CHAPTER ONE

THE PORTFOLIO MANAGEMENT PROCESS

• Investors know that risk drives return hence the practice of managing and investing
funds should focus on managing risk rather than returns.
• Maintaining a reasonable and disciplined approach to investing will increase the
likelihood of investment success over time.

Step 1

Investors short term and long-term needs, expectations, familiarity with the markets,
history, risk tolerance, financial distress, risk tolerance, constraints investment strategy,
objectives.

Step 2

Examine current and projected financial, political, economic, and social conditions. These
help in constructing the portfolio and these conditions jointly determine the investment
strategy.

Step 3

Implement the plan by constructing the portfolio. Meet the investors needs at minimum
level of risk

Step 4

Monitor and update investment needs, environmental conditions, evaluate portfolio

performance.

This can be a continuous process especially when the environment and investor needs
are changing rapidly.
STATEMENT OF INVESTMENT POLICY

IMPORTANCE

1. Help investors to understand and articulate realistic investor goals, example of a

bad goal ‘to make a lot of money’. Disadvantages of such a goal;

It may not be appropriate for the investor

It is too open ended to provide guidance for specific investments and time frames

It helps investors to understand their needs, objectives and investment constraints and
financial markets and the risks of investing.

A process of communicating; which helps the manager.

2. Standards for evaluating Portfolio Performance

It provides an objective standard too measure performance. The performance should be

measured against guidelines specified in the statement, not on the portfolio’s overall
returns.

3. Protect the client against inappropriate and unethical behaviors

4. Helps other managers to take over in the event of dismissal or promotion of the current
manager, thus it prevents costly delays and misunderstandings.

INVESTMENT OBJECTIVES

These should be expressed in terms of risk and return.

They help to avoid such high-risk investment strategies or ‘Account Churning’ –which
involves moving quickly in and out of investment in an attempt to buy low and sell high.

Risk tolerance is affected by current insurance coverage, cash reserves, family

situation, age and net worth.

1. Capital Preservation
Minimize the risk of loss in real terms

This seeks to maintain the purchasing power of investments e.g return should be greater
than the rate of inflation.

Generally, it’s a strategy for strongly risk averse investors/ for funds needed in the short
term e.g tuition fees or down payment for a house.

2. Capital Appreciation

The portfolio should grow in real terms to meet future needs.

Growth occurs mainly thru capital gains

This is an aggressive strategy for investors willing to take on the risk (risk lovers).

Appropriate for long term investors seeking to save for retirement /education (young
people).

3. Current Income

The portfolio should generate income than capital gains

Usually for supplementing earnings to meet living expenses e.g retirees

4. Total Return

The investor wants the portfolio to grow over time to meet a future need.

It seeks to achieve appreciation thru both capital gains and re-investing current income.

Risk exposure lies between current income and capital appreciation.

INVESTMENT CONSTRAINTS

1. Liquidity needs

Investors can have liquidity needs that the investment plan should consider.

Near term goal might require available funds.

Wealthy individuals with huge tax obligations need adequate liquidity to pay taxes, some
retirees’ need cash for daily expenses, eg a 25 year old investor might not need/ need
little liquidity since his focus is on long term retirement fund.

Unemployment, honeymoon expenses, house down payment may need cash.

2. Time Horizon

There exist a close r/ship between liquidity and time horizon and ability to handle risk.

Investors with long term horizon require less liquidity and can tolerate risk (typical young
investor).

Short term investors require less risky assets with a higher degree of liquidity because
losses are harder to overcome in a short period horizon.

3. Tax Concerns

Taxable income from Income, Dividends and rents is taxable at the investors marginal
tax rate .

Capital gains are taxed differently from income tax , capital gains …capital gains is paid
only when the asset is sold.

Some sources of investment income are exempt from taxes eg income on federal
securities, TBs, notes and bonds.

High Taxed individuals have a high propensity to purchase tax exempt investments.

4. Legal and Regulatory Factors

These can constrain the investment strategies e.g penalties paid upon early withdrawal
– this can be a constraint to an investor with substantial needs.

Insider trading, Prescribed assets, IPEC Limits.

5. Unique needs and preferences.

These are idiosyncratic concerns

No firms that manufacture tobacco, alcohol, pornography or environmentally harmful
products….?

Some use social responsibility criteria

Time and expertise of the investor to manage his portfolio.

ASSET ALLOCATION (AA)

Though a policy statement does not indicate which specific securities to purchase and
when they should be sold, it should provide guidelines as to the asset classes to include
and the relative proportions of the investors funds to invest in each asset class.

AA is the process of dividing funds into different asset classes.

It is advisable to present it in ranges than strict numbers to allow the manager some
freedom based on his forecast of market trends.

It constitutes the decisions like;

• What asset classes should be considered for investment;

• What policy weights should be assigned to each eligible class

Ibbotson and Kaplan (2000), Brinson, Hood and Beebower (1986) and Brinson, Singer
and Beebower (1991) examined the effect of normal policy weights on investment
performance using data from pension funds and mutual funds from 1970-1990s . They
found that about 90% of a fund’s returns over time can be explained by its target asset
allocation policy.

Also, across a set of different funds, about 40% of the difference in fund returns is
explained by the difference in asset allocation policy.

Also due to market efficiency, fund managers practicing market timing and security
selection on average, have difficulty surpassing passively invested index returns after
taking into account the expenses and fees. Is this true for our financial market???
STRATEGIC ASSET ALLOCATION

Represent the optimal combination of various asset classes in an efficient market.

It is basically an indexed portfolio which would actually be held if a passive, pure

investment strategy is to be employed.

It is the measure against which portfolio returns will be measured against to find out
whether speculative strategies are adding value.

TACTICAL ASSET ALLOCATION

Are speculative transactions i.e timing and selection decisions carried out with the belief
that such transactions generate excess risk adjusted returns.

Timing decisions over- or underweight various asset classes, industries or economic

sectors from the SAA.

Selection deal with securities within a given asset class, industry, sector and attempt to
determine which securities should be over/underweight.

RISK MANAGEMENT VIEW

AA is a risk management strategy that can help reduce the effects of market fluctuations
by recognizing and balancing the different characteristics of stocks, bonds and cash in
relation to your goals and tolerance of risk.

REDUCE VOLATILITY OVER TIME

AA can help improve chances of achieving a desired total return over the long term by
understanding the different ways stocks, bonds and cash have performed historically.

The assets don’t usually gain/lose value concurrently so they can assist in reducing
volatility over time.

AA is a decision affected by investment goal, horizon and tolerance of risk.

If there are more than one investment goal, then there should be different levels of risk
and achieve goals.

Diversifying within an asset class can help spread the risk in that category, so that overall
portfolio results will not be largely affected by the performance of any one investment.

Equity diversification includes holding stocks from different sectors and industries within
different market caps i.e large and small caps and different styles such as growth and
value or even international component.

Fixed income diversification includes bonds with staggered maturities i.e laddering or
holding bonds from various sectors and varying credit quality.

Cash…..CDs, TBs and money funds

CLIENT UTILITY AND RISK TOLERANCE

Risk averse investors are willing to only consider only a Rf or speculative prospects with
positive risk premium.

They penalize the E(R) of a risky portfolio by a certain % to account for risk involved.

The greater the risk, the larger the penalty

Each investor assigns a welfare/utility score to competing investments based on E(R) and
δ

The utility can be used to rank portfolios, and higher utilities are assigned to portfolios
with more attractive risk return profiles i.e high E(R) and lower δ.

U = E(R)-0.005Aδ2

U = utility, E(R) = expected return, A = index of risk aversion, 0.005 is a scaling factor that
allow us to express the E(r) and δ as a %.
The U provided by a Rf portfolio is simply the rate of return on the portfolio because there
is no penalization of risk.

CHOICE BETWEEN ASSETS

E(r) =22%, Rf =5%, δ =34%, Aversion =3

U =22-0.005(3) (342)

=4.66%

Though risk premium is 17% (large) (22-5), the utility is less than the Rf rate.

The penalty for risk adjusts E(R) from 22% to 4.66% by a factor of 17.34%.

If the investor is less risk tolerant i.e A=2 then the E(R) will be adjusted by only 11.56%
and the utility level become 10.44% wc is higher than the Rf rate. Accept the project.

EXERCISE

E(R) =20%, δ =20%, TB rate =7%. Which investment alternative will be chosen by an
investor where A =4? What if A =8?

We can call the investor’s utility value the Certainty Equivalent Rate which is described
as the rate that risk free investments would need to offer with certainty to be considered
equally attractive as the risky portfolio.

PASSIVE AND ACTIVE STRATEGIES

Passive strategists believe that the market is efficient hence all the securities are correctly
priced. If ever there is mispricing, then it will be a small portion wc can quickly correct or
pursuing it will be made useless by the transaction costs involved in buying and selling.

They contend that the risk created by buying and selling is not worth it since securities
are properly priced, so no excess risk adjusted returns can be generated. They believe in
indexed portfolios (replicate the performance of a given index) and buy and hold strategy
i.e what Buffet called Buy and Switch off the market.

In bonds, their aim becomes to manage Interest rate risk, say, through immunization
technique.

Active strategists believe markets are not efficient hence there is room for making above
market returns through buying and selling of mispriced securities. In the bond markets,
they try to interest rates and try to anticipate movements.

They generate abnormal returns if and only if the analyst’s information or sight is superior
to that of the market. You cannot profit from the info that rates are about to fall if it is
already reflected in the asset prices.

These believe in Fundamental and Technical Analysis.