portfolio management notes

Portfolio Management: An

Overview Reading 41

IFT Notes for the 2015 Level 1 CFA exam

Portfolio Management: An Overview irfanullah.co

Copyright Irfanullah Financial Training. All rights reserved. Page 2

Contents

1. Introduction ................................................................................................................................. 3

2. A Portfolio Perspective on Investing .......................................................................................... 3

3. Investment Clients ...................................................................................................................... 5

4. Steps in the Portfolio Management Process................................................................................ 7

5. Pooled Investments ..................................................................................................................... 8

Appendix ....................................................................................................................................... 16

Summary ....................................................................................................................................... 17

Next Steps ..................................................................................................................................... 17

This document should be read in conjunction with the corresponding reading in the 2015 Level I

CFA Program curriculum.

Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute.

Reproduced and republished with permission from CFA Institute. All rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality

of the products or services offered by Irfanullah Financial Training. CFA Institute, CFA, and

Chartered Financial Analyst are trademarks owned by CFA Institute.



1. Introduction

In this reading, we will see the importance of portfolio approach to investing, the different types

of investors and their financial needs, steps in the portfolio management process and different

types of pooled investments like mutual funds.

2. A Portfolio Perspective on Investing

What is portfolio approach?

Portfolio approach means evaluating individual investments by their contribution to risk and return

of an investors portfolio. Assume an investors portfolio has three stocks A, B, and C. He is

evaluating whether to add another stock D to the portfolio or not. In a portfolio approach, the

investor will analyze what will happen to the risk and return of the portfolio with and without stock

D; whereas, in an isolated approach, he will only look at the merits (risk/return) of the stock.

2.1 Portfolio Diversification

Diversification helps investors avoid disastrous outcomes. The curriculum cites the example of

many Enron employees who held all of their retirement funds in Enron shares. When the Enron

share tumbled from $90 to zero between January 2001 and 2002, it completely ruined their

financial wealth; this emphasizes the need to diversify ones portfolio. Instead, if the Enron

employees had held shares of other companies or other products, the consequence would not have

been as bad.

Diversification also helps investors reduce risk without compromising their expected rate of return.

A simple measure of diversification risk is the diversification ratio. Lets take the example of the

same portfolio consisting of three stocks: A, B and C with each stock belonging to a different

industry. There is a high probability that the movements of A, B, and C are not correlated with

each other i.e. when A moves up, B may move down or C may move down. The benefit of

diversification is that the movements of individual stocks cancel each other out to some extent.



If the amount invested in each of these three shares were the same, then it is an equally weighted

portfolio. The returns on the equally weighted portfolio are just the average returns of the

individual shares.

Equation 1:

Diversification ratio = risk of equally weighted portfolio of n securities

risk of single security selected at random

Lower the ratio, better is the diversification

Now, if we use standard deviation of returns as a measure of risk, will the standard deviation of

the portfolio be the average of the standard deviation of the individual shares? Assume the standard

deviation of each of the stocks is 20%. But, the standard deviation of the portfolio is 15% and not

20%. The standard deviation of returns of an equally weighted portfolio is lower than the average

of the individual standard deviations due to diversification. In this case, the diversification ratio is

15/20 = 0.75 = 75%. This means that the equally weighted portfolios standard deviation is 75

percent of one of the three stocks selected at random. A lower value for diversification ratio is

better as benefits from risk reduction are higher.

2.2 Composition Matters for the Risk-Return Trade-Off

This concept is addressed in detail in the next reading. We will look at it briefly here. Assume

there are two portfolios with stocks A, B and C. The table below shows two portfolios with

different compositions of A, B and C.

Two portfolios with same stocks but different compositions

Weight of each stock

Portfolio Stock A Stock B Stock C Expected

Return

Standard

Deviation

Portfolio 1 33% 33% 33% 11% 13.1%

Portfolio 2 50% 25% 25% 11% 14%



As you can see both the portfolios have the same expected return, but portfolio 1 has a better risk-

return trade-off than portfolio 2 as the risk assumed is lower for the same return.

2.3 Portfolios do not provide guaranteed downside protection

The underlying concept here is that although portfolio diversification reduces risk, the level of risk

reduction is not the same at times of financial crises. In recent times, the degree to which individual

markets tend to move together has increased. For example, following the Euro credit crisis that

began in 2010, most world markets experienced a significant downturn in 2011-2012. Their

movements were highly correlated on a daily basis and even diversification offered minimal

downside protection. The benefits of risk reduction from diversification are best seen under normal

market conditions.

3. Investment Clients

At a high level investors can be categorized as individual investors and institutional investors. A

simplified version of the investment motives of individual investors are presented below:

One avenue of saving for retirement for individuals is the defined contribution (DC) plan. In a DC

plan the contribution amount is defined. Part of the amount is contributed by employees and part

by the employer. The investment risk and responsibility to ensure there are enough funds for a

regular income in retirement is borne by the employee. Example: 401(k) plan in the United States.

There are several types of institutional investors:

Defined Benefit pension plan: obligation to pay a specified amount to employees in

retirement (future benefit)



University endowments: provide financial support to university and students

Charitable foundations: manage funds to meet foundations objectives

Banks: accept deposits, give loans, and invest excess reserves

Insurance Companies: receive premiums for policies written. Invest premiums to earn a

return and pay claims

Investment Companies: companies that manage mutual funds

Sovereign wealth funds: large government-owned investment funds. Ex: $627 billion Abu

Dhabi Investment authority

Exhibit 14 in the curriculum covers the investment needs by client type. A snapshot of this exhibit

is given below:

Time Horizon Risk Tolerance Income Needs Liquidity Needs

Individual

Investors

Depends on time

left for goal

Depends on the

ability and

willingness to take

risk; generally if

time horizon is

long the risk

tolerance is low

Depends on the

amount of the

income that a

client needs from

the investment

Depends on the

need for extra

funds

DB pension

plans

Generally long

term but depends

on the amount of

time left for

employees to

retire

High risk

tolerance if time

horizon is long

term

High if pension

benefits are to be

paid immediately

(mature funds);

low for growing

funds

Low

Endowments

and foundations

Very long term High Meet spending

commitments

Typically low

Banks Short Low Low (pay interest

on deposits)

High (repayment

of deposits)



Time Horizon Risk Tolerance Income Needs Liquidity Needs

Insurance

Companies

(P&C)

Short Low Low High (to meet

claims)

Insurance

Companies

(Life)

Long Low-despite a

long time horizon,

the reason for low

risk tolerance is

the high liquidity

need

Low High

Investment

Companies

Varies by fund Varies by fund Varies by fund High to meet

redemptions

Note: One easy way to remember is that generally if the time horizon is long, then the risk tolerance

is high. In the case of institutional investors, liquidity needs are low only for DB plans, endowments

and foundations.

4. Steps in the Portfolio Management Process

The three steps in the portfolio management process are: planning, execution and feedback.

1. The Planning Step: In this step, the portfolio manager needs to understand a clients needs

and develop an investment policy statement (IPS). IPS is a written document that states the

clients objectives and constraints. Objectives are return and risk objectives which may be

stated in absolute terms or relative terms. Constraints may include liquidity, unique

circumstances, time horizon, legal, and taxes.

2. The Execution Step: Based on the IPS, a portfolio is constructed in this step. Under

execution, the first activity is asset allocation. Here the portfolio manager decides what

asset classes must be included in the clients portfolio and in what proportion. Stocks,

bonds and alternative investments are examples of different asset classes. As an example,



a clients asset allocation may consist of 60% equities, 30% fixed-income securities and

10% alternative investments.

Asset allocation is followed by security section which is the analysis and selection of

individual securities. In other words, the specific securities to be purchased are identified.

For example, if 60% is allocated to equities, the analyst will identify what specific stocks

to purchase.

Once the securities are selected they are purchased through a broker or dealer. This is called

portfolio construction.

3. The Feedback Step: A portfolio managers responsibility does not end with constructing

a portfolio. The portfolio also needs to be monitored and rebalanced at regular intervals.

For example, if the stock market performs very well in a particular period, the asset

allocation drifts away from the intended levels. In this case the portfolio needs to be

rebalanced. The frequency at which performance is measured is pre-decided for instance,

it could be on a monthly or quarterly basis.

The feedback step also involves performance measurement and reporting. Analysis must

include how the portfolio performed over time, were the objectives met, what assets

attributed to the good/poor performance, how the portfolio performed against the

benchmark, and so on.

5. Pooled Investments

Pooled investments are where money is collected from several individual investors to be invested

in a large portfolio. As the name implies, it is pooling money together for an investment. The funds

where this collected money is invested could range from mutual funds to private equity depending

on the risk, capital required, strategy, and how it is managed. The different types of investment

products are listed on the following page.



Investment Products by Minimum Investment

Investment Product Minimum Investment

Mutual Funds $50 +

Exchange Traded Funds (ETFs) $50 +

Separately Managed Accounts $100,000 +

Hedge Funds $1,000,000 +

Private Equity Funds $1,000,000 +

In the rest of this section we understand what a mutual fund is, the different types of mutual funds

and how the other investment products are different from mutual funds.

5.1 Mutual Funds

What is a mutual fund? A mutual fund is a comingled investment pool in which each investor

has a pro-rata claim on the income and value of the fund.

Consider the following example: An investment firms raises $100,000 for a stock-based mutual

fund from five investors and issues 10,000 shares. Each share has a value of $10. There are three

individual investors and two institutional investors. The number of shares is based on the amount

invested relative to the total amount.

Investor Amount Invested % of Total Number of Shares

John 4,000 4% 400

Jill 6,000 6% 600

Joe 10,000 10% 1,000

Jones Co. 50,000 50% 5,000

Widget Co. 30,000 30% 3,000

Assume the $100,000 is invested in various stocks and it grows to $150,000. The value of each

share goes up by 50% to $15. The advantage of this structure is that the investment firm can have

one or two managers managing this entire pool of money and each individual investor need not



hire a manager to manage his relatively small amount of money. This is a cost effective way of

managing money.

5.2 More on Mutual Funds

In the context of mutual funds it is important to understand the following terms:

Net asset value: Net asset value = value of assets liabilities. The value of a mutual fund

is called the net asset value. It is calculated on a daily basis based on the closing price of

the stocks held in the funds portfolio. The NAV per share is calculate as: NAV/number

of total shares. The NAV per share in our previous example was 100,000/10,000 = $10 per

share

Open-end fund: A mutual fund with no restrictions on when new shares can be issued or

when funds can be withdrawn. The fund accepts new investment money and issues

additional shares at a price equal to the net asset value at the time of investment. Similarly,

when an investor redeems shares, the fund sells the underlying assets/securities to retire so

many shares at the current net asset value. Because of this, an open-end fund trades close

to NAV. NAV is based on closing prices. They can be bought/sold only once during the

day. They are also called evergreen funds.

Closed-end fund: Unlike open-ended fund, in a closed-end fund, no new investment

money is accepted. A new investor may invest in the fund if an existing investor is willing

to sell his shares. So, the outstanding shares stay the same. Since there is no liquidation of

underlying assets and the share base is unchanged, the NAV may trade either at a premium

or discount to net asset value based on the demand for shares. The units issued by closed-

end funds trade like regular shares they can be bought or sold on margin, shorted etc.

No-load fund: Most mutual funds have an annual fee for managing the fund, which is a

percentage of the funds net asset value. In a no-load fund, only an annual fee is charged

but there is no fee for investing or redemption.

Load fund, a percentage is charged for investing and redemption (called entry and exit

load) in addition to the annual fee.

Funds can be categorized based on types of assets they invest in:

- Money market taxable or non-taxable



- Bond mutual funds taxable or non-taxable

- Stock mutual funds domestic or international

- Index funds

- Hybrid/balanced funds

Funds can be categorized as actively management or passively managed

- With actively managed funds the manager tries to identify securities which will

outperform the market; these funds have high fees relative to passively managed

funds

- With passively managed funds the manager purchases the same securities as a

benchmark index. This helps ensure that the performance of the fund is similar to

the performance of the benchmark.

5.3 Exchange Traded Funds

Like mutual funds, ETFs are a pooled investment vehicle, often based on an index. With index

mutual funds, investors buy shares directly from the fund. With ETFs, investors buy shares from

other investors.



The diagram above gives a snapshot of how ETFs work. A fund manager creates the ETF by

determining what assets the ETF will hold. Once the securities are decided, the fund sponsor

contacts an institutional investor who owns those securities. The institutional investor deposits the

basket of securities with the fund sponsor (held through a custodian), and in return, receives

creation units for the deposited securities. The creation units typically represent 50,000 to100, 000

ETF shares.

It is important to note that the weight of securities deposited is often in the proportion of what it is

trying to represent. For example, the weight of Athena Health in iShares Russell 2000 Growth

Index Fund is 0.61%, and it is roughly the same as in Russell 2000 Growth Index. The

institutional investor then sells the creation units as ETF shares to the public; investors buy shares

from other investors, so it works like a closed mutual fund. The institutional investor may redeem

the original securities by returning the ETF creation units.

How ETFs are Similar to Mutual Funds

ETFs combine features of close-end and open-end funds:

Trade like closed-end mutual funds; can be shorted and bought on margin.

Because of unique redemption procedure, their prices are close to net asset value like open-

end funds.

Expenses tend to be low relative to mutual funds but brokerage fee needs to be paid.

Unlike mutual funds, ETFs do not have capital gains distributions.

Types of ETFs

Exhibit 23 in the curriculum lists these major types of ETFs traded based on the asset class:

Broad-based equity: large-cap, mid-cap

Sector: commodities, real estate, natural resources, technology, utilities, gold etc.

Global: global, international, regional, emerging markets, single country

Hybrid

Bond: government, municipal, corporate, and international



Differences between Index Mutual Funds and ETFs

Index Mutual Funds Index ETFs

How shares are bought Investors buy shares directly from

the fund

Investors buy shares from other

investors (like in closed-end fund)

Short sales and margin

trading

Generally not possible Can be shorted or bought on margin

Expenses A little higher than ETFs Expenses are lower than mutual

funds. There is a brokerage cost on

every transaction unlike mutual

funds.

Trading Purchases and redemptions once

at the close of business at the

same price.

Trading takes place throughout the

day like shares at the prevailing

market price.

Dividends Dividends are usually reinvested Dividends paid to shareholders

Minimum investment Usually higher than ETFs Usually much smaller than mutual

funds

Taxes Mutual funds generate more

taxable capital gains because of

money flowing into and out of

funds. There is a capital gain

because of liquidation of assets to

meet redemptions on which taxes

are paid.

Beneficial from a tax perspective

5.4 Other Pooled Investments

Separately Managed Accounts

A separately managed account is an investment portfolio managed privately for an

individual or institution by a brokerage firm or individual investment professional

(financial advisor).

The investment must be substantial to qualify as a separately managed account, usually

between $100,000 and $500,000.



The advantage is that the portfolio is managed exclusively to meet the clients needs with

respect to objectives, risk tolerance, and constraints.

Also called managed account, wrap account and individually managed account.

How SMA differs from a mutual fund:

In a SMA, the investor owns the individual underlying share whereas in a mutual fund, the

investor owns a unit/share in a pool of underlying securities which are owned by the mutual

fund.

Since the investor owns the shares, he has more control over when the securities are bought

and sold, and their timing.

Tax implications are considered when buying or selling as it meets the specific needs of

the investor.

Hedge Funds

Started out as a hedge against long-only stock positions i.e. creating a portfolio of short

positions to offset the long positions in stocks. The industry has grown considerably since

the 1940s and now encompasses several strategies.

They tend to use high leverage which leads to high risk.

Most hedge funds are exempt from reporting requirements of a typical public investment

company. For instance, in U.S. they do not have to register with SEC if there are 100 or

less investors.

The curriculum lists a few strategies used by hedge funds. These are discussed in detail at

Level III.

Note: Though not highly testable, you may go through the strategies once without getting into the

details.

Name of Strategy What does the strategy involve

Convertible arbitrage Buy convertible bonds that can converted in to shares while

simultaneously selling stocks short.

Dedicated short bias More short positions than long positions.



Name of Strategy What does the strategy involve

Emerging markets Purchasing sovereign or corporate securities of companies in

emerging markets.

Equity market neutral Eliminates effect of market movement by going long on

undervalued securities and short on overvalued securities.

Event Driven Taking advantage of company specific events like earnings

announcements, or one-time events like a merger announcement,

or FDA approval for a drug.

Fixed-Income Arbitrage Trading on price differences in interest-rate securities.

Global Macro Trading on global economies using derivatives on currencies or

interest rates.

Long/Short Going long on equities expected to perform well and short on

equities expected to underperform. The difference from equity

market neutral strategy is that it tries to profit from market

movements.

Buyout Funds and Venture Capital funds are collectively referred to as Private Equity

As the name implies, these are privately held and actively managed equity positions. With

a private equity investment, a firm makes an investment in a company and then is actively

involved in the management of that company.

The equity they hold is private and not traded in public markets. The intention is to exit out

of the investment in a few years.

Buyout Funds

- Make a few large investments in established private companies with the goal of

increasing cash flow. Idea is to buy public companies, make them private,

restructure and then sell it or take it public.

- In leveraged buyout, the level of debt is high (75%) which is paid off by the cash

flows generated from the restructured companys operations.

- Finite investment horizon: usually three to five years through IPO or sale to another

company.

- Buyout(s) make a few large investments.



Venture Capital Funds

- VC funds make small investments in startup companies unlike buyout funds that

invest in established companies.

- Finite investment horizon: usually three to five years.

- Active participation in the invested business providing advice; closely monitor the

operations.

- Make several small investments as the belief is that a small number will succeed.

Appendix

This reading introduces the following terms which a Level I candidate should be familiar with:

top-down analysis, bottom-up analysis, bottom-up analysis, buy-side firms and sell-side firms.

Top-down analysis: While doing asset allocation, analysts may select securities either based on

top-down analysis or bottom-up analysis. In a top-down analysis, macroeconomic conditions (for

different countries) are analyzed first followed by industry and markets, and then specific

companies within the industry. For example, consider this top-down analysis in early 2010.

Analysts may have forecasted the Australian economy to grow above a certain rate, the mining

industry to do particularly well in Australia, and within mining selected Rio Tinto plc.

Bottom-up: In a bottom-up analysis, the focus is exclusively on the company-specific

circumstances, and not from an economy or industry perspective.

Buy-side firms: Investment management companies like mutual funds that use the services of

sell-side firms.

Sell-side firms: A broker or dealer that sells securities to and provides investment research and

recommendations to investment management companies.



Summary Note: This summary has been adapted from the CFA Program curriculum.

In this reading we have discussed how a 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.

We have outlined the differing investment needs of various types of individual and

institutional investors. Institutional clients include defined benefit pension plans,

endowments and foundations, banks, insurance companies, investment companies, and

sovereign wealth funds.

Understanding the needs of your client and creating an investment policy statement represent

the first steps of the portfolio management process. Those steps are followed by security

analysis, portfolio construction, monitoring, and performance measurement stages.

We also discussed the different types of investment products that investors can use to create

their portfolio. These range from mutual funds, to exchange traded funds, to hedge funds, to

private equity funds.

Next Steps

Solve the practice problems in the curriculum.

Solve the IFT Practice Questions associated with this reading.

Review the learning outcomes presented in the curriculum. Make sure that you can perform

the implied actions.

portfolio management notes

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