Chapter: Seven

Portfolio Management

Portfolio Management
Portfolio management is the art and science of making decisions about investment mix and
policy, matching investments to objectives, asset allocation for individuals and institutions, and
balancing risk against performance. Portfolio management is all about determining strengths,
weaknesses, opportunities and threats in the choice of debt vs. equity, domestic vs. international,
growth vs. safety, and much other trade-offs encountered in the attempt to maximize return at a
given appetite for risk.

Portfolio management refers to the professional management of securities and other assets.
Also referred to as "asset management" and "wealth management

Portfolio management includes a range of professional services to manage an individual's and

company's securities, such as stocks and bonds, and other assets, such as real estate.  The
management is executed in accordance with a specific investment goal and investment profile
and takes into consideration the level of risk, diversification, period of investment and maturity
(i.e. when the returns are needed or desired) that the investor seeks.

In cases of sophisticated portfolio management, services may include research, financial

analysis, and asset valuation, monitoring and reporting.

The fee for portfolio management services can vary widely among management companies.  In
terms of structure, fees may include an asset-based management fee, which is calculated on the
basis of the asset valuation at the beginning of the service.  Since this fee is guaranteed to the
manager, it is typically a lower amount.  Alternatively, the fee may be tied to profits earned by
the portfolio manager for the owner.  In such cases, the risk-based fee is usually much higher.

The Key Elements of Portfolio Management

Asset Allocation: The key to effective portfolio management is the long-term mix of assets.
Asset allocation is based on the understanding that different types of assets do not move in
concert, and some are more volatile than others. Asset allocation seeks to optimize the risk/return
profile of an investor by investing in a mix of assets that have low correlation to each other.
Investors with a more aggressive profile can weight their portfolio toward more volatile
investments. Investors with a more conservative profile can weight their portfolio toward more
stable investments.

Diversification: The only certainty in investing is it is impossible to consistently predict the

winners and losers, so the prudent approach is to create a basket of investments that provide
broad exposure within an asset class. Diversification is the spreading of risk and reward within
an asset class. Because it is difficult to know which particular subset of an asset class or sector is
likely to outperform another, diversification seeks to capture the returns of all of the sectors over

1
time but with less volatility at any one time. Proper diversification takes place across different
classes of securities, sectors of the economy and geographical regions.

Rebalancing: This is a method used to return a portfolio to its original target allocation at annual
intervals. It is important for retaining the asset mix that best reflects an investor’s risk/return
profile. Otherwise, the movements of the markets could expose the portfolio to greater risk or
reduced return opportunities. For example, a portfolio that starts out with a 70% equity and 30%
fixed-income allocation could, through an extended market rally, shift to an 80/20 allocation that
exposes the portfolio to more risk than the investor can tolerate. Rebalancing almost always
entails the sale of high-priced/low-value securities and the redeployment of the proceeds into
low-priced/high-value or out-of-favor securities. The annual iteration of rebalancing enables
investors to capture gains and expand the opportunity for growth in high potential sectors while
keeping the portfolio aligned with the investor’s risk/return profile.

Portfolio Performance Evaluation

The portfolio performance evaluation primarily refers to the determination of how a particular
investment portfolio has performed relative to some comparison benchmark. The evaluation can
indicate the extent to which the portfolio has outperformed or under-performed, or whether it has
performed at par with the benchmark.

The evaluation of portfolio performance is important for several reasons. First, the investor,
whose funds have been invested in the portfolio, needs to know the relative performance of the
portfolio. The performance review must generate and provide information that will help the
investor to assess any need for rebalancing of his investments. Second, the management of the
portfolio needs this information to evaluate the performance of the manager of the portfolio and
to determine the manager’s compensation, if that is tied to the portfolio performance. The
performance evaluation methods generally fall into two categories, namely conventional and
risk-adjusted methods.

Investing in a portfolio involves both returns and risks. In order to evaluate the performance, we
should consider both the aspects. Evaluating a portfolio's performance involves comparing it to
an appropriate benchmark.

Let's assume you have invested in a portfolio that gave a return of 20% over a year, whereas the
market index has given returns of 15% over the same year. You might think that your portfolio
has generated better returns, but how do you confirm this? In order to have a proper comparison
against the benchmark, you should have methods to evaluate both returns and risk.

We will now understand how to measure the returns and risks of a portfolio.

Portfolio Return
The return of a portfolio is derived from the weighted average returns of the assets in the
portfolio. For a portfolio with n number of assets, the portfolio returns are:

2
Portfolio Risk

Total risk of the portfolio can be determined by its volatility, which is nothing but the standard
deviation of its returns over a period of time. For n-period returns of a portfolio, volatility is:

The total risk has two components:

1. Systematic risk: Systematic Risk of a portfolio is defined as the inherent risk in the
portfolio which cannot be diversified. It is measured as beta, relative to the market as a
whole.
2. Unsystematic risk: This is the component of risk that can be diversified away.

Let's assume that over the year, your portfolio had a standard deviation of 12% and that of the
market index was 7%. So now you can see that your portfolio had more risk than the benchmark.

Methods of Performance Evaluation

There are two broad categories of portfolio performance evaluation methods:

1. Conventional Method
The conventional method of performance evaluation doesn't take into account the risks taken by
the portfolio manager. In this method, the performance of a portfolio is evaluated by comparing
the portfolio returns to the returns of a benchmark, which can be a market index, such as S&P
500, or another similar portfolio.

Comparing only the returns, your portfolio has given better returns (20%) than the market index,
which gave 15%, irrespective of the fact that it had higher risk than the market.

2. Risk-adjusted Methods
In these methods, the returns of the portfolio are compared to the returns of the benchmark,
considering the difference in their risk levels. The most common methods to do this are:

Sharpe Ratio
The Sharpe ratio is defined as the risk premium of the portfolio per unit of total risk in the
portfolio. Risk premium calculated by subtracting risk-free returns from the portfolio returns.

The risk-free returns are measured as the risk-free interest rate of Treasury bonds.
Let's assume, the Treasury bonds interest rate was 3% over the year.

The Sharpe ratio of your portfolio is:

3
The Sharpe ratio of the market index is:

Thus, the Sharpe ratio of your portfolio is lower than the Sharpe ratio of the market index,
meaning that your portfolio underperformed the market index on a risk-adjusted basis even
though its returns were higher than the index's returns.

Treynor Ratio
The Treynor ratio of a portfolio is calculated by dividing the risk premium by the systematic risk
of the portfolio. It assumes that no diversifiable risk is present in the portfolio.

Let's assume that the beta of your portfolio is 1.5. The beta of the market portfolio is, by
definition, 1. These numbers tell that the portfolio has 1.5 times more systematic risk than the
market, but it is not enough to compare the relative performance.

The Treynor ratio of the portfolio is:

and the Treynor ratio of the market index is:

In the multi-asset strategies the three important issues in portfolio evaluation and some
institutional investors’ best practices.

1. How should we deal with the conflict between long-term investment goals and short-
term evaluation cycles?

Many investment managers follow investment processes that are inherently long term. For
example, value strategies often take a full market cycle to bear fruit. If investors hold such
managers to a quarterly evaluation cycle, conflicts often arise. Understandably such managers’
returns may end up in the bottom quartile in a quarter. Investors expecting otherwise will be
disappointed. Worse, if the managers are forced to modify their process and deliver more
consistent returns, they might be become disoriented.

2. Should performance evaluation be quantitative or qualitative?

4
Various formulas come to mind when people talk about performance evaluation. The standard
attribution formula is an integral part of the CFA® curriculum. also uses regression analysis over
various periods to measure return drivers in their portfolio, such as equity, emerging markets,
and credit. The team will then adjust portfolio exposures accordingly where necessary.

3. Should performance for active and passive portfolios be measured differently?

An important caveat is that we need not lose sight of the long-term goal (total return) of
investing when drilling down to drivers of active returns. Total returns are apparently more
relevant for asset owners and average investors while understanding active return drivers is of
critical importance in manager selection. Only a holistic review provides the full picture.

In summary, portfolio evaluation can be much more than just producing a score card. There are
various approaches investors can take in the process to enhance portfolio performance.

Passive Vs Active Portfolio Management

Investors have two main investment strategies that can be used to generate a return on their
investment accounts: active portfolio management and passive portfolio management. These
approaches differ in how the account manager utilizes investments held in the portfolio over
time. Active portfolio management focuses on outperforming the market compared to a specific
benchmark, while passive portfolio management aims to mimic the investment holdings of a
particular index.

Active Portfolio Management

Investors who implement an active management approach use fund managers or brokers to buy
and sell stocks in an attempt to outperform a specific index, such as the Standard & Poor's
500 Index or the Russell 1000.

An actively-managed investment fund has an individual portfolio manager, co-managers or a

team of managers actively making investment decisions for the fund. The success of an actively-
managed fund is dependent on combining in-depth research, market forecasting and the
experience and expertise of the portfolio manager or management team.

Portfolio managers engaged in active investing pay close attention to market trends, shifts in the
economy, changes to the political landscape and factors that may affect specific companies. This
data is used to time the purchase or sale of investments in an effort to take advantage of
irregularities. Active managers claim that these processes will boost the potential for greater
returns than those achieved by simply mimicking the stocks or other securities listed on a
particular index.

Since the objective of a portfolio manager in an actively-managed fund is to beat the market, he
or she must take on additional market risk to obtain the returns necessary to achieve this end.
Indexing eliminates this, as there is no risk of human error in terms of stock selection. Index
funds are also traded less frequently, which means that they incur lower expense ratios and are
more tax-efficient than actively-managed funds.

5
Passive Portfolio Management
Passive management, also referred to as index fund management, involves the creation of a
portfolio intended to track the returns of a particular market index or benchmark as closely as
possible. Managers select stocks and other securities listed on an index and apply the same
weighting. The purpose of passive portfolio management is to generate a return that is the same
as the chosen index instead of outperforming it.

A passive strategy does not have a management team making investment decisions and can be
structured as an exchange-traded fund (ETF), a mutual fund or a unit investment trust. Index
funds are branded as passively managed because each has a portfolio manager replicating the
index, rather than trading securities based on his or her knowledge of the risk and reward
characteristics of various securities. Because this investment strategy is not proactive,
the management fees assessed on passive portfolios or funds are often far lower than active
management strategies.

The process of portfolio management

Starting with writing the policy statement, then determining an investment strategy to
constructing a portfolio of assets, the portfolio management system ends with continual
monitoring of the investor’s needs and capital market conditions

An asset class comprises securities that have similar characteristics, attributes, and risk return
relationships.

Asset allocation is the process of deciding how to distribute your wealth among different asset
classes for investment purpose. An asset class comprises securities that have similar
characteristics, attributes, and risk return relationships. The asset allocation decision is not an
isolated choice rather, it is a component of a portfolio management process. Let us discuss the
portfolio management process.

Policy statement
The first step in the portfolio management process is to construct a policy statement. It is like a
road map wherein investors should assess the types of risks they are willing to take and their
investment goals and constraints. All investment decisions are based on the policy statement to
ensure they are appropriate for the investor. As investor needs change over time, the policy
statement must be periodically reviewed and updated. A policy statement does not guarantee
investment success but will provide discipline for the investment process and reduce the
possibility of making hasty, inappropriate decisions. But it helps the investor to decide on
realistic investment goals after learning about the financial markets and the risks of investing.

6
Investment strategy
In the second step of the portfolio management process, the investor should assess current
financial and economic conditions and forecast future trends. Investor needs, as reflected in the
policy statement, and financial market expectations will jointly determine investment strategy.
Economies are dynamic and they are affected by numerous industry struggles, politics, and
changing demographics and social attitudes. Thus, the portfolio
will require constant monitoring and updating to reflect changes in financial market expectations

Implement the plan

The third step of the portfolio management process is construction of the portfolio. With the
investor’s policy statement and financial market forecasts as inputs, one should implement the
investment strategy and determine how to allocate available funds across different markets, asset
classes, and securities. This involves constructing a portfolio that will minimise the investor’s
risks while meeting the needs specified in the policy statement.

Continuous monitoring
The fourth step in the portfolio management process is the continual monitoring of the investor’s
needs and capital market conditions and, when necessary, updating the policy statement. Based
upon all of this, the investment strategy is modified accordingly. A component of the monitoring
process is to evaluate a portfolio’s performance and compare the relative results to the
expectations and the requirements listed in the policy statement.

A carefully constructed policy statement determines the types of assets that should be included in
a portfolio. The asset allocation decision, not the selection of specific stocks and bonds,
determines most of the portfolio’s returns over time. Although seemingly risky, investors seeking
capital appreciation, income, or even capital preservation over long time periods will do well to
include a sizable allocation to the equity portion in their portfolio.

As noted, a strategy’s risk may depend on the investor’s goals and time horizon. At times,
investing in treasury bills may be a riskier strategy than investing in common stocks due to
reinvestment risks and the risk of not meeting long-term investment return goals after
considering inflation and taxes. To conclude, although there are no shortcuts or guarantees to
investment success, maintaining a reasonable and disciplined approach to investing will increase
the likelihood of investment success over time.

7
Once the type of investment client has been determined along with their financial goals, a
series of steps needs to be followed to ensure those goals and needs are met.
1. The Planning Step
Once the client’s objectives and constraints have been established, an investment policy
statement (IPS) must be developed. This is a written document describing all the investment
objectives and constraints that apply to a client’s portfolio and may also contain a reference to a
benchmark. A benchmark can be used to assess investment performance and evaluate whether
the objectives have been achieved.
2. The Execution Step
The execution step has three stages – asset allocation, security analysis, and portfolio
construction.
Asset Allocation
The analyst or portfolio manager will form a view on the economic and capital market
expectations for various available asset classes. This analysis may be top-down which starts with
a consideration of the macroeconomic or industry environment and an evaluation of those asset
classes expected to perform well given the environment. Or, the analysis may be bottom-up,
which rather than looking at macroeconomic or industry data, focuses on company-specific
factors. A decision will then be taken on the allocation of assets to the available asset classes.
Assets classes can include equities, bonds, and cash as well as real estate, commodities, hedge
funds and private equity.

Security Analysis
Top-down and bottom-up views can be combined in selecting individual securities to assess the
level of returns and risk and therefore assign a valuation to securities being considered for
portfolio inclusion.

Portfolio Construction
Using the IPS, the desired asset allocation, and security analysis, a diversified portfolio can be
constructed. Along with the goal of achieving investment performance, risk management is an
important focus of the portfolio construction process. The IPS will outline the client’s risk
tolerance and the portfolio manager must ensure the portfolio is aligned to this risk profile. Once
the portfolio manager has decided exactly which securities to buy and in which amounts, the
trades will be implemented.

3. The Feedback Step

After the portfolio has been constructed, it needs to be reviewed and monitored at an appropriate
interval.
Portfolio Monitoring and Rebalancing
Portfolio rebalancing is carried out when the portfolio has drifted from the targeted asset
allocation due to market movements. If the top-down or bottom-up views change, an individual
security or asset class may need to be changed.

Portfolio Measurement and Reporting

The portfolio performance must be evaluated to establish whether the client’s objectives have
been met. The portfolio performance may be assessed relative to the benchmark set out in the
IPS.

8
 So how do portfolio managers meet their clients’ financial goals, and what does a
portfolio manager do? Portfolio managers conduct the following steps to add value

1. Originating Ideas
Where does a portfolio manager start in his quest to beat the market? Fresh ideas.

There are more than 7,000 listed companies in the world, and a portfolio manager needs to know
where to look. Cheah prefers to look beyond the index and the obvious, especially the ones
shopped around by sell-side analysts. Admittedly, this could be hard in such cases as the internet
bubble period in the United States and the policy-driven market in China. Looking in the right
direction, however, has strategic importance in achieving the objective of adding alpha as well as
improving manager efficiency.

2. Conducting Research
Research is not the exclusive realm of research analysts — far from it.

Analysts and managers often perform fundamental analysis on these companies together to
assess their potentials. The difference, in my opinion, is that managers are responsible for the
ranking and analysis process and ensure that the investment philosophy is consistently carried
out. Value managers usually place more emphasis on such valuation variables as intrinsic value
arrived at using discount cash flow models or price multiples, whereas growth managers tend to
put more weight on sales and profit growth, pricing power, and market share, etc.

3. Making Decisions
Investors are often better at investigating investment opportunities than making investment
decisions because they are afraid of making mistakes that they’ll regret. It is critical, however,
for a portfolio manager to be able to pull the trigger when presented with a killer opportunity.

Making decisions is also hard because it requires that we project into the future based on past
facts. As much as we may hope otherwise, there is no way of knowing for sure whether any of
our projections will turn out to be accurate. Even the talented complain that investing is a lonely
business. The decision to buy or not to buy often comes down to gut feeling and is often a close
call, as many seasoned and successful investment managers have told me over the years.

4. Structuring Transactions
There are many ways of investing in a company. Buying shares in the open market is only one of
them.

The portfolio managers need to invest in ways that benefit investors the most. Given the firm’s
size and the liquidity of some Asian markets, this is not surprising. Although open markets
remain the benchmark, buying directly from the company, where possible, could make more
sense. A manager needs to familiarize herself with the intricacies of these transactions, including
accounting, legal, and tax implications.

9
5. Executing Transactions
A portfolio manager also needs to work with traders and ensure that ideas become investments.

Traders are ultimately responsible for trading. Portfolio managers, however, need to have an
appreciation for how their investment decision may affect the market. In my days as a portfolio
manager, our traders were early pioneers in breaking trades into smaller ones and executing them
on electronic trading platforms to minimize price impact. Trading techniques and technologies
have progressed by leaps and bounds over the last decade. Electronic trading has become
prevalent and is no longer considered an edge. Still, not keeping up with the industry can cost
investors dearly, not to mention may introduce trading errors.

6. Maintaining Investments
Adding an investment to the portfolio is not the end of the story. Portfolio managers need to
continue paying attention to portfolio companies once initial investments are made. This is a
continuation of the research process.

I was struck by his choice of words. “Maintain” has much richer meanings than “monitor,”
which feels a bit cold-hearted, distant, or at least matter of fact. To maintain is to show affection
and care, which is the right attitude for portfolio managers to take toward their investments.

7. Exiting Investments
Conventional wisdom seems to hold that exiting an investment is almost more important than
entering one. And it could be right.

If portfolio managers hesitate when they exit positions, they often run the risk of letting small
losses balloon into major headaches. Similarly, if portfolio managers do not lock in profits when
they should, it could be equally damaging to their performance.

8. Manage risk
By selecting weights for each asset classes, portfolio managers have control over the amount of
1) Security selection risk, 2) style risk, and 3) risk taken by the portfolio.

 Security selection risk arises from the manager’s SAA actions. The only way the manager
can avoid security selection risk is to hold the market index directly; this ensures that the
manager’s asset class returns are exactly the same as that of the benchmark asset class.
 Style risk arises from the manager’s investment style. For instance, “growth” managers
usually beat the benchmark returns when the market index is doing well, but
underperform when the index is doing poorly. Contrarily, “value” managers struggle to
beat the benchmark returns when the market index is doing well, but beat the market
when it’s doing poorly.
 The manager can only avoid TAA risk by choosing the same systematic risk (β) as the
benchmark index. By not choosing this path, and instead betting on TAA, the manager is
exposed to higher levels of volatility.

10
 9. Measure performance
The performance of portfolios can be measured using the CAPM model. The CAPM
performance measures can be derived from a regression of excess portfolio return on excess
market return. This yields the systematic risk (β), the portfolio’s value-added (α), and the
residual risk. and the calculations of the Treynor ratio and Sharpe ratio, as well as the
information ratio.

 The Treynor ratio, calculated as Tp = (Rp-Rf)/ β, measures the amount of excess return
gained by taking on an additional unit of systematic risk.

 The Sharpe ratio, calculated as Sp = (Rp-Rf)/ σ, where σ = Stdev(Rp-Rf), measures the

excess return per unit of total risk.

 Comparing the Treynor and Sharpe ratios can tell us if a manager is undertaking a lot of
unsystematic, or idiosyncratic, risk. Idiosyncratic risks can be managed by diversification
within the portfolio.

 The information ratio is calculated as: Ip = [(Rp-Rf)- β(Rm-Rf)]/ω = α/ω, where ω

represents unsystematic risk. As the numerator is value-added, and the denominator is the
risk taken in order to achieve the added value, it is the most useful tool to assess the reward-
to-risk of a manager’s value-added.

11