Reading 48-Portfolio Management An Overview

Portfolio Management
Portfolio Management: An
Overview
Study Session 17
Reading No – 48
Version 2022
Learning Outcome Statements
The candidate Should be able to:
a. describe the portfolio approach to investing;
b. describe the steps in the portfolio management process;
c. describe types of investors and distinctive characteristics and needs of each;
d. describe defined contribution and defined benefit pension plans;
e. describe aspects of the asset management industry;
f. describe mutual funds and compare them with other pooled investment products.
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Los a: Portfolio Approach to Investing
Diversification: The Air Bags
The word diversification might sound like a very casual term but its
like the air bags in a car, you pay a high price to get them which
probably you will never use but when the day comes it can be a life
safer.
Wealth Creation is more Risk Management Than Returns.
Unfortunately the majority focus on returns, but the idea is to
survive long enough and the wealth gets created by itself.
Look at some of these stocks in India which were big names but
probably destroyed wealth for concentrated investments
Los a: Risk
Random Portfolio of 5 Stocks NSE A Spreadsheet calculation is equal to thousand
12000 words. So we took a random pick of 5 stocks
from NSE and invested INR 10,000 equally
10000
9195.221011 across 5 stocks. Lets look at the stats.
7645.716712
Weights Return SD Min Max
8000
Avanti Feeds 20.000% 27% 9% 5% 20%
HDFC 20.000% 20% 27% 5% 20%
5828.907039 Infosys 20.000% 26% 49% 5% 20%
6000
4792.618602
Tata motors 20.000% 1% 5% 5% 20%
Reliance 20.000% 35% 20% 5% 20%
4000 Portfolio 100% 21.84% 23.38%
Sharpe 0.720028
2542.528702
Notice that that if you do a simple average of
2000
individual SD’s you get 22% but the portfolio
0
level SD is actually 23.8%.
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Avanti Feeds HDFC Infosys Maruti Reliance
Equal is Not Always Good
Weights Return SD Min Max If we took an equal weighted portfolio just like
Avanti Feeds 20.000% 27% 9% 5% 20%
HDFC 20.000% 20% 27% 5% 20%
the previous slide, you see that the Sharpe is
Infosys 20.000% 26% 49% 5% 20% 0.72 with an RF( Assumed at 5%) and 100%
Tata motors 20.000% 1% 5% 5% 20%
Reliance 20.000% 35% 20% 5% 20%
investing but that doesn’t mean that this is the
Portfolio 100% 21.84% 23.38% optimal portfolio
Sharpe 0.720028
Weights Return SD Min Max

Avanti Feeds 8.948% 27% 49% 5% 20%
HDFC 20.191% 20% 25% 5% 20% If we now use some techniques on excel to get
Infosys 34.827% 26% 29% 5% 20%
Tata Motors 0.000% 1% 48% 5% 20%
another variant after hit and trial then the
Reliance 36.034% 35% 31% 5% 20% Sharpe can be increased to 5.43, while
Portfolio 100% 28.16% 4.26% minimising the SD
Sharpe 5.432315
Los a: Diversification within Asset Class
You need to understand that although diversification can help you in reducing the company or
sector specific risk or unsystematic risk but cannot really diversify world wide systematic risk with all
markets in a particular asset class:
• For eg even if you had the perfect portfolio during 2007, all and everything would have crumbled
in 2008
• Hence diversification within an asset class can only provide risk immunity during normal times
Los a: Modern Portfolio Theory
Harry Marowitz in 1952 published the article “
Modern Portfolio Theory” or MPT.
Understand this example:
A “rational investor” is asked to choose between
two investments: Investment A and Investment B.
Both are expected to increase in value by 6 percent
each year. However, Investment B is considered
twice as volatile as Investment A, meaning its value
fluctuates at twice the magnitude of Investment A’s
value fluctuations
Any rational investor would choose Investment A,
because it gives the same expected return with
lower volatility.
The conclusion is that as opposed to the generalized
thinking that all investors are alike, an investor
could create his own set of combinations for
different set of risk. In the process choose the one
which suits him/ her the most.
CFA Curriculum Question
Investors should use a portfolio approach to:
A reduce risk.
B monitor risk.
C eliminate risk.
Solution
A is correct. Combining assets into a portfolio should reduce the portfolio’s volatility. Specifically, “individuals
and institutions should hold portfolios to reduce risk.” As illustrated in the reading, however, risk reduction may
not be as great during a period of dramatic economic change.
Los b: Steps in Portfolio Management
Understand
Client Needs
Prepare a
Measurement &
Investment
Reporting
Policy Statement
Rebalancing Asset Allocation
Monitoring Security Analysis
Portfolio
Construction
Los c,d: Types of Investors and their needs
Client Time Horizon Risk Tolerance Income Needs Liquidity Needs
Individual Varies Varies Varies Varies

Defined Benefit Long Term High High for Mature Varies by maturity
Funds, Low for of the plan
Growing Funds
Endowment Very Long Term High Meet Spending Low
Needs
Banks Short Term Low Int on Deposits and High
Operational
Expenses
Insurance Short Term Low Low High
Investment Varies Varies Varies High to meet
Companies redemption
Sovereign Varies Varies Varies Varies
Wealth Funds
Types of Investors
1. Individual: Typical save for retirement or certain persona goals
2. Defined Benefit: Pension plans by companies, typically with the objective of meeting pensions later
3. Defined Contribution: Different from defined benefit, here the employee decides the risk and the employer
contributes an equal amount
4. Endowment or Foundations: Non profit institutions that help institutions provide service. They invest to meet the
expenses of any activity that the foundation might take
5. Sovereign Wealth Fund: State owned investment funds that invest in real or financial assets
Solution
• C is correct. Portfolio 3 has the same equity exposure as Portfolio 1 and has a higher exposure to alternative
assets, which have greater volatility
Los c,d: Structure of Asset Management
Industry
Asset
Management
Sell Side
Research and
Services To Buy
Side
Active Passive Traditional Alternatives
Buy Side
Los c,d: Active Vs Passive Management in U.S
Active Management means services, in which the asset manager actively looks out for opportunities to
beat the indexes, passive management is avoiding the search and directly buying the index. In the Data
above you can see that although active management is still high overall but passive management flows
have been increasing at a considerable pace post 2013.
Los c,d: Traditional vs Non Traditional Asset
Managers
Asset Manager
Types
2% Fee Pooled fund
Traditional
Objective to Beat the
benchmark
2% Fee +
Performance Fee
Objective to generate
Non Traditional
absolute Returns
Reduce Volatility
Los c,d: Trends in Asset Management
1. Growth of Passive Investing: The key reason is the low cost for management and the fact that
most of the active managers fail to beat the benchmark post fees and taxes
2. Use of Big Data: Apart from just financial data, now there are many third party providers who
analyse social media data, imagery and sensor data of companies and use it for research and
investment decision making
3. Robo Advisors: estimated to be around $180 bn in 2017, this growth is fuelled by demand
from young investors, lower fees, large new companies in this space
Los f: Types of Mutual Funds
Global Vs
Domestic
Open or
Closed
Government
Hybrid Mutual
Bonds & Stocks
Funds
Mutual Fund
Corporate
Types
Treasury bills
High Yield
Money Market Certificate of
Mutual Funds Deposits
Commercial
Large cap
Paper
Mid Cap
Equity Mutual
Small Cap
Funds
Sector or
Themmatic
Bond Mutual
Funds
Los f: Other Pooled Products
Open Ended usually
Traded on exchange
ETF
Can be purchased or
sold any time
Low Transaction cost
Short selling takes

place
Absolute Return
Separately Managed Objective
Account
Other Asset Products
Hedge Funds Use of leverage
Example could be PMS
Managed Separately
For an Individual Low correlation
Performance Fee
Structure
ManagementFees
Carried Interrest-
Private Equity
Performance fee 20%
Transaction charges-
various activities
1. Which of the following pooled investments is most likely characterized by a few large investments?
A Hedge funds.
B Buyout funds.
C Venture capital funds.
2 :Which of the following investment products is most likely to trade at their net asset value per share?
A Exchange traded funds.
B Open-end mutual funds.
C Closed-end mutual funds.
Solution
• B is correct. Buyout funds or private equity firms make only a few large investments in private companies
with the intent of selling the restructured companies in three to five years. Venture capital funds also have a
short time horizon; however, these funds consist of many small investments in companies with the
expectation that only a few will have a large payoff (and that most will fail).
• B is correct. Open-end funds trade at their net asset value per share, whereas closed-end funds and
exchange traded funds can trade at a premium or a discount.
Summary
• Portfolio approach to investing could be preferable to simply investing in individual securities.
• The problem with focusing on individual securities is that this approach may lead to the investor “putting all her
eggs in one basket.”
• Portfolios provide important diversification benefits, allowing risk to be reduced without necessarily affecting or
compromising return.
• Understanding the needs of your client and preparing an investment policy statement represent the first steps of
the portfolio management process. Those steps are followed by asset allocation, security y analysis, portfolio
construction, portfolio monitoring and rebalancing, and performance measurement and reporting.
• Types of investors include individual and institutional investors. Institutional investors include defined benefit
pension plans, endowments and foundations, banks, insurance companies, and sovereign wealth funds.
• The asset management industry is an integral component of the global financial services sector. Asset managers
offer either active management, passive management, or both. Asset managers are typically categorized as
traditional or alternative, although the line between traditional and alternative has blurred.
• Three key trends in the asset management industry include the growth of passive investing, “big data” in the
investment process, and robo-advisers in the wealth management industry.
• ■■ Investors use different types of investment products in their portfolios. These include mutual funds, separately
managed accounts, exchange-traded funds, hedge funds, and private equity and venture capital funds.

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Portfolio Management

Weights Return SD Min Max

Rebalancing Asset Allocation

Monitoring Security Analysis

Individual Varies Varies Varies Varies

Low Transaction cost

Short selling takes

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