Corporate Financial Policy

Coursework 2008

Q1.

By Ravi Waghela

Q1a)

Portfolio management is the process of managing assets of a mutual fund, including choosing and monitoring appropriate investments and allocating funds accordingly.

A mutual fund is an open-ended fund managed by an investment company which raises money from shareholders and invests in a group of assets. Mutual funds raise money by selling shares to the public.

In return for the money, shareholders receive an equity position in the fund and, in effecting each of its underlying securities.

Investors often hold more shares in more than one company and there are two approaches to portfolio management.

The two types are:

  • Active
  • Passive

Maximising the expected utility of the excess return over a chosen benchmark is known as active portfolio management, whilst passive portfolio management just tracks the benchmark.

The simplest example of passive management is the index fund that is designed to replicate exactly a well-defined index of common stock, such as S&P 500.The fund buys each stock in the index in exactly the proportion it represents the index. If J.P. Morgan Chase represents 3% of the index, the fund places 3% of its money in J.P. Morgan Chase stock.

Passive portfolio management involves a buy and hold strategy that is buying a portfolio of securities and holding them for a long period of time.

Passive portfolio management have two conditions that need to be satisfied:

  • Market Efficiency – EMH
  • Homogeneity of expectations.

If markets are efficient, then security prices change instantaneously and fully reflect all relevant available information. All security prices will be fairly priced at all times and no misvaluation, so there is no incentive to actively trade.

On the other hand Active portfolio involves frequent and often substantial adjustments to the portfolio as active managers believe that the prices are not continuously efficient and that they can profit from misvaluation of priced securities.

There are three stages in active management. The first stage is asset allocation. At this stage the portfolio manager decides what proportions of the total portfolio to invest in broad asset categories such as shares, bonds and money market securities. The asset allocation is important as it dominates the performance of most portfolios.

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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 – ...

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