Passively enhancing the active monitoring of valued growth opportunities

Let’s assume the investor’s IPS is being put in effect – so the risk return parameters have been decided. The constraints of time horizon, liquidity, legal and regulatory requirements, taxes and other unique circumstances have been determined and recorded. On the basis of the above, we have now determined the asset allocation strategy. The requisite process now has to be initiated for investing the proportion of the funds earmarked for equities.
For starters, the simplistic question – why would one look at equities? Not only do they have a higher return and greater diversification, if we target international markets as well, but they also provide a useful inflation hedge. Fixed income instruments have a fixed cash flow, the value of which will decrease with increasing inflation. However, in the case of securities, there is a useful hedge, particularly if the firms can pass on the inflation to the end-customer, depending on their industry and competitive position.

So now we have determined the asset allocation for equities. Next step, what is the approach to be followed for investing the funds – passive, enhanced indexing or active investment. Passive investing is preferred when the manager believes in the efficiency of the market, doesn’t have sufficient information about international or small/mid-cap markets or does not want to take on the burden of taxes due to the increased turnover associated with active management. The active approach varies depending on the active return to be generated and the acceptable active risk i.e. the standard deviation of the active return over the benchmark. The propensity of the investor to accept active risk depends on their belief that the selected portfolio manger can generate that active return or alpha. However alpha is not easily generated and in a lot of cases, the manager is measured against a passive benchmark and hence will be further hesitant to take on active risk or deviate from the benchmark.

The two strategies that can be followed are the core-satellite approach and the completeness fund approach. In the core-satellite approach, the investor has a core holding with passive or enhanced indexing. This is supported by a satellite of active holdings. The satellite holdings generate the active returns and the core holdings mitigate the active risk. In the completeness fund, the investment manager has an active portfolio which is supported by the completeness fund such that the combined portfolios have a risk exposure similar to the benchmark. The problem as I understand is that the active fund will be benchmarked to a relevant benchmark rather than the broader market benchmark. Hence from the investor’s perspective, there will be a misfit risk i.e. variation with respect to the broader market benchmark which is the required performance measurement criteria.

Before we move any further, let’s define these benchmarks that we have been talking about. There are various broad market indices that we are all familiar with which are used for passive indexing. There are also institutions which create a range of indices for mutual funds, ETFs etc to measure their performance against. Indices can be categorised as price weighted, market weighted and equal weighted i.e. one share of all securities in the market, equal value and equal amounts invested in all shares in the market. The most preferred is the free float adjusted value weighted index. When the indices are needed for active management, they can be constituted based on their style as value stocks, growth stocks, high earning stocks, high price multiple stocks etc. A stock can be allocated to a single index. It can also be allocated across various indices if the style of the security is measured as a quantity. Indices can also be reconstituted depending on requirement but that may cause a drift away from the intended purpose of the index.

And what is this style that we were just talking about: the investor has the option to follow value/ growth or market strategies depending on the ‘style’ of the security. (While I’ve covered this in a previous blog, just a summary once again) Value investing is when the stock is undervalued (looking at the multiples) and the investor expects it to revert to the mean. The kind of stocks that would be looked at would be high dividend yield stocks, low priced or contrarian to the market. It may also be investment in high volatility cyclical stocks which are down at a certain cycle in the market. The growth investor would invest in stocks which have historically been exhibiting high growth numbers – i.e. long term high growth, high sales, high earnings – i.e. momentum or constant performance stocks. Market of course is the average and could just be a sector rotation, reasonably priced growth or a slight tilt to any of the other two.

The investor would monitor various managers and their style preference either on the basis of their total return analysis with respect to mutually exclusive and exhaustive benchmark indices over a single period of time, over multiple periods of time or analyse their holdings to determine the strategy that they are following.

So, going back to the investment of the funds – what are the strategies for passive investing? One could have a portfolio invested along the lines of a selected index, invest in mutual funds, buy ETFs, buy index futures, or equity swaps. The last is the preferred option for international index exposure or for avoiding withholding tax. If we consider the first i.e. manually indexing to a selected index – the question arises – how do you select the securities that you should be buying. The options are - buy them all, select them in a stratified manner or try various models and map the factor exposures of the index.

For enhanced indexing, the investor can go long/short index stocks, depending on their beliefs of the stock or the industry, thus changing their weighting in the benchmark index being followed. They could also use the cash position to change the duration of the portfolio by investing in equity futures or short term fixed income securities.

And then we move on to active investment. After undertaking active fundamental analysis – either top-down or down up – to identify mispriced securities, the investor can either go long under priced securities or use the long-short approach which can generate two alphas, allow symmetric distribution of weights, allow elimination of systematic risk but also increase the risk due to the leveraged component i.e. securities which may have to be returned when the pricing is not conducive. Now, lets assume that the investor has decided on the long-short strategy and created a market neutral portfolio but now wants to add some systematic risk or duration to the portfolio. She could then go long either ETFs or futures – the options (or rather derivatives) are always there.

Moreover, there are numerous theories and disciplines around active investing. So to categorise when the investor would sell – we have given them various names – opportunity cost, target price reached, valuation reached, deteriorating fundamentals, down from cost, up from cost. The only fact which has been analysed and observed is that value investors typically have much lower turnovers as compared to growth investors.

So to summarise – what is equity portfolio management all about? Deciding how much of the portfolio should be under passive, enhanced, active management. Is the focus on value, growth, mid-cap, large-cap etc? What is the tool to be used for the passive fund investment? What are the tools to be used for the enhanced fund investment? What are the tools for active fund investment? For each of these, how will the performance be monitored? If temporary changes are to be wrought, how can the investment manager go about it?

Et voila – c’est tout.