The Process of Portfolio Management. Presentation by: William Wood CFP

Transcription

1 The Process of Portfolio Management Presentation by: William Wood CFP 1

2 Investments Traditional investment processes cover: Security analysis Involves estimating the merits of individual investments Portfolio management Deals with the construction and maintenance of a collection of investments 2

3 Security Analysis A three-step process 1) The investor considers prospects for the economy, given the stage of the business cycle, 2) Determines which industries are likely to fare well in the forecasted economic conditions, 3) Chooses particular companies within the favored industries EIC (Economy, Industry, Company) analysis (a top-down approach) 3

4 Portfolio Management Literature supports the efficient markets hypothesis On a well-developed securities exchange, asset prices accurately reflect the tradeoff between relative risk and potential returns of a security Efforts to identify undervalued securities will be essentially fruitless Free lunches are difficult to find 4

5 Portfolio Management (cont d) Market efficiency and portfolio management A properly constructed portfolio achieves a given level of expected return with the least possible risk 5

6 Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return Consider two $10,000 investments: 1) Earns 10 percent per year for each of ten years (low risk) 2) Earns 9 percent, 11 percent, 10 percent, 8 percent, 12 percent, 46 percent, 8 percent, 20 percent, 12 percent, and 10 percent in the ten years, respectively (high risk) 6

7 Low Risk vs. High Risk Investments $30,000 $25,937 $10,000 $23,642 $20,000 $10,000 Low Risk High Risk $0 ' '99 '01 '03 '05 '07 Both investments have a mean return of 10 percent. 7

8 Low Risk vs. High Risk Investments (cont d) 1) Earns 10 percent per year for each of ten years (low risk) Terminal value is $25,937 2) Earns 9 percent, 11 percent, 10 percent, 8 percent, 12 percent, 46 percent, 8 percent, 20 percent, 12 percent, and 10 percent in the ten years, respectively (high risk) Terminal value is $23,642 The lower the dispersion in the returns, the greater the accumulated value of equal investments 8

9 Managing Your Portfolio Begins with a statement of investment policy, which outlines: Return requirements: given the funds available for investment, what ROI do I need to reach my goal. Risk tolerance: how much risk am I comfortable with. Portfolio constraints: when do I need the money. 9

10 Six Steps of Portfolio Management 1) Learn the basic principles of finance 2) Set portfolio objectives 3) Formulate an investment strategy 4) Have a game plan for portfolio revision 5) Evaluate the performance 6) Protect the portfolio when appropriate 10

11 Step One Background, Basic Principles, and Investment Policy A investor cannot effectively manage a portfolio without a solid grounding in the basic principles of finance Egos sometimes get involved Take time to review simple material Fluff and bluster have no place in the formation of investment policy or strategy 11

12 Step One Background, Basic Principles, and Investment Policy (cont d) There is a distinction between good companies and good investments The stock of a well-managed company may be too expensive The stock of a poorly-run company can be a great investment if it is cheap enough 12

13 Step One Background, Basic Principles, and Investment Policy (cont d) The two key concepts in finance are: 1) A dollar today is worth more than a dollar tomorrow inflation erodes the purching power of a dollar! 2) A safe dollar is worth more than a risky dollar These two ideas form the basis for all aspects of portfolio management 13

14 Step Two Set Portfolio Objectives Setting objectives It is difficult to accomplish your objectives until you know what they are Terms like growth or income may mean different things to different people 14

15 Step Two (con t) Investment Policy Investment policy The separation of investment policy from investment management is a fundamental tenet of money management 15

16 Step Three Portfolio Construction Formulate an investment strategy based on the investment policy statement Investors must understand the basic elements of capital market theory Informed diversification Naïve diversification Beta 16

17 Step Three Portfolio Construction (cont d) Informed Diversification Security screening A screen is a logical protocol to reduce the security universe to a workable number for closer investigation 17

18 Step Four Portfolio Management Subsequent to portfolio construction: Economic conditions change Market conditions change Portfolios need maintenance 18

19 Step Four Portfolio Management (cont d) Passive management has the following characteristics: Follow a predetermined investment strategy that is invariant to market conditions Do nothing Let the chips fall where they may Buy and Hold 19

20 Portfolio Management (cont d) Passive Management Less knowledge required Reduced psychological anxiety in management When to buy and sell?? The argument for index investing with mutual funds? 20

21 Step Four Portfolio Management (cont d) Active management: Requires the periodic changing of the portfolio components as the investor s outlook for the market changes; business cycles evolve; Black Swan events change the playing field. 21

22 Active Management Through Rebalancing the Portfolio Rebalancing a portfolio is the process of periodically adjusting it to maintain the original conditions

23 Rebalancing Within the Equity Portfolio Constant Mix Constant Proportion Portfolio Insurance Constant Beta Portfolio

24 Constant Mix Strategy The constant mix strategy: Is one in which the investor makes adjustments to maintain the relative weighting of the asset classes within the portfolio as their prices change Requires the purchase of securities that have performed poorly and the sale of securities that have performed the best

25 Constant Mix Strategy (cont d) Example (cont d) Date Portfolio Value Actual Allocation Stock Bonds 1 Jan $2,000,000 60%/40% $1,200,000 $800,000 1 Apr $2,500,000 56%/44% $1,400,000 $1,100,000 What dollar amount of stock should the portfolio manager buy to rebalance this portfolio? What dollar amount of bonds should he sell?

26 Constant Proportion Portfolio Insurance A constant proportion portfolio insurance (CPPI) strategy requires the investor to invest a percentage of the portfolio in stocks

27 Constant Proportion Portfolio Insurance (cont d) Example A portfolio has a market value of $2 million. The investment policy statement specifies a floor value of $1.7 million and a multiplier of 2. What is the dollar amount that should be invested in stocks according to the CPPI strategy?

28 Constant Proportion Portfolio Insurance (cont d) Example (cont d) Solution: $600,000 should be invested in stock: $ in stocks = 2.0 ($2,000,000 $1,700,000) = $600,000 If the portfolio value is $2.2 million one quarter later, with $650,000 in stock, what is the desired equity position under the CPPI strategy? What is the ending asset mix after rebalancing?

29 Relative Performance of Constant Mix and CPPI A constant mix strategy sells stock as it rises A CPPI strategy buys stock as it rises

30 Relative Performance of Constant Mix and CPPI (cont d) In a rising market, the CPPI strategy outperforms constant mix In a declining market, the CPPI strategy outperforms constant mix In a flat market, neither strategy has an obvious advantage In a volatile market, the constant mix strategy outperforms CPPI

31 Relative Performance of Constant Mix and CPPI (cont d) The relative performance of the strategies depends on the performance of the market during the evaluation period In the long run, the market will probably rise, which favors CPPI In the short run, the market will be volatile, which favors constant mix

32 Constant Proportion A constant proportion strategy within an equity portfolio requires maintaining the same percentage investment in each stock May be mitigated by avoidance of odd lot transactions Constant proportion rebalancing requires selling winners and buying losers on an individual stock basis

33 Constant Proportion (cont d) Example An investor attempts to invest approximately one third of funds in each of the stocks. Consider the following information: Stock Price Shares Value % of Total Portfolio FC , HG , YH , Total $28,

34 Constant Proportion (cont d) Example (cont d) After one quarter, the portfolio values are as shown below. Recommend specific actions to rebalance the portfolio in order to maintain the constant proportion in each stock. Stock Price Shares Value % of Total Portfolio FC , HG , YH , Total $36,

35 Constant Proportion (cont d) Example (cont d) Solution: The worksheet below shows a possible revision which requires an additional investment of $1,000: Stock Price Shares Value Before Action Value After % of Portfolio FC ,000 Buy , HG ,500 Buy , YH ,000 Sell 50 13, Total $36,500 $37,

36 Constant Beta Portfolio A constant beta portfolio requires maintaining the same portfolio beta It is more likely to have requirements that beta be within some given range To increase or reduce the portfolio beta, the portfolio manager can: Reduce or increase the amount of cash in the portfolio Purchase stocks with higher or lower betas than the target figure Sell high-beta stocks or low-beta stocks Buy high-beta stocks or low-beta stocks

37 Tactical Asset Allocation What Is Tactical Asset Allocation? How TAA Can Benefit a Portfolio Designing a TAA Program Caveats Regarding TAA Performance Costs of Revision Contributions to the Portfolio

38 Tactical Asset Allocation Tactical asset allocation (TAA) managers: Seek to improve the performance of their funds by shifting the relative proportion of their investments into and out of asset classes as the relative prospects of those asset classes change For example, shift to stocks if stocks are expected to outperform bonds

39 Definition (cont d) TAA attempts to take advantage of shortterm deviations from long-term trends The most difficult part of TAA is asset class appraisal The process of determining the relative merits of the various asset classes given current economic conditions

40 Overview of Active Management Techniques

41 Efficient Market Implications Active management strategies implicitly assume it is possible to outperform a buyand-hold strategy by shifting asset classes, or proportions or mix or risk Inconsistent with the efficient market hypothesis Some fund managers have good records compared to the market Might be skill or luck

42 Step Five Evaluate Performance Performance evaluation Interpreting the numbers How much did the portfolio earn? How much risk did the portfolio bear? Must consider risk in conjunction with return How does performance and risk compare to the IPS requirements? 42

43 Traditional Performance Measures Sharpe Measure Treynor Measures Jensen Alpha

44 Sharpe and Treynor Measures (cont d) The Sharpe measure evaluates return relative to total risk Appropriate for a well-diversified portfolio, but not for individual securities The Treynor measure evaluates the return relative to beta, a measure of systematic risk It ignores any unsystematic risk

45 Jensen Alpha The Jensen measure stems directly from the CAPM: R R R R it ft i mt ft

46 Step Six Portfolio Protection and Contemporary Issues Portfolio protection Called portfolio insurance prior to 1987 A managerial tool to reduce the likelihood that a portfolio will fall in value below a predetermined minimum level 46

47 Step Six Portfolio Protection and Contemporary Issues (cont d) Futures Related to options Use of derivative assets to: Generate additional income Manage risk Interest rate risk Duration 47

48 Final Thoughts Hindsight is an inappropriate perspective for investment decision making Everything you do as a portfolio manager must be logically justifiable at the time you do it Everything you do as a portfolio manager must be tested against expected outcome did it work? Discipline