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Those who are familiar with the investment world are inundated with information about investment products, primarily investments in bonds and/or equities, either directly or indirectly. But how familiar are we with the investment processes and varying management styles portfolio managers use to generate performance? The investment process can either take an active or passive approach to generating investment returns. Passive investing generally consists of the process of replicating the constituents of a reference benchmark with (close to) equal weightings and asset holdings. Typical examples of such products/instruments would be Index funds and Exchange Traded Funds (ETFs).
Whoever invests puts their hard earned money to work 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 operation to cater for such demands. Active Investment managers seek to generate value added returns in excess to returns on a reference benchmark, what we term as alpha, in more technical jargon.
There are also key ratios that fund managers usually 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 gives a weighting of 15% to an asset class, with the fund manager having a conviction that the asset class has upside potential, s/he can replicate the positions in a benchmark but assigns a higher weighting to such an asset class. In doing so, the manager would go about beating 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.
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 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, 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 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 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.
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