Portfolio management Chapter 13

Introduction

A portfolio is
• the combination/group of individual securities held by an investor/institution

Portfolio management is
• making decisions about the asset mix and asset allocation (investment) and the
policy(objectives)
• balancing risk against performances by choosing the optimal portfolio taking into account its risk-
return characteristics. It requires constant review and monitoring

Advantage of a portfolio:
• A group of securities (portfolio) is more diversified than individual investments (less diversified)
held in isolation
• Thus, it reduce total risk (volatility) and securities in portfolio are less correlated, without
sacrificing returns.

Two forms of portfolio management:

• Passive portfolio management
• Tracks a market index to achieve a return equal to the market return
• Active management
• Attempts to beat market return by actively managing a portfolio through investment
decisions based on research

Purpose of this chapter

• Illustrate the significant elements of portfolio management (which is asset allocation and portfolio
construction) and to explain and apply the basic principles.

Investment policy statement (IPS)

The first step is to compile an investment policy statement (IPS) (see chapter 1)
• Defines objectives and constrains.
• Aim of IPS:
• Guides and controls investment objectives (which is strongly influenced by the investor’s
life cycle)
• Describes strategies that will be used to meet them. This contains information such as
asset allocation, risk tolerance, investment style and liquidity requirements
• Encourages the investor follow long-term investment discipline instead of short-term
impulsive approach
• Allows changes in investment decisions
Objectives and constraints

• When an investor needs professional advice, the financial advisor must gather information
(research) about the investor. This is summarised in IPS as guideline

Information needed in IPS process:

• Determine the investor’s investment objectives (risk and return)
• Determine portfolio constraints
• Define the investment strategies that will be used based upon objectives and constraints.
• Determine asset allocation
• Execute portfolio decisions, and after a certain period, evaluation performance
• Make changes in investment decisions as needed

• The risk and return objectives of each individual is different and depend on, but not limited to
the following:
• Age, marital status, living expenses, wealth etc. to indicate the degree of risk (risk
tolerance) he/she is willing to take.
• Also, every investor has unique investment goals/objectives. These investment goals and plans
are influenced by constraints.

Objectives and constraints will dictate:

• The appropriate investment strategies to be followed
• Asset allocation
• Investment style to be followed
• The way to evaluate portfolio performance

Each investors rate of return objectives are influenced by their restilarance levels but other
factors also apply: Constraints include:
• Liquidity needs, tax concerns, time horizons and preferences.

• Objectives (Financial goals seeking to achieve, e.g. retirement, education: depending on short-,
medium- and long-term objectives)
• Each investor has a unique combination of goals, time horizons, liquidity needs, etc.

The 3 objectives are (not in text book)

1. Capital preservation
• The objective is geared towards maintaining purchasing power
• Although the individual wants to maintain a particular quality of life, they also want their
investments to grow – at least at the current level of inflation. E.g. investments include bonds,
money market instruments.
2. Capital appreciation
• The objective is geared towards yielding returns above the level of inflation – aggressive objective
• Capital appreciation will probably mean that the individual invests in a shares portfolio
3. Current income
• A current income objective comes from the notion that only income can be spent and
all capital gains should be reinvested. This objective/portfolio is created for retired
individuals to receive a steady income. Income is generated from bond interest payments
and dividends.

Constraints:

• Risk tolerance (An investor’s willingness and need to accept risk (loss) of and investment)
– influence expected returns, asset types and weight restrictions
• Time horizon (Amount of time available to achieve a financial goal, e.g. retirement. Time it
takes to recover losses)
• Liquidity and marketability (Ability and ease to convert an asset at its current market
price without losing principal)
• Taxes (Consider your personal income tax, estate tax, trust tax, capital gains tax, after tax
returns) – e.g. rare gold coins
• Legal and regulatory factors (Regulations on investments differ between countries) –
Regulation 28
• Unique needs and personal preferences (Limitations that individuals have on what
types of investment are suitable for their portfolio, e.g. not prefer shares in tobacco
companies)

Life cycle

• In addition to objectives and constraints, financial advisor uses the life cycle of investor to
indicate the investor’s risk and return preferences based on their age
• Investment strategies and time horizons change during the investor’s lifetime as there is a
inverse relationship between age and risk tolerance

• Why? The younger you are, the more you are able and willing to accept high risk. Younger
investors have more opportunity to recover from market downturns and can therefore tolerate
high risk.
• The older you get, the less risk you are willing to take. All the investors portfolios should be
less aggressive and more conservative.
The life cycle of an individual

• Investor moves to 4 phases in his life. (Photo above)

Accumulation phase:
• typically young individuals accumulate assets such as house/ car and making provisions for
other short term goals such as holidays. Provision for long term goals: children’s education/
retirement. Young individuals take higher risk because they have a longer life expectancy.
Young individuals invest heavily in equity to achieve above average rate of return.
Consolidation phase:
• Individual has paid off many outstanding debts and has earnings that exceed expenses.
Capitol preservation becomes more important since retirement is closer. Portfolios based on
medium risk – equity exposures gradually reduce in favour of fixed income instruments such
as high quality bonds. Those individuals focus on capitol preservation, the investor should
also guard against inflation.
Spending phase:
• Typical investor is retired or semi-retired. Children are usually no longer dependent on their
parents and major debts such as a house are paid off. The individual lives of investments
or money saved for retirements. Income may decrease but this is likely to go with a
decrease in living expenses. Focus shifts to capitol protection – individual invests in low risk
investments like treasury bills and spend only in interest income.
Gifting phase:
• Concurrent with the spending phase. Individuals with reasonable savings are unlikely to
spend all their money during their remaining life span and start giving away. Believing that
there are exes amounts available in a portfolio, the investor may decide to give it away in
a form of education or donations.
The life cycle of an individual (formal)

Accumulation phase
• Accumulating assets such as house, cars, making provision for short term goals (e.g. car,
house deposit) and long term goals, e.g. (children's education, retirement etc.)
• Taking higher risk because you have a longer life expectancy when you are young
• Invest heavily in equity

Consolidation phase
• Most individual’s debt has been repaid by now, earnings exceed expenses
• Capital preservation becomes more important since retirement is closer. Portfolio is based
on medium risk (equity exposure is gradually reduced in favour of fixed income instruments,
e.g. high quality bonds)

Spending phase
• The focus shift to capital protection (low risk investments, e.g. treasury bills), only spending
interest income
• The individual is financially independent and lives of investments and retirement portfolios

Gifting phase
• Excess amounts (accumulated wealth) available in the portfolio and investor will give it away
in the form of education sponsorships, donations, etc.
 Asset allocation

• Asset allocation can be defined as the process of allocating funds of a portfolio to classes of
assets such as bonds, equities and cash
• Used to reduce risk
• Combines various assets in the same or different asset classes
• 3 major asset categories = equity, bonds and cash. Other asset categories include real estate,
precious metals, private equity and other commodities.
• Asset classes generating the most volatility…

Diversification:
• The main reason for diversification is to reduce risk
• The less correlated assets are, the less risk

The importance of asset allocation

• According to studies, 90% of a portfolio’s performance depends on asset allocation

Determination of the asset mix

• Policy / Strategic asset allocation – Passive approach is followed , i.e. allocation changes due to
investor’s objectives and constrains instead of changes in the market
• Tactical asset allocation – Active approach (economic forecasting, market assessments, equity
and bond research). i.e. beat the market return by shifting asset allocation due to changing
market conditions

Portfolio construction

In deciding which assets to include in a portfolio, the most important criteria are risk and return

Step 1 :Measuring return for single securities

Expected return

• The less correlated securities you include in a portfolio, the more diversify a portfolio will be.
• By investing in various companies across different sectors, industries or countries reduced to
correlation. Different industries and sectors do not move up and down at the same time or
rate which provides for a more consistent overall portfolio performance. In selecting individual
securities to be included in the portfolio, one has to calculate the risk and return associated
with each security as well as the correlation between the securities.
Step 2: Measuring risk of single securities

Standard deviation
Step 3: Measuring portfolio return of two asset portfolio

Step 4 and 5: Measuring portfolio risk of two asset portfolio

Covariance: It a measure of the directional relationship between the returns on two risky assets
• The sign of the cov. shows the tendency in the linear relationship between assets
• + (-) cov. = asset returns move together (inversely) - similar behaviour (opposite behaviour)
• High cov. = strong linear relationship

The magnitude of the covariance = not easy to predict

Correlation: measure the degree of strength of relationship or dependence between two variables.
• Numerical value between + 1 and – 1
• + (positive relationship - securities’ returns move up/down together)
• - (negative relationship - securities moves inversely, i.e. return of one share decreases, the
return on the other increases)
• The closer the coefficient is to +1 or -1, the stronger the correlation between these assets
• Correlation of 0 shows no relationship, the two variables are random
Step 6: Calculate the risk of the portfolio
Step 7: Calculate the optimal asset allocation
 RECAP: Steps to construct a portfolio
Step 1
• Calculate the return of each security (see Ch. 1) (Share A & Share B, respectively)
Step 2
• Calculate the risk of each security (see Ch. 1) (Share A & Share B, respectively)
Step 3
• Calculate the return of the portfolio (using the proposed investment weights given (A &B,
respectively)
Step 4
• Calculate the covariance of both securities (A,B)
Step 5
• Calculate the correlation of both securities (A,B)
Step 6
• Calculate the risk of the portfolio (using the correlation (A,B)
Step 7
• Calculate the optimal asset allocation (either using the Factor A method or minimum variance
allocation technique) to determine the weight of each security (A & B) respectively that must
be invested in the portfolio to produce the highest return with the lowest risk.

Portfolio management strategies

1. Passive management (long-term horizon)

• No forecasting, market timing or some form of analysis to select or pick a particular share.
• Intention is not to outperform the market.
• Tendency to have low trading costs (rebalance not often).

Methods:

Buy and hold

• Investors buys shares or bonds and hold them for long time (matching their investment
horizon), regardless of short term market fluctuations.
Indexing (e.g. types like full replication vs sampling)
• Invest in a portfolio that will match the performance of a selected index or index fund or
portfolio index. E.g. ETF (Satrix 40 ETF)
Fund of funds
• Holding a portfolio of other investment funds rather than investing directly in shares, bonds or
other securities
2. Active management (short-term horizon)

• Specific shares (or other securities) are selected with the goal of outperforming some
investment benchmark index.
• Use technical and fundamental analysis.
• Market timing is important. Attempts to predict the future direction of the market.
• Tendency to have high trading costs (rebalance often).

Methods:

Market timing
Investor attempts to predict the market’s future direction using historical data, technical data,
skills and experience. Short term strategy. Investor continuously monitors his/her investment.

Momentum strategy
• Investors believe that past ‘winners’ on average will continue to outperform past ‘losers’.
However, the portfolio is rebalanced regularly to establish the recent ‘winners’ that should be
invested in.
• Interest rate anticipation
• Valuation analysis
• Credit analysis
Yield spread analysis
Yield curve strategies
Riding the yield curve
 Calculate the optimal portfolio weight

After conducting a fundamental analysis, a portfolio manager of VEGA investments identifies two
shares for inclusion in one of her portfolios. She observes four possible states of the South
African economy, each with its own probability of occurrence. She also estimates the expected
performance of the two shares under each state of the economy.

The following calculations regarding the two shares have already been done:

3
Calculate the expected return on a portfollo made up of Share A and Share B according to the
proposed investment amounts.

③
0 55
.
x 0 046
.
+
0 . 45 x
0 . 0045
Portfolio return
=
0 027325
.
or 2 .
7325 %

The expected risk of a portfolio made up of Share A and Share B according to the proposed
investment amount.

But ,
first you need :

⑭
⑤
 Covariance
Covariance AB =
Pka- A ki- EB Correlation =

OAX OB

. 15
0 -

0 18 -

0 046 0 04 -

0 0045
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0 176307x0 027473
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=
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0 .
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+
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.
5540 45x .
-

0 951136x0 176307x0 027473

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. 529556
8 % or 0 085296 .

G Optimal weight of portfolio F(A) where factor (A) : o Lovas

F(A)
2
1 +
COVAB
OA

0 0274732 0 004607
Factor A
-

=
0 153572
.
.

.
0 1763072 -

0 004607 .

0 153572
.

1 + 0 153572
.

=
0 133127
.
-
13 .
312736 %

Share t 33 3 /

,
312736 = 86 69 %
.
 Calculator

1. Clear memory
2. Reset to stat mode: mode (1, 1) Reset to normal: mode: 1
3. Set up 6 decimals: Set up (0; 0; 6)

IE
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