Active portfolio strategy – definition and meaning
An active portfolio strategy is an investment strategy that tries to generate maximum value to a portfolio.
Investors, as well as fund managers use various techniques that evaluate which financial securities will yield the greatest returns – yield refers to what percentage of return an investment generates.
There are two main types of portfolio strategies: passive and active strategies.
A passive strategy has a more hands-off approach, while an active strategy involves the on-going trading of investments.
An active portfolio strategy tries to generate maximum value by using as much information that is available and forecasting techniques to outperform a buy and hold portfolio. It has a long-term aim of moving capital on a consistent basis into profitable securities.
Active portfolio strategy – the aim
Portfolio managers say that an active portfolio strategy probably performs better than a buy-and-hold portfolio. With an active portfolio, investors try to move capital away from poor performing stocks. Above all, the aim is to transfer the money into potentially higher performing securities.
For example, active portfolio managers, whose benchmark is the Standard and Poor’s 500 index, will attempt to generate returns that outperform the index.
They will do this by over-weighting certain industries or securities – essentially allocating more to specific sectors than the index does. They believe that these targeted sectors are outperforming others.
Portfolio managers could choose not to employ an active strategy based strictly on future interest-rate movements. They could make an interest-rate bet to account for inferior performance relative to a benchmark.
Essentially, this portfolio strategy is more dynamic than others, because investment decisions change much more frequently. It attempts to make the most of market inefficiencies. However, active portfolio strategies are more costly.
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.
A trend is a perceived tendency in the market, i.e., which way (up or down) it is going.
There are two main types of active management approaches to choosing stocks:
Top-down – this approach involves analyzing the market and then predicting which industries will perform the best. The focus is on 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 according to the strength of a company’s financial performance. Additionally, they analyze what senior management is planning for the future.
The bottom-up approach assumes that firms performing well will continue doing so even in volatile markets.
There is one major drawback with active management approaches. It is very uncommon for active portfolio managers to beat the market. Consequently, many investors prefer a simple indexing strategy.
Most investors prefer a 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.
Written by Joseph Nordqvist