Investment and Portfolio Analysis (FIN552)

Paired Assignment

“Passive and Active Management Techniques”

STUDENTS NAME MATRIC NUMBER

NURUL AMIRAH AMANINA BT ABDUL 2019405936

RAHMAN

NURUL SYAFIZAH BT MOHD ALI 2019229968

DATE OF SUBMISSION: 25th JUNE 2021

PREPARED FOR: MADAM ZAINORA AB WAHID
 Acknowledgement

First and foremost, we would want to express our gratitude to Allah SWT for
providing us with the chance to improve ourselves in every way. As of our assignment
552, we are able to accomplish the pair task.

Second, a big thanks to Madam Zainora Ab. Wahid, our Investment and
Portfolio Analysis lecturer, because without her assistance, our assignment would not
be able to be completed and done properly. Her valuable input aided us in developing
a succinct but comprehensive trading strategy and plan. Furthermore, we would like to
convey our heartfelt gratitude for her support with each and every inquiry we have
asked, without which we would have been blind as a man seeking light in a dark cave.

Last but not least, we are grateful to our family and friends that have provided
us with the encouragement and motivation we need to succeed. They have always
been a pillar of support and counsel. They have been nothing but helpful and persistent
in their pursuit of success. We would have been perplexed and lost if it had not been
for them. May this expression of gratitude demonstrate the depth of our thanks to
everyone who has helped make this possible.
 Equity portfolio management is a planning and implementation of various
methods and strategies in making portfolios to the investors. Equity portfolio
management strategies can be divided into two which are passive portfolio and active
portfolio management. Passive portfolio management is known as a long-term-buy-
and-hold strategy meanwhile active portfolio management is an attempt to outperform
by generating high returns but with riskier and higher management fees. There are
three basic approaches in building passive portfolio management which are full
replication, sampling, and quadratic optimization. Same goes to active portfolio
management whereby the three techniques that can be used in constructing a portfolio
include market timing, management style, and factor models. The important question
is between passive and active portfolio management, which is the most suitable and
useful tactic in making the financial market efficient? Now, we will discuss more about
both of the strategies.

Passive portfolio management can be defined as a management that

generates a return in which it mimics the particular market index. Basically, they focus
on maximizing diversity with not much presumption input that is implied. For example,
the passive management investments which are exchange-traded funds and index
mutual funds whereby the managers do not do much in planning or working on
strategies. In fact, they only copy the performance of the benchmark indices in order
for them to generate returns that are pretty similar with the benchmark indices. In other
words, the investor’s money is neither underperform or outperform the index. We can
see that passive portfolio management is not risky as it has a low transaction and
management cost, and also helps the investors to preserve the diversified portfolio.
However, the securities need to be bought and sold due to cash flows and outflows,
and the merger and bankruptcies of the firm, which means there are certainly
unavoidable differences between portfolio and benchmark returns over time. The
managers definitely need to do readjustment back, as a result there will be a delay in
benchmark index because of the long-run return performance of index funds.

In constructing passive index portfolios, there are three main techniques which
are full replication, sampling, and programming. Firstly, full replication. A strategy
where all of the securities indexes are bought according to the proportion of weight in
the index. However, this approach may be poor even though it helps the managers in
keeping track closely because it will increase the transaction charge while minimizing
the performance since they need to buy a lot of bonds. Besides, the return on
investment of dividends results in high commissions when most companies pay little
dividends at separate times in a year. Meanwhile, sampling is resolving the dispute of
various stock issues in which the managers will only buy a sample of shares that are
included in the benchmark index. Plus, there might be less issue in the return on
investment of dividend since the manager needed to acquire little bonds for balancing
the portfolio back. Unfortunately, this sampling technique will not be able to keep track
of the portfolio returns of the benchmark index as much as full replication strategy. Last
but not least, programming or mostly called quadratic optimization. This technique
relies on past information regarding price changes and correlation between bonds,
where the manager will store them in a computer program which will determine the
structure of the portfolio and minimize the tracking error with the benchmark. Because
this strategy depends on past data and if those changes over time, the portfolio will
face huge tracking errors which is not good.

Another approach that investors can use to boost profits on their investment
accounts is active portfolio management. On a risk-adjusted basis, net of transaction
costs, active management techniques strive to outperform the market in comparison
to a specific benchmark, such as the Standard & Poor's 500 Index and invest in small
capitalization stocks with low P/E ratio. As the name implies, active portfolio
management necessitates more frequent trading than passive portfolio management.
As a result, active portfolio managers should be compared to the broad market index
if they invest mostly in small-cap stocks with low P/E ratios since their clients requested
it. Market timing or tactical asset allocation, managerial style, and factor models are
the three main techniques.

Market timing refers to the process of shifting the fund's asset allocation among
assets over time in order to capitalise on gains in bull markets while avoiding losses in
bear markets. There are three different management styles to choose from. It is a value
manager and a growth manager, with top-down or bottom-up strategies. The factor
models are the last but not least. It is to use Arbitrage Pricing Theory to determine the
return on securities (APT). Interest rate anticipation, value analysis, credit analysis,
yield spread analysis, and bond swap are all examples of active management tactics.
It is a risky technique that depends on uncertain estimates for interest rate anticipation.
Following that, a portfolio manager attempts to choose bonds for value analysis based
on their intrinsic worth. Credit analysis, on the other hand, is a thorough examination
of the bond issuer in order to determine expected changes in its default risk.
Furthermore, yield spread analysis implies that the yields of bonds in different sectors
have a regular relationship. Last but not least, there is the bond swap. It involves selling
a current position and at the same time purchasing a new issue by identical
characteristics with a higher potential return.

A large volume of investors and fund managers are actively involved in the
market. The idea or belief of strong historical returns would lead to high future returns
is one of the reasons why managers are active. Active portfolio managers keep a close
eye on the market and can react swiftly to market movements. The fund managers
have complete control over the stocks they invest in. The goal of choosing a portfolio
is to outperform the benchmark while minimising tracking error variations (TEV). The
TEV of a portfolio is the difference between the portfolio and benchmark returns.
Baptista and Alexander (2009). Technical and fundamental analysis are two
methodologies that managers employ in order to obtain above-market returns. Based
on previous price movement, technical analysts believe they can forecast future prices.
The managers that use this method believe that the only way to make extraordinary
gains is to research previous prices.

On the other hand, many other portfolio managers focus on fundamental

analysis. Fundamental analysis is a sort of research that examines a company's
historical and current financial information, such as its financial report, cash flow, and
dividend policy. Arbarbanell and Bushee (1997) investigated if fundamental analysis
could provide aberrant results. They were able to demonstrate that fundamental
analysis can provide insight into future returns. According to Alton and Gruber (1997),
the decision to use active portfolio management is largely based on the portfolio
manager's estimate of market efficiency. Elton and Gruber (1997) claim that actively
managed portfolios have higher expected returns than passively managed portfolios,
but they also have higher management fees. Because the fund provides active
analysis and investment flexibility, the charges are substantial. They also mentioned
that the approach for buying active managed funds is determined by the return offered,
alpha value, dividend and gain tax rate, and the investor's time horizon. Actively
managed funds attempt to produce shareholder value in two ways: first, by selecting a
portfolio with an above-average return on investment, and second, by using market
timing, in which managers attempt to predict the market's future direction.

To conclude, there are numerous differences between passive and active

portfolio management that make active portfolio management more advantageous
than passive. The active management portfolio has positive thoughts that says the
market price inefficiencies generate investing opportunities, whereas the passive
management portfolio contends that "beating the market" is difficult or impossible.In
conclusion, one strength of active portfolio management is that it allows investors to
outperform the market. The fact that some actively managed mutual funds outperform
their passively managed peers with the same benchmark indicates that there are
market inefficiencies that skilled portfolio managers can exploit. Instead of picking one
strategy over the other, an investor's risk profile and time horizon may require a
combination of both.
References

Jaafar Mohamad, & Rohani Abdul Ghani. (n.d.). Portfolio Management and
Application. Institut Perkembangan Pendidikan 2004.

Lowell Weiss, W. J. (2020). Active vs. Passive Portfolio Management, 2.

Retrieved from
https://www.raymondjames.com/weisswealthmanagement/pdf/active_v
s_passive.pdf

Mierlo, X. v. (n.d.). Bachelor Thesis. Active versus Passive Portfolio

Management. Retrieved from http://arno.uvt.nl/show.cgi?fid=129537