FORMULATION OF PORTFOLIO STRATEGY:

1.FORMULATION OF PORTFOLIO STRATEGY:

Two broad choices are required for the formulation of an appropriate Portfolio Strategy.

They are

1.Active Portfolio Strategy and

2.Passive Portfolio Strategy.

1. Active Portfolio Strategy (APS) :

An APS is followed by most investment professionals and aggressive investors who strive to earn superior return after adjustment for risk.

The vast majority of funds (or schemes) available in India follow an “active” investment approach, where fund managers of “active” funds spend a great deal of time on researching individual companies, gathering extensive data about financial performance, business strategies and management characteristics.

In other words, “active” fund managers try to identify and invest in shares of those companies that they think will produce better returns and beat the overall market (or Index).

There are four principles of active strategy. These are:

(a) Market Timing :

This involves departing from the normal i.e. strategy for long run asset mix to reflect assessment of the prospect of various assets in the near future.

Market timing is based on an explicit or implicit forecast of general market movement. A variety of tools are employed for market timing analysis namely business cycle analysis, moving average analysis, advance-decline analysis, Econometric models.

The forecast for the general market movement derived with the help of one or more of these tools is tempted by the subjective judgment of the investors.

In most cases investors may go largely by its market sense. Those who reveal the fluctuation in the market may be tempted to play the game of market timing but few will succeed in this game. And an investment manager has to forecast the market correctly, 75% of the time just to break even after taking into account the cost of errors and cost of transactions.

According to Fisher Black, the market is just as well as on an average when the investor is out of the market as it does when he is in. So he loses money relative to a single buy and sale strategy by being out of the market part of the time.

(b) Sector Rotation:

Sector or group rotation may apply to both share and bond components of the portfolio. It is used more compulsorily with respect to strategy. The components of the portfolio are used when it involves shifting.

The weighting for various industry sectors is based on their asset outlook. If one thinks that steel and pharmaceutical would do well as compared to other sectors in the forthcoming period he may overweigh the sector relative to their position in the market portfolio, with the result that his portfolio will be tilted more towards these sectors in comparison to the market portfolio.

With respect to bond portfolio sector rotation it implies a shift in the composition of the bond portfolio in terms of quality as reflected in credit rating, coupon rate, term of maturity etc. If one anticipates a rise in the interest rate one may shift for long term bonds to medium and short term. A long term bond is more sensitive to interest rate variation compared to a short term bond.

(c) Financial Instruments Selection:

Financial instruments selection involves a search for under price financial instruments If one has to resort to active share selection he may employ fundamental / technical analysis to identify shares

which seems to promise superior return and concentrate the share components of the portfolio on them.

Such shares will be over weighted relative to their position in the market portfolio. Likewise shares which are perceived to be unattractive will be under weighted relative to their position in the market portfolio.

As far as bonds are concerned, financial instruments selection calls for choosing bonds which offer the highest yields to maturity and at a given level of risk.

(d) Use of Specialised Investment Concept:

To achieve superior return, one has to employ a specialised concept / philosophy particularly with respect to investment in shares. The concept which

have been exploited successfully are growth shares, neglected or out of favour shares, asset shares, technology shares and cyclical shares.

The advantage of cultivating a specialized investment concept is that it helps to:

(i) Focus one’s effort on a certain kind of investment that reflects one’s ability and talent.

(ii) Avoid the distraction of pursuing other alternatives.

(iii) Master an approach or style through sustained practice and continual self criticism.

The greatest disadvantage of focusing exclusively on a specialized concept is that it may become obsolete. The changes in the market risk may cast a shadow over the validity of the basic premise underlying the investor philosophy.

2. Passive Portfolio Strategy :

Active strategy was based on the premise that the capital market is characterized by efficiency which can be exploited by resorting to market timing or sector rotation or financial instruments selection or use of special concepts or some combination of these sectors.

Passive strategy, on the other hand, rests on the tenet that the capital market is fairly efficient with respect to the available information. Hence they search for superior return. Basically, passive strategy involves adhering to two guidelines.

They are:

(a) Create a well diversified portfolio at a predetermined level of risk.

(b) Hold the portfolio relatively unchanged over time unless it becomes adequately diversified or inconsistent with the investor risk return preference.

A fund which is passively managed is called index funds. An Index fund is a mutual fund scheme that invests in the financial Instruments of the target Index in the same proportion or weightage.

Though it is designed to provide returns that closely track the benchmark Index, an Index Fund carries all the risks normally associated with the type of asset the fund holds.

So, when the overall share market rises/falls, you can expect the price of shares in the index fund to rise/fall, too. In short, an index fund does not mitigate market risks.

Indexing merely ensures that your returns will not stray far from the returns on the Index that the fund mimics. In other words, an index fund is a fund whose daily returns are the same as the daily returns obtained from an index.

Thus, it is passively managed in the sense that an index fund manager invests in a portfolio which is exactly the same as the portfolio which makes up an index.

For instance, the NSE-50 index (Nifty) is a market index which is made up of 50 companies. A Nifty index fund has all its money invested in the Nifty fifty companies, held in the same weights of the companies which are held in the index.

2.2 Selection of Financial Instruments :

There are certain criteria which must be kept in mind while selecting Financial Instruments. The selection criteria for both bonds and equity shares are given as following:

2.2.1 Selection of Bonds :

Bonds are fixed income avenues. The following factors have to be evaluated in selecting fixed income avenues:

(a) Yield to maturity: The yield to maturity for a fixed income avenue represents the rate of return earned by the investor, if he invests in the fixed income avenues and holds it till its maturity.

(b) Risk of Default: To assess such risk on a bond, one has to look at the credit rating of the bond. If no credit rating is available relevant financial ratios of the firm have to be examined such as debt equity, interest coverage, earning power etc and the general prospect of the industry to which the firm belongs has to be assessed.

(c) Tax Shield: In the past, several fixed income avenues offered tax shields but at present only a few of them do so.

(d) Liquidity: If the fixed income avenues can be converted wholly or substantially into cash at a fairly short notice it possesses a liquidity of a high order.

2.2.2 Selection of Share (Equity Share):

Three approaches are applied for selection of equity shares-, Fundamental analysis,

Technical analysis, Random analysis.

(a) Fundamental analysis focuses on fundamental factors like earning level, growth prospects and risk exposure to establish the intrinsic value of a share. The recommendation to buy, hold or sell is based on comparison of intrinsic value and prevailing market price.

(b) Technical analysis looks at price behaviours and volume data to determine whether the share will move up or down or remain trend less.

(c) Random selection analysis is based on the premise that the market is efficient and financial instruments are properly priced.

Levels of Market Efficiency And Approach To Financial Instruments Selection