liquidity, investors may optimise the replication by determining the proportion of companies which largely affect the underlying movement in the index. At a technical level, this is done by using the inverse of the Hirschman Herfindahl Index. When applying this technique to the MSE Equity Price Index, it emerges that the top ten companies by market cap listed on the MSE market describe the majority of the variability in the index. Therefore, buying a cap–weighted share in each of these ten companies is relatively equivalent to buying the index.

The passive versus active debate is an age old argument among professional investors. In an increasingly online world, which nowadays also involve robots and machine learning has largely reduced the inefficiencies of the past, squeezing the opportunities for the active investor. There undoubtedly remains a place in the market for skilled active investors, which are predominantly based on the largely popular fundamental investing principles, first pioneered by Benjamin Graham and popularised by Warren Buffett. This is especially true in markets which are overlooked by mainstream investors due to liquidity and other constraints.

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