The Portfolio Management Process and the Investment Policy

Chapter 1
Managing Investment Portfolios
integrated set of steps undertaken in a consistent
manner to create and maintain an appropriate
portfolio to meet clients’ stated goals
◦ portfolio – group of assets
◦ planning
◦ execution
◦ feedback
investment policy statement (IPS) – written document
that clearly sets out a client’s return objectives and risk
tolerance over that client’s relevant time horizon, along
with applicable constraints such as liquidity needs, tax
considerations, regulatory requirements, and unique
service of professionally investing money
investment management firms
◦ revenues / size of firm
◦ investors
◦ employees
growth in industry due to importance of
defined benefit plans in second half of 20th
◦ shift in 1980s and 1990s to retirement plans
focusing on participant responsibility resulted in
growth of individual-oriented investment advisors
focus on aggregate of all investor’s holdings
“because economic fundamentals influence the average
returns of many assets, the risk associated with one asset’s
return is generally related to the risk associated with other
assets’ returns – if we evaluate the prospects of each asset in
isolation and ignore the interrelationships, we will likely
misunderstand the risk and return prospects of the investor’s
total investment position – our most basic concern”
Harry Markowitz (1952) father of modern portfolio theory
◦ analysis of rational portfolio choices based on the efficient use of risk
“demand” for the portfolio perspective
◦ emergence of importance of institutional investing
◦ growth in technology
◦ professionalization of investment management field
continuous and systematic process complete
with feedback loops for monitoring and
an integrated set of steps undertaken in a
consistent manner to create and maintain
appropriate combinations of investment
◦ planning
◦ execution
◦ feedback
◦ investor-related input factors
 specification and quantification of investor objectives,
constraints, and preferences
 objectives are desired investment outcomes that mainly
pertain to return and risk
 constraints are limitations on investor’s ability to take full
or partial advantage of particular investments
 portfolio policies and strategies
◦ economic and market input
 relevant economic, social, political, and sector
 capital market expectations
governing document for all investment decision
elements of a typical IPS:
◦ brief client description
◦ purpose of establishing policies and guidelines
◦ duties and investment responsibilities or parties
◦ statement of investment goals, objectives, and
◦ schedule for review of financial performance
◦ performance measures and benchmarks to be used
◦ investment strategies and styles
◦ guidelines for rebalancing based on feedback
IPS is basis for strategic asset allocation
investment strategy – manager’s approach to
investment analysis and security selection
◦ organizes and clarifies basis for investment
◦ guides those decisions toward achieving investment
types of investment strategies
◦ passive
◦ active
◦ semiactive
Investment style
strategic asset allocation
◦ natural grouping of investment disciplines that has some
predictive power in explaining the future dispersion in
returns across portfolios
◦ combines IPS and capital market expectations to determine
target asset class weights
 maximum and minimum permissible asset class weights set to
control risk
execution step – portfolio selection and composition
◦ interacts constantly with feedback step as changes are
◦ use portfolio optimization – quantitative tools for
combining assets efficiently to achieve a set of return and
risk objectives
transaction costs
◦ explicit – commissions paid to brokers, fees paid to
exchanges, taxes
◦ implicit – bid-ask spreads, market price impacts of
large trades, missed trade opportunities, and delay
feedback step
◦ monitoring and rebalancing
 use feedback to manage ongoing exposures to
available investment opportunities so that the client’s
current objectives and constraints continue to be
◦ performance evaluation
performance measurement – involves
calculation of the portfolio’s rate of return
performance attribution – examines why the
portfolio performed as it did and involves
determining the sources of a portfolio’s
performance appraisal – evaluation of
whether the manager is doing a good job
based on how the portfolio did relative to a
sources of return
investment objectives and constraints are
identified and specified
investment strategies are developed
portfolio composition is decided in detail
portfolio decisions are initiated by portfolio
managers and implemented by traders
portfolio performance is measured and
investor and market conditions are monitored
necessary rebalancing is implemented
objectives are interdependent
◦ risk
◦ return
How do I measure risk?
◦ absolute vs. relative risk
◦ absolute
 variance
 standard deviation
◦ relative
 tracking error
What is the investor’s willingness to take on
What is investor’s ability to take on risk?
◦ In terms of spending needs, how much volatility would
inconvenience an investor who depends on investments?
Or how much volatility would inconvenience an investor
who cannot afford to incur substantial short-term
◦ In terms of long-run wealth targets or obligations, how
much volatility might prevent the investor from reaching
these goals?
◦ What are the investor’s liabilities or psudeo-liabilities?
◦ What is the investor’s financial strength – that is, the
ability to increase the savings/contribution level if the
portfolio cannot support the planned spending?
How much risk is the investor both willing
and able to bear?
◦ risk tolerance – capacity to accept risk
What are the specific risk objective(s)?
◦ absolute vs. relative risk objectives
◦ example
How should the investor allocate risk?
◦ risk budgeting
How is return measured?
◦ total return – capital appreciation plus investment
◦ absolute vs. relative
◦ nominal vs. real
◦ pre-tax vs. post-tax
How much return does the investor say she
How much return does the investor need to
achieve, on average?
◦ required return
◦ examples
 amount a pension fund needs to earn to fund liabilities
to current and future fund holders
 amount an individual investor needs to have to fund
retirement at a certain level
 amount that a retired investor needs to earn on
portfolio to cover his living expenses
What are the specific return objectives?
married couple needs £2 million in 18 years to
fund retirement (incorporates inflation)
current investable assets are £1.2 million
need to earn 2.88% per year after tax to achieve goal
How did we get 2.88%?
Suppose couple needs to liquidate £22,000 from
portfolio at end of each year. What return is needed?*
◦ If all investment returns are taxed at 30%, what pretax return would you need?
time horizon
◦ How does the length of the time horizon modify the
investor’s ability to take risk?
◦ How does the length of the time horizon modify the
investor’s asset allocation?
◦ How does the investor’s willingness and ability to bear
fluctuations in portfolio value modify the asset
◦ How does a multistage time horizon constrain the
investor’s asset allocation?
tax concerns
legal and regulatory factors
unique circumstances
taking the inputs from analysts, economists,
etc. and moving step by step through the
orderly process of converting this raw
material into a portfolio that:
◦ maximizes expected return relative to the investor’s
ability to bear risk
◦ meets investor’s constraints and preferences
◦ integrates portfolio policies with expectational
factors and market uncertainties

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