Download The Process of Portfolio Management

The Process of Portfolio
Management
Presentation by:
William Wood CFP®
1
Investments
 Traditional investment
processes cover:
• Security analysis
– Involves estimating the merits of individual
investments
• Portfolio management
– Deals with the construction and maintenance of a
collection of investments
2
Security Analysis

A three-step process
1) The investor considers prospects for the economy,
given the stage of the business cycle,
2) Determines which industries are likely to fare well in
the forecasted economic conditions,
3) Chooses particular companies within the favored
industries
• EIC (Economy, Industry, Company) analysis
(a top-down approach)
3
Portfolio Management
Literature supports the

•
•
efficient markets hypothesis
On a well-developed securities exchange,
asset prices accurately reflect the tradeoff
between relative risk and potential returns of a
security
– Efforts to identify undervalued securities will be
essentially fruitless
– Free lunches are difficult to find
4
Portfolio Management (cont’d)
Market efficiency and portfolio
management

•
A properly constructed portfolio achieves a
given level of expected return with the least
possible risk
5
Purpose of Portfolio
Management
Portfolio management primarily involves
reducing risk rather than increasing return

•
Consider two $10,000 investments:
1) Earns 10 percent per year for each of ten years
(low risk)
2) Earns 9 percent, –11 percent, 10 percent, 8
percent, 12 percent, 46 percent, 8 percent, 20
percent, –12 percent, and 10 percent in the ten
years, respectively (high risk)
6
Low Risk vs. High Risk
Investments
$30,000
$25,937
$23,642
$20,000
$10,000
$10,000
Low
Risk
High
Risk
$0
'
'99
'01
Both investments have a mean return of 10 percent.
'03
'05
'07
7
Low Risk vs. High Risk
Investments (cont’d)
1) Earns 10 percent per year for each of ten years
(low risk)
•
Terminal value is $25,937
2) Earns 9 percent, –11 percent, 10 percent, 8
percent, 12 percent, 46 percent, 8 percent, 20
percent, –12 percent, and 10 percent in the ten
years, respectively (high risk)
•

Terminal value is $23,642
The lower the dispersion in the returns, the
greater the accumulated value of equal
investments
8
Managing Your Portfolio
Begins with a statement of investment
policy, which outlines:

•
•
•
Return requirements: given the funds
available for investment, what ROI do I need
to reach my goal.
Risk tolerance: how much risk am I
comfortable with.
Portfolio constraints: when do I need the
money.
9
Six Steps of Portfolio
Management
1)
2)
3)
4)
5)
6)
Learn the basic principles of finance
Set portfolio objectives
Formulate an investment strategy
Have a game plan for portfolio revision
Evaluate the performance
Protect the portfolio when appropriate
10
Step One
Background, Basic Principles, and
Investment Policy
A
investor cannot effectively manage a
portfolio without a solid grounding in the
basic principles of finance
 Egos sometimes get involved
• Take time to review “simple” material
• Fluff and bluster have no place in the formation
of investment policy or strategy
11
Step One
Background, Basic Principles, and
Investment Policy (cont’d)
 There
is a distinction between “good
companies” and “good investments”
• The stock of a well-managed company may be
too expensive
• The stock of a poorly-run company can be a
great investment if it is cheap enough
12
Step One
Background, Basic Principles, and
Investment Policy (cont’d)

The two key concepts in finance are:
1) A dollar today is worth more than a dollar
tomorrow…inflation erodes the purching
power of a dollar!
2) A safe dollar is worth more than a risky dollar

These two ideas form the basis for all
aspects of portfolio management
13
Step Two
Set Portfolio Objectives
Setting objectives

•
It is difficult to accomplish your objectives
until you know what they are
•
Terms like growth or income may mean
different things to different people
14
Step Two (con’t)
Investment Policy
Investment policy

•
The separation of investment policy from
investment management is a fundamental
tenet of money management
15
Step Three
Portfolio Construction
Formulate an investment strategy based
on the investment policy statement

•
Investors must understand the basic elements
of capital market theory
– Informed diversification
– Naïve diversification
– Beta
16
Step Three
Portfolio Construction (cont’d)
Informed Diversification
Security screening


•
A screen is a logical protocol to reduce the security
universe to a workable number for closer
investigation
17
Step Four
Portfolio Management
Subsequent to portfolio construction:

•
•
•
Economic conditions change
Market conditions change
Portfolios need maintenance
18
Step Four
Portfolio Management (cont’d)
Passive management has the following
characteristics:

•
•
•
•
Follow a predetermined investment strategy
that is invariant to market conditions
Do nothing
Let the chips fall where they may
Buy and Hold
19
Portfolio Management (cont’d)
Passive Management
 Less
knowledge required
 Reduced psychological anxiety in
management
• When to buy and sell??
 The
argument for index investing with
mutual funds?
20
Step Four
Portfolio Management (cont’d)
Active management:

•
Requires the periodic changing of the
portfolio components as the investor’s
outlook for the market changes; business
cycles evolve; Black Swan events change the
playing field.
21
Active Management Through
Rebalancing the Portfolio
 Rebalancing
a portfolio is the process of
periodically adjusting it to maintain the
original conditions
Rebalancing Within the
Equity Portfolio
 Constant
Mix
 Constant Proportion Portfolio Insurance
 Constant Beta Portfolio
Constant Mix Strategy
 The
constant mix strategy:
• Is one in which the investor makes adjustments
to maintain the relative weighting of the asset
classes within the portfolio as their prices
change
• Requires the purchase of securities that have
performed poorly and the sale of securities that
have performed the best
Constant Mix Strategy (cont’d)
Example (cont’d)
Date
Portfolio Value Actual Allocation
Stock
Bonds
1 Jan
$2,000,000
60%/40%
$1,200,000 $800,000
1 Apr
$2,500,000
56%/44%
$1,400,000 $1,100,000
What dollar amount of stock should the portfolio
manager buy to rebalance this portfolio? What dollar
amount of bonds should he sell?
Constant Proportion
Portfolio Insurance
A
constant proportion portfolio
insurance (CPPI) strategy requires the
investor to invest a percentage of the
portfolio in stocks
Constant Proportion
Portfolio Insurance (cont’d)
Example
A portfolio has a market value of $2 million. The
investment policy statement specifies a floor value of $1.7
million and a multiplier of 2.
What is the dollar amount that should be invested in
stocks according to the CPPI strategy?
Constant Proportion
Portfolio Insurance (cont’d)
Example (cont’d)
Solution: $600,000 should be invested in stock:
$ in stocks = 2.0 × ($2,000,000 – $1,700,000)
= $600,000
If the portfolio value is $2.2 million one quarter later, with
$650,000 in stock, what is the desired equity position
under the CPPI strategy? What is the ending asset mix
after rebalancing?
Relative Performance of
Constant Mix and CPPI
A
constant mix strategy sells stock as it
rises
A
CPPI strategy buys stock as it rises
Relative Performance of Constant
Mix and CPPI (cont’d)
 In
a rising market, the CPPI strategy
outperforms constant mix
 In a declining market, the CPPI strategy
outperforms constant mix
 In a flat market, neither strategy has an
obvious advantage
 In a volatile market, the constant mix
strategy outperforms CPPI
Relative Performance of Constant
Mix and CPPI (cont’d)
 The
relative performance of the strategies
depends on the performance of the market
during the evaluation period
 In the long run, the market will probably
rise, which favors CPPI
 In the short run, the market will be volatile,
which favors constant mix
Constant Proportion
A
constant proportion strategy within an
equity portfolio requires maintaining the
same percentage investment in each stock
• May be mitigated by avoidance of odd lot
transactions
 Constant
proportion rebalancing requires
selling winners and buying losers on an
individual stock basis
Constant Proportion (cont’d)
Example
An investor attempts to invest approximately one third of funds in
each of the stocks. Consider the following information:
Stock
Price
Shares
Value
% of Total Portfolio
FC
22.00
400
8,800
31.15
HG
13.50
700
9,450
33.45
YH
50.00
200
10,000
35.40
$28,250
100.00
Total
Constant Proportion (cont’d)
Example (cont’d)
After one quarter, the portfolio values are as shown below.
Recommend specific actions to rebalance the portfolio in order to
maintain the constant proportion in each stock.
Stock
Price
Shares
Value
% of Total Portfolio
FC
20.00
400
8,000
21.92
HG
15.00
700
10,500
28.77
YH
90.00
200
18,000
49.32
$36,500
100.00
Total
Constant Proportion (cont’d)
Example (cont’d)
Solution: The worksheet below shows a possible revision which
requires an additional investment of $1,000:
Stock
Price
Shares
Value
Before
FC
20.00
400
8,000
Buy 200
12,000
32.00
HG
15.00
700
10,500
Buy 100
12,000
32.00
YH
90.00
200
18,000
Sell 50
13,500
36.00
$37,500
100.00
Total
$36,500
Action
Value
After
% of
Portfolio
Constant Beta Portfolio
A constant beta portfolio requires maintaining
the same portfolio beta
 It is more likely to have requirements that beta be
within some given range
 To increase or reduce the portfolio beta, the
portfolio manager can:

• Reduce or increase the amount of cash in the portfolio
• Purchase stocks with higher or lower betas than the
target figure
• Sell high-beta stocks or low-beta stocks
• Buy high-beta stocks or low-beta stocks
Tactical Asset Allocation
 What
Is Tactical Asset Allocation?
 How TAA Can Benefit a Portfolio
 Designing a TAA Program
 Caveats Regarding TAA Performance
 Costs of Revision
 Contributions to the Portfolio
Tactical Asset Allocation
 Tactical asset
allocation (TAA) managers:
• Seek to improve the performance of their funds
by shifting the relative proportion of their
investments into and out of asset classes as the
relative prospects of those asset classes change
 For
example, shift to stocks if stocks are
expected to outperform bonds
Definition (cont’d)
 TAA
attempts to take advantage of shortterm deviations from long-term trends
 The
most difficult part of TAA is asset
class appraisal
• The process of determining the relative merits
of the various asset classes given current
economic conditions
Overview of Active
Management Techniques
Efficient Market Implications
 Active
management strategies implicitly
assume it is possible to outperform a buyand-hold strategy by shifting asset classes,
or proportions or mix or risk…
• Inconsistent with the efficient market
hypothesis
 Some
fund managers have good records
compared to the market
• Might be skill or luck
Step Five
Evaluate Performance
Performance evaluation

•
Interpreting the numbers
– How much did the portfolio earn?
– How much risk did the portfolio bear?
– Must consider risk in conjunction with return
• How does performance and risk compare to the
IPS requirements?
42
Traditional
Performance Measures
 Sharpe
Measure
 Treynor Measures
 Jensen Alpha
Sharpe and
Treynor Measures (cont’d)
 The
Sharpe measure evaluates return
relative to total risk
• Appropriate for a well-diversified portfolio, but
not for individual securities
 The
Treynor measure evaluates the return
relative to beta, a measure of systematic risk
• It ignores any unsystematic risk
Jensen Alpha
 The
Jensen measure stems directly from the
CAPM:
Rit  R ft     i  Rmt  R ft 
Step Six
Portfolio Protection and
Contemporary Issues
Portfolio protection

•
Called portfolio insurance prior to 1987
•
A managerial tool to reduce the likelihood
that a portfolio will fall in value below a
predetermined minimum level
46
Step Six
Portfolio Protection and
Contemporary Issues (cont’d)
Futures

•
•
Related to options
Use of derivative assets to:
– Generate additional income
– Manage risk
Interest rate risk

•
Duration
47
Final Thoughts

Hindsight is an inappropriate perspective for
investment decision making
• Everything you do as a portfolio manager must be
logically justifiable at the time you do it
• Everything you do as a portfolio manager must be
tested against expected outcome…did it work?

Discipline