What You Should Know About Active Investing

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Active Investing 

This is going to be a fun topic all about the joys of active investment management and it’s various complexities made as straight forward as possible.

It’s also a special post as Troy isn’t going to feature as I couldn’t think of any Dreamie or cat analogies, so maybe next time. 

First thing – Here is a quick glossary of terms that I’ll use throughout. 

Glossary

What is an Index/Market?

An index is a form of measurement that tracks the performance of a group of assets (click here for more on assets) such as the top 100 qualifying companies by market value in the UK, hence the FTSE 100.  Indices are worldwide and range from the UK with the FTSE 100 to the U.S with the S&P 500. 

The market value of company is the number of shares the company has in issue multiplied by the its current share price. 

What Is A Benchmark?

A benchmark uses an index or group of assets as a point of comparison which the performance of your investments can be compared against.  If the FTSE 100 generates a 20% return, and your portfolio has generated a 15% return then you have underperformed the FTSE 100 by 5%.  

What Is A Fund/Investment Portfolio?

A fund/investment portfolio usually consists of a range of assets (often stocks/shares) all collectively bundled into one place.  You, and many other investors, will put your money into a fund/investment portfolio and the manager of that fund/investment portfolio will decide what investments are made with your money.  Instead of you buying one company you’ll get a piece of many companies. 

Right, on to the good stuff…

 

What is Active Investment Management?

In short, active investment management is where a portfolio manager actively buys and sells the investments within his/her portfolio.  The manager conducts research to decide whether to buy, sell or hold this investment.

They do this in the hope that the changes they make will generate a better return when compared to a benchmark or an index/market.

The most common actively managed investments are Investment Trusts and OEIC’s (Open Ended Investment Company). Both are a great way to invest money into many different companies.  Each have different structures and rules around them and I tend to use investment trusts over OEIC’s.  Due to the complexity of these I will get into these in more detail another time.

Example:

If I were a portfolio manager, and I managed a portfolio of equities.  I’m considering adding Apple to my portfolio.  

Before I do I first want to make sure that Apple, as a company, fits my criteria and what level of risk it might pose to my overall portfolio.  I’ll check Apple’s profit, cash flow, assets/liabilities, dividend payouts, all against its current share price.  

If I add it to my portfolio then I will monitor Apple to ensure it continues to meet my criteria.  If at any point I feel it’s not longer beneficial to my portfolio I may sell Apple and replace it with another company.

Spoilt For Choice!

There are thousands of actively managed investments around the world and they all do something different.  Some may invest in US stocks, some may only invest in Tech stocks, some may invest in China and so on.  There’s a portfolio for whatever you want to invest in so the diversity is huge.   With all of that diversity comes a lot of choice, too much choice in fact. How in the world do you pick the right one?  Well, that’s a difficult question, and some like to leave it to a professional to make that choice. 

Fund Of Funds/Multi Manager Funds

A fund of funds/multi manager funds are a portfolio of actively managed investments.  Remember, an active portfolio has various underlying assets and every portfolio will invest differently depending on how the manager of that portfolio wants to invest.  To diversify further it would be good to invest in various funds and this is where a fund of funds comes in.  The fund of fund manager is responsible for building a portfolio of actively managed investments and then checking the performance of the portfolios.  He/she will then add or replace them depending on their performance.

Supermarket Sweep

Imagine it like this:

A department store, like Selfridges, has various departments, each with a department manager.  A department represents a portfolio, the department manager represents the portfolio manager. 

Managing all of the department managers is the department store manager, who represents the fund of fund manager.

department store manager will hire/fire a department manager based on the departments performance.  A fund of fund manager will add or remove funds from their portfolio depending on the each of the portfolio managers performance.

Can I do it myself?

Of course you can!

The first option is creating your own portfolio which will include stock picking and a lot of research.  I will go into this in a future post of how to pick your own stocks as it’s too vast to cover here.  I wouldn’t recommend this option if you’re just starting out, it’s hard to get it right and even experienced traders often get it wrong.

The second option is like being your own fund of fund manager.  You can select from the various funds already built and add as many as you feel necessary.  

One website I like to use for option two is www.trustnet.com, it has options for both Investment Trusts and OEIC’s and you can check the manager performance, charges, and what they invest in.  It’s great!

Pros

  1. The portfolio is being reviewed regularly by the managers.
  2. The portfolio will be kept in line with your level of risk, meaning you aren’t going to take more risk than you’re comfortable with.
  3. The portfolio manager could outperform the market through their selection generating you a better return.
  4. The manager can be reactive to changes in the market making quick adjustments where needed.
  5. When markets are dropping the manager could react and amend the portfolio to protect it.

Cons

  1. Active portfolios can be expensive, you’re paying a premium for their expertise, time and research.
  2. The portfolio manager might not produce a better performance, they could underperform the markets.
  3. If there is a better performance compared to the benchmark, the charges you’ve paid could erode that additional performance.