Secondly at the security selection stage the fund manager selects securities from that category and, finally, the last stage is market timing. Market timing is the practise of switching amongst mutual fund asset classes in an attempt to profit from the changes. A fund manager engages in security selection when he accepts the market portfolio but believes the individual securities are mis-valued.
Every portfolio manager needs to decide if s/he will approach an active or passive approach to portfolio management.
Factors that needs to be considered when choosing a portfolio strategy are the following:
- Cost/ Fees – It’s much cheaper to run an indexed portfolio than an actively managed one. Every time a portfolio manager is trading on behalf of an investor and is adjusting the portfolio the investor is charged a fee, which is often a substantial amount of money, and sometimes can prove to be too costly if the returns are not high.
- Taxes - Index funds sell stock only when companies enter or leave the index they’re mirroring, which is infrequent, so shareholders rarely incur capital-tax gains tax. In contrast to active management, every time a sale has made a profit shareholders are liable for capital gains tax.
- State of the economy – some firms may be very sensitive to the state of the economy, some not so. The index decreases during a recession, so investors need to be aware of which companies are very susceptible to the state of the economy. For example during a recession share value of Tesco may not decrease as much as share price of a manufacturing firm during a recession. The reason being is that people still need to eat and so Tesco will have sales no matter what the state of the economy.
- Time Horizon – Investors that want to invest in the long term, go for index, and will track the market. For example the S&P 500 is higher today (even with the looming depression) at 1360.54 compared to 3 years ago at 1171.36 open on 31/1/05 (FTSE – charting)
Source:
Investors investing over a short time period, such as day traders will actively manage a portfolio and be selling and buying shares very quickly and following the market very closely to make as much money as possible as quickly as possible.
The time horizon can coincide with the goals they are trying to achieve, be it long, medium or short term. If the investor is faced with a short term goal, then it is possible that the investor will approach an active management strategy to make the most money as quickly as possible. Having an active approach over a long period of time can prove to be costly.
- Attitude towards risk – an investor’s attitude towards risk will play a integral part in the decision of managing a portfolio passively or actively. If I was an investor and my attitude was risk loving I would actively manage a portfolio, as this involves picking stock, based on forecasts of the stock being under priced and market timing. The believe, is the higher the risk the higher the return. However if I were a risk averse investor I would not like to run the risk of individually picking stock and would prefer to spread the risk by investing in a well-defined Index.
Both strategies have its positive and negative points and the approach taken by the investor is depended on personal preferences to risk and the situation the investor is facing.
I, personally, would take the passive approach to portfolio management. The reasons behind this choice is that I am risk averse, so I would not like to run the risk of picking stock in the believe that the market has not been able to price the stock correctly and instantaneously to its true value. The costs of managing an active portfolio are high. These costs include transaction costs and taxes. So to reduce my costs of managing a portfolio I would choose a passive approach so that I am not paying out to brokers and to the government. Lastly I believe that the market is efficient and so this does not allow big amounts of profits to be generated as the market corrects any inefficiency.
Q1b)
The CAPM provides the relationship between an investments’ systematic risk and its expected return. “The treatment of risk in the CAPM refines the notions of systematic and unsystematic risk developed by Harry. M. Markowitz”
Unsystematic risk is the risk to an assets value caused by factors that are specific to an organisation, such as quality of management, R&D, marketing effectiveness. A fundamental principle of portfolio theory is that unsystematic risk can be diversified away.
Systematic risk is risk that cannot be diversified away. This risk represents the variation in an assets value caused by economic fluctuations. The market only provides a return for risk that cannot be diversified away.
The CAPM assumptions can be divided into two groups. First set of assumptions are for the investors and the second is for the financial market environment within which investments are bought and sold.
The assumptions behind CAPM for investors are
- Investors are rational, risk averse and utility maximisers
- Investors perceive utility in terms of return.
- Investors measure risk by the standard deviation of return
- Investors have a single period investment time horizon
- Investors have the same expectations about what the future holds.
The assumptions for the financial market are perfect and that
- there are no taxes
- there are no transaction cost
- investors’ can both lend and borrow at the risk free rate of return.
As one can see these assumptions are highly restrictive and not a real representation of reality, as we live in complex world. Yet with these set of assumptions the model still gives an accurate picture, to a certain extent, of what investors experience when investing.
I will go through all the assumptions in turn and explain what the result will be if they are untrue.
Firstly in reality investors may be rational but not all are risk-averse, some are risk-loving and will be high risk investors in the hope to reap in high returns. This may not be the most efficient portfolio or share and as a result the investor will not be on the Capital Market Line.
Secondly if the assumption of investors perceive utility was untrue then it would not be possible to measure the efficient portfolio set.
Whilst return is a dominant factor in determining utility other factors come into play. An investor will consider utility factors such as:
- will this investment complicate my tax calculations
- Would I be better off consuming this wealth instead?
- Could the investor gain any lifestyle benefits from this investment (ie. Art)
Thirdly, not all investors understand statistics and hence do not know what standard deviation is so investors do not look at the standard deviation of return. Alternatively they can see risk in terms of the state of the economy, recent business conditions and trading information. As a result the CAPM should not solely rely on standard deviation of returns, as the measurement of risk is more complex and certain aspects are difficult to measure.
In addition, investors rarely have a single time period of investment time horizon. All investors are different and have different time horizons of investment. For this reason this assumption makes the model static, but as we very well know the world is dynamic in which investors are free to manipulate their portfolio.
One of the other assumptions of the model is that all investors are homogeneous and have the same expectations of the future. Clearly this is untrue in the real world. Not all investors share the same view; some are optimistic others are not so. As a result this would lead to different investors to hold different portfolio sets.
We have seen what the results are if the assumptions of the investors are untrue. Now I will move on to discuss what the results will be if the assumptions of the financial market are untrue.
The model assumes the market is perfect, I will show that this is not true and the results of the assumptions being untrue.
The model assumes no taxes, no transaction costs and investors can borrow and lend at the risk free rate. In the real world there are taxes and transaction costs and very few people, (if any) can borrow at the risk free rate. Tax treatment for dividends and capital gains tax are different. If we recognise the existence of taxes, the equilibrium prices should change, leading to investors to judge the return and risk on their portfolio after taxes.
If the assumption of investors can borrow and lend at the risk-free rate is untrue then the investor would not invest at point N, but his investment would lie between N and X (and beyond). Also the investor would need to make a higher return on his investment so that he can pay the debt back with the higher rate of interest. “In fact I would predict that the CML line should kink downward for riskier portfolios (B > 1) to reflect the higher cost of risk free borrowing compared to risk free lending.”
Blake, D - Financial Market Analysis, 2nd edition, Wiley, 2000
Portfolio selection, Journal of finance, no.7 (1952)