Download The Portfolio Management Process

Investment Analysis and
Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown
Portfolio Management
Process and Strategies
(From Chs. 2 & 22)
Version 1.2
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Part 1
The Portfolio Management Process
(From Chapter 2)
Figure 2.2
The Portfolio Management Process
1. Policy statement - Focus: Investor’s short-term and longterm needs, familiarity with capital market history, and
expectations
2. Examine current and project financial, economic,
political, and social conditions - Focus: Short-term and
intermediate-term expected conditions to use in
constructing a specific portfolio
3. Implement the plan by constructing the portfolio - Focus:
Meet the investor’s needs at the minimum risk levels
4. Feedback loop: Monitor and update investor needs,
environmental conditions, portfolio performance
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The Portfolio Management Process
1. Policy statement
– specifies investment goals and
acceptable risk levels
– should be reviewed periodically
– guides all investment decisions
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The Portfolio Management Process
2. Study current financial and
economic conditions and forecast
future trends
– determine strategies to meet goals
– requires monitoring and updates
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The Portfolio Management Process
3. Construct the portfolio
– allocate available funds to meet
goals and minimize investor’s risks
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The Portfolio Management Process
4. Monitor and update
– revise policy statement as needed
– modify investment strategy
accordingly
– evaluate portfolio performance
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The Need For A Policy Statement
• Understand and articulate realistic investor
goals
– needs, objectives, and constraints
– financial markets and risks of investing
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Constructing A Policy Statement
• What are the real risks of an adverse
financial outcome, especially in the short
run?
• What probable emotional reactions will I
have to an adverse financial outcome?
• How knowledgeable am I about investments
and markets?
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Constructing A Policy Statement
• What other capital or income sources do I
have? How important is this particular
portfolio to my overall financial position?
• What, if any, legal restrictions may affect
my investment needs?
• What, if any, unanticipated consequences of
interim fluctuations in portfolio value might
affect my investment policy?
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Standards For Evaluating
Portfolio Performance
• Benchmark portfolio
– risk and return
• Matches risk preferences and
investment needs
– analysis of risk tolerance
– return objective goals
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Realistic Investor Goals
• Capital preservation
– minimize risk of real loss
– strongly risk-averse or funds needed soon
• Capital appreciation
– capital gains to provide real growth over time
for future need
– aggressive strategy with accepted risk
• Current income
– generate spendable funds
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Realistic Investor Goals
• Total return
– capital gains and income reinvestment
– moderate risk exposure
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Investment Constraints
• Liquidity needs
– near-term goals
• Time horizon
– longer time horizon favors risk acceptability
– short time horizon favors less risky investments
because losses are harder to overcome in a short
time frame
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Investment Constraints
• Tax concerns
– interest and dividends taxed at investor’s
marginal tax rate
– capital gains may be unrealized
– basis and gain or loss realized
– revisions to capital gains tax rates
– tradeoff with diversification needs for
employer’s stock holdings
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Legal and Regulatory Factors
• Limitations or penalties on withdrawals
• Fiduciary responsibilities “prudent man” rule
• Investment laws prohibit insider trading
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Unique Needs and Preferences
• Personal preferences - socially conscious
investments
• Time constraints or expertise for managing
the portfolio may require professional
management
• Large investment in employer may require
consideration of diversification needs and
realistic liquidity
• Institutional investors needs
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Constructing the Policy Statement
• Objectives - risk and return
• Constraints - liquidity, time horizon, tax
factors, legal and regulatory constraints, and
unique needs and preferences
• Developing a plan depends on
understanding the relationship between risk
and return and the importance of
diversification
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The Importance
of Asset Allocation
• An investment strategy is based on four
decisions
– What asset classes to consider for investment
– What normal or policy weights to assign to each
eligible class
– The allowable allocation ranges based on policy
weights
– What specific securities to purchase for the
portfolio
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The Importance
of Asset Allocation
• Most (85% to 95%) of the overall
investment return is due to the first two
decisions, not the selection of individual
investments
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The Effect of Taxes and Inflation on
Investment Returns, 1926 - 1998
Figure 2.6
12
10
8
6
4
Common Stocks
Before
Taxes
After After
Taxes Taxes
and
Inflation
Long-Term
Government
Bonds
Treasury Bills
2
Municipal Bonds
0
-2
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Returns and Risk of Different
Asset Classes
• Higher returns compensate for risk
• Policy statements must provide risk
guidelines
• Measuring risk by standard deviation of
returns over time indicates stocks are more
risky than T-bills
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Returns and Risk of Different
Asset Classes
• Measuring risk by probability of not
meeting your investment return objective
indicates risk of equities is small and risk of
T-bills is large because of different expected
returns
• Focusing only on return variability ignores
reinvestment risk
• Changes in returns from year to year
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Asset Allocation Summary
• Policy statement determines types of assets
to include in portfolio
• Asset allocation determines portfolio return
more than stock selection
• Over long time periods sizable allocation to
equity will improve results
• Risk of a strategy depends on the investor’s
goals and time horizon
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Asset Allocation and
Cultural Differences
• Social, political, and tax environments
• U.S. institutional investors average 45%
allocation in equities
• In the United Kingdom, equities make up
72% of assets
• In Germany, equities are 11%
• In Japan, equities are 24% of assets
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Summary
• Develop an investment policy statement
– Identify investment needs, risk tolerance, and
familiarity with capital markets
– Identify objectives and constraints
– Investment plans are enhanced by accurate
formulation of a policy statement
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Summary
• Asset allocation determines long-run returns
and risk
– Success depends on construction of the policy
statement
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Part 2
Portfolio Management Strategies
(From Chapter 22)
Passive versus Active Management
• Passive equity portfolio management
–
–
–
–
Long-term buy-and-hold strategy
Usually track an index over time
Designed to match market performance
Manager is judged on how well they track the target
index
• Active equity portfolio management
– Attempts to outperform a passive benchmark portfolio
on a risk-adjusted basis
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An Overview of Passive Equity
Portfolio Management Strategies
• Replicate the performance of an index
• May slightly underperform the target index
due to fees and commissions
• Costs of active management (1 to 2 percent)
are hard to overcome in risk-adjusted
performance
• Many different market indexes are used for
tracking portfolios
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Passive Equity Portfolio
Management Techniques
• Full replication
• Sampling
• Quadratic optimization or
programming
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Full Replication
• All securities in the index are
purchased in proportion to weights in
the index
• This helps ensure close tracking
• Increases transaction costs, particularly
with dividend reinvestment
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Sampling
• Buys a representative sample of stocks in the
benchmark index according to their weights in
the index
• Fewer stocks means lower commissions
• Reinvestment of dividends is less difficult
• Will not track the index as closely, so there will
be some tracking error
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Expected Tracking Error Between the S&P 500 Index
and Portfolio Samples of Less Than 500 Stocks
Expected Tracking
Error (Percent)
Figure 22.1
4.0
3.0
2.0
1.0
500
400
300
200
100
0
Number of Stocks
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Quadratic Optimization
(or programming techniques)
• Historical information on price changes and
correlations between securities are input
into a computer program that determines the
composition of a portfolio that will
minimize tracking error with the benchmark
• This relies on historical correlations, which
may change over time, leading to failure to
track the index
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Completeness Funds
• Passive portfolio customized to
complement active portfolios which do
not cover the entire market
• Performance compared to a specialized
benchmark that incorporates the
characteristics of stocks not covered by
the active managers
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Other Passive Portfolios
• Meet unique needs
• Socially responsible investments
• Dollar-cost averaging
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An Overview of Active Equity
Portfolio Management Strategies
• Goal is to earn a portfolio return that
exceeds the return of a passive benchmark
portfolio, net of transaction costs, on a
risk-adjusted basis
• Practical difficulties of active manager
– Transactions costs must be offset
– Risk can exceed passive benchmark
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Three Strategies
• Market timing - shifting funds into and out of
stocks, bonds, and T-bills depending on broad
market forecasts and estimated risk premiums
• Shifting funds among different equity sectors and
industries or among investment styles to catch
hot concepts before the market does
• Stockpicking - individual issues
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Global Investing
• Identify countries with markets undervalued or
overvalued and weight the portfolio accordingly
• Manage the global portfolio from an industry
perspective rather than from a country perspective
• Focus on global economic trends, industry
competitive forces, and company strengths and
strategies
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Sector Rotation
• Position a portfolio to take advantage of the market’s
next move
• Screening can be based on various stock
characteristics:
–
–
–
–
–
Value
Growth
P/E
Capitalization
Sensitivity to economic variables
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Value versus Growth
• Growth stocks will outperform value
stocks for a time and then the opposite
occurs
• Over time value stocks have offered
somewhat higher returns than growth
stocks
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Value versus Growth
• Growth-oriented investor will:
– focus on EPS and its economic
determinants
– look for companies expected to have rapid
EPS growth
– assumes constant P/E ratio
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Value versus Growth
• Value-oriented investor will:
– focus on the price component
– not care much about current earnings
– assume the P/E ratio is below its natural
level
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Style
• Construct a portfolio to capture one or more of
the characteristics of equity securities
• Small-capitalization stocks, low-P/E stocks,
etc…
• Value stocks appear to be underpriced
– price/book or price/earnings
• Growth stocks enjoy above-average earnings
per share increases
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Does Style Matter?
• Choice to align with investment style communicates
information to clients
• Determining style is useful in measuring performance
relative to a benchmark
• Style identification allows an investor to diversify by
portfolio
• Style investing allows control of the total portfolio to be
shared between the investment managers and a sponsor
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Determining Style
• Style grid:
– firm size
– value-growth characteristics
• Style analysis
– constrained least squares
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Benchmark Portfolios
• Sharpe
– T-bills, intermediate-term government bonds,
long-term government bonds, corporate bonds,
mortgage related securities, large-capitalization
value stocks, large-capitalization growth stocks,
medium-capitalization stocks, smallcapitalization stocks, non-U.S. bonds, European
stocks, and Japanese stocks
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Benchmark Portfolios
• Sharpe
• BARRA
– Uses portfolios formed around 13 different
security characteristics, including variability in
markets, past firm success, firm size, trading
activity, growth orientation, earnings-to-price
ratio, book-to-price ratio, earnings variability,
financial leverage, foreign income, labor
intensity, yield, and low capitalization
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Benchmark Portfolios
• Sharpe
• BARRA
• Ibbotson Associates
– simplest style model uses portfolios formed
around five different characteristics: cash (Tbills), large-capitalization growth, smallcapitalization growth, large-capitalization
value, and small-capitalization value
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Timing Between Styles
• Variations in returns
among mutual funds are
largely attributable to
differences in styles
• Different styles tend to
move at different times
in the business cycle
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Asset Allocation Strategies
• Integrated asset allocation
– capital market conditions
– investor’s objectives and constraints
• Strategic asset allocation
– constant-mix
• Tactical asset allocation
– mean reversion
– inherently contrarian
• Insured asset allocation
– constant proportion
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Asset Allocation Strategies
• Selecting an allocation method depends on:
– Perceptions of variability in the client’s
objectives and constraints
– Perceived relationship between the past and
future capital market conditions
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