It is certainly true that investors have to identify the most appropriate strategy or combination of those to acquire an efficient portfolio. On the one hand, an investor can be a passive portfolio manager; on the other hand, he or she can choose active equity portfolio management strategies. There are particular techniques for these management styles, nevertheless, they shares a common goal on maximizing investors' gains.
In term of passive portfolio management, investors would construct a well-diversified portfolio in order to reproduce a market index without efforts to seek mis- price items. In such method, investors are less likely to give a try on examining security analysis with the intention to enhance investment performance (Bodie, Kane and Marcus 2011 p.10). In other words, the portfolio will include many securities; hence the percentage of each security is quite small. Because a passive manager could hold a highly or well-diversified portfolio in long-term strategy, the risk of that portfolio is close to the systematic risk of the market. Precisely, the unsystematic risk of securities has been reduced or eliminated out of the portfolio (Reilly and Brown 2002 p.862). Suppose that a passive manager purchases all ten stocks in part A in proportion to their weights in the index overtime. Visibly, this full replication technique lessens tracking error but raises transaction costs. Moreover, investors can use Sampling technique so as to buy an exemplification stocks corresponding to the benchmark (Reilly and Brown 2002 p.655). The fewer securities, the fewer transaction costs. Otherwise, this tactic helps investors to rebalance easier but they cannot match closely the returns of the index.
In case of active portfolio strategy, investors are more likely to utilize present information and techniques to anticipate and search out higher quality performance rather than long-term buy and hold strategy. In order to diagnose overvalued and undervalued stocks and future trends, portfolio managers have to recognize challenges (Grinold and Kahn 2006 p.2). It was stated that this approach aims to obtain returns surpassing the return of a passive benchmark portfolio (Reilly and Brown 2006 p.660). The behaviour of purchasing underestimated securities and then selling at excessive prices is associated with the increasing risks. Thereby, it is indispensable to choose appropriate benchmark index. In the practical portfolio construction part, the first and second short sales allowed portfolios represent the price momentum strategy with stocks BATS, PFC, RRS, and CRDA, PSON, RR, respectively. It is based on the assumption that stock prices would continue with movement over the past years. The stock RRS in the first portfolio instance of the contrarian investment strategy when investors purchase stock at its lowest price and sell approximately at its top. Another simple strategy is bottom - up approach which draws attention to select stocks without initial industry analysis and security analysis. Similar to ten stocks in part A, investors can shift funds among different securities sectors such as financial stocks, technology stocks, etc. This method depends on how market is predicted to raise or plump. Clearly, investors can change from overvalued stocks to undervalued ones or, conversely, in opposite direction corresponding to the market anticipation.
Question 2: Discuss how you may apply industry analysis and security analysis to your portfolio construction and active management
Because an active portfolio manager is likely to use available information and techniques to predict and search out better stock, thus he or she is necessary to examine analyses in order to select securities which might outperform the market. Indeed, industry analysis and security analysis are two proper processes that we need to incorporate while constructing portfolio.
One reason explain why investors should do industry analysis is that it can help them to identify and isolate investment opportunities with favourable return - risk characteristics (Reilly and Brown 2002). Briefly, it is the behaviour of comparing the relationship between various companies working in the same sector. When investors do industry analysis, they want to specify the long term trend of the industry, and to discover cyclical movement around its long - term trend (Hearth and Zaima 1998). To reach these objectives, sector rotation is a strategy on determining what industries will be outweighed in reaction to the economic changes. We move the portfolio more tremendously into industries which are predicted to do better depending on the state of business cycle (Bodie, Kane and Marcus 2011). In other words, the idea is to shift funds among various industries or sectors to grasp trend opportunely before other investors realize it. Also, it is integral to draw a line between industries to clearly distinguish them, however, this is a difficult action in practice. Broadly, an industry might be counted as a community with similar characteristics. According to the table in Appendix 1, BATS and ULVR are two outweighed securities because their industries are strong in the recession. Certainly, when recession or contraction starts, some industries such as tobacco, food and pharmaceuticals are more defensive and less sensitivity to the business cycle (Bodie, Kane and Marcus 2011). These industries attract investors as they have high profit. Meanwhile, financial institutions and banks are easy to be hurt when economy is at the top of contraction. Once the economy enters the trough of downturn, it tends to recover and expand. Thus, industries including equipment, machinery, and transportation, take considerable proportion of portfolio at this time. As shown in the Appendix 1, PFC and WEIR are typical examples of those industries. In other respects, BRBY and RR stocks are sensitive to economic state because they are cyclical industry. Nevertheless, in the expansion, cyclical industries will earn higher profits compared to other industries in common. Lately, in the end of recovery stage, there might be a decrease in customers' expectations, and energy security such as TLW would outperform in the portfolio.
Investors take into account not only industry analysis but also security analysis to beat the market with appropriate choices. In general, nearly all investors buy securities with attempting to generate profits. Particularly, profits may come from the periodic cash dividend payments or putting up for sales at higher price than buying prices. While technical analysis assumes that historical security prices can be used to anticipate future prices, fundamental analysis derive from using expectations about company to settle intrinsic value of stocks (Hearth and Zaima 1998 p.200). Intrinsic value of a stock includes the following variables, current dividend, the expected dividend growth rate and required rate of return. The current dividend is already recognised, nonetheless, industry surroundings make impact on the remaining variables. This explains why we should incorporate industry analysis with security analysis. Investors can calculate intrinsic value in accordance with types of industries such as cyclical, defensive and growth. If the intrinsic value is higher than market price, it represents undervalued securities. Meanwhile, overvalues securities occur when market price is higher than the intrinsic value. Investors can use technical analysis to predict future price changes. Additionally, they can utilize fundamental analysis to select undervalued securities by an analysis of companies' aspects such as earnings, growth, dividend, expected interest rates, and risk evaluation. Besides, we can use dividend discount model, growth rate of dividend, free cash flow to equity model, gross domestic product estimation, sales per share for market series estimation, corporate net profits analysis, and relative valuation techniques to estimate stock value.
References
Bodie, Z., Kane, A., & Marcus, A. J. (2011) Investments and Portfolio Management (9th edn.). USA: McGraw-Hill/Irwin.
Grinold, R. C., & Kahn, R. N. (1999) Active Portfolio Management (2nd edn.). USA: McGraw-Hill.
Hearth, D., & Zaima, J. K. (1998) Contemporary Investments (2th edn.). USA: The Dryden Press.
Reilly, F. K., & Brown, K. C. (2002) Investment Analysis and Portfolio Management (7th edn.). USA: South-Western College Pub.
