In a previous article, we introduced the
CFA Institute Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7
modules, covering all the essential topics in finance, economics, ethics and
regulations. This series of articles
will highlight the core knowledge of each chapter.
Chapter 17 provides an overview of the investment
management. The learning outcome of chapter 17 is as follows:
·
Describe
systematic risk and specific risk;
·
Describe
how diversification affects the risk of a portfolio;
·
Describe
how portfolios are constructed to address client investment objectives and
constraints;
·
Describe
strategic and tactical asset allocation;
·
Compare
passive and active investment management;
·
Explain
factors necessary for successful active management;
·
Describe
how active managers attempt to identify and capture market inefficiencies.
Beyond deciding on asset allocation, an
investor must decide whether to use a passive or active management approach to
asset selection.
Passive managers manage a portfolio designed to match
the performance of a specified benchmark.
Active managers attempt to add value to a portfolio by
selecting investments that are expected, on the basis of analysis, to
outperform a specified benchmark.
The choice between the two approaches
typically hinges on the relative costs of active management compared with passive
management and on the investor’s expectation of the success of active
management. The expectation is related to the investor’s beliefs about the
efficiency of the markets being invested in. An investor may decide to use a
passive approach in some markets and an active approach in other markets based
on an assessment of the efficiency of each market.
Passive management is typically cheaper
to implement than active management because successfully replicating or
tracking a benchmark requires fewer analytical resources than researching and
identifying investments with superior return potential. The passive approach
requires some skill, such as knowing which investments to include in the
benchmark and their respective values and weights in the benchmark. Although
the costs of passive management are lower than the costs of active management,
the return earned by the passive investor will typically be less than the index
return because of costs.
Active approaches require a more
detailed analysis of each relevant investment or asset class, which is costly
because investment firms need skilled employees and/or expensive technology.
Active management typically also has higher transaction costs because of more
frequent trading in the portfolio. If active management does achieve returns
that are higher than the benchmark, the excess return may compensate for the
higher employee, technology, and transaction costs and the net returns to the
investor may be higher.
Is investing passively in an index, such
as the Hang Seng Index, the S&P 500 Index, or the FTSE 100 Index, the best
way to increase your wealth? Or is hiring an active investment manager with a
record of past success a better option? Unfortunately, it is never possible to
know for sure. But the choice between passive and active management is a key
issue for investors and the decision must be weighed carefully. Investor may decide to use a passive approach
in some markets and an active approach in other markets based on an assessment
of the efficiency of each market, which will be covered in next article, stay
onlined!
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