A portfolio is the collection of securities held in a mutual fund. As a dealing representative, it is very important that you have a good understanding of the portfolio management approaches and methodologies used in selecting and managing the investments within a mutual fund portfolio. Let’s understand portfolio management.
Role of the Portfolio Manager
One of the advantages of mutual funds is that investors can take advantage of the services of professional money managers.
Each mutual fund has specific investment objectives as laid out in the prospectus. It is the responsibility of the portfolio manager(s) to ensure that those objectives are met. Their goal is to attain the highest return possible while complying with the stated investment objectives and risk constraints of the mutual fund.
The portfolio manager selects the securities held in a mutual fund. Some mutual funds have a single portfolio manager while others use a team approach. They may be employees of the investment fund manager or an outside entity that specializes in portfolio management. Some investment fund managers have in-house portfolio managers for their Canadian funds while using outside specialists for foreign mutual funds, which require familiarity with those markets.
Investors can receive updates on the most recent investment decisions and actions taken by the portfolio manager in the mutual fund’s commentary or Management Report and Fund Performance (MRFP).
Portfolio Manager Qualifications
Portfolio managers are required to be registered with the provincial securities commissions in the provinces in which they choose to operate. Registration is only granted to individuals who satisfy certain educational and experience requirements as specified in National Instrument 31-103.
In terms of education, portfolio managers must obtain an approved designation such as the Chartered Financial Analyst® (CFA)® designation, which is bestowed by the CFA Institute. The Charter is granted to those who have completed an intensive course of study, passed a series of rigorous exams, and fulfilled a work experience requirement.
In addition, regulators require portfolio managers to have relevant investment management experience. They must show that they have performed portfolio management duties for a minimum length of time.
Investment Management Strategies
There are two general strategies for mutual funds:
- passive portfolio management
- active portfolio management
Knowing whether a portfolio manager uses an active or passive strategy can help you manage your client’s expectations. The investment strategy of a mutual fund is typically described in the simplified prospectus under the fund’s Investment Strategies section.
Passive Portfolio Management
Portfolio managers that use a passive portfolio management strategy choose securities according to a specific benchmark. The benchmark represents a specific market, such as a stock index (e.g. S&P/TSX composite index). It is often used as a peer group standard to measure the performance of an investment.
Passive portfolio managers do not intend to outperform the benchmark. Rather, their goal is to replicate or track, the return of that benchmark as closely as possible. They can achieve this by either purchasing the exact same securities in the same proportion as the index, purchasing a sample of those securities or by using derivatives.
A passive investment strategy greatly reduces the amount of trading within a mutual fund. Once the initial investments are made, no further trades are usually required unless the make-up of the underlying benchmark changes. This results in lower transaction costs, which translates to lower management expense ratios (MERs) for passively managed funds when compared to actively managed funds.
The passive investment strategy is based on the Efficient Market Hypothesis (EMH) theory. The theory states that market prices of securities already reflect all publicly available information. This being the case, it would be futile for anyone to attempt to find mispriced securities (i.e. securities that are not fairly priced) that may provide a higher return.
For instance, some practitioners of passive portfolio management believe that securities of large U.S. companies are fairly priced. Large U.S. companies are closely followed by analysts and financial journalists. Any information that is related to their value is likely to be reported and disseminated to the public, at which point the market price of the security will quickly adjust to reflect the new information.
Passive Portfolio Management Considerations
|A passively managed fund is required to mirror the performance of a market index. Therefore it will be exposed to all of the ups and downs of the market index. When the market index performs well, the passive mutual fund will benefit. Of course, the return of the mutual fund will be slightly less from the management fees and any discrepancies between the actual portfolio and the underlying market index. There is a risk associated with passive investments. If the market index drops, the passive mutual fund will suffer. In this situation, the portfolio manager is unable to protect against the downside risk of the market index since he or she only makes adjustments to the portfolio when there is a change to the benchmark. This limitation also affects the portfolio manager’s ability to make profits by selling securities that perform well in their portfolios. They are not able to capture these gains when they occur.|
Active Portfolio Management
In contrast to passive portfolio management, active portfolio management is based on the idea that not all information about
securities is widely known. Hence, there are opportunities to discover securities that are not properly priced because of this market inefficiency.
Practitioners of active portfolio management believe that through their skill in research and analysis they can find these
securities. By relying on their abilities to pick securities and construct a portfolio, active portfolio managers attempt to outperform the benchmark.
For instance, an active portfolio manager may discover through research and analysis that a large U.S. company has a competitive advantage over its peers in making products at lower cost, which will increase the company’s earnings and security value over time. This information about the company is not commonly known, nor is it yet reflected in the security’s current market price. The portfolio manager sees an opportunity for higher returns by investing in this security, which the portfolio manager believes is mis-priced, compared to one that is already fairly priced.
An active portfolio management strategy has the flexibility to select securities as long as they are aligned with the investment mandate of the mutual fund.
Active Portfolio Management Considerations
The fact that active portfolio managers select the securities in a mutual fund has its advantages and disadvantages.
Since active managers control their transactions, they decide what to buy or sell and when. This flexibility allows them to seize new investment opportunities when they arise and realize profits at favorable times. They are not restricted by the market index.
Alternatively, they can adopt defensive strategies to protect the portfolio from market downturns. The risk of being able to pick and change the securities of the mutual fund is that the portfolio manager may select a poorly performing security or miss an investment opportunity.
Due to an increased amount of trading, actively managed funds incur more transaction costs than those that are passively managed. Their management expense ratios (MERs) are also higher since there is a cost to the portfolio manager performing research and analysis. However, many feel that if the fund is outperforming its benchmark, these costs are acceptable in exchange for higher returns.
Active Management Approaches
Active portfolio managers generally use one of two approaches to select securities for their mutual funds:
The top-down approach begins with looking at the overall economy and current market trends to determine the industries, markets and/or countries that are expected to perform well.
Portfolio managers look at macroeconomic variables such as the Gross Domestic Product (GDP) of various countries, interest rates and employment rates. From there, they narrow down their search by identifying the industry, sector, or countries that look favourable considering the economic conditions. Finally, they select companies that they feel have the most potential and meet the mutual fund’s investment objectives.
Portfolio managers that take the bottom-up approach focus on individual companies, the economy and market cycles are secondary considerations. They believe good companies can succeed even if a particular industry, country, or region is struggling.
Part of the portfolio managers’ investment process includes reviewing a company’s business prospects, meeting with its management team, and evaluating its financial statements.
Investment Selection Methodology
|Technical and fundamental analyses are the two types of security selection methodologies that portfolio managers use for finding and analyzing securities. |
Technical analysis is a method of evaluating securities based on studying past trends in market activity, prices, and volume. Technical analysts look for patterns or indicators to predict future price movements. Technical analysts are often referred to as chartists since they rely heavily on charts of share-price behavior and trading volume to make their extrapolations. Below is a sample chart.
|Fundamental analysis involves looking at the fundamentals of a company such as revenues, assets, profits, and competitive position. Fundamental analysts study a company’s financial statements, may speak with its management, customers, and suppliers, and consider macroeconomic factors such as the economy, inflation, and the interest rates that could impact a company’s earning potential. They attempt to predict the future prospects of a company by becoming intimately acquainted with the details of the company.|
Modern Portfolio Theory
Although the concept of diversification has been around for a long time, it was the introduction of the Modern Portfolio Theory that really brought this concept to the forefront of the investment world.
Modern portfolio theory explains the benefits of taking a portfolio approach to investments rather than focusing on single investments. Accordingly, investments should not be evaluated only on their own characteristics, but also in relation to other types of investments. If investors diversify their portfolios they can effectively reduce the overall risk within their portfolios and enhance their potential return.
Modern portfolio theory provides a mathematical framework for constructing a diversified portfolio.
For instance, bonds and equities generally do not perform similarly. In addition, various types of risks affect them differently. Considering their dissimilarities, combining bonds with equities can help reduce the overall volatility of the portfolio, thereby protecting the portfolio from suffering large losses.
Since Modern Portfolio Theory provides a mathematical approach to portfolio construction, it then becomes possible to determine the optimal portfolio. The optimal portfolio is one that provides the highest return given a particular level of risk. Because investors have different risk levels, there are a multitude of optimal or efficient portfolios. These optimal portfolios can be plotted on a graph called the efficient frontier.
All portfolios on the efficient frontier provide the highest return for a given amount of risk. Portfolios that are below the frontier are considered inefficient and inferior because they either offer portfolios with the same return but at a higher risk, or they offer a lower return for the same level of risk.
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