Study Notes for Portfolio Management: An Overview

Portfolio Management: An Overview

In the world of investments, one of the most important ideas is that of a portfolio. A portfolio simply refers to a mix of an investor’s investments in different asset classes such as equities, bonds, commodities and real estate.

We know that the maximum return an investor can earn is by investing all the money in a single asset. However, this approach is dangerous and poses high risk to your investment. Instead of investing everything in one asset investors prefer to put their money on different assets even though their overall returns may reduce. This is simply because of the benefits of diversification offered by a portfolio containing more number of assets.

Since most assets have a degree of correlation with each other that is less than 1, the risk from one asset cancels out the risk (atleast partially) from another asset and the overall risk reduces. Diversification reduces returns also, but the benefits in terms of risk reduction are much higher compared to the return reduction. We should also note that a portfolio approach does not necessarily provide downside protection or eliminate risk. It is however effective at reducing the level of risk (portfolio’s volatility).

While taking the portfolio perspective, another important point of importance is how we evaluate a new security that we are considering adding to the already existing security. The key idea is that we already have a portfolio with certain risk/return profile. Now when we bring in a new security we need to evaluate how it affects the risk-return profile of our portfolio. For example, how much additional risk the investment manager is taking for adding one additional unit of risk?

Another important point is about how risk is measured. Before 1950s, we did not have a way of quantifying the risk a person faced for his investment. We knew the returns we will get from our investments. We also intuitively knew that one investment was more risky compared to another. However, we didn’t have a way of quantifying the risk. Then in 1950s, Henry Markowitz proposed his framework where we could use standard deviation as a measure of risk.  This was proposed in his article on portfolio selection which now forms the basis of Modern Portfolio Theory (MPT). The key idea of MPT is that investors should not just hold a portfolio but also pay attention to how the individual securities are related to one another.

The Portfolio Perspective for Investing

As a portfolio manager you will be looking after the investment needs of a variety of investment clients whether you are employed by a fund management company or directly contracted by the client. In this article we will describe the key investment clients which can be broadly classified as individuals and institutional investors.

<strong>Individual Investors</strong>

These are the individuals who are looking at managing their wealth with a variety of goals. Some investors may have a short-term goal of providing for their children’s education or marriage, while some investors may have a long-term goal of saving for their retirement. These different investors will also have different risk profiles. Someone who is more scared of risk may want his money to be invested in very safe assets such as government bonds or fixed deposits, while someone else may want to take more risk for extra returns which may be done by investing in stocks. One investor may be looking for growth of his capital while another may be looking for a regular income which will involve investing in bonds and dividend-paying stocks. The investment needs of the individual investors will vary depending on their financial needs, requirements, myths and beliefs.

<strong>Institutional Investors</strong>

The major institutional investors include banks, insurance companies, investment companies, university endowments, foundations, and Defined Benefit pension plans. All these institutional investors have their own investment objectives, time horizon, risk profiles, and income needs.

For example the university endowment funds are created for the purpose of providing continual financial support to the university. They typically have long time horizon and high risk tolerance. The largest endowment fund is that of Harvard University. Similarly the charitable foundations invest the donations that they receive in line with the foundation’s grant objectives. Banks invest their excess returns, which is generally more conservative in nature by investing more in bonds and money-market instruments and less in equities. Banks have a short time-horizon, low risk tolerance, and high liquidity needs.  The insurance companies invest the insurance premium they receive. The money will be needed for settling claims and therefore the investments should be in accordance with the claim statistics. In general they follow a conservative approach to investing because of the crucial nature of the use of the money. They have low time horizon, low risk tolerance, low income needs, but high liquidity needs.

The investment companies are the companies that manage mutual funds. The investments for each mutual fund will be different and will be according to the individual fund’s objectives. There are a variety of mutual funds suiting the needs to every type of investor. The defined benefit pension plans are contributions of employers towards the retirement funds of the employees. For these pension plans, the timing of cash flows is important as the benefits need to be provided at specific times. These plans will generally have a long time horizon and will have high risk tolerance.

Investment Clients for Portfolio Managers

The investment managers will typically follow the following investment management process to manage a client’s investment portfolio.

<strong>Planning</strong>

The first step is planning, which involves understanding the needs of the customer. This involves analysing the investor’s objectives and constraints, and creating an Investment Policy Statement (IPS). Without really understanding investor’s objectives for investing and the constraints they have, it is difficult for an investment manager to come up with a suitable investment plan. The IPS is a written document that officially documents the objectives and constrains for each investor and that needs to be followed for making the investments. The investment manager will typically review the IPS every few months or on the occurrence of a specific event and make any necessary revisions.

<strong>Execution</strong>

Once the planning is done and the Investment Policy Statement has been made, the next step is to actually make the investments. This starts by first deciding on how we will allocate the funds between different asset classes. This is called asset allocation. The major asset classes include equities, fixed income, commodities, and real estate. After asset allocation, we need to analyse the individual securities for possible investment. Finally the portfolio manager will construct the portfolio by considering all the information he has including the investment policy statement, asset allocation, and security analysis. While constructing the portfolio the portfolio manager has to make many decisions including weights for different asset classes, weights for assets within an asset class, security selection, etc. This step also involves trading in the financial markets as the manager will have to actually purchase the required securities for the required amounts.

<strong>Feedback</strong>

This step involves monitoring and rebalancing the portfolio as the market conditions and product prices change. For example, if the original plan was to invest 80% in equities and 20% in fixed income, and equities have done really well, then with the new prices, the proportion would have changed and equity portion would have become higher (e.g., 85:15). In this case the portfolio manager will rebalance the portfolio by selling some equity (mostly the ones not performing well) to bring the balance back to 80%:20%. The portfolio manager depending on his style will monitor and rebalance the portfolio from time to time.

As a part of the feedback process, the portfolio manager will also measure the performance of the portfolio in terms of meeting the investor objective such as the risk-return objectives. Such performance evaluation may bring up the need for reviewing and making adjustments to the portfolio or to revise the investment objectives.

Steps in Portfolio Management Process

Mutual funds are a type of pooled investments that require a small investment for participation as opposed to hedge funds which can require a minimum of US$1 million, sometimes more. The kinds of products that are available in a financial supermarket vary therefore on the proposed investment. Certain mutual funds require investments as small as $50, while others are available in the range of US $1,000,000 and more.

Mutual funds can be defined as a co-mingled investment pool in which investors in the fund each have a pro-rata (in proportion to) claim on the income and the value of the fund.

The value of a mutual fund is called the net asset value or NAV. It is calculated on a daily basis, on the closing value of the securities in its portfolio. Given below is a snapshot of the global mutual fund market between 2005 and 2011. (Source: Fact sheet 2012 of the Investment Company Institute)

<img class="aligncenter size-full wp-image-8716" title="mf1" src="https://financetrain.com/wp-content/uploads/mf1.gif" alt="" width="504" height="286" />

If we were to look at 2011 percentage figures for these continents it would look like this:

<img class="aligncenter size-full wp-image-8717" title="mf2" src="https://financetrain.com/wp-content/uploads/mf2.gif" alt="" width="501" height="333" />

Mutual funds are favored by investors and institutions alike. To understand how a mutual fund works let us look at an example. An investment firm that wants to start a fund has decided to do so with a target of US$10million. It aims to do this with five individuals and two institutions.

<img class="aligncenter size-full wp-image-8718" title="mf3" src="https://financetrain.com/wp-content/uploads/mf3.gif" alt="" width="516" height="233" />

The net asset value of the fund is US$10 million. This is divided into 100,000 shares with each share having an initial value of $100. This fund is given to a portfolio manager to manage. The net asset value will change depending on the value of the assets in the portfolio. The fund is christened FastGrowth100.

The FastGrowth100 mutual fund is an open-ended fund. This fund will accept fresh investment money and issue additional shares at a value equal to the net asset value of the fund at the time of investment. An open ended fund will allow for removal of funds at the NAV at that point of time. If the fund value increases to US$15 million, the new value per share would be $150. If an investor wants to put in US$0.96 million, it would create 6400 new shares. Post investment the Net Asset Value of the fund would be 15.96 million, with a total of 106400 shares.

Let’s say investor C wants to withdraw her shares from the fund totally. Now the fund will need to liquidate $0.75 million in assets to retire 5000 shares at a NAV of US$150. There is a net inflow US$210,000 and 1400 new shares would be created.

Close ended funds are also available; here no new investments are accepted. New investors will have to buy shares from existing investors and those wishing to liquidate their shares will do so by selling their shares to new investors. The number of shares in an open-ended fund stay the same. The sale of shares will happen at premium or discounted prices to NAV depending on the demand for those shares.

The portfolio manager of an open ended fund needs to manage the inflows and outflows. Liquidations would mean redemptions, which the manager has to account for. Likewise new inflow of investments would require of the portfolio manager to seek new investments. These issues are not present in a close ended fund, but then the scope for growth is also limited.

Mutual funds can be classified based on how the funds management is compensated. When no fee is levied for investing or redemption in the fund it is called a no load fund. When funds levy a percentage fee in addition to an annual fee to invest in or redeem shares it is called a load fund.

Mutual funds are also classified based on the assets they invest in. Mutual funds can be stock funds; taxable/non-taxable bond funds; balanced funds that invest in stocks and bonds; and money market funds. We will look a little more into these funds in our next article on the types of mutual funds.

An Overview of Mutual Funds

In this article we will go slightly more in-depth to understand the types of mutual funds according to asset types they invest in. The U.S. has the largest mutual fund market in the world, with $11.6 trillion under management. The mutual funds can be classified as follows:
<ul>
	<li>Money Market Mutual Fund</li>
	<li>Bond Mutual Fund</li>
	<li>Stock Mutual Fund</li>
	<li>Hybrid or Balanced Fund</li>
</ul>
<blockquote><em>“</em><em>Equity funds made up 45 percent of U.S. mutual fund assets at year-end 2011. Domestic equity funds (those that invest primarily in shares of U.S. corporations) held 33 percent of total industry assets. World equity funds (those that invest primarily in nondomestic corporations) accounted for another 12 percent. Bond funds accounted for 25 percent of U.S. mutual fund assets. Money market funds (23 percent) and hybrid funds (7 percent) held the remainder of total U.S. mutual fund assets” - </em>2012 Investment Company Factbook</blockquote>
<strong>Money Market Fund</strong>

Money market funds are often used by investors as substitutes for bank saving deposits. Of course it does not have the capital guarantee of a bank saving account. There are taxable and tax free money market funds. Taxable money market funds invest in federal debt and short term high quality debt. Tax free money market funds invest in short term state and local government debt. The underlying asset matures in not more than 90 days, and sometimes just overnight. There have been instances in money market funds where the NAV (Net Asset Value) of the shares has dipped below US$1 per share. This was known as ‘breaking the buck’. It took the Federal Reserve’s intervention to stop the worsening downward trend. The outflows from money market mutual funds is only now slowing down. Poor interest rates and the European debt crisis have meant poor demand for these funds.

<strong>Bond Mutual Funds</strong>

A bond mutual fund has in its portfolio a number of individual bonds and sometimes preferred shares. NAV in bond mutual funds is calculated by taking the value of each bond and dividing it by the value of each share. Individual bonds are available in the range of $10,000 to $100,000. By investing into a bond mutual fund an investor can invest in a bond fund with just $100. Maturity of underlying asset in bond mutual funds can vary from 1 year to 30 years. The various kinds of bond mutual funds include:

<img class="aligncenter size-full wp-image-8722" title="mf4" src="https://financetrain.com/wp-content/uploads/mf4.gif" alt="" width="529" height="291" />

$124 billion was added to bond fund holdings in 2011. This is a reduced rate compared to the previous year’s $241 billion. Some factors for this slowdown include a reduced appetite across all age groups, an ageing population and lower tolerance for long maturity periods. This has seen more investments flowing to fixed income securities.

<strong>Stock Mutual Funds</strong>

These funds are traded the most and can be further classified based on portfolio management styles. In an actively managed fund, the portfolio manager hand picks the portfolio stocks. These funds have higher fees as they have dedicated researchers and these funds aim to outperform, not match indices. Trading activity in these funds is higher than passively managed funds. Capital gains and income need to be distributed across the fund and therefore higher taxes. In a passively managed fund, the portfolio is benchmarked against or tracks the performance of different indices. Passively managed funds have lesser opportunities to trade and use a buy and hold strategy and tend to have lower capital gains and therefore lower taxes.

<strong>Hybrid or Balanced Funds</strong>

Funds that invest in both equities and bonds are called hybrid funds. Hybrid funds are extremely popular now with 90% of assets managed in the funds of  funds (funds that invest in other mutual funds). In 2011 there were 1047 fund of funds with total net assets crossing $1 trillion. Balanced funds promise the aggression of equity funds mixed with the promise of long term gains of the bond funds. The balanced fund is usually loaded towards shares in the earlier part of the investors investment and tends to become more conservative as it grows older towards retirement.

Types of Mutual Funds

In the recent years, Exchange Traded Funds (ETFs) have become quite popular and many different products in this category have entered in the market.

An exchange-traded fund is an investment fund, similar to a mutual fund, which is pegged to a financial index. Unlike mutual funds, which are priced once in a day, an exchange traded fund trades on exchanges throughout the day, just like stocks. ETFs track indexes such as S&amp;P500 in case of stocks. There are also Gold ETFs which track the Gold index such as London Gold.

There are many reasons why investors prefer ETFs.



1. The most important benefits is that they combine the features from both mutual funds and stocks.

2. The cost involved in buying and selling ETFS is low compared to index funds or mutual funds.

3. They are also tax efficient.

4. ETFs enable small investors to access the market of their choice. Most index funds have a minimum investment amount. However, with an ETF, an investor can even buy a single share. Similarly it is easier to buy Gold ETF, rather then physically storing gold.
<h3>Costs Associated with ETFs</h3>
ETFs have some costs associated to the. This fee, known as management fees, is deducted directly from the assets of the ETF. This fee is also referred to in the prospectus as “expense ratio”, “management fee”, or “investor fee”. This fee makes the returns from the ETFs lower than that of the underlying benchmarked index. It is expressed as an annualized percentage and currently ranges from less than 0.10% up to about 1.00%. The ETF’s management fee is included in the daily published NAV and thus is incorporated in the bid and asked prices in the secondary market.

Similar to stocks, you also need to pay commissions and/or transaction costs while buying and selling ETFs.
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<h3>How are ETFs Valued?</h3>
An ETF’s NAV is generally determined at the close of each trading day. This value is then used to price creation and redemption units and is disseminated to the public before the market opens the next day. During the day, however, ETF shares are bought and sold at prices, which are determined by the market forces of supply and demand. An ETF’s market price is often closely related to its NAV, but it may differ. The following are some of the reasons why an ETF’s market price may differ from its NAV:
<ul>
	<li>Because      ETFs are bought and sold in transactions between investors, at times there      may be insufficient liquidity in the marketplace, which can result in an      imbalance in buying and selling interest in an ETF. The creation/redemption      process, however, is intended to mitigate pricing imbalances since      professional traders may create new ETF shares and offer them for sale in      the secondary market.</li>
</ul>
<ul>
	<li>The      underlying components of the ETF (i.e., the basket of securities that      comprise the ETF) may not be trading during the same hours as the ETF, or      trading in a component security may be halted. In either event, the ETF      may be priced to anticipate a future price in the underlying when it      reopens for trading.</li>
</ul>
<ul>
	<li>The      underlying components of the ETF may contain securities that trade      infrequently or are based on relatively wide bid-ask spreads (e.g.,      corporate bonds or municipal securities) and are therefore difficult to      price based on last sale data. This situation is not unusual for certain      fixed income ETFs.</li>
</ul>
<h3>Risks Associated with ETFs</h3>
ETF shareholders are subject to risks similar to those of holders of other portfolios, such as mutual funds. In addition to these general risks, there are risks specific to each ETF, which are described in the relevant prospectus. Risks may include the following:
<ul>
	<li>The      general value of securities held may decline, thus adversely affecting the      value of an ETF that represents an interest in those securities. This      could occur with equities, commodities, fixed income, futures, or other      investments the fund may hold on behalf of the shareholders.</li>
</ul>
<ul>
	<li>For      ETFs for which the stated investment objective is to track a particular      industry or asset sector, the fund may be adversely affected by the      performance of that specific industry or sector.</li>
</ul>
<ul>
	<li>Fund      holdings of international investments may involve risk of capital loss      from unfavorable fluctuations in currency exchange rates, differences in      generally accepted accounting principles, or economic or political      instability in other nations.</li>
</ul>
<ul>
	<li>Although      ETFs are designed to provide investment results that generally correspond      to the price and yield performance of their respective underlying indexes,      the trusts may not be able to exactly replicate that performance because      of trust expenses and other factors. This is sometimes referred to as      “tracking error”.</li>
</ul>
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Portfolio Management - An Overview

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