Question

23. As an active equity manager you must deliver competitive relative performance on a consistent basis in order to attract and keep clients. In order to deliver that performance, you must structure your portfolio and make decisions to take advantage of several factors. What are those factors and why are they important?

Answer 1

Solution:-

Whenever an investor (Institutional or retail) is comparing performances of funds, they essentially look at two factors combined together:

1. Risk of the portfolio
2. Historical returns generated

In other words, what investors is looking at is the risk-adjusted rates of returns earned by a fund manager. The investors is looking for fund managers who can earn high returns without taking too much risk. Higher the return generated per unit of risk taken, better the risk adjusted performance and vice-versa.

In order to structure a portfolio to deliver favourable performance as described above, the fund manager must ensure the following factors are taken advantage of:-

• Diversification is probably the most important factor that a fund must possess to attract investments. Diversification can be done at various levels and forms. In Equities, the fund should be diversified to include stocks from various industries. This diversifies the operating risk of the portfolio and makes sure that bearish conditions in an industry or bad performance of a stock doesn't impact the performance of the fund in a significant way. Similarly, diversification can also be done to include multiple asset classes such as Equities, commodities, real estate, bonds, etc which will help to diversify potential risks in a particular asset class such as risks in bonds due to changing interest rates.
• Hedging macro risk: While all funds are impacted by macro risk, it can be partially hedged by including asset classes that perform differently in bearish macro situations. For e.g. including gold in the portfolio will hedge macro risk to an extent as gold does well when macro situations are bad and Equities are performing poorly. This ensures that loss in one segment of the portfolio is compensated by gains in another segment.
• Balance between Growth stocks and dividend stocks: The fund must include a good balance of growth stocks and dividend stocks in the portfolio, i.e. stocks which are not mature but offer a significant upside of growth potential in earnings as well as stocks that are mature and offer steady streams of dividend incomes. This ensures a good balance of returns and risk in the portfolio
• Fund management fee structure: The manager must decide the fund management fees to be charged from investors. In a competitive scenario, it's important to ensure that the fund management fee structure is competitive, performance based and therefore encourage investors to invest.
• Geographic span of portfolio Investments: The Portfolio could be structured to include investments in different geographies and economies around the world. This also helps in taking advantage of varying opportunities in different economies around the world

Therefore, the above factors are very crucial for any fund manager to analyse and decide the structure of their funds, such that they can maximise the potential returns by taking least possible risk, thus offering most competitive risk adjusted returns.