MEB

Financial Strategy

Session 3 – portfolio management

 BASICS OF PORTFOLIO MANAGEMENT
PROCESS
• Portfolio management is an integrated set of steps aimed at
2 establishing and maintaining a portfolio of investment assets ,
where risk and return achieve the investor’s objective
• Five steps make up the portfolio management process:
• Understand the investor’s requirements and use them to
determine portfolio policy and strategies
• Assess expectations of the markets and the likely performance
of individual assets
• Decide on particular management style to construct an initial
portfolio that takes into consideration both the investor’s
requirements and a market assessment
• Continually review both investor’s situation and the capital
markets , which continually change and may impact the
holdings of a portfolio
• Measure and evaluate performance
 BASICS OF PORTFOLIO MANAGEMENT
PROCESS
3

• Investors always are interested in evaluating the

performance of their portfolios
• It is both expensive and time consuming to analyze and
select securities for a portfolio, so an individual, company, or
institution must determine whether this effort is worth the
time and money invested in it.
• Investors managing their own portfolios should evaluate
their performance as should those who pay one or several
professional money managers.
• In the latter case, it is imperative to determine whether the
investment performance justifies the service’s cost.
 REQUIREMENTS OF PORTFOLIO MANAGER

There are two major requirements of a portfolio manager:

1. The ability to derive above-average returns for a given risk
class
2. The ability to diversify the portfolio completely to eliminate
all unsystematic risk, relative to the portfolio’s benchmark
 EQUITY PORTFOLIO STRATEGIES
5
Determinants of Portfolio Policies

Objectives Constraints Policies

Return Requirements Liquidity Asset Allocation
Risk Tolerance Horizon Diversification
Regulations Risk Positioning
Taxes Tax Positioning
Unique Needs Income Generation
Matrix of Objectives
Type of Investor Return Requirement Risk Tolerance

Individual and
Personal Trusts Life Cycle Life Cycle
Mutual Funds Variable Variable
Pension Funds Assumed actuarial rate Depends on payouts
Endowment Funds Determined by income needs and Generally conservative
asset growth to maintain real value
Matrix of Objectives (cont’d)

Type of Investor Return Requirement Risk Tolerance

Life Insurance Spread over cost of Conservative funds and
actuarial rates

Nonlife Ins. Co. No minimum Conservative

Banks Interest Spread Variable

Constraints on Investment Policies
• Liquidity
• Ease (speed) with which an asset can be sold and
created into cash
• Investment horizon - planned liquidation date of
the investment
• Regulations
• Prudent man law
• Tax considerations
• Unique needs
Managing Portfolios of Individual Investors
Overriding consideration is life cycle
• Needs for current income
• Appropriate level of risk
• Appropriate level and type of life insurance
• Taxes and tax planning
Tax Sheltering for Individual Investors
• Tax-deferral option - controlling the timing of gains
on investments
• Tax-deferred retirement plans
• IRAs
• Keogh plans
• Deferred annuities
• Fixed
• Variable
Institutional investors
Pension Funds
• Basic types of plans
• Defined contribution plans
• Defined benefit plans
• Pension investment strategies
• Defined contribution versus defined benefit
• Contingent immunization
• Investing in equities
The private manager job in the asset management process:
financial planning:

Phases

1 Analysis of investors characteristics and targets

2 Identification of management constraints

3 Strategic asset allocation

4 Choice of the management methodology

4 Tactical Asset Allocation

5 Market timing and stock picking

5 Performance Measurement and possible feedback

14
The private banker job: know your customer as investor

Fundamental factors: Description

Total assets Personal / family: the more capital available, the higher is in general the degree of acceptable risk,
because on large property the principle of diversification can be implemented more effectively, nd
therefore under equal conditions you can choose a more aggressive investment

Saving propension Intended as a percentage of income or rather as monthly flows of income and outcome: the higher
the percentage of your income you can set aside, the more you can move towards greater
investment in equity , because of the lower need of constant new liquidity

Risk propension If the investor who sees a decrease of the value of his investment can not resist the temptation to
sell, it will not be suitable for a risky instrument. Risk appetite can also be deduced from a
consideration of their own personal history, through the question: "how many shares the investor
has held on average over the last 3 years? Would you replicate your choice or have you run a risk
too much high?"

Financial knowledge of the fundamental relationships between the variables that determine the
background performance of financial markets: basically, the more the investor is an expert on the markets, the
more suitable he is for risky investments

15
The private banker job: identify the target

Tre key factor to keep in mind:

1. Liquidity needs

2. Costant cash flow revenue

3. Time investment horizon

16
 Market analysis
Definition of financial position  investor

Understanding of the objectives , constraints and

the preferences of the investor and Determining position
definition of its financial investor
function of risk tolerance

Identification of the degree Setting expectations in terms

Risk bearable risk return and correlation

Construction and revision

Portfolio :

asset allocation

Updating factors updating

Performance measurement and
related investor Markets Predictions
comparison between objectives and results

Portfolio rebalancing
Management methodologies

Methodologies Description

• It is based on the replica of the structure of a benchmark ( benchmark )

Passive
management • The benchmark is set up as an instrument of ex ante and ex post essential in building an
optimal portfolio
• Requires Diversification
• Assumed market efficiency
• It assumes control risk , to the great exposure to falls
• It should have low transaction costs

• Can not imply diversification

Active
• It requires rotation of sectors
managment
• Stock picking is based on ( find undervalued stocks )
• It is important to the market timing

18
Tactical asset allocation

Market analysis aimed at seizing the opportunities of return arising

from a market performance through a redistribution of the weights
( over or under ) between the different asset classes defined
upstream strategic asset allocation ( within a predefined range ) .

The technical management of a.a. tactics can be traced to :

• technical buy and hold
• Technical constant mix
• Technical core portfolio and swing portfolio
• techniques a.a. searching for alpha

19
Management Techniques (1/3)

Tecniques Description

BUY & HOLD It consists in buying and holding to maturity of the investment mix of activities initially
considered optimal

CONSTANT MIX It maintains the relative proportion of the assets in the portfolio , despite the changes in
the prices which would tend to edit it. Requires constant rebalancing of assets

CORE-SWING It divides the capital available for investment in two different portfolios . On the first
(core ) it is entrusted essentially a function of risk control of the investment as a whole
with oriented returns on long- term optical ; for this is organized privileging the aspect of
diversification and managed using the technique of constant mix . The second ( swing ) is
instead oriented to the pursuit of profit objectives through the management of dynamic
linked to a short-term , while fewer restrictions are imposed on the appearance of risk .

ALFA SERCH The manager decides to accept immediately and completely control the allocation by
changing the weight percentage of the various asset classes in the portfolio according to
the forecast of appreciation or depreciation of the related

20
Management Techniques (2/3)

Activism Pros Cons

Consultant

Buy & Hold Very low • Management simplicity • Risk of reduction of the
• Low transaction costs level of diversification
• Since it is not a real
• Maximizing the return of
business of
portfolio assets with
management, any "
constant trend
management fees " are
hardly sustainable from
a commercial

• Correspondence
Constant mix Low continues with respect to
• High transaction costs
the optimal composition • No maximizing the
of LT defined From the performance of the
year . strategic portfolio if the various
• Maximization of the asset classes have
constant performance
assets included in the
trends
portfolio with high levels
of volatility

21
Management Techniques (3/3)

Activism Pros Cons

Consultant

CORE- Quite high • Better economic results • The technique efficacy depends
SWING if you implement a on the degrees of freedom that
strategy of effective and the consultant maintains with
appropriate market reference to the swing portfolio
timing • Increase of the uncertainty of
the performance, with the
possibility of tracking errors
both positive or negative

ALFA high • The portfolio is updated • High transaction costs

SERCH promptly and economically: if No performance maximization of
you plan an appreciation of the portfolio if the various asset
an asset class, it increases its classes have constant
relative weight in comparison performance trends
to the others (and vice
versa)
Purpose: beat the
benchmark

22
Ibbotson (1997) says that long-term factors which determine
PORTFOLIO PERFORMANCE are as follows

23
Contribution % to portfolio performance

100

80
Timing
60 Asset Allocation

40 Stock Selection

20

0
0 6 mesi 1 anno 5 anni 10 anni

24
Factors influencing portfolio behavior

Another study by Brinson, Singer, Beebouwer (1986), concludes that the factors that better
explain portfolio variability during time are :

25
More nobel prize winners reach similar conclusions...

Harry Markovitz - says about 95% of investment returns depend on how assets are split between stocks,
bonds, cash, real estate .

Sharpe - says that the split bewteen stocks, bonds and cash accounts for 90% of investment returns. The
remaining 10% depends on which specific issue you choose (single stocks, funds, etc.) and on when you
decide to buy/sell

26
THERE IS NO PERFECT TIME TO BUY OR
SELL

$100.69

$105

$90
12.22%
$75 Average Return

$60
$26.44
$45

$30
8.76%
$15
Average Return
$0 Monthly Stock
Bad Market Timing Buy and Hold Returns from
(Miss 12 Best Months) (Fully Invested 1960 through
At All Times) 1999

27
 TIME IS THE BEST ALLY OF AN INVESTOR

12000

18000
11500 S&P 500 Index During S&P 500 Index from
Sept & Oct of 1987 16000 3/30/1971 - 3/30/2001
11000

14000
10500

12000
10000

10000
9500

8000
9000

6000
8500

4000
8000

7500
2000

7000 0

30/04/198
08/05/198
18/05/198
27/05/198
04/06/198
12/06/198
22/06/198
30/06/198
09/07/198
17/07/198
27/07/198
04/08/198
12/08/198
20/08/198
28/08/198
08/09/198
16/09/198
24/09/198
02/10/198
12/10/198
20/10/198
28/10/198
05/11/198
13/11/198
23/11/198
02/12/198
10/12/198
18/12/198
29/12/198
07/01/198
15/01/198
25/01/198
02/02/198
10/02/198
19/02/198
29/02/198
08/03/198
16/03/198
24/03/198
04/04/198
12/04/198
20/04/198
28/04/198 27/02/1970
30/04/1971
30/06/1972
31/08/1973
31/10/1974
31/12/1975
28/02/1977
28/04/1978
29/06/1979
29/08/1980
30/10/1981
31/12/1982
29/02/1984
30/04/1985
30/06/1986
31/08/1987
31/10/1988
29/12/1989
28/02/1991
30/04/1992
30/06/1993
31/08/1994
31/10/1995
31/12/1996
27/02/1998
30/04/1999
30/06/2000
7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 7 8 8 8 8 8 8 8 8 8 8 8 8 8 8

28
What is really important in portfolio selection?

What we think it matters What really matters

Stock picking and market Stock picking and market

timing timing
60% 10%

Optimization
Strategic Asset 15% - 20%
Allocation
20% Strategic Asset Allocation
30% - 35%

Investiment process
20% Investment process
40%

29
Market timing? No thanks !!

Examples

• An investiment of 1.000 dollars in Standard & Poor's index on 31 december 1978, would have
reterurned 26.000 dollars on 31 december 1998, but , excluding the best 15 months the final value
would reduce to 7.000 dollars.

• Of 41 months which is the average duration of a bull phase, only 8 months have produced more
than 60% of total return .

• To have lost the best 10 months in terms of return of S&P 500 in the period 1960-1998 means to
obtain a monthly average return simlar to a short term bond investment.

• The trader or investor that wants to be sucessful with market timing must ne right on 3 times out of
4 just to be in line with competitors who do not trade (SHARPE).

30
Conclusion

How you choose your allocation between different main asset classes is the key decision in order for your
portfolio to accomplish your financial goals according to your time horizon

Unfortunately this key decision is mostly disregarded in favour of more short term considerations

31
 Asset Allocation Combining Them Into An Efficient Portfolio Requires
Is A Key Element Of An Significant Expertise
Investment Strategy Risk / Return Tradeoff: HFR Fund of Funds with Global Stocks and Bonds
January 1990 – December 1999
Asset allocation explains 93.6% of
portfolio performance 13
100% HFR FOF
Sharpe Ratio = 1.26
Stock index: MSCI World (TR) (USD)
Bond Index: Salomon WGB (USD)
HFR Fund of Funds Index: Actual returns (USD)

Factors Contributing to Portfolio Performance 50% HFR FOF

30% Stocks
12 75% HFR FOF 20% Bonds

Annualized Return
15% Stocks Sharpe Ratio = 1.04
Asset Allocation 10% Bonds 10% HFR FOF
Individual Stock Sharpe Ratio = 1.24 54% Stocks
Bond Selection 36% Bonds
60% Stocks
Market Timing 11
Sharpe Ratio = 0.65
40% Bonds
Undertermined Sharpe Ratio = 0.57
25% HFR FOF
45% Stocks
30% Bonds
Sharpe Ratio = 0.78
Source: Financial Analysts Journal, July - August 1986 10
5 6 7 8 9 10
Risk (+/-)

There Are Many Asset

Classes To Choose From Asset Classes Have Different Risk Return Characteristics
s
Stocks:

Very High
Bonds: nd y /
Fu teg s
- Value - Short-Term Bonds e a d
dg Str un Venture
He lti- e F Capital
- Growth - Investment grade u yl
M St
- Large Company e tes
Currencies
Bonds ur
ct No Equities
- Small Company tru e ns

Return
- Emerging Markets it S com Loa Convertible Bonds
d n
- International - Mortgage-Backed e I d
Cr r & age High Yield Bonds
i o an
- Emerging Bonds n
Se M High Yield Loans
n
Markets - International Bonds e ctio Corporate Bonds
t
ro Government Bonds
- High Yield al
P

Very Low
cip Short-Term Bonds
Alternative Investments: Pr
in
Fiduciary Deposits
- Hedge Funds Cash
- Private Equity Risk
Very Low (Standard Deviation) Very High 32
* Investment Diversification/Consulting Group
 VALUATION PROCESS

• Valuation process in general

• There are two general approaches to the valuation process:
(1) the top-down, three-step approach; or
(2) the bottom-up, stock valuation, stock picking approach.
• Both of these approaches can be implemented by either
fundamentalists or technicians.
• The difference between the two approaches is the perceived
importance of the economy and a firm’s industry on the valuation of
a firm and its stock.

33
 VALUATION PROCESS
• Three-step approach is consisted of:
• top-down valuation process in which you first examine the influence of the
general economy on all firms and the security markets,
• then analyze the prospects for various global industries with the best
outlooks in this economic environment, and
• finally turn to the analysis of individual firms in the preferred industries and
to the common stock of these firms.

34
OVERVIEW OF THE INVESTMENT PROCESS

35
COMPANY ANALYSIS AND STOCK VALUATION

36
Managing Fixed Income Securities: Basic
Strategies
• Active strategy
• Trade on interest rate predictions
• Trade on market inefficiencies
• Passive strategy
• Control risk
• Balance risk and return
Bond Pricing Relationships
• Inverse relationship between price and yield
• An increase in a bond’s yield to maturity results in a smaller price
decline than the gain associated with a decrease in yield
• Long-term bonds tend to be more price sensitive than short-term
bonds
Bond Pricing Relationships (cont’d)
• As maturity increases, price sensitivity increases at a decreasing rate
• Price sensitivity is inversely related to a bond’s coupon rate
• Price sensitivity is inversely related to the yield to maturity at which
the bond is selling
Passive Management
• Bond-Index Funds
• Immunization of interest rate risk
• Net worth immunization
Duration of assets = Duration of liabilities
• Target date immunization
Holding Period matches Duration
• Cash flow matching and dedication
Duration and Convexity
Price

Pricing Error from

convexity

Duration

Yield
Correction for Convexity

1 n
 CFt 
Convexity 
P  (1  y ) 2   (1  y ) t (t  t )
t 1 
2


Correction for Convexity:

P 1
  D  y  [Conveixity  (y ) ]
2

P 2
Active Bond Management:
Swapping Strategies
• Substitution swap
• Intermarket swap
• Rate anticipation swap
• Pure yield pickup
• Tax swap
Yield Curve Ride
Yield to
Maturity %

1.5
1.25
.75

Maturity
3 mon 6 mon 9 mon
Lure of Active Management
Are markets totally efficient?
• Some managers outperform the market for extended periods
• While the abnormal performance may not be too large, it is too large to be
attributed solely to noise
• Evidence of anomalies such as the turn of the year exist
The evidence suggests that there is some role for active management
Market Timing
• Adjust the portfolio for movements in the market
• Shift between stocks and money market instruments or
bonds
• Results: higher returns, lower risk (downside is
eliminated)
• With perfect ability to forecast behaves like an option
Rate of Return of a
Perfect Market Timer

rf

rM
rf
Returns from 1987 - 1996
Year Lg. Stock Return T-Bill Return
87 5.34 5.50
88 16.86 6.44
89 31.34 8.32
90 -3.20 7.86
91 30.66 5.65
92 7.71 3.54
93 9.87 2.97
94 1.29 3.91
95 37.71 5.58
96 23.00 5.20
Average 16.06
Standard Dev. 14.05
With Perfect Forecasting Ability
• Switch to T-Bills in 87, 90 and 94
• No negative returns or losses
• Average Ret. = 17.44%
• S.D. Ret. = 12.38%
• Results with perfect timing
• Increase in mean return
• Lower S.D.
With Imperfect Ability to Forecast

• Long horizon to judge the ability

• Judge proportions of correct calls
• Bull markets and bear market calls
Superior Selection Ability
• Concentrate funds in undervalued stocks or undervalued sectors or
industries
• Balance funds in an active portfolio and in a passive portfolio
• Active selection will mean some unsystematic risk
Treynor-Black Model
• Model used to combine actively managed stocks with a passively
managed portfolio
• Using a reward-to-risk measure that is similar to the the Sharpe
Measure, the optimal combination of active and passive portfolios
can be determined
Treynor-Black Model:
Assumptions
• Analysts will have a limited ability to find a select number of
undervalued securities
• Portfolio managers can estimate the expected return and risk, and the
abnormal performance for the actively-managed portfolio
• Portfolio managers can estimate the expected risk and return
parameters for a broad market (passively managed) portfolio
Reward to Variability Measures

Passive Portfolio :
2
2 E (r m ) - r f
S m =[  ]
m
Reward to Variability Measures
Appraisal Ratio:
α A

 (eA)

α A = Alpha for the active portfolio

 (eA) = Unsystematic standard
deviation for active
Reward to Variability Measures

Combined Portfolio :

2
2 E (r m ) - r f A
2
S p =[ ] +[ ]
 m  eA
Treynor-Black Allocation
CAL
E(r) CML

P A

Rf


Summary Points:
Treynor-Black Model
• Sharpe Measure will increase with added ability to
pick stocks
• Slope of CAL>CML
(rp-rf)/p > (rm-rf)/p
• P is the portfolio that combines the passively
managed portfolio with the actively managed
portfolio
• The combined efficient frontier has a higher return
for the same level of risk
The cycle of investing process

high prices
Growth

Momentum Negative shocks

Rising prices Falling prices

positive shocks Dog

Value

Low prices

59
Asymmetries...
 Basic Principles

Relationships Framework
1. Commodity prices and bond prices usually trend in the opposite direction. (Commodity prices
and bond yields usually trend in the same direction.)
2. Bonds and stocks move together (unless in deflation)
3. Bonds lead the stock market at the turns
4. The dollar and commodities move inversely (particularly gold).
5. A rising dollar is normally good for U.S. stocks and bonds because it is noninflationary.
6. Gold leads turns in the CRB at the turns

Equally Important :
7. Relationships between various futures markets and related stock groups
(e.g. COMEX Gold & gold mining shares)
8. The relationship between the CRB Index and the various commodity groups
9. Action between related commodity groups (precious metals and energy markets)
1O. Action within commodity groups (gold to platinum, crude and heating oil)
11. Action between currency pairs
Correlation matrix : an example

LARGE CAP NAT. RES.

S&P500 NASDAQ UTILITY BOND GOLD

62
Rising Bond Prices are Usually Good for Stock Prices
The line along the bottom shows the positive correlation between
T-bond prices and the S&P 500
Commodity Prices and Bond Prices Normally Trend in the Opposite
Directions
A Rising Dollar Normally has a Depressing Effect on Commodity Markets
The US$ and Gold Prices Usually Trend in Opposite Directions
Usually a Very Close Linkage Between
Bond Prices and Utilities
Asset Allocation & Market Timing Uses

Economic Forecasting
Asset Allocation & Market Timing Uses

Sector Rotation
Adding hedge funds to diversify...different strategies

71
Adding hedge funds? Some examples

HEDGED
TRADING
L+S ARBITRAGE
L>S or L<S L or S
DIRECTIONAL L
L=S

Long and short Lond and short Maximum exposure

Simultaneously with neutral to market
market exposure
Traditional strategy
long –only
Riduce 
Pure
 Complementary to
  E genera
  0
Arbitrage

74
 PRIVATE MANAGEMENT FIRM

•
 CASE STUDY

•
•
 CASE STUDY