Active Fund Management - Free Essay Example

Sample details Pages: 6 Words: 1917 Downloads: 3 Date added: 2017/06/26 Category Management Essay Type Analytical essay Did you like this example? 1. Introduction Investors, by their very nature, wish to achieve good returns on their investments, and that too, mostly without taking disproportionate risks. This, unfortunately, is an inherently contradictory desire as high returns are always associated with greater risk. Don’t waste time! Our writers will create an original "Active Fund Management" essay for you Create order The current economic scenario provides investors with a number of alternative avenues for growing their assets, which, inter alia, include real estate, bullion, land, art, bonds, bank deposits and of course equity. Equity markets have, in particular, fascinated investors for decades with their promise of huge profits, â€Å"killings† and stories of fortunes built from nothing. Most of these stories, which deal with huge trading profits made by individuals, are of questionable authenticity and anecdotal in nature; nevertheless, they serve to engage the attention of investors and keep their hopes alive through boom and bust times, through depressions and terrorist attacks. In recent years, the activity of investing in equity markets has become increasingly complex and most people have started trusting in the services of specialist organisations that operate through pooled funds; which contain monies contributed by numerous clients. Barclays, the leading global asset management f irm controls assets worth more than 1400 billion dollars.[1] These funds charge fees from their members and employ trained and experienced managers, who are conversant with equity and bond markets and focus solely on optimising the monies entrusted to them. Most fund managers are recruited with care, trained extensively and paid handsomely by their employers. These funds, widely known as Mutual Funds, have a variety of schemes for the benefit of their clients. Mutual funds are often categorised by investment policy. Major policy groups include money market funds; equity funds, which are further grouped according to emphasis on income versus growth; fixed-income funds; balanced and income funds; asset allocation funds; index funds; and specialized sector funds [2] It is the objective of this essay to analyse the functions and methodologies of actively managed funds, with reference to other modes of equity investment, and determine whether their inclusion, in the portfolio of risk-averse investors is desirable. Active fund management refers to a strategy wherein fund managers actively pursue objectives of outperforming specified benchmark indices; in other words they aim to provide returns better than what the market can theoretically give to investors. Active funds, like other mutual funds levy a host of charges on investors that are payable at entry, exit and during the time investors keep their money with them. Fund managers use an assortment of means to achieve their targets, which include the use of ratios, specific sector bets, short selling, use of market inefficiencies and investments in small cap stocks. In a number of cases these measures entail a significant amount of risk. Losses, if and when they occur, are borne by the investors, mostly through the Net Asset Value (NAV) mechanism. 2. The Methodology and Risks Associated with Active Fund Management Actively managed funds are among the fastest growing funds worldwide and increasing num bers of investors are putting their financial assets in the hands of fund managers. Researchers have actively worked on the various mechanisms involved in actual fund management, not only to assess their methodology but also to ascertain their level of success. Studies generally indicate that active funds rarely outperform index funds over sustained periods of time even though there may be phases when they are significantly ahead of index funds. If the cost of fund management is factored into the scheme of things there is a real possibility of the return from actively managed funds not being commensurate with the risks involved; in such case it is difficult to understand how active funds are able to attract so much capital. One school of thought states that the returns from actively managed funds depend upon the quality of fund managers and well managed active funds are able to regularly outperform index or passive funds. However, active management, when thoughtfully executed, ca n potentially add value relative to a static asset allocation implemented through index funds. Investors and their advisors can maximize a portfolio’s potential for alpha by selecting talented managers with low costs and incorporating them into the portfolio in a manner that does not sacrifice control of systematic risk factors.[3] This theory about performance of actively funded funds being dependent upon their management is empirically borne out, to a certain extent, because of the superior long-term performance of some actively managed funds. However, the variables associated with the equity market, the inherent unpredictability of individual share and collective market behavior and the extent of factors that can influence the market, and which remain beyond the forecasting ability, knowledge and control of active fund managers, make such claims untenable. Active fund managers use the help of statistical forecasting tools, fundamental and technical analysis, accepted ma rket models and established stock market theories to make their portfolio decisions. Individual judgmental decisions are seldom, if ever, used. The efficient market hypotheses and the use of the Capital Asset Pricing Model (CAPM) are some of the important theories that help in explaining the nature of equity markets Efficient Market Hypotheses The efficient market hypotheses have three sections, the weak form, the semi strong form and the strong form.[4] The weak form postulates that prices of shares reflect all information in past and current prices and transaction volumes, thus making movements unpredictable and the chances of making profitable trades just about even. The semi strong form goes a step further to state that prices have already factored in additional information such as company and industry data, as well as broad economic data including interest and currency fluctuations and inflation. These two hypotheses, in effect, state that as current share prices factor i n all the variables used in technical and fundamental analyses, future movement is inherently unpredictable and investment decisions of fund managers nothing more than shots in the dark. Finally the strong form hypothesis states that all information, public and private is reflected in share prices. This is possibly an untenable hypothesis as there may be a number of facts available with the management that may not be available with market operators. A case in point is Enron, where a great deal of inside information, available with the management, was not passed on to the market, enabling the top management to use the undisclosed facts to their advantage. While the efficient market hypotheses rule out the possibility of predictability in stocks, analysts believe this is only partially true and the hypotheses do not address the issue of market momentum, wherein groups of stocks do show the tendency for unilateral predictable movement, a fact that can be used by fund managers to inc rease returns on investments. Capital Asset Pricing Model (CAPM) The CAPM was conceptualised by William Sharpe as far back as the early sixties and has since evolved into one of the chief models for managers to control risks while taking investment decisions. It is an equilibrium model that describes the pricing of assets as well as derivatives. The CAPM is the single most used model for valuing securities and uses the Discounted Cash Flow system with risk adjusted discount rates. The CAPM postulates that entry into markets opens investors to two types of risks, systematic risks that arise from just being present in the market, and unsystematic risks, which arise from investing in particular companies. As unsystematic risks can be controlled through a process of diversification, the main risk in portfolio decisions comes from systematic risks.[5] The use of CAPM and other models like the Arbitrage Pricing Theory and Black Scholes provide alternative tools for fund managers to tackle risks and make informed and calculated investment decisions. It is evident from the foregoing analyses that most investment decisions associated with active fund management have significant elements of risk. In most cases, except when fund managers are privy to information that is unavailable to the market, the probability of profitable decision making is not more than even, and it is possible for results to go either way. The only time when chances of profits are relatively high relate to working in equity markets that have gained momentum. Even in momentum led markets, while the movement of a group of shares can be predicted, it is difficult to do the same for individual shares. 3. Analysis and Conclusion Existing theories on market hypotheses make the point that both fundamental and technical analyses do not provide credible tools to fund managers to help them in making profitable investment decisions. Profitable decisions are facilitated mostly when fund managers have access to information unavailable to the market or operate in markets that have generated significant momentum. Such opportunities however, arise very occasionally. While use of CAPM and other existing models help in constructing risk controlled portfolios, the risk of remaining in the market is permanent and cannot be eliminated. These facts are corroborated to a great extent by the fact that actively managed funds have been outperformed by indices regularly for the last fifteen years.[6] Index funds invest in a selection of equities that comprise the index. Their performances are similar to that of the index. They, however, trail the index marginally in returns because of the associated transaction costs. The costs of index funds are however much less than that of actively managed funds and with most active funds trailing the indices, the rates of return of actively managed funds are significantly lower than those of index funds. Prima facie, there appears to be very litt le reason for the risk-averse investor to invest in actively managed funds. Statistically, their average performance is poorer than that of index funds, their costs are significantly higher and risk profiles obviously greater. Risk-averse investors might still however wish to participate in the far higher returns that some actively managed funds are achieving, especially in the current climate of economic buoyancy. These investors can consider two alternatives. First, investors could choose actively managed funds that have an extended history, i.e., more than five years, of outperforming indices. This is a judgmental decision and does not guarantee future performance. Second, they could opt for funds which operate on a core and satellite system. These funds have a core portfolio of index funds that help in reducing the risk factor considerably. Deployment of the satellite funds is through active fund management and is subject to greater chances of risks and profits. This could be a suitable avenue for risk-averse investors who wish to control risks, but aim to increase their return. Bibliography Active Fund Management and Investment Strategies, 2006, Investment Management, Retrieved November 14 2006 from www.londonexternal.ac.uk//lse/lse_pdf/further_units/invest_man/23_invest_man_chap3.pdf Bodie, Z, Kane, A and Marcus, 2005, Investments, McGraw Hill, USA Burton, J, 1998, Revisiting the Capital Asset Pricing Model, Dow Jones Asset Manager, Retrieved November 12, 2006 from www.stanford.edu/~wfsharpe/art/djam/djam.htm Investment funds from Barclays Global Investors, 2006, Retrieved November 12, 2006 from https://www.bgifunds.com Levy, H, 1996, Introduction to Investments, South-Western College Publishing, USA Wicas, N, 2005, Add active ingredients to spice up passive portfolios, Professional Wealth Management, Retrieved November 12, 2006 from www.pwmnet.com/news/categoryfront.php/id/75/ASSET_ALLOCATION.html Lofthouse, S, 1994, Equity Inves tment Management: How to Select Stocks and Markets, John Wiley and Sons, Inc. Bottom of Form 1 [1] Investment funds from Barclays Global Investors, 2006, https://bgifunds.com [2] Bodie, Kane and Marcus, 2005, Investments, Ch. 4, [3] Wicas, N, 2005, Add active ingredients to spice up passive portfolios, Professional Wealth Management [4] Active Fund Management and Investment Strategies, 2006, Investment Management, [5] Burton, J, 1998, Revisiting the Capital Asset Pricing Model, Dow Jones Asset Manager [6] Wicas, N, 2005