Portfolio strategies can be classified as either active strategies or passive strategies. An active portfolio strategy is an investment strategy that attempts to generate as much value as possible to a portfolio by using various techniques that evaluate which securities will yield the highest return. Yield is the percentage return generated by an investment.
A passive strategy is more hands-off, while an active strategy has on-going trading of investments.
“A strategy that uses available information and forecasting techniques to seek better performance than a buy and hold portfolio.”
This investment strategy has a long term aim of moving capital on a consistent basis into profitable securities, meaning that securities are traded in great frequencies. The term Securities refers to financial instruments (contracts) that are given a value and then traded.
The idea is that an active portfolio strategy is more likely to perform better than a buy-and-hold portfolio, as investors using this tactic try to move capital away from poor performing stocks and transfer it to potentially higher performing ones.
For example, an active portfolio manager, whose benchmark is the Standard and Poor’s 500 index, will attempt to generate returns that outperform the index by overweighting certain industries or securities – essentially allocating more to specific sectors than the index does – in the belief that these certain sectors are outperforming others.
A portfolio manager could choose not to employ an active strategy based strictly on future interest-rate movements, by making an interest-rate bet to account for inferior performance relative to a benchmark.
Essentially, this portfolio strategy is much more dynamic than others, in that investment decisions change on a much more frequent basis. It attempts to make the most of market inefficiencies, but is associated with higher costs.
However, through active management the degree of liquidity for the securities can increase portfolio costs. In contrast, passive management uses infrequent trading trends that minimize portfolio costs.
Stock selection with an active portfolio strategy
There are two main types of active management approaches to choosing stocks:
Top-down – this approach involves analyzing the market and then determining which industries are expected to perform the best in the current economic cycle. Managers then pick stocks in these industries that are likely to do well.
Bottom-up – this approach does not take into account market conditions and trends. Managers choose stocks based on the strength of a company’s financial performance and what it has planned for the future. This approach assumes that companies performing well are going to continue doing well even if the markets experience volatility.
The risks of an active portfolio strategy
There is one major drawback with active management approaches. It is very uncommon for active portfolio managers to actually beat the market. Many investors prefer a simple indexing strategy, which allows a portfolio to grow from the long-term growth of the economy.
Video – Lecture on Portfolio Management
This interesting Harvard lecture focuses on Portfolio Management, highlighting some key principles in strategic portfolio management.