Active Management Strategies

The active approach of selecting and managing stocks in a portfolio is composed of:

1. Security selection.
2. Sector analysis.
3. Market timing.

I. Security Selection

Security selection involves choosing stocks that are expected to offer superior risk-return characteristics. An investor with a high information ratio has the requisite skill and patience. This allows them to pinpoint undervalued stocks. Since investment decisions are surrounded by uncertainties, rational and intelligent investors will diversify their portfolios to minimize the likelihood of such risks.

In addition, a more aggressive investor invests in funds that only seek capital appreciation. The conservative one, on the other hand, seeks a fund that considers both capital preservation and capital appreciation. It is imperative to appreciate that active investors seek opportunities for outperforming the indexes. They usually choose from among various actively managed funds.

II. Sector Rotation

Companies within the same industry are typically affected by the same economic and market conditions. Nevertheless, there are periods when one economic or market sector outperforms the other. If investors could transition from an under-performing sector into a better-performing sector before a change in performance, they would generate superior returns. Getting the timing right is, of course, very difficult.

Note that the fundamental law of active management implies that security selection should have an information ratio that is higher than other strategies for a given skill level, followed by sector rotation.

III. Market Timing

Market timing is an investment strategy that involves the variation of the proportion of portfolio assets in equity investments. An investor can observe a chart of stock prices over time to appreciate the profit potential of being in the stock market at the right time and being out of the stock market during bad times.

Market timers base the information coefficient on the proportion of correct calls. That is,

$$ IC=\frac{2N_c}{N}-1 $$

Where:

• \(N_c\) is the number of correct calls.
• \(N\) is the total number of calls.

Example: Market Timing

James Lazaro is a market timer who makes monthly asset allocation decisions. His decisions are based on his forecast of the direction of the market. If his forecasts are right 52% of the time, calculate his information ratio, given that he constructs an unconstrained portfolio.

Solution

$$ \begin{align*} IC & =\frac{2N_c}{N}-1=2\left(0.52\right)-1=0.04 \\ IR &=IC\times TC\times\sqrt{BR} \end{align*} $$

Therefore,

$$ IR=0.04\times1.0\times\sqrt{12}=0.14 $$

Question

Joyce Wright is a market timer who makes quarterly asset allocation decisions based on the forecasts of market movement. She prides herself on being right on 65% of her bets. Given a transfer coefficient of 0.80, Wright’s information ratio is closest to:

1. 0.3.
2. 0.48.
3. 0.96.

Solution

The correct answer is B.

$$ IC=\frac{2N_c}{N}-1=2\left(0.65\right)-1=0.3 $$

And,

$$ IR=IC\times TC\times\sqrt{BR} $$

Therefore,

$$ IR=0.3\times0.8\times\sqrt4=0.48 $$

Reading 44: Analysis of Active Portfolio Management

LOS 44 (e) Compare active management strategies (including market timing and security selection) and evaluate strategy changes in terms of the fundamental law of active management.