CHAPTER TWENTY-ONEPortfolio Management

Cleary / Jones Investments: Analysis and

Management

Learning ObjectivesLearning Objectives To discuss why portfolio To discuss why portfolio

management should be considered management should be considered a processa process

To describe the steps involved in To describe the steps involved in the portfolio management processthe portfolio management process

To assess related issues such as To assess related issues such as asset allocationasset allocation

Portfolio ManagementPortfolio Management Involves decisions that must be Involves decisions that must be

made by every investor whether an made by every investor whether an active or passive investment active or passive investment approach is followedapproach is followed

Relationships between various Relationships between various investment alternatives must be investment alternatives must be considered if an investor is to hold considered if an investor is to hold an optimal portfolioan optimal portfolio

Portfolio Management Portfolio Management as a Processas a Process

Definite structure everyone can followDefinite structure everyone can follow Integrates a set of activities in a logical Integrates a set of activities in a logical

and orderly mannerand orderly manner Continuous and systematicContinuous and systematic Encompasses all portfolio investmentsEncompasses all portfolio investments With a structured process, anyone can With a structured process, anyone can

execute decisions for an investorexecute decisions for an investor

Portfolio Management Portfolio Management as a Processas a Process

Objectives, constraints, and Objectives, constraints, and preferences are identifiedpreferences are identified– Leads to explicit investment policiesLeads to explicit investment policies

Strategies developed and implementedStrategies developed and implemented Market conditions, asset mix, and Market conditions, asset mix, and

investor circumstances are monitoredinvestor circumstances are monitored Portfolio adjustments are made as Portfolio adjustments are made as

necessarynecessary

Individual vs.Individual vs.Institutional InvestorsInstitutional Investors

Institutional Institutional investorsinvestors– Maintain relatively Maintain relatively

constant profile over constant profile over timetime

– Legal and regulatory Legal and regulatory constraintsconstraints

– Well-defined and Well-defined and effective policy is effective policy is criticalcritical

Individual investorsIndividual investors– Life stage mattersLife stage matters– Risk defined as Risk defined as

“losing money”“losing money”– Characterized by Characterized by

personalitiespersonalities– Goals importantGoals important– Tax management is Tax management is

important part of important part of decisionsdecisions

Institutional InvestorsInstitutional Investors Primary reason for establishing a Primary reason for establishing a

long-term investment policy for long-term investment policy for institutional investors:institutional investors:– Prevents arbitrary revisions of a Prevents arbitrary revisions of a

soundly designed investment policysoundly designed investment policy– Helps portfolio manager to plan and Helps portfolio manager to plan and

execute on a long-term basisexecute on a long-term basis Short-term pressures resistedShort-term pressures resisted

Formulate Investment Formulate Investment PolicyPolicy

Investment policy summarizes the Investment policy summarizes the objectives, constraints, and preferences objectives, constraints, and preferences for the investorfor the investor

Information neededInformation needed– ObjectivesObjectives

Return requirements and risk toleranceReturn requirements and risk tolerance– Constraints and PreferencesConstraints and Preferences

Liquidity, time horizon, laws and regulations, Liquidity, time horizon, laws and regulations, taxes, unique preferences, circumstances taxes, unique preferences, circumstances

Life Cycle ApproachLife Cycle Approach Risk/return position Risk/return position

at various life cycle at various life cycle stagesstagesA: Accumulation phase A: Accumulation phase

- early career- early careerB: Consolidation phase B: Consolidation phase

- mid-to-late career- mid-to-late careerC: Spending phase - C: Spending phase -

spending and spending and giftinggifting

Risk

Return

C

B

A

Investment policy should contain a Investment policy should contain a statement about inflation-adjusted statement about inflation-adjusted returnsreturns– Clearly a problem for investorsClearly a problem for investors– Common stocks are not always an Common stocks are not always an

inflation hedgeinflation hedge Unique needs and circumstancesUnique needs and circumstances

– May restrict certain asset classesMay restrict certain asset classes

Formulate Investment Formulate Investment PolicyPolicy

Constraints and PreferencesConstraints and Preferences– Time horizonTime horizon

Objectives may require specific planning Objectives may require specific planning horizonhorizon

– Liquidity needsLiquidity needs Investors should know future cash needsInvestors should know future cash needs

– Tax considerationsTax considerations Ordinary income vs. capital gainsOrdinary income vs. capital gains Retirement programs offer tax shelteringRetirement programs offer tax sheltering

Formulate Investment Formulate Investment PolicyPolicy

Prudent Man RulePrudent Man Rule– Followed in fiduciary responsibilityFollowed in fiduciary responsibility– Interpretation can change with time Interpretation can change with time

and circumstancesand circumstances– Standard applied to individual Standard applied to individual

investments rather than the portfolio investments rather than the portfolio as a wholeas a whole

Legal and Regulatory Legal and Regulatory RequirementsRequirements

Capital Market Capital Market ExpectationsExpectations

Macro factors Macro factors – Expectations about the capital marketsExpectations about the capital markets

Micro factorsMicro factors– Estimates that influence the selection of Estimates that influence the selection of

a particular asset for a particular portfolioa particular asset for a particular portfolio Rate of return assumptionsRate of return assumptions

– Make them realisticMake them realistic– Study historical returns carefully Study historical returns carefully

Constructing the PortfolioConstructing the Portfolio

Use investment policy and capital Use investment policy and capital market expectations to choose market expectations to choose portfolio of assetsportfolio of assets– Define securities eligible for inclusion in Define securities eligible for inclusion in

a particular portfolioa particular portfolio– Use an optimization procedure to select Use an optimization procedure to select

securities and determine the proper securities and determine the proper portfolio weightsportfolio weights

Markowitz provides a formal modelMarkowitz provides a formal model

Asset AllocationAsset Allocation Involves deciding on weights for Involves deciding on weights for

cash, bonds, and stockscash, bonds, and stocks– Most important decisionMost important decision

Differences in allocation cause Differences in allocation cause differences in portfolio performancedifferences in portfolio performance

Factors to considerFactors to consider– Return requirements, risk tolerance, Return requirements, risk tolerance,

time horizon, age of investortime horizon, age of investor

Strategic asset allocationStrategic asset allocation– Simulation procedures used to determine Simulation procedures used to determine

likely range of outcomes associated with likely range of outcomes associated with each asset mixeach asset mix

Establishes long-run strategic asset mixEstablishes long-run strategic asset mix Tactical asset allocationTactical asset allocation

– Changes in asset mix driven by changes Changes in asset mix driven by changes in expected returnsin expected returns

– Market timing approachMarket timing approach

Asset AllocationAsset Allocation

Monitoring Conditions and Monitoring Conditions and CircumstancesCircumstances

Investor circumstances can change Investor circumstances can change for several reasonsfor several reasons– Wealth changes affect risk toleranceWealth changes affect risk tolerance– Investment horizon changesInvestment horizon changes– Liquidity requirement changesLiquidity requirement changes– Tax circumstance changesTax circumstance changes– Regulatory considerationsRegulatory considerations– Unique needs and circumstancesUnique needs and circumstances

Portfolio AdjustmentsPortfolio Adjustments Portfolio not intended to stay fixedPortfolio not intended to stay fixed Key is to know when to rebalanceKey is to know when to rebalance Rebalancing cost involvesRebalancing cost involves

– Brokerage commissionsBrokerage commissions– Possible impact of trade on market pricePossible impact of trade on market price– Time involved in deciding to tradeTime involved in deciding to trade

Cost of not rebalancing involves Cost of not rebalancing involves holding unfavourable positionsholding unfavourable positions

Performance Performance MeasurementMeasurement

Allows measurement of the success Allows measurement of the success of portfolio managementof portfolio management

Key part of monitoring strategy and Key part of monitoring strategy and evaluating risksevaluating risks

Important for:Important for:– Those who employ a managerThose who employ a manager– Those who invest personal fundsThose who invest personal funds

Find reasons for success or failureFind reasons for success or failure