CHAPTER SEVEN

PORTFOLIO MANAGEMENT PROCESS

1. Introduction
 An investment management, also referred to as portfolio management is a complicated process or
activity which may comprises of the following steps.
1. Specification of investment objectives and constraints
2. Choice of asset mix/ asset allocation
3. Formulation of portfolio strategy
4. Selection of securities
5. Portfolio execution and portfolio revision
6. Portfolio performance evaluation
2. Steps in Portfolio Management

2.1 Specification of Investment Objectives and Constraints

 The first step in the portfolios management process is to specify the investment policy which
summarizes the objectives, constraints, and preferences of the investor. The investment policy may
be expressed as follows:
 Objectives
Return requirements
Risk tolerance
 Constraints and preferences
Liquidity
Investment horizon
Taxes
Regulations
Unique circumstances
A. Objectives: the commonly stated objectives of investment are:
i. Income: to provide a steady stream of income through regular interest/dividend payment
ii. Growth: to increase the value of the principal amount through capital appreciation
iii. Stability: to protect the principal amount invested from the risk of loss
 Since income and growth represent two ways by which return is generated and stability
implies containment or even elimination of risk. Investment objectives may be expressed
more succinctly/ briefly in terms of return and risk. As an investor, you would primarily be
interested in a higher return (in the form of income and /or capital appreciation) and a lower
level of risk. However, return and risk typically go hand in hand. So you have to ordinarily
bear a higher level of risk in order to earn a higher return. How much risk you would be

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 willing to bear to seek a higher return depends on your risk disposition. Your investment
objective should state your preference for return and relative to your distaste for risk.
 You can specify your investment objectives in one of the following ways:
 Maximize the expected rate of return, subject to the risk exposure being held within a
certain limit (the risk tolerance level)
 Minimize the risk exposure, without sacrificing a certain expected rate of return (the target
rate of return).
B. Constraints: In pursuing investment objectives, which is specified in terms of return
requirements and risk tolerance, you should bear in mind the constraints arising out of or relating
to the following factors;
 Liquidity: liquidity refers to the speed and ease with which an asset can be sold, without
suffering a significant cost or discount to its fair market value. Money market instruments are
among the most liquid assets than any other assets like buildings or any other physical assets.
 Investment Horizon: the investment horizon is the time till the investment or part of thereof is
planned to be liquidated to meet a specific need. For example, the investment horizon may be
ten years to fund a child’s college education or thirty years to meet retirement needs. The
investment horizon has an important bearing on the choice of assets
 Taxes: what matters finally is the post-tax return from an investment. Tax considerations
therefore have an important bearing on investment decisions. So carefully review the tax
shelters available to you and incorporate the same in your investment decisions
 Regulations: while individual investors are generally not constrained much by law,
institutional investors have to conform to various regulations.
 Unique circumstances: almost every investor faces unique circumstances. For example, an
individual may have the responsibility of looking after ageing parents. Or an endowment fund
may be precluded from investing in the securities of companies making alcoholic products
and tobacco products.

2.2 Selection of Asset Mix

 Based on the objectives and constraints of investment, investors have to specify their asset
allocation that is they have to decide how much of their portfolio has to be invested in different
asset classes.
 An asset allocation focuses on determining the mixture of asset classes that is most likely to
provide a combination of risk and expected return that is optimal for the investor. Asset allocation
is a bit different from diversification. It focus is on investment in various asset classes.
Diversification, in contrast, tends to focus more on security selection – selecting the specific
securities to be held within an asset class.

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 Asset classes here is understood as groups of securities with similar characteristics and properties
(for example, common stocks; bonds; derivatives, etc.). Asset allocation proceeds other approaches
to investment portfolio management, such as market timing (buy low, sell high) or selecting the
individual securities which are expected to be the “winners”. These activities may be integrated in
the asset allocation process. But the main focus of asset allocation is to find such a combination
of the different asset classes in the investment portfolio which the best matches with the
investor’s goals –expected return on investment and investment risk.
 Asset allocation largely determines an investor’s success or lack thereof. In fact, studies have
shown that as much as 90 % or more of a portfolio’s return comes from asset allocation.
Furthermore, researchers have found that asset allocation has a much greater impact on reducing
total risk than does selecting the best investment vehicle in any single asset category.
 Strategic versus tactical asset allocation: the two categories in asset allocation include:
Strategic asset allocation;
Tactical asset allocation.
 Strategic asset allocation: identifies asset classes and the proportions for those asset classes that
would comprise the normal asset allocation. Strategic asset allocation is used to derive long-
term asset allocation weights. The fixed-weightings approach in strategic asset allocation is
used. Investor using this approach allocates a fixed percentage of the portfolio to each of the
asset classes, of which typically are three to five. Example of asset allocation in the portfolio
might be as follows:
Asset class Allocation
Common stock 40%
Bonds 50%
Short term securities 10%
Total portfolios 100%
 Generally, these weights are not changed over time. When market values change, the investor
may have to adjust the portfolio annually or after major market moves to maintain the desired
fixed-percentage allocation.
 Tactical asset allocation: produces temporary asset allocation weights that occur in response to
temporary changes in capital market conditions. The investor’s goals and risk- return
preferences are assumed to remain unchanged as the asset weights are occasionally revised to
help attain the investor’s constant goals. For example, if the investor believes some sector of the
market is over- or under valuated. The passive asset allocation will not have any changes in
weights of asset classes in the investor’s portfolio – the weights identified by strategic asset
allocation are used.

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  Alternative asset allocations are often related with the different approaches to risk and return,
identifying conservative, moderate and aggressive asset allocation. The conservative allocation
is focused on providing low return with low risk; the moderate – average return with average
risk and the aggressive – high return and high risk.

 For asset allocation decisions Markowitz portfolio model as a selection techniques can be used.
Although Markowitz model was developed for selecting portfolios of individual securities, but
thinking in terms of asset classes, this model can be applied successfully to find the optimal
allocation of assets in the portfolio. Programs exist to calculate efficient frontiers using asset
classes and Markowitz model is frequently used for the asset allocation in institutional
investors’ portfolios. The correlation between asset classes is obviously a key factor in building
an optimal portfolio. Investors are looking to have in their portfolios asset classes that are
negatively correlated with each other, or at least not highly positively correlated with each
other. It is obvious that correlation coefficients between asset classes returns change over time.
 It is also important to note that the historical correlation between different asset classes will
vary depending on the time period chosen, the frequency of the data and the asset class, used to
estimate the correlation. Using not historical but future correlation coefficients between assets
could influence the results remarkably, because the historical data may be different from the
expectations.

2.3 Formulation of Portfolio Strategy

 After an investor has chosen a certain asset mix, she/he has to formulate an appropriate portfolio
strategy. The two broad choices of portfolio strategy include; active portfolio strategy and
passive portfolio strategy
 Active Portfolio Strategy: is followed by most investment professionals and aggressive
investors who strive to earn superior returns, after adjustment for risk.
 The main points for the active portfolio management:
active investors believe that from time to time there are mispriced securities or groups of
securities in the market;
the active investors do not act as if they believe that security markets are efficient;
The active investors use deviant predictions – their forecast of risk and return differ from
consensus opinions.

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 Passive Strategy: is based on the premise that the capital market is characterized by
inefficiencies which can be exploited by resorting to market timing or sector rotation or security
selection or use of a specialized concept or some combination of these vectors. The passive
strategy on the other hand rests on the principle that the capital market is fairly efficient with
respect to the available information. Hence, the search for superior returns through an active
strategy is considered futile.
 Operationally, how is the passive strategy implemented? Basically it involves adhering to
the following two guidelines;
Create a well-diversified portfolio at a pre-determined level of risk
Hold the portfolio relatively unchanged or with small and infrequent changes overtime,
unless it becomes inadequately diversified or inconsistent with the investor’s risk-return
preferences.
 The reasons when the investors with passive portfolio management make changes in their
portfolios:
The investor’s preferences change;
The risk free rate changes;
The consensus forecast about the risk and return of the benchmark portfolio changes.
 Choice of Strategy: the active approach takes a lot of time and consumes a great deal of
energy, whereas the passive approach takes little time or effort but calls for an ascetic aloofness
from a tempting hullabaloo of the market. Charles Ellis explained the active approach as
intellectually and physically taxing, while the passive approach is emotionally burdensome.
 Which approach should be selected? Jason Zweig, a well-known investment commentator,
provides a help full advice: “If you have time to spare, highly competitive, think like a
sports fan, and relish a complicated challenge, then the active approach is up your alley. If
you always feel rushed, crave simplicity, and don’t relish thinking about money, then the
passive approach is for you. He continues, both approaches are equally intelligent, and you
can be successful with either – but only if you know yourself well enough to pick the right
one, stick with it over the course of your investing lifetime, and keep your costs and
emotions under control.
 However, there are arguments for both active and passive investing though it is probably a
case that a larger percentage of institutional investors invest passively than do individual
investors. Of course, the active versus passive investment management decision does not
have to be a strictly either/ or choice. One common investment strategy is to invest passively
in the markets investor considers to be efficient and actively in the markets investor
considers inefficient.
 Investors also combine the two by investing part of the portfolio passively and another part
actively.
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2.4 Selection of Securities
I. Selection of Bonds (Fixed Income Securities):
Investors should evaluate the following factors in selecting fixed income avenues.
 Yield to Maturity: As discussed earlier, the yield to maturity for a fixed income security
represents the rate of return earned by the investor if he/she invests in the fixed income vehicle
and holds it till its maturity.
 Risk of Default: to assess the risk of default on a bond, investors may look at the credit rating of
the bond. If no credit rating is available, examine relevant financial ratios (like debt-to-equity
ratio, times interest earned ratio, and earning power) of the firm and assess the general prospects
of the industry to which the firm belongs.
 Tax shield: In the past, several fixed income securities offered tax shield ; now very few do so
 Liquidity: if the fixed income security can be converted wholly or substantially in to cash at a
fairly short notice, it possesses liquidity of a high value.
II. Selection of Stocks (equity Shares);
Three broad approaches are employed for the selection of equity shares; technical analysis,
fundamental analysis, and random selection.
 Technical analysis looks at price behavior and volume data to determine whether the share will
move up or down or remain trendless.
 Fundamental analysis focuses on fundamental factors like the earnings level, growth
prospects, and risk exposure to establish the intrinsic value of a share. The recommendation to
buy, hold, or sell is based on a comparison of the intrinsic value and the prevailing market price.
 The random selection approach is based on the premise that the market is efficient and
securities are properly priced.

2.5 Monitoring and revision of the portfolio

 Portfolio revision is the process of selling certain assets in portfolio and purchasing new ones to
replace them. The main reasons for the necessity of the investment portfolio revision:
As the economy changes, certain industries and companies become either less or more
attractive as investments;

The investor over the time may change his/her investment objectives and in this way his/ her
portfolio isn’t longer optimal;

The constant need for diversification of the portfolio. Individual securities in the portfolio
often change in risk-return characteristics and their diversification effect may be lessened.

 Three areas to monitor when implementing investor’s portfolio monitoring:

1. Changes in market conditions;

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 2. Changes in investor’s circumstances;
3. Asset mix in the portfolio.
 The need to monitor changes in the market is obvious. Investment decisions are made in
dynamic investment environment, where changes occur permanently. The key macroeconomic
indicators (such as GDP growth, inflation rate, interest rates, others), as well as the new
information about industries and companies should be observed by investor on the regular basis,
because these changes can influence the returns and risk of the investments in the portfolio.
Investor can monitor these changes using various sources of information, especially specialized
websites (most frequently used are presented in relevant websites).
 It is important to identify he major changes in the investment environment and to assess
whether these changes should negatively influence investor’s currently held portfolio. If it so
investor must take an actions to rebalance his/ her portfolio. When monitoring the changes in
the investor’s circumstances, following aspects must be taken into account:
Change in wealth
Change in time horizon
Change in liquidity requirements
Change in tax circumstances
Change in legal considerations
Change in other circumstances and investor’s needs.

2.6 Portfolio performance measures

 Portfolio performance evaluation involves determining periodically how the portfolio
performed in terms of not only the return earned, but also the risk experienced by the investor.
For portfolio evaluation appropriate measures of return and risk as well as relevant standards (or
“benchmarks”) are needed.
 In general, the market value of a portfolio at a point of time is determined by adding the
markets value of all the securities held at that particular time. The market value of the portfolio
at the end of the period is calculated in the same way, only using end-of-period prices of the
securities held in the portfolio.
 The return on the portfolio (rp): the essential idea behind performance evaluation is to
compare the returns which were obtained on portfolio with the results that could be obtained if
more appropriate alternative portfolios had been chosen for the investment. Such comparison
portfolios are often referred to as benchmark portfolios. In selecting them investor should be
certain that they are relevant, feasible and known in advance. The benchmark should reflect the
objectives of the investor.