Section 4 – Investment Strategies
The next two topics cover the larger questions of what to include in an investment portfolio, and what strategies achieve particular objectives.
Having looked at the range of assets and financial instruments available to investors in the previous section, it’s time to “put it all together.” This section considers the following questions:
+ What – to include in an investment portfolio, and how much should be invested in each asset, or asset class? The composition question.
+ When – to invest, when to buy, when to sell. The timing question.
+ Why? – invest now, why sell now? How is the investment strategy meeting the investment goals? The optimizing question.
+ Understand the benefits of diversification
+ Discover the pros and cons of mutual funds
+ Assess hedge fund goals and performance
+ See why ETFs have become so popular
Lecture: Portfolio Analysis
Part I – Diversification
Diversification is a general risk-management strategy. If you don’t want to lose all your digital photographs, don’t store them all on the little card in the camera, or on the hard drive of your computer! Copy them to discs or an external hard drive and store that off site. “Don’t put all your eggs in one basket” is the oldest reference to diversification. Since risk is an ever-present element of investing, managing those risks through diversification is attractive and desirable. Here’s the theory behind diversification:
Consider asset A with an expected (average) return of Ra, and a risk, measured by the variance of the expected return, of Va (the square root of this is the standard deviation of the return, Sa.) There is another asset B with expected return Rb, and variance of return Vb (and square root Sb.) Construct a portfolio with equal parts A and B. The expected return to the portfolio is the average of the returns to the component assets, but the risk, measured by the variance, or its square root, the standard deviation, is not so simply calculated. See below:
Although the mathematics is interesting the MAIN POINT is that the portfolio risk, as measured by the variance or standard deviation of the expected return to the portfolio, is less than the average risk of the two component assets (so long as the two assets do not have perfectly correlated returns.) If the portfolio consists of assets that move exactly with each other then adding more just leaves the investor exposed to the same amount of risk. But if an investor adds assets (eg more shares of different companies) that are in any way uncorrelated–even a little–then the portfolio risk is lower. If the returns are negatively correlated, the effect is much more pronounced!
Many people, including investors, think that diversification is about adding more assets to the portfolio, but the number of assets (even different stocks) is not the important element. What adds diversification–and the resulting lowering of risks–is adding assets that are imperfectly correlated with each other. The reason why portfolio risk is reduced when there are large numbers of different assets in them is because there are very few asset returns that are perfectly correlated. But when an investor simply adds more assets (say stocks) to a portfolio, the reduced risk is more a function of luck than good choices!
It is often asked “how many different stocks do I need in my portfolio to get the most benefit from diversification?” Is it 100, 50, 25, or just 10? The above suggests that the simple answer is that the number of different stocks is not important, but how the returns correlate with each other. It is quite possible to achieve a very high degree of diversification with just 10 stocks, or 5 stocks and an ETF!
The mathematics of diversification also explains why the “market portfolio” in the Capital Asset Pricing Model is optimal. The market bundle, by definition, reflects the diversity of the market, and captures all imperfect correlations in the returns across all companies, industries and sectors. It also explains the attraction of Exchange Traded Funds (ETFs).
Part II – Mutual funds
About 80% of mutual funds under-perform the market (according to Motley Fool.) Not surprising if the market really is efficient, but depressing nonetheless.
A mutual fund is an organization that buys a portfolio of assets, often equities, or bonds, but sometimes mixtures of many different financial and real assets, and sells shares in that portfolio. This has two big advantages for investors:
(i) An investor can buy a small share of a larger portfolio that could not afford to buy on their own, and
(ii) The investor enjoys the benefits of diversification through the holdings of the mutual fund.
There may be another advantage, although this is often debated especially when so many mutual funds do worse than the S&P500 Index:
(iii) Benefit from active management by professional investors employed by the mutual funds.
There are many mutual funds available–Fidelity alone offers over 10,000 different funds! Funds offer broad portfolios as well as those focussed on a geographical region, industry, sector or social philosophy (eg “green” investments.) Shares in mutual funds are purchased at the Net Asset Value (NAV) which is essentially the value of the portfolio less liabilities divided by the number of shares. This can change frequently and is generally not a good indicator of the value of the portfolio since the number of shares can change. The return on the portfolio over a period of time is the best indicator of mutual fund performance. Mutual funds charge fees, including management fees and trading fees (since the fund buys and sells instruments such as shares which incur fees.) While many funds are “no-load” funds, meaning they do not charge certain fees, all funds charge some fees. Actively managed funds tend to charge higher fees because of the salaries of managers and their support staff, as well as marketing and office expenses. Since funds provide investors with a service, it is reasonable for them to charge fees.
Mutual funds are regulated, they must publish a prospectus to interested investors, and they must pay out capital gains to investors, which become taxable income. There are many criticisms of mutual funds, mainly focused on the fees, both directly and indirectly. The management and operational fees are pretty easy to understand, but there are also behaviors that increase costs and lower returns to investors. The main offender in this regard is churning, or turnover. Mutual funds must report what percentage of the fund holdings are traded each year. Low turnover reflects a buy-and-hold strategy whereas turnover ratios above 100% suggest managers are buying and selling frequently. Mutual funds are rated by companies such as Morningstar and Lipper. Many investors use these ratings of goals, service and performance to help choose mutual funds to invest their retirement savings, or inheritances.
Mutual funds offer investors a way of “hitting above your weight” in the market than they could otherwise, and provide built-in diversification. But they also charge fees that eat into the capital gains, and the majority of actively managed funds don’t do very well compared to an index fund. But they are regulated, unlike hedge funds…
Part III – Hedge funds
According to the Managed Funds Association, hedge funds “…provide investors with the latitude to tailor their investment strategies based on current market conditions in order to manage risk and maximize return.” Sounds like pap. But although hedge funds are like mutual funds in that they sell shares in managed investment portfolios, their are two significant differences:
(1) Strategies – mutual funds tend (not all, or always) to take long positions on assets, whereas the “more aggressive” strategies of hedge funds include taking short positions and using derivatives. Short positions and options can be used to hedge (insure) against a downturn or bear (contractionary) market, while derivatives can take advantage of leverage.
(2) Regulation – Mutual funds are regulated by the Securities and Exchange Commission (SEC), but hedge funds are not regulated by any US government agency. This has a large influence on how funds report activities to shareholders: mutual funds must report formally and regularly, hedge funds not so formally, not so regularly!
Most hedge funds are set up as limited partnerships. Not everyone can invest in a hedge fund: usually people with over a million dollars in non-real estate wealth qualify, although there are other ways to qualify as an “accredited investor.” Hedge funds are usually limited to 100 investors. This explains in part why there are over 10,000 hedge funds.
A common fee structure for hedge funds is the “2+20” which charges a flat 2% management fee on funds invested, and 20% of any return above an agreed-on benchmark return. Although competition for investors has put pressure on this “industry standard” it remains the benchmark for those wanting to invest in hedge funds.
Some mutual funds exist to offer investors access to hedge funds at a lower price. These are so-called funds of funds. The portfolio of this kind of fund consists of hedge funds rather than the more standard equities, bonds, and real assets. They offer a considerable amount of diversification, but as pointed out above, whether this is optimal or not is an open question. Funds of funds may also incur higher fees due to having to pay the higher hedge fund fees as well as the standard mutual fund management fees.
Part IV – Exchange Traded Funds
Exchange Traded Funds (ETFs) are like mutual funds. They are portfolios of securities and other financial assets. Investors can buy shares in these funds, like mutual funds, but unlike mutual funds, shares in ETFs are traded on stock exchanges just like other equity shares. The value of an ETF share is the price paid in the market for that share, whereas the value of a share of a mutual fund is the calculated net asset value (NAV.)
Most ETFs are designed to have a trading value that moves in line with an index (stock index or a bond index, for example) or some other composite price. Although the proliferation of ETFs has created more exotic funds, the majority of them are passively managed with little turnover as they track an index, so fees are low and tax liability is relatively low also (more on taxes later in the course.)
ETFs have become very popular and there is an estimated $1trillion invested in them. They offer risk reduction through diversity. They offer low transaction fees and almost negligible management fees.
ETFs are attractive to investors for a number of reasons, including Warren Buffett. (click to read.) If the investor believes in the Efficient Market Hypothesis (EMH) then the best they can do in the long run is to achieve the return on the market bundle, which is closely approximated by a large index like the S&P 500, for example. Since the vast majority of mutual funds under-perform the market, an index ETF will offer an investor a higher return than a mutual fund! Risk may be lower due to the diversity inherent in the market bundle of asset. (In technical terms ETFs are subject to systematic risk, but eliminate idiosyncratic risk.)
The Quiz is available on the Learn website.
1. There’s a whole series of tutorials on Investopedia about mutual funds:
2. Hedge funds generate lots of interesting investigative journalism, such as the Vanity Fair article:
and this New Yorker article:
4. Wall Street Journal article about hedge fund fees:
Write a one page essay on the following topic:
Choose an investment goal (eg retirement, 3-month trip to Europe, college education for your child) and briefly describe what portfolio you would recommend to achieve that goal.
Discuss the following question:
ETFs are like mutual funds–being portfolios of financial assets that track particular targets. Do you think they are more attractive than mutual funds, and why?