Considerations on Passive Portfolio Management Finance Essay

In the last decades, portfolio management became a very important activity on the financial markets. In this way today we could speak about a truly financial industry in US and in Europe, too. Starting with Markowitz [1952] [1] , modern portfolio theory was developed in order to propose standards for returns, associated risks and for evaluating the quality of the portfolio management.

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On the financial markets, these activities could be build up in a passive or in an active manner. Passive portfolio approach is recommended especially in the case of efficient capital markets. As long as there are no agents that can acquire systematic abnormal earnings, it is not useful to try to “beat” the market. The best solution will be to form a portfolio, which will replicate market index. In this way, portfolio return will equal exactly the market return. On the other hand, active portfolio management supposes that not every agent is rational. There are noisy traders (naAƒA¯ve agents), too. In this case, the purpose of active management is to find and to invest in undervalued or overvalued assets and, applying this strategy of investments, the rational agents will reach abnormal earnings buying undervalued assets and selling overvalued assets.

Based on these assumptions, the main question in choosing a right style on portfolio management is if the financial market is efficient. If markets are efficient, it seems to be reasonable to replicate the market index. Thus, every agent will obtain a normal return, equal to the market one. If the investors would follow to gain higher than market return, that it could be possible, according to Fama [1998], only by luck [2] .

Practically, the intrinsic logic of passive management is explained by CAPM [3] . Investors will require a higher return only if they will accept a higher risk for their investments. No agents will be able to make judgements in a more suitable way than the other investors will, so no one could achieve abnormal systematic earnings. Certainly, it is possible to reach abnormal earnings, but these ones will have no systematic status. On the other hand, active portfolio could be entirely explained by arbitrage model, based exactly on arbitrage principle [4] .

If markets are not efficient, a reasonable hypothesis seems to be that every agent could obtain systematic abnormal earnings. However, this assumption is not true every time. For example, DragotA„Æ’ and MitricA„Æ’ [2004] [5] had proven, for Romanian capital markets, even some tests could validate the market is not efficient, the lack in liquidity offers no possibility to obtain abnormal earnings. More, DragotA„Æ’, DragotA„Æ’ and Stoian [2004] [6] had reveal it is possible that no agent to obtain abnormal earnings, but assets values to be different than the market prices. For these reasons, it could be accepted that, even for inefficient markets, passive portfolio management to be an appropriate solution. Thus, the portfolio manager could justify his own performance based on the market one, which it seems to be a reasonable benchmark. So, it is possible that a 25% portfolio return not to fulfil the investors’ request if the inefficient market give an opportunity for the exact level, but it is sure that a (-25%) portfolio return will not be acceptable for the investors’ request if the market “gain” was around (-5%).

2. How to achieve a passive portfolio structure?

Portfolio Management construction is based on “top-down” approach. According to this approach, first, funds are invested on different markets (e.g. capital market, monetary market, real estate market etc.), and then the money allocation for every market will be made relying on portfolio objectives. Second, the money allocated on every market is invested in the most appropriate components (e.g. for capital market the money allocation could be stocks and bonds). Finally, these funds are invested in particular assets, based on some partial objectives (see Figure no.1). Only at this moment the exact assets will be chosen, depending on their performances.

ASSET TYPE 1

ASSET TYPE 2

SUB-CATEG. 1.1

SUB-CATEG. 1.2

SUB-CATEG. 1.I

SUB-CATEG 2.1

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A¢â‚¬A¦

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SUB-CATEG. 1.J

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ASSET 1.1.1

ASSET 1.1.2

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ASSET 1.1.S

Figure no.1: “Top-down” approach in portfolio management

Source: DragotA„Æ’ & DragotA„Æ’ [2004] [7

To build a passive portfolio, the manager should try to replicate the whole market structure, so to establish what percents should be invested on capital markets, in banks deposits, in insurance policies, etc. After that, for example, capital markets investments could be organised in: (1) stocks markets, (2) bonds markets, and (3) other instruments markets. Next step is to structure stocks markets in: (1.1) listed shares, and (1.2) unlisted shares (see Figure no.2).

STOCKS MARKETS

BONDS MARKETS

OTHER INSTRUMENTS MARKETS

LISTED SHARES

UNLISTED SHARES

FINANCIAL MARKETS

CAPITAL MARKETS

Figure no.2: Passive portfolio management

In this case, market structure should be known for each component. Financial markets structure could be based on official statistics. For instance, for European Countries based on German financial system, deposits on banks, and, for US, capital markets, could be the most important part. For suitable organising the listed stocks’ market, the structure of the official Stock Exchange Index for that country could be used as portfolio composition.

For example, in Romania, Bucharest Stock Exchange is listing four official indices, named as BET, ROTX, BET-FI and BET-C. For a correct choosing of one or another index for portfolio manager is important to define the proposed liquidity target. Thus, for a portfolio with daily trading, a credible choice would be BET index or ROTX, which contains the most 10, respectively 6, liquid stocks on capital market. If the manager will propose an infrequently trading with portfolio assets, probably the proper index will be BET-C, which contain every stocks listed on BVB.

3. Some questionable solutions

Even if passive portfolio management follows a very logical approach some questions still remains open. These questions are related to the extension of the financial markets and to the markets efficiency.

Regarding to the financial markets as a whole, it must be pay attention to every opportunity that investors have. Sometimes, it could be interesting to invest, for example, in some physical assets like gold or jewels. If the portfolio has big dimensions, could be considered some direct investments (companies’ acquiring). One very interesting opportunity is given by real estate market. One real estate property could be considered as an investments, but, also, as a good (for personal use).

On the other side, some companies have restrictions related to the ability to invest in specific sectors. A very appropriate example could be the Romanian insurance companies, which has legal restrictions relating to the classes and to the percentage allowed for every class for investing their technical reserves: maximum 60% in municipal bonds, 40% in real estate assets, 50% in listed stocks etc.

Because each type of investments could be taking into account for portfolio construction, the market structure should be different from one portfolio to another. Subsequently, we can’t discuss about a general market index, because the market is understand in a different manner, as a concept, from an investor to another.

Related to market efficiency, the main problem in developing a portfolio structure is that markets are not entirely efficient. There are some markets with a higher level of efficiency (see the listed shares markets), and markets with a lower grade of efficiency (see the real estate markets). In these circumstances, the quantity of available information will affect investors’ decision. On some markets, investments could follow a clear rule (e.g., a portfolio of listed shares will follow the Stock Exchange Index structure) but this is not the case for other markets (see real estate market).

4. Conclusions

Concluding, depending on the market where the passive portfolio management is applied, we will probably have different manner to do this, and the results will be different, too. The most important variables could be the market liquidity, the degree of its efficiency and every investor’s awareness concerning the financial markets concept.

The degree of liquidity will affect the proportion established for every assets class and the quickness associated to every trading, the form of market efficiency (weak, semi-strong or strong) or, by the contrary, its inefficiency will give the degree of importance for passive or active portfolio management. To be more specific, the least aspect could determine the investor to choose a mixed approach, for example to maintain, generally, a passive type of management, but with active accents, because it is difficult to identify a market 100% efficient or inefficient.

If the investor had chosen a passive portfolio management, he must find the most appropriate index to replicate its structure. As we mentioned for Romanian case, only for capital market we have four official indices and some other (unmentioned) unofficial ones. At this moment, we can conclude by referring to the third important aspect to take into account, the degree of extension when we talk about “financial market” concept. Sometimes, based on easiness argument or because the investors are not very well informed, the whole concept of financial markets are reduced to the capital markets’ one. We sustain the opinion to consider every component of the financial markets first, and finally, based on a rational selection, to build the most appropriate structure for the financial assets portfolio.

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Considerations On Passive Portfolio Management Finance Essay. (2017, Jun 26). Retrieved November 27, 2022 , from
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