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Introduction to Portfolio Management
• Portfolio Management:
Portfolio management deals with the analysis of individual securities as
well as with the theory and practice of optimally combining securities into
portfolios. Choice depends upon the risk-return characteristics of
individual securities.
• Elements of Portfolio Management:
Evaluating investor and market characteristics
Developing an investment policy statement
Determining an asset allocation strategy
Measuring and evaluating performance
Monitoring dynamic investor objectives and capital market conditions
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Introduction to Portfolio Management
•Steps in the Portfolio Management Process: Planning, Execution and Feedback
•Investment Objectives: Risk and Return
•Investment Constraints
Liquidity constraints: Cash outflows > income : Higher liquidty requirements mean lower
risk tolerance
Time horizon constraints: Time period over which portfolio is expected to generate
returns: Length affects ability to take risk and asset allocation
Tax Consideration: Government takes a cut on returns : Important for individual
investors
Legal and regulatory factors: External constraints : Important for institutional investors
Unique circumstances: Catch all category : Individual investor with special needs child
Investment Policy Statement
Investment Strategies: Passive, Active, Semi-Active
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Strategic
Allocations:
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Investment Objectives of Individual
and Institutional Investors
Investor
Return Requirement
Risk Tolerance
Individual investor
Depends on life cycle stage
Defined benefit pension plan
Sufficient to fund pension Depends on plan features, age
liability while accounting for of workforce, and funding
inflation
status of plan
Defined
pension plan
Endowments
foundations
contribution Depends on life cycle stage
of beneficiaries
Sufficient to cover spending
and needs,
expenses,
and
inflation
Life insurance companies
Non-life
companies
Function of
reserve rates
insurance Function of
and financial
Banks
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Depends on life cycle stage
Depends on risk tolerance of
beneficiaries
Generally average or above
average
Below average because of
policy holder significant
regulatory
constraints
Below average because of
policy pricing significant
regulatory
strength
constraints
Function of cost of funds
Depends on business model
and financial strength
Introduction to Portfolio Management
Phases of Portfolio Management:
Security analysis
Portfolio analysis
Portfolio selection
Portfolio revision
Portfolio evaluation
Evolution of Portfolio Management
Role of Portfolio Management
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Introduction to Portfolio Management
Phases of Portfolio Management:
Security analysis
Portfolio analysis
Portfolio selection
Portfolio revision
Portfolio evaluation
Evolution of Portfolio Management
Role of Portfolio Management
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Portfolio Management Process and Investment
Policy Statement
1.
2.
3.
4.
5.
6.
7.
8.
Investment Management
The Portfolio Perspective
Portfolio Management as a Process
The Portfolio Management Process Logic
Investment Objectives and Constraints
The Dynamics of the Process
The Future of Portfolio Management
The Ethical Responsibilities of Portfolio Management
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Portfolio Perspective and Portfolio
Management Process
•Risk Return evaluated at portfolio level
Recognizes benefits of diversification
Attention on Systematic risk
Analyze portfolio risk/return and not risk/return of individual securities.
1. Planning
Analyzing objectives and constraints
Developing IPS
Determining investment strategy
Asset allocation
2.
Execution
3.
Feedback
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Investment Objectives
•Risk Objectives
Investor’s willingness to take risk
Investor’s ability to take risk
•Individual : Behavioral factors (willingness)
•Institutions: Portfolio constraints (ability)
Factors affecting ability to take risk:
Required spending needs
Long term wealth target
Financial strength
Liabilities
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Introduction to Portfolio Management
Ability to Take Risk
Willingness
Take Risk
Below Average
Above Average
to
Below Average
Above Average
Education/
resolution
required
Lower risk tolerance
Education/
resolution
required
Higher risk tolerance
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Investment Objectives: Returns
•Return Objectives
Desired return (stated by client)
Required return (determined by long term goals)
Must be consistent with risk objective: Total return perspective
• More on time horizons
Short, Long, Multi stage (ST to LT)
Life cycle considerations
Future beneficiaries
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Introduction to Portfolio Management
Ability to Take Risk
Willingness
Take Risk
Below Average
Above Average
to
Below Average
Above Average
Education/
resolution
required
Lower risk tolerance
Education/
resolution
required
Higher risk tolerance
For a given set of securities, any number of portfolios can be constructed.
A rational investor attempts to find the most efficient of these portfolios.
The efficiency of each portfolio can be evaluated only in terms of the
expected return and risk of the portfolio as such. It is known as
“Portfolio Analysis”.
It is based on “Mean-Variance” Analysis.
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Points to Remember

According to the portfolio perspective, individual investments should be judged in the
context of how much risk they add to a portfolio rather than on how risky they are on a standalone basis.
 The three steps in the portfolio management process are the planning step (objectives and
constraint determination, investment policy statement creation, capital market expectation
formation, and strategic asset allocation creation); the execution step (portfolio
selection/composition and portfolio implementation); and the feedback step (performance
evaluation and portfolio monitoring and rebalancing).
 Investment objectives are specific and measurable desired performance outcomes, and
constraints are limitations on the ability to make use of particular investments. The two types
of objectives are risk and return. The two types of constraints are internal (posed by the
characteristics of the investor) and external (imposed by outside agencies).
 An investment policy statement is a written planning document that governs all investment
decisions for the client. This document integrates a client’s needs, preferences, and
circumstances into a statement of that client’s objectives and constraints.
 A policy or strategic asset allocation establishes exposures to IPS-permissible asset
classes in a manner designed to satisfy the client’s long-run objectives and constraints. The
plan reflects the interaction of objectives and constraints with long-run capital market
expectations.
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Points to Remember
In
A passive investment strategy approach, portfolio composition does not react to
changes in expectations; an example is indexing, which involves a fixed portfolio
designed to replicate the returns on an index. An active approach involves holding a
portfolio different from a benchmark or comparison portfolio for the purpose of producing
positive excess risk-adjusted returns. A semiactive approach refers to an indexing
approach with controlled use of weights different from the benchmark.
 The portfolio selection/composition decision concerns portfolio construction and often
uses portfolio optimization to combine assets efficiently to achieve return and risk
objectives. The portfolio implementation decision concerns the trading desk function of
implementing portfolio decisions and involves explicit and implicit transaction costs.
 The elements of performance evaluation are performance measurement, attribution,
and appraisal. Performance measurement is the calculation of portfolio rates of return.
Performance attribution is the analysis of those rates of return to determine the factors
that explain how the return was achieved. Performance appraisal assesses how well the
portfolio manager performed on a risk-adjusted basis, whether absolute or relative to a
benchmark.
 Portfolio monitoring and rebalancing use feedback to manage ongoing exposures to
available investment opportunities in order to continually satisfy the client’s current
objectives
and constraints.
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
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Points to Remember
In

Portfolio
management is an ongoing process in which the investment objectives and
constraints are identified and specified, investment policies and strategies are
developed, the portfolio composition is decided in detail, portfolio decisions are initiated
by portfolio managers and implemented by traders, portfolio performance is evaluated,
investor and market conditions are monitored, and any necessary rebalancing is
implemented.
 To determine a risk objective, there are several steps: specify a risk measure (or
measures) such as standard deviation, determine the investor’s willingness to take risk,
determine the investor’s ability to take risk, synthesize the investor’s willingness and
ability into the investor’s risk tolerance, and specify an objective using the measure(s) in
the first step above.
 To determine a return objective, there are several steps: specify a return measure such
as total nominal return, determine the investor’s stated return desire, determine the
investor’s required rate of return, and specify an objective in terms of the return measure
in the first step above.
A liquidity requirement is a need for cash in excess of the contribution rate or the
savings rate at a specified point in time. This need may be either anticipated or
unanticipated.
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Points to Remember
In

A
time horizon is the time period associated with an investment objective. Investment
objectives and associated time horizons may be short term, long term, or a combination
of these two. A multistage horizon is a combination of shorter term and longer term
horizons. A time horizon can be considered a constraint because shorter time horizons
generally indicate lower risk tolerance and hence constrain portfolio choice, making it
more conservative.
 A tax concern is any issue arising from a tax structure that reduces the amount of the
total return that can be used for current needs or reinvested for future growth. Tax
concerns constrain portfolio choice. If differences exist between the tax rates applying to
investment income and capital gains, tax considerations will influence the choice of
investment.
 Legal and regulatory factors are external considerations that may constrain
investment decision making. For example, a government agency may limit the use of
certain asset classes in retirement portfolios.
 Unique circumstances are internal factors (other than a liquidity requirement, time
horizon, or tax concerns) that may constrain portfolio choices. For example, an investor
seeking to avoid investments in tobacco companies will place an internal constraint on
portfolio choice.
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