1. 1 Portfolio Management- Asset Allocation 1. Objective 2. Know Your Limitations Risk Tolerance 3. Have an Investment Philosophy Some portfolio managers have inherit bias toward small growth-comparisons; some try to play the ‘cycle’; some buy based on strong fundamentals.

2. 2 Play relative Earnings Growth: Firms earnings growing faster than the overall industry; Play relative Earnings Growth: Firms earnings growing faster than the overall industry; Play Relative P/E Ratio. Play Relative P/E Ratio. 4. Develop an Investment Strategy - E ssential to implementation of investment philosophy For an investment strategy, need to know the ‘character of the economy’, such as: For an investment strategy, need to know the ‘character of the economy’, such as: Inflation forecasts – high or lowInflation forecasts – high or low Productivity gains/lossProductivity gains/loss Segment of economy that is strongSegment of economy that is strong

3. 3 Should the portfolio be weighed by capital growth or be skewed from Cyclical Stocks? Should the portfolio be weighed by capital growth or be skewed from Cyclical Stocks? 5. Construction of Portfolio: Risk/Return Analysis Risk/Return Analysis 6. Revision and Portfolio Performance

4. 4 2. Portfolio Management of Stocks Return accruing to an individual stock is derived from: 1) Overall market effect 2) Affiliation to the industry 3) Unique characteristics of individual security Corresponding Risk Corresponding Risk 1) Market risk 2) Extra market covariance/group risk 3) Specific or residual risk

5. 5 3. Portfolio Management Style a) Passive b) Disciplined Stock Selection c) Active d) Asset Allocation Schemes e) Modern Portfolio Theory

6. 6 Active Strategy can be applied with respect to I) Market Component – Market timer. Organization will forecast rising market, raise ß by moving from 1) cash to equity, or 2) high ß assets. Forecast declining market, opposite... Forecast declining market, opposite... Passive for market timer, maintain ß in line with portfolio objective, regardless of market forecast. Passive for market timer, maintain ß in line with portfolio objective, regardless of market forecast.

7. 7 II) Active strategy with respect to industry: Group Rotation - under-weighting or over-weighting depending on the industry, favorable or unfavorable Tech Sector, Drug Sector, etc., over time; Tech Sector, Drug Sector, etc., over time; Passive Strategy: Organization that believes that it has no capability to forecast in this respect would set portfolio weight with respect to broad market sector and major industries in line with their weighting in the market index. Passive Strategy: Organization that believes that it has no capability to forecast in this respect would set portfolio weight with respect to broad market sector and major industries in line with their weighting in the market index.

8. 8 III) Active strategy with respect to individual stocks: Stocks identified as most attractive will have more weight relative to market index, and less attractive will weigh less relative to market index. Organizations hold many stocks because their forecasts about individual stock is imperfect, known as diversification. Organizations hold many stocks because their forecasts about individual stock is imperfect, known as diversification. Passive strategy with respect to Individual Stocks: Index Fund Passive strategy with respect to Individual Stocks: Index Fund

9. 9 A) Disciplined stock selection: Several critical elements must be present 1) Must have predictive capability with respect to individual stocks Fundamental analysis Fundamental analysis Quantitative analysis Quantitative analysis Technical analysis Technical analysis 2) Systematic Portfolio Construction Process 3) Routine Portfolio Rebalancing/ Transaction Cost

10. 10 4.Asset Allocation Asset Allocation: Purpose is to put assets together in such a way as to maximize return at a level of risk consistent with investor’s objectives. Asset Allocation: Purpose is to put assets together in such a way as to maximize return at a level of risk consistent with investor’s objectives. Process involves 4 key elements: 1) Investors need to determine the assets that are eligible for the portfolio. 1) Investors need to determine the assets that are eligible for the portfolio. 2) Necessary to determine E(R) for these eligible assets over a holding period.

11. 11 3) Once returns have been estimated and risk accessed, optimization technique is used. 4) Choose portfolio from efficient frontier, provides maximum return, minimal risk. 4) Choose portfolio from efficient frontier, provides maximum return, minimal risk.

12. 12 Approaches to Asset Allocation Three approaches to Asset allocation: Three approaches to Asset allocation: Fixed Weight: Fixed percentage of the portfolio to each asset category – 3 to 5 in total. Fixed does not mean equal weight. Common Stock30% Bonds50 Foreign Securities15 Short term Securities 5 Allocation does not change over time, may be adjusted after a major market move to keep the desired fixed allocation Allocation does not change over time, may be adjusted after a major market move to keep the desired fixed allocation

13. 13 Flexible Weight - also known as strategic asset allocation: Weight changes on the basis of market analysis. Favorable domestic inflation forecast compared to foreign may result in revised allocation. Flexible Weight - also known as strategic asset allocation: Weight changes on the basis of market analysis. Favorable domestic inflation forecast compared to foreign may result in revised allocation. Common Stock30% to45% Bonds50to40 Foreign Securities15to10 Short term Securities 5to 5 Weights are changed to capture greater returns in changing market. Weights are changed to capture greater returns in changing market.

14. 14 Tactical Asset Allocation: Form of market timing that uses stock index futures and bond futures to change a portfolio’s asset allocation. Stocks are forecasted to be less attractive than bonds, sell stock index futures and buy bond futures. Bonds are forecasted to be less attractive than stocks, buy stock index futures and sell bond futures. Requires sophisticated technique, large portfolio, quantitative modeling. Appropriate for large institutional investors.