PPORTF. ORTF. MMGMT. GMT. PPROCESS & ROCESS &

IINVST. NVST. PPOLICY OLICY SSTATEMENTTATEMENT

Portfolio Management

Ali Nejadmalayeri

Investment Management

• Service of professionally investing money

• 15000+ money managers in US for $23B

• 54000 mutual funds; only 15% in US

• Fee and asset base determine revenues

• Clientele now includes large institutions; high net-worth individuals and small investor

• portfolio managers, analysts, traders as well marketing and support staff– Sell side:Sell side: brokerage houses– Buy side:Buy side: investment managers and institutions

Portfolio Perspective

• Markowitz Modern Portfolio Theory (MPT) help the industry to explode– Managers understood importance of risk

management in reaching objectives– MPT models spread the usage of quantitative

methods in portfolio construction and management

• Three majors shifts in the industry– Rise of institutions as major players – Explosive growth of cheap, fast computing– Professionalization of the industry with designations

like CFA, CFP, etc.

Portfolio Management Process

• A process to help with construction and management of large portfolios– Dynamic and flexible concepts

• Useful for portfolios and organizations in charge

– Continuous and systemic with feedback loops• Constant monitoring and re-evaluation

– Complex and highly quantitative or simple and institutive

• Enables the manager and everyone involve to make better decisions

The Logic behind the Process• Planning Step:

– Investor inputs and Economic/Market Inputs– Identifying & Specifying Investor’s Objectives &

Constraints– Creating Investment Policy Statement (IPS)– Forming Capital Market Expectations– Creating Strategic Asset Allocation

• Execution Step• Feedback Step:

– Monitoring, Rebalancing – Performance Evaluation

The ProcessSpecification and quantification of

investor’s objectives, constraints, and

preferences

Portfolio Policy and Strategies

Specification and quantification of

investor’s objectives, constraints, and

preferences

Portfolio Construction and Revision

Asset Allocation, Portfolio Optimization,

Security Selection, Implementation, and

Execution

Monitoring investor-related input factors

Capital Markets’ Expectations

Monitoring economic and market input

factors

Attainment of Investor

Objectives

Performance Measurement

Investment Policy Statement• A brief description of the client• The purpose of establishing policies and guidelines• The duties and responsibilities of those involved

– Fiduciary, communication, efficiency, accountability

– Clients, investment committee, managers, custodians

• The statement of goals, objectives, and constraints• The schedule for review of performance and IPS itself• Performance measures and benchmarks to be used• Any considerations for strategic asset allocations• Investment strategies and styles• Guidelines for rebalancing based on feedbacks

Investment Strategy

• Passive Approach– 1) Indexing & 2) Fixed (Buy-and-Hold)

• Active Approach– Goal is to enhance alpha (risk will be taken)

• Different weights from benchmark based on expectations

• Semi-active, risk-controlled active or enhanced index Approach – Seeking alpha with tight leash on risk-taking

• Tilting weights of the benchmark marginally

Strategic Asset Allocation

• Depending on market conditions and manager’s expectations, set:– Target weights for different asset classes– Minimum and maximum on weights allowed– Single- vs. Multi-period risk-return considerations

• Multi-period should account for tax and liquidity concerns arising from portfolio rebalancing

Execution of Plan

• Portfolio Selection/Composition– Asset classes and specific securities

• Portfolio Implementation– Basked on analysis and with help trading desk– Timing of trade, price pressure, etc. are concerns

• Portfolio Optimization– Optimal allocation to achieve efficiency

• Tactical Asset Allocation– Response to short-term changes in market

conditions rather than investors’ expectations

Feedback Plan• Monitoring and Rebalancing

– Constant feedback on exposure to opportunities– Investor related factors

• Spouse dies or pension plan terminates

– Market/economic related factors • Sharp rises in certain asset classes create imbalances

• Performance Evaluation– Measurement

• Calculation of returns

– Attributions• What are sources of returns

– Appraisal: TimingTiming vs. vs. SelectionSelection vs. vs. DiversificationDiversification

IPS Objectives & Constraints

• Objectives– Risk– Return

• Constraints– Liquidity– Time Horizon– Tax Concerns– Legal and Regulatory– Unique Circumstances

Risk Objective• Measurement:

– Variance; Std. Dev.; Semi-Variance; Tracking Risk; VaR • Investor’s Willingness:• Investor’s Ability:

– Spending needs, long-term wealth goals, liabilities, financial strength

• Specific Risk Objectives:

• Investor’s Risk Allocation:

Risk Measures• Variance:

– Sum of squared differences from mean

• Standard Deviation:• Semi-Deviations:

– Sum of squared differences from benchmark when below benchmark

• Tracking Risk:– Std Dev of difference between porfolio and

benchmark returns

• Value at Risk (VaR)– Value lost at the worst 5% of the times

Semi-Deviations

• Semi-deviation from benchmark:

• Downside beta:

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Value at Risk

• Normal Dist. Returns – VaR @ 1% for N days:

• Normal Dist. Returns – VaR @ 5% for N days:

NVVaR Portfoliodaily 33.2%1

NVVaR Portfoliodaily 65.1%5

Return Objective

• Measurement:– Real vs. Nominal; Pre-tax;

• Investor’s Desire:– Investor wants 20% per year!

• Investor’s Need to Achieve:– Terminal wealth and interim cash needs counts

• Specific Objectives:– Consistency with risk tolerance– Mandates must be considered– Absolute vs. Relative Return Requirements

Return Requirements

• Individual has $1.2M and want to end up with $2M in 18 year. What’s return requirement?

• What if he needs $2500 per year?

• What if there 35% tax rates?

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Liquidity Constraint

• Liquidity Requirements:– Cash needs in excess of new contributions– Savings

• Liquidity Events:– Building a new business college– Pay for kid’s college

• Liquidity Risk– Asset-side: emerging market stocks – Liability-side: retiree pension payments due

Time Horizon Constraint

• Time & Investor’s Ability to Take Risk:– The longer the horizon, the more the risk

• Time & Investor’s Asset Allocation:– Greater allocation to riskier classes with time

• Time & Investor’s Willingness and Ability to Weather Market Fluctuations:– Even with long horizon, aversion to unanticipated

events may limit allocations to risky assets

• Multistage Plans & Investor’s Asset Allocation:– Compromises needed to match short- & long-term

Tax Concerns Constraint

• Current Tax Status

• Future Tax Liabilities

• Special Tax Liabilities; stock options, etc.

• Expected change in overall tax policy

Legal & Regulatory Const.

• Federal, Local, and International Laws

• More restrictive regulations prevail

• Laws pertaining insider holdings

• Regulation pertaining securities sales

• Pension and Retirement Fund Regulations

Unique Circumstances Const.

• Social responsible investing

• Religious and ethical constraints

• Individual sudden change of circumstances– Death – Health – Support of Dependents