Value add investment strategy refers to actively managing a portfolio of assets to generate returns exceeding that of a benchmark index. It involves identifying mispriced assets, exploiting inefficiencies, and making strategic bets across asset classes, sectors, or securities. Investors pursue value add strategies to boost risk-adjusted returns through skilled asset selection, trading, and risk management. However, value add is not guaranteed and depends on the manager’s expertise. This strategy contrasts with passive indexing and requires more resources for research, trading, and monitoring. Value add strategies are common in institutional investing and practiced across asset classes like equities, fixed income, real estate, and alternatives.
Value add exploits market inefficiencies with active management
The goal of value add investing is to generate alpha, or excess return over a benchmark, by exploiting inefficiencies in asset pricing. This relies on the manager’s skill in identifying mispriced assets before the market corrects itself. The additional return relative to passive indexing compensates investors for the extra risk of being actively managed. Value add strategies include:
– Security selection – Fundamental research and valuation to pick undervalued stocks.
– Market timing – Adjusting beta exposure based on predictive signals.
– Sector rotation – Overweighting assets poised to outperform.
– Trading strategies – Providing liquidity to profit from bid-ask spreads.
– Risk management – Using derivatives overlays to hedge unwanted risks.
A value add manager combines quantitative models, fundamental analysis and subjective judgment to spot opportunities. The flexibility to invest across assets allows allocating to the most attractive parts of the market.
Skilled execution and discipline are key to creating value add
Delivering consistent value add is difficult and requires skill in executing the strategy. Key requirements include:
– Having an edge – A sound investment process based on robust research and analytics.
– Taking prudent risks – Bearing some smart factor risks but avoiding unnecessary risks.
– Adequate resources – Technology, trading infrastructure and research team to implement strategies.
– Discipline – Sticking to pre-defined risk limits, position sizes and investment process without emotional bias.
– Monitoring effectiveness – Evaluating if the strategy is working as expected and adding value.
A manager must demonstrate skill over multiple market cycles to validate their edge. Investors should evaluate the investment team, portfolio construction process, risk management and potential capacity constraints before investing.
Value add improves portfolio return and risk characteristics
Adding value add strategies can potentially improve the overall portfolio’s return to risk profile. By generating excess returns from active management, value add helps boost portfolio returns. The diversification benefit from exploiting a different set of risk factors also reduces total portfolio volatility. However, investors take on active manager risk as value add is not guaranteed.
At the overall portfolio level, allocating to value add strategies expands the efficient frontier outward. Investors can then optimize the mix of passive and value add strategies to achieve their required risk-return objective. But value add performance tends to be cyclical, so blending active and passive makes portfolios more robust across market environments. Value add strategies are suitable for investors with long horizons, tolerance for short term underperformance and adequate due diligence resources.
Value add investing aims to enhance portfolio returns through active management and exploiting market inefficiencies. Skilled managers can potentially generate alpha but require the expertise and discipline to maintain an edge. Adding value add complements passive indexing strategies, improving overall portfolio efficiency, but investors should evaluate manager skill and have reasonable return expectations over a cycle.