Portfolio management is the science of structuring a portfolio of investments to protect the capital of clients (investors) and generate steady returns in both rising and falling markets.
The performance of a portfolio management strategy is measured by its Sharpe ratio which summarises in one number the investment return generated compared to the risk undertaken.
Successful portfolio managers generate sharpe ratios between 1.0 and 3.0 in all market environments including economic recessions and bear markets.
The aim of portfolio managers is to generate consistent adjusted returns with high sharpe ratios, compounded over many years to generate growth and wealth creation.
There are two portfolio management approaches: discretionary trading and systematic trading.
Discretionary trading relies on the subjective judgement of the portfolio manager. It is in the portfolio manager’s discretion to decide which market to trade, when to trade, and how much to risk.
Systematic trading relies solely on signals produced by software development and data analysis. The task of the portfolio manager is to develop quantitative strategies that generate stable returns in all market environments, with low downside volatility and high sharpe ratios.
Active vs Passive Management
Passive portfolio management is investing in one or more mutual funds or exchange traded index funds (ETF). This is also called index investing. Active portfolio management on the other hand, involves the selection of different financial securities to structure and manage an investment portfolio which beats the performance of an index (the benchmark) in terms of the annual returns generated versus the risk (volatility) undertaken.
Evaluating Portfolio Management Strategies
To examine a portfolio management strategy, you need to analyse the following metrics for a historical period including bear markets, bull markets and different economic environments:
- Average Annual returns: Average annual return (AAR) is the percentage historical return of an investment portfolio.
- Volatility: Volatility describes the degree to which an investment portfolio’s value moves up and down. This is the portfolio’s risk. If an investment portfolio has an average annual return of 10% with a volatility of 15%, investors should expect annual returns to fall within a range of 5% (10% minus 15%) to 25% (10% plus 15%).
- Sharpe Ratio: Sharpe ratio helps investor understand the return of an investment portfolio compared to its risk. Successful portfolio management strategies generate the highest return possible with the lowest volatility. Successful portfolio managers generate sharpe ratios between 1.0 and 3.0.
- Maximum Drawdown: An portfolio management strategy suffers a drawdown when it loses money. Maximum drawdown measures the largest single drop from peak to bottom in the portfolio’s value. Investors in a fund with a max drawdown of 50% saw their portfolios lose half of their value. Investors should select portfolio managers which have historically generate good returns with the lowest possible maximum drawdown. Portfolios with Maximum Drawdown between 5% and 20% are considered professionally managed portfolios.
- Performance Consistency: A portfolio manager’s performance should be examined for long historical periods of at least 10 years to confirm how an portfolio performed during different market environments (Growth, Recession, bull and bear markets).
Market crashes:Special attention must be given on how an investment portfolio performed during market crisis like 2000 dot-com bubble, 2008-2009 crash etc.
Longer periods of historical performance often guarantee similar future portfolio performance irrespective of the market environment.
Comparing Portfolio Management strategies
Before selecting a portfolio manager, you should compare his portfolio’s historical performance with benchmarks like the US stock market index (S&P 500). However, the correct metric to compare the performance of a portfolio manager with a benchmark is not the annual return generated but the sharpe ratio generated. You need to compare the return generated per unit of the volatility experienced. To make thigs clearer check below the comparison of 2 investment portfolios.
Assume you had to choose between two portfolio managers with the portfolio’s performances displayed above. Although portfolio manager two has a higher ending value than portfolio manager one, his portfolio experienced a much higher volatility and drawdown than portfolio manager one. Most probably, portfolio manager one structure a more diversified, balanced investment portfolio which was able to generate smoother returns with lower volatility. The investment portfolio of the manager one outperformed the portfolio of portfolio manager two generating a sharpe ratio three times higher.
In the example above, during the second half of 2013, the second portfolio value dropped from $160,000 to $105,000 losing 35% of its value. On the other hand, the first portfolio experienced during the same period a maximum drawdown of just 4.5%.
Active Portfolio Management
A portfolio manager also known as a professional trader is a full-time trader working at an Investment Bank or Hedge fund.
The aim of portfolio managers managing a typical portfolio involves structuring a long / short diversified portfolio of 10 to 20 uncorrelated investment positions.
Professional active portfolio managers in hedge funds, investment banks and other investment firms follow a specific approach to manage their portfolios. The approach is summarised by the following steps below:
- Top Down analysis
- Trade Ideas
- Technical analysis
- Portfolio Risk Management
if you are interested in active portfolio management which aims to achieve higher returns with lower risk when compare to passive investment strategies, begin with the first step which is the top down approach.