STOCK PORTFOLIO MANAGEMENT STRATEGIES

Stock portfolio management strategies are divided into two categories: passive and active manage­ment strategies (O’Shaughnessy, 2005, p. 1). Portfolio managers decide between these strategies according to the volume of the fund they govern and customer demands (Karan, 2004, p.

Passive Portfolio Management

Passive portfolio management is based on the Separation Theorem which accepts all forms of the Efficient Market Hypothesis (Mittra & Gassen, 1981, pp. 599-600). This Hypothesis accepts that the market is so efficient it is nearly impossible to create another portfolio superior to it because in an efficient market the share prices provide all necessary information. Therefore, it is perfectly clear there cannot be any single under-valued share and the the investors cannot obtain additional profit through insider informa­tion. Consequently, passive portfolio management argues that the investor cannot do anything bet­ter than to hold the market portfolio. Therefore, passive portfolio management essentially follows the principles of buy and hold. (French, 1989, p. 505). In this strategy, the profits of portfolios are monitored through comparisons with some particular market indexes (e.g., IMKB 100, S&P 500). In this strategy, surpassing the market is not considered. Passive portfolios have lower rate of turnover, transaction and administrative costs, and nonsystematic risk. However, this strategy does not permit an investor to take advantage of various markets and instruments which would provide additional profit.

Investors preferring passive portfolio manage­ment usually possess two types of passive manage­ment styles (Uludag, 2007, pp. 1-2):

• Buy and Hold Method.

• Indexing (Indeks Funds.)

Buy and Hold

In this method, the investors choose and buy assets (i.e., stocks and bonds) meeting their requirements which they hold for an extended period.

Indexing

In this practical passive investment strategy, a market Index is selected (e.g., S&P 500) and the securities which will be included in the portfolio are decided according to that particular Index. The investment goes to the equity shares according to their percentage within the Index (²ÌÊÂ, 2008, 8). The goal is to obtain a profit which is equal or close to the one in the market Index. Because a certain Index is followed throughout the process in this strategy, it is called “Indexing” (Uludag, 2007, p. 2). Index funds are big portfolios created via buying a diversified share portfolio (French, 1989, p. 505).

The supporters of this strategy argue that when the market is efficient, the best estimated price of a security will be its own price, thus allowing the best diversification and eliminating nonsys- tematic risk. (Karan, 2004, p. 537). In the passive share portfolio management strategy, revaluation and rebalancing are performed only when the profit shares are intended to be reinvested, market portfolios, the investor’s utility function or risk preferences change, the selling is inevitable as there is a primary need for cash (Mittra & Gassen, 1981, pp.

In passive portfolio management strategies, reevaluation and rebalancing are performed only when the following conditions are in the question (Mittra & Gassen, 1981, pp. 599-600; French, 1989, p. 505; Reilly & Brown, 1999, p. 653):

• Dividends are intended to be reinvested.

• The market portfolios, the investor’s utility function and the risk preferences change.

• The selling of shares for a primary need for cash.

Active Portfolio Management

Active portfolio management strategies are based on the idea that the portfolio should be monitored closely to make value raising arrangements pos­sible at anytime. From collecting information to the application process, the active management process requires constant and consistent observa­tions as well as feedback concerning the perfor­mance of the investment (Grinold & Kahn, 2000, p. 8). The supporters of this strategy assume the market is not always efficient and there might always be under-valued equity shares. Thus, they believe that through systematic buying and sell­ing it is possible to realize profit which is higher than that of the market (Bodie, Kane & Marcus, 2003, p. 597). The basic idea behind effective ac­tive management strategies is that of estimating the future well.

The primary goal of active portfolio manage­ment is to earn profit above that of the market portfolio profit (Reilly & Brown, 1999, p. 660), meaning the investor assumes higher risk as well as additional transaction costs. Therefore, active port­folio managers should possess unique skills such as forecasting the future accurately on a consistent basis, correctly estimating under-valued shares, and precisely determining risk-profit positions.

• Construct the Stock Universe: Stock uni­verse refers to the group of all stocks being traded in the market. Investors first select the desired sector(s) which the portfolio manager will then administer by deter­mining the stocks that will be added to the portfolio through analysis.

• The Expected Return: The present values of stocks are identified before employing basic analysis techniques regarding the economy, sector(s), companies, and esti­mated future profits. The holding period profit is also calculated.

• Stock Beta: Presently many financial insti­tutions publish their stocks by calculating their stock beta. A stock analyst collects and subsequently calculates the beta of the stocks from available sources.

• Security Market Line Construction: Stocks are first divided into two catego­ries from lowest to highest risk. Then, the stocks are spotted on a grap according to their risk level. The dots are then merged forming a line called the Stock Market Line (SML). This method permits detec­tion of under- and over-valued stocks.

• The Decision Band: SML is actually used as a decision line. An active portfolio manager includes the under-valued stocks while excluding over-valued ones.

• Investor’s Risk Preference: The portfolio manager identifies the investor’s risk pref­erences before constructing the portfolio by classifying the investor as a risk taker or as risk averse according to the investor’s income, psychological structure, and risk preferences. Considering these facts allows the manager to decide which stocks will be added to the portfolio. For better diversifi­cation, it is necessary to examine the stocks from different sectors.

• Portfolio Construction: In this final stage, the manager constructs the portfolio con­sidering the investor’s resources and pref­erences by randomly selecting stocks or via special computer software.

Active portfolio managers are inclined to con­struct riskier portfolios to obtain higher profits than those of the market portfolio by increasing portfolio performance through timely detection of under-valued stocks. Recently, one of the most remarkable changes in portfolio management was the development of Value and Growth-focused investments (Uludag, 2007, p. 2). The overview structure of portfolio management is shown in Figure 2 (Elton & Gruber, 1995, p. 688):

Investors should decide between Indexing inherently possessing lower costs and risks with active portfolio management inherently possessing higher costs and returns (Reilly & Brown, 1999, p. 653). The most important factor in selecting the most appropriate method is the portfolio managers’ decision making skills. Passive man­agement strategies are preferred less often when management skills are high (Sorensen, Miller, & Samak, 1998).