INVESTMENT AND PORTFOLIO MANAGEMENT

Week 11-12: MODULE 6. Portfolio Management Strategies April 1, 2024

Learning Objectives:

1. Differentiate between active and passive portfolio management strategies.

2. Understand factor investing and its role in portfolio construction.

3. Apply tactical asset allocation techniques.

4. Implement effective portfolio rebalancing and monitoring strategies.

Sub-Topics:

a. Active vs. Passive Management April 1, 2024

b. Factor Investing April 8, 2024

c. Tactical Asset Allocation

d. Rebalancing and Monitoring Portfolios Apri

DISCUSSION:

A. Active vs. passive management is a perennial debate in the world of portfolio

management, with proponents and critics on both sides arguing their case vehemently.

Active management involves the frequent buying and selling of securities in an attempt to
outperform the market or a specific benchmark.

This strategy relies on the skill and expertise of fund managers or investors to identify mispriced
securities or market trends that can be exploited for higher returns.

Proponents of active management argue that skilled managers can generate alpha, or excess
returns, through their expertise and research, potentially justifying the higher fees associated
with actively managed funds.

On the other hand, passive management, often associated with index investing, aims to
replicate the performance of a specific market index rather than trying to outperform it.

Passive investors typically achieve this by investing in index funds or exchange-traded funds
(ETFs) that hold the same securities as the chosen index in the same proportions.

Advocates of passive management highlight lower fees, reduced portfolio turnover, and the
consistent tracking of market performance as its key advantages.

They argue that active managers, on average, fail to consistently beat the market after
accounting for fees and transaction costs.

The debate between active and passive management revolves around several key
points:

Performance: One of the central questions is whether active managers can consistently
outperform their passive counterparts over the long term. Proponents of active management
point to periods where skilled managers have indeed beaten the market, while advocates for
passive management emphasize the difficulty of consistently identifying outperforming
managers in advance.

Active Management Example: A mutual fund manager specializing in tech stocks

accurately predicts a major industry trend and strategically allocates the fund's assets, resulting
in a significant outperformance compared to the broader market index.

Passive Management Example: An investor chooses to invest in a low-cost S&P 500

index fund that tracks the performance of the S&P 500. Over a 10-year period, the index fund
consistently matches or slightly outperforms the average returns of actively managed funds in
the same asset class.

Costs: Active management tends to come with higher fees due to the expenses associated with
research, trading, and management. Passive management, particularly through index funds and
ETFs, typically has lower fees since it requires minimal trading and research.

Active Management Example: An actively managed hedge fund charges a management

fee of 2% of assets under management (AUM) and a performance fee of 20% of profits earned.
These fees significantly erode the fund's returns over time, especially if the fund fails to
outperform the market.

Passive Management Example: An investor chooses to invest in a passive ETF

(exchange taded-funds) that tracks the performance of the MSCI World Index. The ETF has an
expense ratio of only 0.10%, significantly lower than the fees associated with actively managed
funds.

Risk: Both active and passive management strategies carry their own risks. Active
management risks underperformance if the manager's bets don't pay off, while passive
management risks tracking error, where the fund's performance deviates from the index it aims
to replicate.

Active Management Example: An actively managed portfolio heavily invests in a few

high-risk stocks based on the manager's predictions. If these stocks underperform or face
unforeseen challenges, the portfolio may experience significant losses.

Passive Management Example: A passive investor holds a diversified portfolio of index

funds representing various asset classes. While the portfolio's performance closely mirrors the
broader market, it is subject to systematic risk inherent in the market itself.

Market Efficiency: The debate also touches on the Efficient Market Hypothesis (EMH), which
posits that asset prices reflect all available information. Proponents of passive management
argue that markets are generally efficient, making it difficult for active managers to consistently
beat the market after accounting for costs.

Active Management Example: A portfolio manager conducts extensive research and

analysis to identify undervalued stocks in the energy sector. Despite their efforts, the market
quickly adjusts to new information, making it challenging to consistently beat the market.

Passive Management Example: A passive investor believes in the efficient market

hypothesis and chooses to invest in a broad-market index fund. They accept that while they
may not outperform the market, they also won't underperform it after accounting for fees and
transaction costs.
Investor Preferences: Ultimately, the choice between active and passive management may
come down to individual investor preferences, risk tolerance, and investment goals. Some
investors may prefer the potential for higher returns offered by active management, while
others may prioritize the lower costs and simplicity of passive strategies.

Active Management Example: An investor with a high risk tolerance seeks potentially
higher returns and is willing to pay higher fees for the opportunity to invest in actively managed
funds with skilled managers who actively seek alpha.

Passive Management Example: An investor with a long-term investment horizon and a

preference for simplicity chooses passive strategies, such as index funds or ETFs, to build a
diversified portfolio with minimal ongoing maintenance and lower costs.

These examples highlight how the active vs. passive management debate plays out in real-
world investment scenarios, considering factors such as performance, costs, risk, market
efficiency, and investor preferences.

In conclusion, the active vs. passive management debate is multifaceted and ongoing,
with proponents on both sides advocating for their preferred approach based on various factors
such as performance, costs, risk, market efficiency, and investor preferences. Ultimately, the
best approach for any given investor may depend on their individual circumstances and beliefs
about the market.

The simplest definition of a portfolio in investment is a collection of financial assets such as

stocks, bonds, cash, and other investments held by an individual or an institution.

LET US WATCH THIS VIDEO: TOP 5 Management Portfolio Techniques

https://www.youtube.com/watch?v=ornAXWzIgxE&t=13s

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SUB- TOPIC 2: FACTOR INVESTING April 8, 2024

Let's delve deeper into factor investing by discussing some common factors, their definitions,
and examples of how they manifest in investment strategies:

1. Value Factor:

Definition: The value factor identifies stocks that are priced lower relative to their fundamental
value metrics such as earnings, book value, or cash flow. Essentially, it seeks to identify
undervalued stocks.

Example: A classic example of a value investing strategy is buying stocks with low price-to-
earnings (P/E) ratios or low price-to-book (P/B) ratios. Investors employing this strategy believe
that these stocks are trading at a discount and have the potential for higher returns as the
market corrects the undervaluation.

2. Momentum Factor:
Definition: The momentum factor identifies stocks that have exhibited strong recent
performance and expects them to continue performing well in the short to medium term. It's
based on the idea that trends tend to persist.

Example: Momentum investors might buy stocks that have shown strong price appreciation
over the past 6-12 months, expecting that the positive price trend will continue. An example
could be investing in technology stocks that have recently experienced rapid growth in revenue
and earnings.

3. Size Factor:

Definition: The size factor focuses on the market capitalization of stocks, identifying small-cap
stocks that historically have outperformed large-cap stocks over the long term.

Example: An investor employing a size factor strategy might allocate more to small-cap stocks
in their portfolio based on the belief that smaller companies have greater growth potential and
room for expansion compared to larger, more established companies.

4. Quality Factor:

Definition: The quality factor seeks to identify stocks of companies with strong fundamentals,
stable earnings, low debt, and high profitability. It prioritizes companies with consistent
performance and financial health.

Example: Investing in companies with high return on equity (ROE), low debt-to-equity ratios,
and steady earnings growth is an example of a quality factor strategy. These companies are
often perceived as more resilient and less susceptible to economic downturns.

5. Low Volatility Factor:

Definition: The low volatility factor focuses on stocks with lower price fluctuations or volatility
compared to the broader market. It aims to provide more stable returns and downside
protection during market downturns.

Example: A low volatility strategy might involve investing in defensive sectors such as utilities,
consumer staples, or healthcare, which tend to have more stable earnings and lower volatility
compared to cyclical sectors like technology or industrials.

These examples illustrate how different factors can be incorporated into investment strategies
to potentially enhance returns, manage risk, or achieve specific objectives.

Factor investing doesn't necessarily involve picking individual stocks but rather constructing
portfolios that tilt towards or away from certain factors based on investment objectives and
market conditions.

Additionally, investors often combine multiple factors within a single portfolio to diversify risk
and capture various sources of return.

ASSESSMENT: Multiple-choice questions about factor investing:

1. Which of the following best defines factor investing?

a) Investing solely based on economic indicators.

b) Focusing on individual stock selection.

c) Targeting specific attributes or characteristics that historically drive returns.

d) Implementing a passive investment strategy.

2. Which of the following is NOT considered a common factor in factor investing?

a) Value

b) Growth

c) Momentum
 d) Quality

3. What is the primary objective of factor investing?

a) Maximizing short-term returns

b) Achieving broad market exposure

c) Capturing specific sources of risk and return

d) Avoiding market volatility

4. Which factor investing strategy involves identifying stocks with lower price fluctuations?

a) Value investing

b) Growth investing

c) Low volatility investing

d) Momentum investing

5. How does factor investing differ from traditional market-cap weighted indexing?

a) Factor investing focuses on individual stock selection.

b) Factor investing seeks to capture specific attributes associated with higher returns.

c) Factor investing involves passive investment strategies only.

d) Factor investing does not consider market dynamics.

Answers:

c) Targeting specific attributes or characteristics that historically drive returns.

b) Growth

c) Capturing specific sources of risk and return

c) Low volatility investing

b) Factor investing seeks to capture specific attributes associated with higher returns.

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SUB-TOPIC 3: TACTIAL ASSET ALLOCATION (TAA)

Tactical Asset Allocation (TAA) is an investment strategy that involves actively adjusting the
allocation of assets in a portfolio based on short to medium-term market forecasts, economic
indicators, or valuation metrics.

Unlike strategic asset allocation, which maintains a fixed allocation over the long term, TAA
allows investors to take advantage of market opportunities or manage risks dynamically.

Tactical Asset Allocation along with examples:

1. Understanding Tactical Asset Allocation:

Tactical Asset Allocation involves making strategic shifts in asset allocation to capitalize on
short-term market inefficiencies or changes in market conditions. It typically involves deviating
from the portfolio's long-term strategic asset allocation targets.

2. Objectives of Tactical Asset Allocation:

Enhance returns: TAA aims to generate excess returns by exploiting short-term mispricing or
market trends.

Manage risk: TAA seeks to mitigate downside risk by reducing exposure to overvalued or risky
assets during periods of market turbulence.

Adapt to changing market conditions: TAA allows investors to adjust portfolio allocations in
response to evolving economic, geopolitical, or market factors.

3. Implementation of Tactical Asset Allocation:

Quantitative models: Some investors use quantitative models or algorithms that analyze
various indicators such as valuation metrics, economic data, market sentiment, and technical
factors to make allocation decisions.

Expert judgment: Experienced portfolio managers or investment committees may rely on

their judgment, market insights, and qualitative analysis to make tactical allocation decisions.

Strategic tilts: TAA may involve tilting the portfolio towards or away from certain asset
classes, sectors, or factors based on short-term expectations for market performance.

4. Examples of Tactical Asset Allocation:

Market timing: An investor may increase allocation to equities during periods of

undervaluation or economic expansion and reduce exposure during overvaluation or economic
contraction.

Sector rotation: TAA may involve rotating allocations among different sectors based on their
relative attractiveness or expected performance. For example, increasing exposure to defensive
sectors like utilities and consumer staples during economic downturns.

Fixed-income duration management: TAA strategies in fixed income may adjust the
duration of bond holdings based on interest rate expectations. Shortening duration to mitigate
interest rate risk during periods of rising rates or extending duration to capture higher yields
during rate declines.

Geographic allocation: TAA may involve overweighting or underweighting geographic

regions or countries based on macroeconomic factors, geopolitical developments, or currency
outlooks.

Factor-based tilts: TAA strategies may incorporate factor-based tilts, such as increasing
exposure to value or momentum factors during favorable market conditions or reducing
exposure during adverse market environments.

5. Challenges and Considerations:

Market timing risk: TAA strategies may face challenges in accurately timing market
movements, leading to potential underperformance or increased transaction costs.

Overfitting and model risk: Quantitative TAA models may suffer from overfitting biases or
model risk, leading to suboptimal allocation decisions.

Costs and tax implications: Frequent portfolio rebalancing or trading in TAA strategies can
result in higher transaction costs and tax consequences, impacting overall returns.

Performance evaluation: Evaluating the effectiveness of TAA strategies requires

distinguishing between skill and luck, as short-term performance may be influenced by factors
beyond the investor's control.

In conclusion, Tactical Asset Allocation offers investors flexibility to adjust portfolio allocations
based on short-term market dynamics and expectations.

While TAA can potentially enhance returns and manage risks, it also poses challenges and
requires careful implementation and monitoring to achieve desired outcomes.

ASSESSMENT: True or False questions about Tactical Asset Allocation:

1. Tactical Asset Allocation involves making frequent changes to the portfolio based on
short-term market forecasts and economic indicators.
2. Tactical Asset Allocation strategies primarily focus on maintaining a fixed allocation to
different asset classes over the long term.
3. Tactical Asset Allocation can be implemented using quantitative models, expert
judgment, or strategic tilts based on market conditions.
4. Tactical Asset Allocation aims to outperform the market by accurately timing short-term
market movements.
5. Tactical Asset Allocation strategies typically involve higher portfolio turnover and
transaction costs compared to passive indexing strategies.

Answers:

1. True
2. False
3. True
4. True
5. True

SUB-TOPIC 5: PORTFOLIO REBALANCING AND MONITORING

Introduction:

Explore the critical practices of portfolio rebalancing and monitoring.

Imagine you have a diversified investment portfolio consisting of stocks, bonds, and real estate.
Over time, due to market fluctuations, the allocation of your portfolio starts to deviate from
your original targets. This is where portfolio rebalancing and monitoring come into play.

Example 1: Rebalancing Strategies:

Consider a scenario where your target allocation is 60% stocks and 40% bonds. After a year of
strong stock market performance, the value of your stocks has increased significantly, causing
your portfolio to become overweight in stocks at 70%. Meanwhile, the allocation to bonds has
decreased to 30%. To bring your portfolio back to its original allocation, you decide to sell some
stocks and buy more bonds to rebalance to the 60/40 split.

Example 2: Impact of Rebalancing:

Let's delve into the impact of rebalancing on portfolio performance. Imagine you started with a
$100,000 portfolio split equally between stocks and bonds. Over the next year, stocks
outperform bonds, increasing their value to $60,000, while bonds decrease to $40,000. Despite
the higher returns from stocks, rebalancing would involve selling $10,000 of stocks and buying
$10,000 of bonds to maintain the 50/50 allocation. While this may seem counterintuitive as it
involves selling the outperforming asset, it helps manage risk by preventing the portfolio from
becoming too heavily skewed towards stocks during market rallies.

Example 3: Challenges and Considerations:

Consider the challenges associated with portfolio rebalancing, such as transaction costs and tax
implications. Suppose you rebalance your portfolio by selling assets to restore the target
allocation. However, these transactions may incur brokerage fees or capital gains taxes,
reducing the overall return of your portfolio. To mitigate this, you may opt for tax-efficient
rebalancing strategies, such as utilizing tax-deferred accounts or offsetting gains with losses.

Example 4: Monitoring Portfolio Performance:

Now, let's discuss the importance of monitoring portfolio performance. Imagine you have a
target annual return of 7% for your portfolio. After six months, you review your portfolio's
performance and find that it has only achieved a 4% return. By closely monitoring performance,
you can identify underperforming assets or areas of the portfolio that may need adjustments to
align with your investment goals and objectives.

Example 5: Adjusting Portfolio Strategies:

Lastly, let's explore the need for adjusting portfolio strategies based on changing
circumstances. Suppose you initially had a high-risk tolerance and allocated a significant portion
of your portfolio to equities. However, as you approach retirement, you may decide to reduce
your exposure to stocks and increase allocations to more conservative assets like bonds or cash
to protect your savings from market volatility and preserve capital.

In conclusion, portfolio rebalancing and monitoring are essential practices for maintaining the
desired risk-return profile of your investments over time. By implementing effective strategies
and closely monitoring performance, investors can stay on track to achieve their financial
objectives while navigating changing market conditions.

CASE STUDIES AND REAL-WORLD EXAMPLES:

Case Study 1: Rebalancing Strategies

Scenario:

Juana is a 45-year-old investor with a diversified investment portfolio consisting of stocks,

bonds, and real estate investment trusts (REITs). Her target allocation is 60% stocks, 30%
bonds, and 10% REITs. Over the past year, due to strong performance in the stock market, the
value of her stocks has increased significantly, causing her portfolio to become overweight in
stocks at 70%. Meanwhile, the allocation to bonds has decreased to 25%, and the allocation to
REITs has remained unchanged at 5%.
Case Study 2: Monitoring Portfolio Performance

Scenario:

Johnny is a 55-year-old investor who has been diligently saving for retirement. He has a target
annual return of 7% for his investment portfolio, which consists of a mix of stocks, bonds, and
mutual funds. After six months, John reviews his portfolio performance and finds that it has
only achieved a 4% return, falling short of his target.

ASSESSMENT

1.A. Present case studies or real-world examples of successful portfolio rebalancing and
monitoring practices.

1.B. Highlight how institutional investors, financial advisors, or individual investors navigate
rebalancing decisions and monitor portfolio performance in practice.

1.C. Discuss lessons learned and best practices derived from these examples.

ANSWER.

CASE STUDY I

Action:

Sarah decides to rebalance her portfolio to its original target allocation. She sells a portion of
her stocks and uses the proceeds to buy more bonds and REITs. After rebalancing, her portfolio
allocation returns to 60% stocks, 30% bonds, and 10% REITs.

Outcome:

By rebalancing her portfolio, Sarah ensures that her investments remain aligned with her long-
term goals and risk tolerance. While selling some of her stocks may seem counterintuitive after
a period of strong performance, rebalancing helps manage risk by preventing her portfolio from
becoming too heavily skewed towards stocks.

CASE STUDY 2

Action:

John decides to closely monitor his portfolio to identify areas of underperformance. He analyzes
the performance of individual assets and asset classes to determine potential reasons for the
shortfall. After conducting a thorough review, he identifies that his bond holdings have
underperformed relative to expectations.
Outcome:

By monitoring his portfolio performance, John is able to proactively identify areas that may
need adjustments. He decides to reallocate some of his investments from underperforming
bonds to other assets with better growth potential, such as diversified equity funds. This
adjustment aims to improve the overall performance of his portfolio and bring it closer to his
target return.

These case studies demonstrate the importance of portfolio rebalancing and monitoring in
maintaining the desired risk-return profile of investments and achieving long-term financial
goals. By implementing effective strategies and closely monitoring performance, investors can
navigate changing market conditions and stay on track towards their objectives.