The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

SELECTING A PORTFOLIO STRATEGY

The next task in the investment management process is selecting a portfolio strategy that is consistent with the investment objectives and investment policy guidelines. The selection can be made from a wide range of portfolio strategies. In general, portfolio strategies can be classified as either active or passive.

An active portfolio strategy uses available information and forecasting techniques to seek a better performance than a portfolio that is simply diversified broadly. Essential to all active strategies are expectations about the factors that have been found to influence the performance of an asset class. A passive portfolio strategy involves minimal expectational input, and instead relies on diversification to match the performance of some market index. In effect, a passive strategy assumes that market prices impound all available information. Between these extremes of active and passive strategies, several strategies have sprung up that have elements of both.

Given the choice among active and passive strategies, which should be selected? The answer depends on (1) the client’s or money manager’s view of how “price-efficient” the market is; (2) the client’s risk tolerance; and (3) the nature of the client’s liabilities. By “marketplace price efficiency,” we mean how difficult it would be to earn a greater return than passive management after adjusting for the risk associated with a strategy and the transaction costs associated with ...