Active investment managers try to beat a benchmark by making informed decisions about what to put into their portfolio. Their decisions can be categorised into two main groups. These two decision groups then also define how the investment manager’s performance is evaluated. The two decision groups are:
- Security selection, and
- Asset allocation
Security selection is the process of deciding between individual securities. For example, security selection within equities might involve deciding whether to buy BP or Royal Dutch Shell. The security selection decision is not concerned with whether to buy equities in the first place.
The asset allocation decision is the process of deciding between groups of securities at a less granular level than the individual security level. To build on the example above, asset allocation within equities might involve deciding whether to buy the ‘energy’ sector or the ‘consumer staples’ sector. There are multiple asset allocation dimensions; for example, the investment manager could make sectoral asset allocation decisions (as above), regional asset allocation decisions, and asset allocation decisions at the overall asset class level (e.g. equities vs bonds), amongst other decisions.
It is probably quite obvious that asset allocation decisions will generally explain most of an investment manager’s overall portfolio performance. After all, if the energy sector goes down by 30%, how much will it really matter whether you owned BP or Shell?
And that will hold true for your overall portfolio too. Being invested ‘in the right area’ will generally be more important than selecting the best performing stock within a given area. But both sets of active decisions are important and can complement one another when both are being utilised in a portfolio.
This article leads naturally onto another, where we discuss the difference between ‘beta’ and ‘alpha’.
We refer to lots of linked posts in this post. We hope that by following the links you can answer any questions you might have, but if anything is unclear in this post, or you have any questions relating to anything investment-related, please submit comments or questions in the section below and we’ll do our best to answer them.
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