1. Chapter 1 Managing Investment Portfolios

2.  integrated set of steps undertaken in a consistent manner to create and maintain an appropriate portfolio to meet clients’ stated goals ◦ portfolio – group of assets  steps ◦ planning ◦ execution ◦ feedback  investment policy statement (IPS) – written document that clearly sets out a client’s return objectives and risk tolerance over that client’s relevant time horizon, along with applicable constraints such as liquidity needs, tax considerations, regulatory requirements, and unique circumstances

3.  service of professionally investing money  investment management firms ◦ revenues / size of firm ◦ investors ◦ employees  growth in industry due to importance of defined benefit plans in second half of 20 th century ◦ shift in 1980s and 1990s to retirement plans focusing on participant responsibility resulted in growth of individual-oriented investment advisors

4.  focus on aggregate of all investor’s holdings  “because economic fundamentals influence the average returns of many assets, the risk associated with one asset’s return is generally related to the risk associated with other assets’ returns – if we evaluate the prospects of each asset in isolation and ignore the interrelationships, we will likely misunderstand the risk and return prospects of the investor’s total investment position – our most basic concern”  Harry Markowitz (1952) father of modern portfolio theory ◦ analysis of rational portfolio choices based on the efficient use of risk  “demand” for the portfolio perspective ◦ emergence of importance of institutional investing ◦ growth in technology ◦ professionalization of investment management field

5.  continuous and systematic process complete with feedback loops for monitoring and rebalancing  an integrated set of steps undertaken in a consistent manner to create and maintain appropriate combinations of investment assets  steps ◦ planning ◦ execution ◦ feedback

6.  planning ◦ investor-related input factors  specification and quantification of investor objectives, constraints, and preferences  objectives are desired investment outcomes that mainly pertain to return and risk  constraints are limitations on investor’s ability to take full or partial advantage of particular investments  portfolio policies and strategies ◦ economic and market input  relevant economic, social, political, and sector considerations  capital market expectations

7.  governing document for all investment decision making  elements of a typical IPS: ◦ brief client description ◦ purpose of establishing policies and guidelines ◦ duties and investment responsibilities or parties involved ◦ statement of investment goals, objectives, and constraints ◦ schedule for review of financial performance ◦ performance measures and benchmarks to be used ◦ investment strategies and styles ◦ guidelines for rebalancing based on feedback

8.  IPS is basis for strategic asset allocation  investment strategy – manager’s approach to investment analysis and security selection ◦ organizes and clarifies basis for investment decisions ◦ guides those decisions toward achieving investment objectives  types of investment strategies ◦ passive ◦ active ◦ semiactive

9.  Investment style ◦ natural grouping of investment disciplines that has some predictive power in explaining the future dispersion in returns across portfolios  strategic asset allocation ◦ combines IPS and capital market expectations to determine target asset class weights  maximum and minimum permissible asset class weights set to control risk  execution step – portfolio selection and composition decision ◦ interacts constantly with feedback step as changes are made ◦ use portfolio optimization – quantitative tools for combining assets efficiently to achieve a set of return and risk objectives

10.  transaction costs ◦ explicit – commissions paid to brokers, fees paid to exchanges, taxes ◦ implicit – bid-ask spreads, market price impacts of large trades, missed trade opportunities, and delay costs  feedback step ◦ monitoring and rebalancing  use feedback to manage ongoing exposures to available investment opportunities so that the client’s current objectives and constraints continue to be satisfied ◦ performance evaluation

11.  performance measurement – involves calculation of the portfolio’s rate of return  performance attribution – examines why the portfolio performed as it did and involves determining the sources of a portfolio’s performance  performance appraisal – evaluation of whether the manager is doing a good job based on how the portfolio did relative to a benchmark  sources of return

12.  investment objectives and constraints are identified and specified  investment strategies are developed  portfolio composition is decided in detail  portfolio decisions are initiated by portfolio managers and implemented by traders  portfolio performance is measured and evaluated  investor and market conditions are monitored  necessary rebalancing is implemented

13.  objectives are interdependent ◦ risk ◦ return

14.  How do I measure risk? ◦ absolute vs. relative risk ◦ absolute  variance  standard deviation ◦ relative  tracking error  What is the investor’s willingness to take on risk?

15.  What is investor’s ability to take on risk? ◦ In terms of spending needs, how much volatility would inconvenience an investor who depends on investments? Or how much volatility would inconvenience an investor who cannot afford to incur substantial short-term losses? ◦ In terms of long-run wealth targets or obligations, how much volatility might prevent the investor from reaching these goals? ◦ What are the investor’s liabilities or psudeo-liabilities? ◦ What is the investor’s financial strength – that is, the ability to increase the savings/contribution level if the portfolio cannot support the planned spending?

16.  How much risk is the investor both willing and able to bear? ◦ risk tolerance – capacity to accept risk  What are the specific risk objective(s)? ◦ absolute vs. relative risk objectives ◦ example  How should the investor allocate risk? ◦ risk budgeting

17.  How is return measured? ◦ total return – capital appreciation plus investment income ◦ absolute vs. relative ◦ nominal vs. real ◦ pre-tax vs. post-tax  How much return does the investor say she wants?

18.  How much return does the investor need to achieve, on average? ◦ required return ◦ examples  amount a pension fund needs to earn to fund liabilities to current and future fund holders  amount an individual investor needs to have to fund retirement at a certain level  amount that a retired investor needs to earn on portfolio to cover his living expenses  What are the specific return objectives?

19.  married couple needs £2 million in 18 years to fund retirement (incorporates inflation) ◦ current investable assets are £1.2 million ◦ need to earn 2.88% per year after tax to achieve goal ◦ How did we get 2.88%? ◦ Suppose couple needs to liquidate £22,000 from portfolio at end of each year. What return is needed?* ◦ If all investment returns are taxed at 30%, what pre- tax return would you need?

20.  liquidity  time horizon ◦ How does the length of the time horizon modify the investor’s ability to take risk? ◦ How does the length of the time horizon modify the investor’s asset allocation? ◦ How does the investor’s willingness and ability to bear fluctuations in portfolio value modify the asset allocation? ◦ How does a multistage time horizon constrain the investor’s asset allocation?  tax concerns  legal and regulatory factors  unique circumstances

21.  taking the inputs from analysts, economists, etc. and moving step by step through the orderly process of converting this raw material into a portfolio that: ◦ maximizes expected return relative to the investor’s ability to bear risk ◦ meets investor’s constraints and preferences ◦ integrates portfolio policies with expectational factors and market uncertainties