Now that I have my investment objective and my investment policies, I must determine how am I going to invest to achieve my goal. The investment strategy is the doctrine that will allow me to achieve my investment goals, it is the tactic that I am going to use to analyze and select assets. A well-done investment strategy represents the cornerstone of the decision-making process. The investment strategy can be divided in 3 groups: passive, active and mixed.
Passive management: it is the strategy that does not require a change in my portfolio when market expectations change. It is important to notice that I do need an expectation; nevertheless, I am not going to react to changes in the expectations. The passive strategy will seek to replicate (or buy) an index or will be a buy-and-hold strategy.
Example 1 – replicate (buy) an index: I believe that the Mexican economy is going to do well so I buy the NAFTRAC, the ETF that replicates the Indice de Precios y Cotizaciones of the Mexican stock exchange. If the market expects an increase in volatility or if the market expects a sector to underperform/underperform, I am not going to make any changes in my portfolio.
Example 2 – replicate (buy) an index: I anticipate that the Mexican REITs are going to outperform the market so I buy an ETF that gives me exposure to that market. Again, if I expect that a REIT is going to underperform/outperform, I am not going to make any changes in my portfolio.
Example 3 – buy and hold: I expect an inflationary period during the next years so I buy an UDIBONO (TIPS) that will expire in 20 years. Therefore, I will be protected from inflation the next 20 years.
A passive strategy is ideal for whom has not enough time to be make exhaustive valuations… or for the skeptical of the active management.
Active management: is the strategy that reacts to changes in market expectations. First I need a market expectation, then I need to re balance my portfolio in accordance to changes in the market expectation. The objective of an active strategy is to generate returns above the benchmark, adjusted for risk (yes, we need a benchmark); in other words, we expect a better return than in a passive strategy.
Example 1 – I believe that the Mexican economy is going to do well (my base case scenario), but I think the telecommunication sector is expensive and the materials sector is cheap. Instead of just buying the NAFTRAC, which is the passive strategy, I buy the stocks to replicate the ETF but I buy less stocks of the telecom sector and more of the materials sector. My benchmark will be the IPC and my portfolio will look like this:
After a couple of months, the market conditions change and now I think the industrial sector is cheap and the financial sector is expensive. My new portfolio would change into this:
Example 2 – I believe that the Mexican economy is going to do well (my base case scenario), but I think GMEXICO, MEXICHEM and PEÑOLES are under valuated. Instead of just buying only the NAFTRAC, which is the passive strategy, I buy the NAFTRAC in a combination with the selected stocks. My benchmark will be the IPC and my portfolio will look like this:
This strategy requires knowledge and time to valuate sectors, companies, regions, countries, etc. The active strategy requires a robust data base, asset management knowledge (economics, statistics, mathematics, etc.), decent software… or at least a good friend who knows all the above and is willing to help.
Mix strategy: as the name suggests, it’s the blend of the passive and active strategy. First I need a market expectation, then I need to re balance my portfolio in accordance to changes in the market expectation… but just a little bit. The objective is to generate returns above the benchmark, adjusted by risk, but without diverging a lot from the benchmark.
Example 1 – I believe that the Mexican economy is going to do well (my base case scenario), but I want to optimize my portfolio by deviating the weights of the sectors from the IPC by less than +/-2%. My benchmark will be the IPC and my portfolio will look like this:
This strategy seeks to generate returns above the benchmark, or reduce the risk, without an extensive due diligence.
Now I can update my investment policies: I like the REITs thing going on and I want to live from their dividends. The core of the investment policies will be the following:
- Broad investment objective. Invest enough during the following 5 years, without sacrificing my current expenses, so that I can live from the cash flows of the REITs starting 6 years from now.
- The objectives of my investment policy. The investment policies will have clear calculation methods of returns and risks. It will have my investment strategy and a process to evaluate that strategy. Finally, a clear process to sell and buy assets.
- Concrete investment objectives. 1)Invest $12,500 each month for the next 60 months, 2) invest in a portfolio with a target return of 10.22% annually, 3) reach an amount of $973,000 at the end of the 60th month, 4) invest that amount in REITs and achieve a cash flow of $5,274 each month.
- Risk limits and an assessment of risks. 1)the portfolio shall not have a daily VaR (historic) at 95% bigger than $9,700, 2) the ratio of annual return/ annual volatility shall not be more than 0.75. 3) the allocation in a single asset shall not exceed 40% of the total value of the portfolio, 4) monthly contributions shall not compromise my normal expenditures.
- A procedure to follow up the investment strategy. My benchmark will be 100% the IRT (Mexican IPC Total Return Index). This benchmark seeks to replicate the IPC assuming the reinvestment of the dividends. Because I can replicate the IPC by buying the NAFTRAC and I can buy more NAFTRAC with the dividends, the benchmark is representative and replicable.
- Investment strategy. I will replicate the sectors from the IPC buying just 1 company from the sector. I will elect the company which appears to be the cheapest compared to its competitors and to its historical values using the P/E, P/BV and P/Sales. I will re-balance my portfolio after the quarter reports.
- A procedure to evaluate my investment objectives. 1)Monthly calculation of the returns (daily, monthly and yearly returns), 2) monthly calculation of the benchmark (daily, monthly and yearly returns), 3) evaluation of the over-under performance of the last month, 4) if I’m underperforming, evaluate the investment strategy, 5) monthly calculation of risk measures (daily, monthly and yearly observations), 6) search for any deviation from the target risk limits and re-balance the portfolio if those deviations exist.