Portfolio management is the professional asset management of various securities aimed to meet the long-term financial objectives of a company. Successful portfolio management requires the ability to consider strengths and weaknesses of each particular asset, follow market fluctuations, and weight opportunities and threats of a wide range of investments (Connor, Goldberg and Korajczyk. 2010). The key elements of portfolio management include effective diversification, cost efficiency, tax efficiency, and a consistent management strategy. When putting together and managing an investment portfolio, a company can opt for an active or passive strategy, involve ETFs into the portfolio construction process, consider various hedging strategies and instruments of regulating portfolio volatility.
Implementation of ETFs
An exchange-traded fund (ETF) is an investment fund that holds assets such as stocks, bonds, or commodities and operates with an arbitrage mechanism designed to keep it trading close to its net asset value. ETFs are similar to mutual funds in that they are both portfolios holding a collection of investments, but ETFs tend to be more liquid and cost-effective as they trade on exchanges like shares or stocks. One share in an ETF is a stake in the portfolio comprising various securities selected by professional traders.
ETFs are becoming increasingly popular as an investment tool, providing companies with a cheap, flexible, and tax-efficient way to build a diversified portfolio. ETFs are usually more stable than shares of specific companies and allow businesses to broaden the diversity of their portfolios by providing low-cost access to a variety of asset classes, industry sectors, and markets. Barry Gordon, the CEO at First Asset Exchange Trading Funds, notes, “With ETFs now encompassing literally hundreds of types of asset classes and markets globally, investors can get access to a wide range of domestic and foreign equities, fixed income, commodities, currencies, and even alternative strategies” (cited in ETFs provide optimal portfolio construction, n. d., para. 2).
Investing in an ETF does not require a traditional management fee, and the entry threshold is low. Another benefit is transparency, with most ETF funds publishing their holdings every day and keeping investors informed about their relative weighting in the fund. Overall, ETFs provide a low-risk and low-cost solution to portfolio diversification.
However, there are some disadvantages that need to be taken into consideration when investing in ETFs. First, because ETFs trade like stocks, there is a commission each time when an ETF is bought or sold. Depending on how often they are traded, the fees can substantially reduce investments’ performance. Second, with lower risks come lower benefits, and while ETFs provide a safe tool for long-term holdings, a company is unlikely to expect a big return (Neves, Fernandes and Martins, 2019). When investing in ETFs, the company should seek out expertise from financial advisers to collect extensive information about prices, underlying holdings, liquidity, and fees of a selected ETF in order to reduce all possible risks.
Hedging
Portfolio hedging is a strategy used to reduce risk exposure and protect a portfolio against volatility and loss of capital. Hedging means taking an equal and opposite position in two negatively correlated assets and investing in one with the aim to protect another. For example, to protect the company from the financial loss of growing metal prices, the managers can buy a futures contract to lock on a lower price for metals. Hedging is a flexible strategy that can be applied broadly over all asset classes in a portfolio, or narrowly to shield individual sectors or specific stocks. It is used to protect a portfolio from stock and commodity price fluctuations, interest rate changes, and currency swings.
Hedging is a popular strategy that has both advantages and disadvantages. On the positive side, hedging helps companies survive hard market periods, minimizing the risk of losses. It does not prevent losses completely because it is not an instrument of controlling and manipulating the market. However, it limits the losses to a great extent in the periods of market instability, providing a flexible short-term solution that does not disturb the company’s long-term goals (Connor, Goldberg and Korajczyk. 2010).
Hedging also increases liquidity because it makes companies invest in various classes of assets. If implemented properly, financial, strategical, and operational benefits of hedging can extend farther than merely avoiding financial distress.
However, like any strategy, hedging has its risks, costs, and consequences. The goal of hedging is not to make money, but to protect the company from losses, and in reducing the risk, hedging also cuts down the potential reward. If the market is performing well and the main position produces profits as planned, hedging becomes an unnecessary expenditure. Furthermore, hedging is a precise trading strategy that requires good trading skills and expertise. In some cases, complex trade-offs and lengthy calculations are required to implement an effective hedging strategy (Stojanovic, 2011). Hedging can be beneficial when used strategically and carefully, and a full understanding of the process and expected results is required to make successful investments.
Active and Passive Portfolio Management
Active and passive portfolio management are the two opposite strategies for managing an investment portfolio. With an actively managed portfolio, the company makes investments with the goal of outperforming a specific investment benchmark, such as the S&P 500. Passive portfolio management attempts to match that benchmark performance while minimizing the expenses. Active management portfolio strives for superior returns but take greater risks and entail larger fees, while passive management portfolios rely on a relatively safe low-lost and low-profit approach.
An active portfolio management strategy is based on the idea that a team of skilled investment managers can generate returns that outperform a benchmark index. In its simplest form, it suggests exploiting market inefficiencies by buying securities that are undervalued and selling those that are overvalued (Reilly and Brown, 2011). As it involves extensive activities of buying and selling assets, an active management strategy requires good knowledge of the market and greatly depends on the skills of the manager and the company’s research staff.
Active management makes use of a number of factors and strategies to construct a portfolio. They include quantitative measures, such as PEG ratios and price-earnings ratios, investments that aim to anticipate long-term macroeconomic trends, and purchasing stocks of companies that are temporarily out-of-favor (Reilly and Brown, 2011). With an active portfolio management strategy, managers need to conduct in-depth market research, follow market trends, shifts in the economy, changes to the political landscape, and many other factors that may affect the company. The strategy is most beneficial when markets are fluctuating, and especially when they are on the upward movement.
Passive portfolio management, on the other hand, is designed to mimic the returns of a particular market index as closely as possible to generate the return that is the same as the chosen index. It is based on the concept of the efficient market, which states that because all investors have access to all the necessary information, it is almost impossible to gain an advantage over competitors (Stewart, Piros and Heisler, 2019). As new information becomes available, market prices adjust in response, and the aim of investment managers is not to outdo the benchmark but simply to follow market fluctuations.
Passive portfolio management does not require a management team to conduct market research and make investment decisions and can be implemented by a single portfolio manager who is in charge of replicating the index. Within this strategy, trading is infrequent and occurs only when the index itself changes, and, therefore, trading costs are lower. Besides, a majority of mutual funds fail to beat broad indexes, which makes the passive strategy generally more beneficial (Reilly and Brown, 2011). With investors recognizing that the costs of an actively managed portfolio are substantial while not always providing a satisfactory result, the safer and less costly passive strategies have grown in popularity in recent years.
Portfolio Volatility
Portfolio volatility is one of the main indicators of the risk inherent within a portfolio. It is a measure of how wildly the total value of stocks within a portfolio appreciates or declines. High volatility means that stock prices move a lot and are hard to predict, which has a large negative impact on investment performance. It is generally considered that the greater portfolio volatility is, the lower is the return on the portfolio.
In general, the risk of a portfolio is lower than the risk of individual securities within it, provided that the portfolio is diversified, and the securities have unrelated price movements. If securities come from different asset classes and their prices move independently, they are less likely to move in the same direction at the same time, minimizing the risk of a financial loss (Bowman, 2019).
In establishing the risk, the volatility of a portfolio is compared to that of a benchmark (Dash, 2010). If the volatility of a portfolio is high but less than the volatility of a benchmark, it suggests lower risk than the low volatility of a portfolio that exceeds the benchmark’s volatility. If the portfolio manager decides to increase portfolio volatility, the expected return of the portfolio is likely to drop down. Measures of reducing portfolio volatility include creating a diversified portfolio by investing in uncorrelated assets, using different investment styles, and implementing hedging strategies.
Conclusion
The goal of portfolio management is to maximize the company’s returns and minimize risks. A range of instruments has been developed that, if implemented effectively, significantly simplify the management process. When developing a portfolio management strategy, the company is faced with a choice of opting either for a passive or an active approach. A passive strategy minimizes the risks while reducing profits, while an active strategy is riskier but promises higher returns.
One of the key principles that should be observed when managing a portfolio is diversification. In can be achieved by investing in exchange-traded funds that provide a low-cost solution to minimizing portfolio risks. Hedging is another strategy that allows to reduce risk exposure and protect the portfolio from volatility. Complex and simpler portfolio management strategies require different numbers of managers and different investment expenses and should be thoroughly analyzed when choosing a strategy fitting a particular company.
Reference List
Bowman, R. (2019) Volatility — why diversification matters and how to reduce risk in your stock portfolio. Web.
Connor, G., Goldberg, L. and Korajczyk, R. (2010). Portfolio risk analysis. Princeton: Princeton University Press.
Dash, A. (2010). Security analysis and portfolio management. Sonipat: I. K. International Pvt Ltd.
Neves, M., Fernandes, C. and Martins, P. (2019). ‘Are ETFs good vehicles for diversification? New evidence for critical investment periods,’ Borsa Istanbul Review, 19(2), pp. 149–157. Web.
ETFs provide optimal portfolio. (n.d.). Web.
Reilly, F. and Brown, K. (2011). Investment analysis and portfolio management. Boston: Cengage Learning.
Stewart, S., Piros, C. and Heisler, J. (2019). Portfolio management: theory and practice. New York: John Wiley & Sons.
Stojanovic, S. (2011). Neutral and indifference portfolio pricing, hedging and investing: with application in equity and FX. Springer Science & Business Media.