the process of portfolio management - fprr · purpose of portfolio management portfolio management...

48
1 The Process of Portfolio Management Presentation by: William Wood CFP ®

Upload: others

Post on 08-Jun-2020

14 views

Category:

Documents


0 download

TRANSCRIPT

Page 1: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

1

The Process of Portfolio

Management

Presentation by:

William Wood CFP®

Page 2: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 3: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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)

Page 4: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 5: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 6: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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)

Page 7: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

7

Low Risk vs. High Risk

Investments

$25,937

$10,000

$23,642

$0

$10,000

$20,000

$30,000

' '99 '01 '03 '05 '07

LowRisk

HighRisk

Both investments have a mean return of 10 percent.

Page 8: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 9: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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.

Page 10: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 11: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 12: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 13: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 14: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 15: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

15

Step Two (con’t)

Investment Policy

Investment policy

• The separation of investment policy from

investment management is a fundamental

tenet of money management

Page 16: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 17: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 18: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

18

Step Four

Portfolio Management

Subsequent to portfolio construction:

• Economic conditions change

• Market conditions change

• Portfolios need maintenance

Page 19: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 20: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 21: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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.

Page 22: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

Active Management Through

Rebalancing the Portfolio

Rebalancing a portfolio is the process of

periodically adjusting it to maintain the

original conditions

Page 23: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

Rebalancing Within the

Equity Portfolio

Constant Mix

Constant Proportion Portfolio Insurance

Constant Beta Portfolio

Page 24: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 25: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

Constant Mix Strategy (cont’d)

Example (cont’d)

What dollar amount of stock should the portfolio

manager buy to rebalance this portfolio? What dollar

amount of bonds should he sell?

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

Page 26: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

Constant Proportion

Portfolio Insurance

A constant proportion portfolio

insurance (CPPI) strategy requires the

investor to invest a percentage of the

portfolio in stocks

Page 27: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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?

Page 28: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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?

Page 29: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

Relative Performance of

Constant Mix and CPPI

A constant mix strategy sells stock as it

rises

A CPPI strategy buys stock as it rises

Page 30: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 31: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 32: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 33: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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 22.00 400 8,800 31.15

HG 13.50 700 9,450 33.45

YH 50.00 200 10,000 35.40

Total $28,250 100.00

Page 34: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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 20.00 400 8,000 21.92

HG 15.00 700 10,500 28.77

YH 90.00 200 18,000 49.32

Total $36,500 100.00

Page 35: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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 20.00 400 8,000 Buy 200 12,000 32.00

HG 15.00 700 10,500 Buy 100 12,000 32.00

YH 90.00 200 18,000 Sell 50 13,500 36.00

Total $36,500 $37,500 100.00

Page 36: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 37: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 38: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 39: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

Definition (cont’d)

TAA attempts to take advantage of short-

term 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

Page 40: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

Overview of Active

Management Techniques

Page 41: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

Efficient Market Implications

Active management strategies implicitly

assume it is possible to outperform a buy-

and-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

Page 42: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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?

Page 43: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

Traditional

Performance Measures

Sharpe Measure

Treynor Measures

Jensen Alpha

Page 44: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 45: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

Jensen Alpha

The Jensen measure stems directly from the

CAPM:

it ft i mt ftR R R R

Page 46: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 47: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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

Page 48: The Process of Portfolio Management - FPRR · Purpose of Portfolio Management Portfolio management primarily involves reducing risk rather than increasing return • Consider two

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