INVESTMENTS:
Analysis and Management
Portfolio Management
Chapter 21
Portfolio Management
Portfolio Management
Involves decisions that must be made by every investor whether an active or passive investment approach is followed Relationships between various investment alternatives must be considered if an investor is to hold an optimal portfolio
Portfolio Management as a Process
Definite structure everyone can follow Integrates a set of activities in a logical and orderly manner Continuous and systematic Encompasses all portfolio investments With a structured process, anyone can execute decisions for an investor
Portfolio Management as a Process
Objectives, constraints, and preferences are identified
Leads to explicit investment policies
Strategies developed and implemented Market conditions, asset mix, and investor circumstances are monitored Portfolio adjustments are made as necessary
Individual vs. Institutional Investors
Institutional investors
Individual investors
Maintain relatively constant profile over time Legal and regulatory constraints Well-defined and effective policy is critical
Life stage matters Risk defined as losing money Characterized by personalities Goals important Tax management is important part of decisions
Institutional Investors
Primary reason for establishing a long-term investment policy for institutional investors:
Prevents arbitrary revisions of a soundly designed investment policy Helps portfolio manager to plan and execute on a long-term basis
Short-term pressures resisted
Formulate Investment Policy
Investment policy summarizes the objectives, constraints, and preferences for the investor Information needed
Objectives
Return requirements and risk tolerance Liquidity, time horizon, laws and regulations, taxes, unique preferences and circumstances
Constraints and Preferences
Life Cycle Approach
Risk/return position at various life cycle stages
A: Accumulation phase early career B: Consolidation phase mid-to-late career C: Spending phase spending and gifting
A
Return B C Risk
Formulate Investment Policy
Investment policy should contain a statement about inflation-adjusted returns
Clearly a problem for investors Common stocks are not always an inflation hedge
Formulate Investment Policy
Constraints and Preferences
Time horizon
Objectives may require specific planning horizon
Liquidity needs
Investors should know future cash needs
Ordinary income vs. capital gains Retirement programs offer tax sheltering
Tax considerations
Legal and Regulatory Requirements
Prudent Man Rule
Followed in fiduciary responsibility Interpretation can change with time and circumstances Standard applied to individual investments rather than the portfolio as a whole
Capital Market Expectations
Macro factors
Expectations about the capital markets Estimates that influence the selection of a particular asset for a particular portfolio Make them realistic Study historical returns carefully
Micro factors
Rate of return assumptions
Constructing the Portfolio
Use investment policy and capital market expectations to choose portfolio of assets
Define securities eligible for inclusion in a particular portfolio Use an optimization procedure to select securities and determine the proper portfolio weights
Markowitz provides a formal model
Asset Allocation
Involves deciding on weights for cash, bonds, and stocks
Most important decision
Differences in allocation cause differences in portfolio performance
Factors to consider
Return requirements, risk tolerance, time horizon, age of investor
Asset Allocation
Strategic asset allocation
Simulation procedures used to determine likely range of outcomes associated with each asset mix
Establishes long-run strategic asset mix
Tactical asset allocation
Changes in asset mix driven by changes in expected returns Market timing approach
Asset Allocation Examples
The following mix may be appropriate for a young, knowledgeable investor with a long time horizon and a high risk tolerance:
5% cash / 15% fixed income / 80% equities
The following mix may be appropriate for a retired investor with a short to medium time horizon, with low risk tolerance, and a need for current income:
20% cash / 60% fixed income / 20% equities
Monitoring Conditions and Circumstances
Investor circumstances can change for several reasons
Wealth changes Investment horizon changes Liquidity requirement changes Tax circumstance changes Legal/Regulatory considerations changes Unique needs and circumstances changes
Portfolio Adjustments
Portfolio not intended to stay fixed Key is to know when to rebalance Rebalancing cost involves
Brokerage commissions Possible impact of trade on market price Time involved in deciding to trade
Cost of not rebalancing involves holding unfavourable positions
Performance Measurement
Allows measurement of the success of portfolio management Key part of monitoring strategy and evaluating risks Important for:
Those who employ a manager Those who invest personal funds
Determine reasons for success or failure
