Portfolio Management

Portfolio Management: An Overview

By Popkarn Arwatchanakarn

1. Introduction

By Popkarn Arwatchanakarn

• A portfolio approach is important to investors in achieving their financial objectives.

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• This chapter outlines ​The steps in the portfolio management process, compares the financial needs of different types of investors and mutual funds and other types of pooled investment products

2. A Portfolio Approach to Investing

• One of the biggest challenges faced by individuals and institutions is to decide how to invest for future needs.

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• One important question is: Should we invest in individual securities, evaluating each in isolation, or should we take a portfolio approach?

By Popkarn Arwatchanakarn

2. A Portfolio Approach to Investing

2.1 Historical Example of Portfolio Diversification

• Portfolio diversification helps investors avoid disastrous investment outcome.

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• This benefit is most convincingly illustrated by examining what may happen when individuals have not diversified.

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2. A Portfolio Approach to Investing

2.1 Historical Example of Portfolio Diversification

• By taking a diversified portfolio approach, investors can spread away some of the risk.

• Rational investors are concerned about the risk–return trade-off of their investments.

• The portfolio approach provides investors with a way to reduce the risk associated with their wealth without necessarily decreasing their expected rate of return.

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By Popkarn Arwatchanakarn

2. A Portfolio Approach to Investing

2.2 Portfolio: Reduce Risk

• portfolios also generally offer equivalent expected returns with lower overall volatility of returns—as represented by a measure such as standard deviation.

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By Popkarn Arwatchanakarn

When we randomly selected one security each quarter, we found an average annualized return of 15.1 percent and an average annualized standard deviation of 24.9 percent.​

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As reported in Exhibit 4, the equally weighted portfolio has an average return of 15.1 percent and a standard deviation of 17.9 percent.​

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This example illustrates one of the critical ideas about portfolios: Portfolios affect risk more than returns​.​

​By Popkarn Arwatchanakarn

2.2 Portfolio: Reduce Risk

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Alternatively, a portfolio with 25 percent in Yue Yuen Industrial (Holdings), 3 percent in Cathay Pacific, 52 percent in Hutchison Whampoa, 20 percent in Li & Fung, and 0 percent in COSCO Pacific produces a portfolio with an expected return of 15.1 percent and a standard deviation of 15.6 percent.

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Compared to a simple equally weighted portfolio, this provides an improved trade-off between risk and return because a lower level of risk was achieved for the same level of return

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2.3 Portfolio: Composition Matters for the Risk-Return Trade-off

2.4 Historical Portfolio: Not Necessarily Downside Protection

A major reason that portfolios can effectively reduce risk is that combining securities whose returns do not move together provides diversification.

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​However, an important issue is that the co-movement or correlation pattern of the securities’ returns in the portfolio can change in a manner unfavorable to the investor.

Some text here about the topic of discussion

Exhibit 9 shows the cumulative quarterly returns of each of the five indexes over this time period. All of the indexes declined in unison.

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The lesson is that although portfolio diversification generally does reduce risk, it does not necessarily provide the same level of risk reduction during times of severe market turmoil.

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In the face of a worldwide contagion, diversification was ineffective, as illustrated at the end of 2008.

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2.4 Historical Portfolio: Not Necessarily Downside Protection

Multiple Choice

Portfolios are most likely to provide:

• risk reduction

• risk elimination

• downside protection

2.5 Modern Portfolio Theory

• The concept of diversification has been around for a long time and has a great deal of intuitive appeal.

• The main conclusion of Modern portfolio theory is that investors should not only hold portfolios but should also focus on how individual securities in the portfolios are related to one another.

• Although MPT has limitations, the concepts and intuitions illustrated in the theory continue to be the foundation of knowledge for portfolio managers

​By Popkarn Arwatchanakarn

3. Steps in the Portfolio Management

1. The Planning Step

   • ​Understanding the client's needs

   • Preparation of an investment policy statement (IP)

2. The Execution Step

   • Asset a​llocation

   • Security analysis

   • Portfolio construction

3. The Feedback ​Step

   • Portfolio monitoring and rebalancing

   • Performance measurement and reporting​

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3. Steps in the Portfolio Management

3.2 The Execution Step

The portfolio execution step consists of first deciding on a target asset allocation, which determines the weighting of asset classes to be included in the portfolio. This step is followed by the analysis, selection, and purchase of individual investment securities.

​By Popkarn Arwatchanakarn

3. Steps in the Portfolio Management

3.2.1 Asset Allocation

Decisions that need to be made in the asset allocation of the portfolio include the distribution between equities, fixed-income securities, and cash; sub-asset classes, such as corporate and government bonds; and geographical weightings within asset classes. Alternative assets—such as real estate, commodities, hedge funds, and private equity—may also be included.

​By Popkarn Arwatchanakarn

3. Steps in the Portfolio Management

3.2.1 Asset Allocation

• Top down—A top-down analysis begins with consideration of macroeconomic conditions. Based on the current and forecasted economic environment, analysts evaluate markets and industries with the purpose of investing in those that are expected to perform well. Finally, specific companies within these industries are considered for investment.

• Bottom up—Rather than emphasizing economic cycles or industry analysis, a bottom-up analysis focuses on company-specific circumstances, such as management quality and business prospects. It is less concerned with broad economic trends than is the case for top-down analysis, but instead focuses on company specifics.

​By Popkarn Arwatchanakarn

3. Steps in the Portfolio Management

3.2.2 Security Analysis

• They will use their detailed knowledge of the companies and industries they cover to assess the expected level and risk of the cash flows that each security will produce.

• This knowledge allows the analysts to assign a valuation to the security and identify preferred investments.

​By Popkarn Arwatchanakarn

3. Steps in the Portfolio Management

3.2.2 Portfolio Construction

• The portfolio manager will then construct the portfolio, taking account of the target asset allocation, security analysis, and the client’s requirements as set out in the IPS.

• A key objective will be to achieve the benefits of diversification

• Although all decisions have an effect on portfolio performance, the asset allocation decision is commonly viewed as having the greatest impact.

• The portfolio construction phase also involves trading.

​By Popkarn Arwatchanakarn

4. Types of Investor

• The portfolio management process described in the previous section may apply to different types of investment clients.

• Such clients are broadly divided among individual (or retail) and institutional investors.

• Each of these segments has distinctive characteristics and needs

​By Popkarn Arwatchanakarn

4. Type of Investors

​4.1 Individual Investors

• Individual investors have a variety of motives for investing and constructing portfolios. Short-term goals can include providing for children’s education, saving for a major purchase (such as a vehicle or a house), or starting a business.

• ​Some individuals will be investing for growth and will therefore seek assets that have the potential for capital gains.

• ​The investment needs of individuals will depend in part on their broader financial circumstances, such as their employment prospects and whether or not they own their own residence.

• Globally, many wealth management firms and asset managers target high-net worth investors. These clients often require more customized investment solutions alongside tax and estate planning services.

​By Popkarn Arwatchanakarn

4. Type of Investors

​4.2 Institutional Investors

• Institutional investors primarily include defined benefit pension plans, endowments and foundations, banks, insurance companies, investment companies, and sovereign wealth funds.

• Each of these has unique goals, asset allocation preferences, and investment strategy needs.

​By Popkarn Arwatchanakarn

4.2.1 Defined Benefit Pension Plans

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Endowments are funds of non-profit institutions that help the institutions provide designated services. In contrast, foundations are grant-making entities.​

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Endowments and foundations collectively represent an estimated US$1.6 trillion in assets in the United States, which is the primary market for endowments and foundations

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4.2.2 Endowments and Foundation

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Pension plans are typically categorized as either defined contribution (DC) or defined benefit (DB).​

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Defined benefit pension plans (DB plans) are company-sponsored plans that offer employees a predefined benefit on retirement.​

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Generally, employers are responsible for the contributions made to a DB plan and bear the risk associated with adequately funding the benefits offered to employees.​

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There may be many different investment philosophies for pension plans, depending on funded status and other variables.​

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4.2.3 Banks

• Banks are financial intermediaries that accept deposits and lend money.

• Banks often have excess reserves that are invested in relatively conservative and very short-duration fixed-income investments, with a goal of earning an excess return above interest obligations due to depositors.

• Many large banks have asset management divisions that offer retail and institutional products to their clients.

​By Popkarn Arwatchanakarn

4.2.4 Insurance Companies

• Insurance companies receive premiums for the policies they write, and they need to invest these premiums in a manner that will allow them to pay claims.

• Many insurance companies have in-house portfolio management teams responsible for managing general account assets. Some insurance companies offer portfolio management services and products in addition to their insurance offerings.

• Several insurers manage investments for third-party clients, often through separately branded subsidiaries.

​By Popkarn Arwatchanakarn

4.2.5 Sovereign Wealth Funds

• Sovereign wealth funds (SWFs) are state-owned investment funds or entities that invest in financial or real assets.

• SWFs do not typically manage specific liability obligations, such as pensions, and have varying investment horizons and objectives based on funding the government’s goals

​By Popkarn Arwatchanakarn

5. The Asset Management Industry

• At the end of 2017, the industry managed more than US$79 trillion of assets owned by a broad range of institutional and individual investors (Exhibit 18).

• Although nearly 80% of the world’s professionally managed assets are in North America and Europe, the fastest-growing markets are in Asia and Latin America.

​By Popkarn Arwatchanakarn

5.1 Active versus Passive Management

• Active management considerably exceeded passive management in terms of global assets under management and industry revenue

  • Through fundamental research, quantitative research, or a combination of both, active asset managers generally attempt to outperform either predetermined performance benchmarks, such as the S&P 500, or, for multi-asset class portfolios

• Passive management has demonstrated significant growth

  • ​passive managers attempt to replicate the returns of a market index.

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​By Popkarn Arwatchanakarn

5.2 Traditional versus Alternative Asset Manager

• Traditional managers generally focus on long-only equity, fixed-income, and multi-asset investment strategies, generating most of their revenues from asset-based management fees.

• Alternative asset managers, however, focus on hedge fund, private equity, and venture capital strategies, among others, while generating revenue from both management and performance fees

• Many traditional managers have introduced higher-margin alternative products to clients. Concurrently, alternative managers, seeking to reduce the revenue volatility associated with performance fees, have increasingly offered retail versions of their institutional alternative strategies as well as long-only investment strategies.

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​By Popkarn Arwatchanakarn

5.3 Ownership Struture

• The ownership structure of an asset manager can play an important role in retaining and incentivizing key personnel.

• The majority of asset management firms are privately owned.

• A prevalent ownership form in the industry is represented by asset management divisions of large, diversified financial services companies that offer asset management alongside insurance and banking services.

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​By Popkarn Arwatchanakarn

5.4 Asset Management Industry Trends

• The asset management industry is evolving and continues to be shaped by socio-economic trends, shifting investor demands, advances in technology, and the expansion of global capital markets.

• Three key trends that we discuss in this section include:

  • growth of passive investing

  • big data in the investment process, and

  • robo-advisers in the wealth management industry

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​By Popkarn Arwatchanakarn

5.4.1 Growth of Passive Investing

• Top three managers account for 70% of industry’s assets.

• One key catalyst supporting the growth of passive investing is low cost for investors

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​By Popkarn Arwatchanakarn

5.4.2 Use of Big Data

• The term “big data” is used to refer to these massively large datasets and their analysis.

• Asset managers are using advanced statistical and machine-learning techniques to help process and analyze these new sources of data.

  • Such techniques are used in both fundamentally driven and quantitatively driven investment processes.

  • For example, computers are used to “read” earnings and economic data releases much faster than humans can and react with short-term trading strategies.

• ​Among the most popular new sources of data are social media data and imagery and sensor data.

• ​The challenge for asset managers is to discover data with predictive potential and to do so faster than fellow market participants.

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​By Popkarn Arwatchanakarn

5.4.3 Robo-Adviser

• Robo-advisers represent technology solutions that use automation and investment algorithms to provide several wealth management services

• Robo-adviser platforms range from exclusively digital investment advice platforms to hybrid offerings that offer both digital investment advice and the services of a human financial adviser.

• This expected rapid growth in robo-advisory assets is based on several industry trends:

  • ​Growing demand from “mass affluent” and younger investors

  • Lower fees

  • New entrants

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​By Popkarn Arwatchanakarn

6. Mutual Funds & Pooled Investment Products

• There is a diverse set of investment products available to investors, ranging from a simple brokerage account to large institutions that employ individual portfolio managers to meet clients’ investment management needs.

• Among the major investment products offered by asset managers are mutual funds and other pooled investment products, such as separately managed accounts, exchange-traded funds, hedge funds, and private equity/venture capital funds.

​By Popkarn Arwatchanakarn

6.1 Mutual Funds

• Rather than assemble a portfolio on their own, individual investors and institutions can turn over the selection and management of their investment portfolio to a third party.

• One way of doing this is through a mutual fund.

• Mutual funds represent a primary investment product of individual investors globally.

• Mutual funds are one of the most important investment vehicles for individuals and institutions.

​By Popkarn Arwatchanakarn

6.1 Mutual Funds

• The fund can be set up as an open-end fund or a closed-end fund.

• If it is an open-end fund, it will accept new investment money and issue additional shares at a value equal to the net asset value of the fund at the time of investment.

• An alternative to setting the fund up would be to create a closed-end fund in which no new investment money is accepted into the fund.

  • New investors invest by buying existing shares, and investors in the fund liquidate by selling their shares to other investors.

  • Hence, the number of outstanding shares does not change.

​By Popkarn Arwatchanakarn

6.2 Types of Mutual Funds

1. Money market funds are mutual funds that invest in short-term money market instruments such as treasury bills, certificates of deposit, and commercial paper.

   • They aim to provide security of principal, high levels of liquidity, and returns in line with money market rates.

2. bond mutual fund is an investment fund consisting of a portfolio of individual bonds and, occasionally, preferred shares.

   • Investors in the mutual fund hold shares, which account for their pro-rata share or interest in the portfolio.

   • The major difference between a bond mutual fund and a money market fund is the maturity of the underlying assets.

​By Popkarn Arwatchanakarn

6.2 Types of Mutual Funds

3. Stock Mutual Funds are the largest types of mutual funds based on market value of assets under management. ​There are two types of stock mutual funds:

   • An actively managed fund in which the portfolio manager seeks outstanding performance through the selection of the appropriate stocks to be included in the portfolio.

   • Passive management is followed by index funds that are very different from actively managed fund

4. Hybrid/Balanced Funds are mutual funds that invest in both bonds and stocks.

   • These types of funds represent a small fraction of the total investment in US mutual funds but are more common in Europe.

   • These types of funds, however, have gained popularity with the growth of lifecycle funds.

​By Popkarn Arwatchanakarn

6.4 Exchange-Traded Funds

• Exchange-traded funds (ETFs) are investment funds that trade on exchanges (similar to individual stocks) and are generally structured as open-end funds.

• ETFs represent one of the fastest-growing investment products in the asset management industry.

• key differences between ETFs and mutual funds relate to transaction price, transaction cost and treatment of dividends and the minimum investment amount.

​By Popkarn Arwatchanakarn

6.4 Hedge Funds

• Hedge funds are private investment vehicles that typically use leverage, derivatives, and long and short investment strategies.

• Hedge funds share a few distinguishing characteristics:

  • Short selling // Absolute return seeking // Leverage // Low correlation // Fee structures

• Hedge funds are not readily available to all investors.

  • typically require a high minimum investment

  • often have restricted liquidity by allowing only periodic (e.g., quarterly) withdrawals or having a long fixed-term commitment.

​By Popkarn Arwatchanakarn

6.4 Private Equity and Venture Capital Funds

• Private equity funds and venture capital funds are alternative funds that seek to buy, optimize, and ultimately sell portfolio companies to generate profits.

• Private equity and venture firms often take a “hands-on” approach to their portfolio companies through

  • a combination of financial engineering (e.g., realizing expense synergies, changing capital structures), installment of executive management and board members, and significant contributions to the development of a target company’s business strategy

• The majority of private equity and venture capital funds are structured as limited partnerships, called the general partner (GP) or limited partners (LPs).

  • The funds generate revenue through several types of fees:​ Management fees // Transaction fees // Carried interest // Investment income

​By Popkarn Arwatchanakarn