Chapter 1
Introduction
Fabozzi:
Investment Management
Learning Objectives
From this chapter...
 You will learn the steps involved in the investment process.
 You will understand the difference between retail and
institutional investors.
 You will study the factors considered in setting investment
policy.
 You will be able to explain what is meant by the allocation
decision.
Learning Objectives
 You will recognize various general portfolio strategies.
 You will be able to define an efficient portfolio.
 You will discover the process of evaluating portfolio
performance.
 You will investigate the structure of the money management
business.
 You will review the ethical issues in investment management.
Investment Management Terms
Portfolio Management/Money Management
An investment manager “runs”money and uses
• Their understanding of investment vehicles
• valuation
• strategies of selection
to accomplish investment objectives
Types of Investors
Retail-Individuals like yourself
Institutional- large firms in a variety of businesses with large inflows of
cash
Banks
Pension Funds
Endowment Funds
Mutual Funds
As most individual investors employ mutual funds rather
than invest in stocks, there has been an institutionalization of
the financial markets.There are fewer retail investors and the
markets are moved by purchases of large blocks of shares,
rather than 50 or 100 share blocks.
Investment Management Process
1. Setting investment objectives
2. Establishing investment policy
3. Selecting a portfolio strategy
4. Selecting the assets
5. Measuring and evaluating performance
Setting Investment Objectives
Objectives will vary depending on the type of institution
Pension Fund: Generating funds to pay to beneficiaries in the
future and current recipients
Life Insurance: Generate profits while meeting obligations of
payments to clients
Banks: Realize returns greater than the cost of funds(interest on
accounts)
Mutual Funds : Generate profits while providing strong
returns for investors.
Establishing Investment Policy
How do we satisfy the objectives?
Begin by determining how to allocate assets among investment
vehicles or assets. A portfolio consists of a group of assets.
Assets can include:
Stocks, bonds, real estate, foreign securities,
commodities, gold
Constraints on how funds can be invested
Regulations
Amount of ownership in one asset, tax
considerations.
Client
Amount of acceptable risk, diversification needs
Selecting a Portfolio Strategy
Active- applies information and forecasting techniques
Financial ratios, historical yield curves, predicting dividend
growth
Passive- diversifies to match a market index
Standard and Poor’s 500
Structured strategy is used for bond holdings where funds received from
investments match the value of the liabilities to be disbursed.
Choosing a Strategy
Use Marketplace Price Efficiency
Defined as how difficult it would be to earn a greater return
than passive management would, after adjusting for risk and
transaction costs associated with the chosen strategy.
Client’s risk tolerance: Are they able to sleep at night while holding
a risky asset or are they more conservative? (Discuss risk tolerance
in daredevil sports or size of a car loan in a budget.)
Nature of the client’s liabilities: Does the client need to access cash
quickly or are they able to effort their lifestyle without drawing on
their investments in an uncontrolled way?
Selecting the Assets
Active Strategy- identify mispriced securities in constructing an
efficient portfolio (sometimes called value investing, can discuss
the difference between a value shop and a growth shop)
An efficient portfolio is one that provides the greatest expected
return for a given level of risk, or the lowest risk for a given
expected return.
Measuring And Evaluating Performance
Compare portfolio result to a benchmark
A benchmark is the performance of a predetermined set of
securities such as an index. Many money managers use a
customized index to match the objectives of the investment.
Structure of the Money Management Process
In-house money managers:
This is the process of making money for your own
organization.
Money made in the markets can be used to fund projects, bonuses,
pay down debt or fund an expansion or acquisition. These money
managers are motivated by their loyalty to their firm and desire to
see it grow and prosper.
It is possible to have both in house and outside money managers.
Structure of the Money Management Process
Outside money managers
are hired to make money for various types of organizations.
If they are successful, they will attract more clients, increase their
money under management and generate more fees for their money
management firm. Organizations include:
Financial institutions: banks, insurance companies, investment
companies.
Non-financial institutions: pension funds and endowment
funds.
(Baby boomer generation is putting billions of dollars
into pension funds and mutual funds to save for retirement.
Discuss lack of confidence in Social Security and subsequent
need to increase personal savings.)
Structure of the Money Management Process
Who are these outside money management firms?
Bank related: trust departments manage funds for individuals (PNC
Asset Management Group)
Insurance related: subsidiaries that manage annuity type investments
(Prudential Insurance)
Brokerage firms: asset management subsidiaries (Merill Lynch Asset
Management)
Independent money management firms: mutual funds (Fidelity or
Putnam)
Ethics in Investment Management
Money managers and broker/dealers provide services to clients.
However, money managers are also the clients of broker/dealers.
This leads to conflict interest.
Lines of defense for client
Trust ethics of service provider
Industry wide policies for ethical and professional
behavior.
Ethics in Investment Management
Violators of regulations set by the Security and Exchange
Commission(SEC) or the national Association of Securities
Dealers(NASD) can:
• Be stripped of the right to transact business on any exchange.
• Be required to compensate the client for monetary damages
• Be required to pay punitive damages
A Chartered Financial Analyst (CFA) can lose their right to use
that designation.
(Discuss The self-study, 3 grueling exams required to become a
CFA and the research jobs that can follow.)
(Discus the genesis of the SEC (1993) from bank and exchange
excesses and fraudulent behavior in the 1920s.)
Organization of the Book
Section I
Chapters 1 and 2:background information and an
overview of market and major asset classes, including historical
performance of stocks and bonds
Section II
Chapters 3-5 :discuss modern portfolio theory and
capital market theory leading to how to determine the
equilibrium price of an asset
Section III
Chapters 6-10 : students will learn about the
considerations in managing the institutions investment portfolio
including client liabilities, tax problems, and regulatory
constraints
Organization of the Book
Section IV
Chapters 11-21 : discuss common stock (equity)portfolio
management including the important idea of pricing efficiency;
technical, fundamental and forecasting analysis techniques;
industry environment; indexing; factor models; options and
futures; and equity trading
Section V
Chapters 22-30 : discuss fixed income portfolio
management including characteristics and analytical tools, yields,
active bond strategies and indexing, and futures and contracts
Section VI
Chapters 31-33 : show the student the mathematical
models used to make asset allocation decisions, and how to
measure and evaluate the performance of a money manager
Organization of the Book
Appendix A : reviews the fundamental concepts of
probability and statistics
Appendix B : reviews of the income statement and
balance sheet