Managing Investment Portfolios: A Dynamic Process

INTRODUCTION

CFA Institute is pleased to provide you with this Investment Series covering major areas in the field of investments. These texts are thoroughly grounded in the highly regarded CFA Program Candidate Body of Knowledge (CBOK®) that draws upon hundreds of practicing investment professionals and serves as the anchor for the three levels of the CFA Examinations. In the year this series is being launched, more than 120,000 aspiring investment professionals will each devote over 250 hours of study to master this material as well as other elements of the Candidate Body of Knowledge in order to obtain the coveted CFA charter. We provide these materials for the same reason we have been chartering investment professionals for over 40 years: to improve the competency and ethical character of those serving the capital markets.

PARENTAGE

One of the valuable attributes of this series derives from its parentage. In the 1940s, a handful of societies had risen to form communities that revolved around common interests and work in what we now think of as the investment industry.

Understand that the idea of purchasing common stock as an investment—as opposed to casino speculation—was only a couple of decades old at most. We were only 10 years past the creation of the U.S. Securities and Exchange Commission and laws that attempted to level the playing field after robber baron and stock market panic episodes.

In January 1945, in what is today CFA Institute Financial Analysts Journal, a fundamentally driven professor and practitioner from Columbia University and Graham-Newman Corporation wrote an article making the case that people who research and manage portfolios should have some sort of credential to demonstrate competence and ethical behavior. This person was none other than Benjamin Graham, the father of security analysis and future mentor to a well-known modern investor, Warren Buffett.

The idea of creating a credential took a mere 16 years to drive to execution but by 1963, 284 brave souls, all over the age of 45, took an exam and launched the CFA credential. What many do not fully understand was that this effort had at its root a desire to create a profession where its practitioners were professionals who provided investing services to individuals in need. In so doing, a fairer and more productive capital market would result.

A profession—whether it be medicine, law, or other—has certain hallmark characteristics. These characteristics are part of what attracts serious individuals to devote the energy of their life’s work to the investment endeavor. First, and tightly connected to this Series, there must be a body of knowledge. Second, there needs to be some entry requirements such as those required to achieve the CFA credential. Third, there must be a commitment to continuing education. Fourth, a profession must serve a purpose beyond one’s direct selfish interest. In this case, by properly conducting one’s affairs and putting client interests first, the investment professional can work as a fair-minded cog in the wheel of the incredibly productive global capital markets. This encourages the citizenry to part with their hard-earned savings to be redeployed in fair and productive pursuit.

As C. Stewart Sheppard, founding executive director of the Institute of Chartered Financial Analysts said, Society demands more from a profession and its members than it does from a professional craftsman in trade, arts, or business. In return for status, prestige, and autonomy, a profession extends a public warranty that it has established and maintains conditions of entry, standards of fair practice, disciplinary procedures, and continuing education for its particular constituency. Much is expected from members of a profession, but over time, more is given.

The Standards for Educational and Psychological Testing, put forth by the American Psychological Association, the American Educational Research Association, and the National Council on Measurement in Education, state that the validity of professional credentialing examinations should be demonstrated primarily by verifying that the content of the examination accurately represents professional practice. In addition, a practice analysis study, which confirms the knowledge and skills required for the competent professional, should be the basis for establishing content validity.

For more than 40 years, hundreds upon hundreds of practitioners and academics have served on CFA Institute curriculum committees sifting through and winnowing all the many investment concepts and ideas to create a body of knowledge and the CFA curriculum. One of the hallmarks of curriculum development at CFA Institute is its extensive use of practitioners in all phases of the process.

CFA Institute has followed a formal practice analysis process since 1995. The effort involves special practice analysis forums held, most recently, at 20 locations around the world. Results of the forums were put forth to 70,000 CFA charterholders for verification and confirmation of the body of knowledge so derived.

What this means for the reader is that the concepts contained in these texts were driven by practicing professionals in the field who understand the responsibilities and knowledge that practitioners in the industry need to be successful. We are pleased to put this extensive effort to work for the benefit of the readers of the Investment Series.

BENEFITS

This series will prove useful both to the new student of capital markets, who is seriously contemplating entry into the extremely competitive field of investment management, and to the more seasoned professional who is looking for a user-friendly way to keep one’s knowledge current. All chapters include extensive references for those who would like to dig deeper into a given concept. The workbooks provide a summary of each chapter’s key points to help organize your thoughts, as well as sample questions and answers to test yourself on your progress.

For the new student, the essential concepts that any investment professional needs to master are presented in a time-tested fashion. This material, in addition to university study and reading the financial press, will help you better understand the investment field. I believe that the general public seriously underestimates the disciplined processes needed for the best investment firms and individuals to prosper. These texts lay the basic groundwork for many of the processes that successful firms use. Without this base level of understanding and an appreciation for how the capital markets work to properly price securities, you may not find competitive success. Furthermore, the concepts herein give a genuine sense of the kind of work that is to be found day to day managing portfolios, doing research, or related endeavors.

The investment profession, despite its relatively lucrative compensation, is not for everyone. It takes a special kind of individual to fundamentally understand and absorb the teachings from this body of work and then convert that into application in the practitioner world. In fact, most individuals who enter the field do not survive in the longer run. The aspiring professional should think long and hard about whether this is the field for him- or herself. There is no better way to make such a critical decision than to be prepared by reading and evaluating the gospel of the profession.

The more experienced professional understands that the nature of the capital markets requires a commitment to continuous learning. Markets evolve as quickly as smart minds can find new ways to create an exposure, to attract capital, or to manage risk. A number of the concepts in these pages were not present a decade or two ago when many of us were starting out in the business. Hedge funds, derivatives, alternative investment concepts, and behavioral finance are examples of new applications and concepts that have altered the capital markets in recent years. As markets invent and reinvent themselves, a best-in-class foundation investment series is of great value.

Those of us who have been at this business for a while know that we must continuously hone our skills and knowledge if we are to compete with the young talent that constantly emerges. In fact, as we talk to major employers about their training needs, we are often told that one of the biggest challenges they face is how to help the experienced professional, laboring under heavy time pressure, keep up with the state of the art and the more recently educated associates. This series can be part of that answer.

CONVENTIONAL WISDOM

It doesn’t take long for the astute investment professional to realize two common characteristics of markets. First, prices are set by conventional wisdom, or a function of the many variables in the market. Truth in markets is, at its essence, what the market believes it is and how it assesses pricing credits or debits on those beliefs. Second, as conventional wisdom is a product of the evolution of general theory and learning, by definition conventional wisdom is often wrong or at the least subject to material change.

When I first entered this industry in the mid-1970s, conventional wisdom held that the concepts examined in these texts were a bit too academic to be heavily employed in the competitive marketplace. Many of those considered to be the best investment firms at the time were led by men who had an eclectic style, an intuitive sense of markets, and a great track record. In the rough-and-tumble world of the practitioner, some of these concepts were considered to be of no use. Could conventional wisdom have been more wrong? If so, I’m not sure when.

During the years of my tenure in the profession, the practitioner investment management firms that evolved successfully were full of determined, intelligent, intellectually curious investment professionals who endeavored to apply these concepts in a serious and disciplined manner. Today, the best firms are run by those who carefully form investment hypotheses and test them rigorously in the marketplace, whether it be in a quant strategy, in comparative shopping for stocks within an industry, or in many hedge fund strategies. Their goal is to create investment processes that can be replicated with some statistical reliability. I believe those who embraced the so-called academic side of the learning equation have been much more successful as real-world investment managers.

THE TEXTS

Approximately 35 percent of the Candidate Body of Knowledge is represented in the initial four texts of the series. Additional texts on corporate finance and international financial statement analysis are in development, and more topics may be forthcoming.

One of the most prominent texts over the years in the investment management industry has been Maginn and Tuttle’s Managing Investment Portfolios: A Dynamic Process. The third edition updates key concepts from the 1990 second edition. Some of the more experienced members of our community, like myself, own the prior two editions and will add this to our library. Not only does this tome take the concepts from the other readings and put them in a portfolio context, it also updates the concepts of alternative investments, performance presentation standards, portfolio execution and, very importantly, managing individual investor portfolios. To direct attention, long focused on institutional portfolios, toward the individual will make this edition an important improvement over the past.

Quantitative Investment Analysis focuses on some key tools that are needed for today’s professional investor. In addition to classic time value of money, discounted cash flow applications, and probability material, there are two aspects that can be of value over traditional thinking.

First are the chapters dealing with correlation and regression that ultimately figure into the formation of hypotheses for purposes of testing. This gets to a critical skill that many professionals are challenged by: the ability to sift out the wheat from the chaff. For most investment researchers and managers, their analysis is not solely the result of newly created data and tests that they perform. Rather, they synthesize and analyze primary research done by others. Without a rigorous manner by which to understand quality research, not only can you not understand good research, you really have no basis by which to evaluate less rigorous research. What is often put forth in the applied world as good quantitative research lacks rigor and validity.

Second, the last chapter on portfolio concepts moves the reader beyond the traditional capital asset pricing model (CAPM) type of tools and into the more practical world of multifactor models and to arbitrage pricing theory. Many have felt that there has been a CAPM bias to the work put forth in the past, and this chapter helps move beyond that point.

Equity Asset Valuation is a particularly cogent and important read for anyone involved in estimating the value of securities and understanding security pricing. A well-informed professional would know that the common forms of equity valuation—dividend discount modeling, free cash flow modeling, price/earnings models, and residual income models (often known by trade names)—can all be reconciled to one another under certain assumptions. With a deep understanding of the underlying assumptions, the professional investor can better understand what other investors assume when calculating their valuation estimates. In my prior life as the head of an equity investment team, this knowledge would give us an edge over other investors.

Fixed Income Analysis has been at the frontier of new concepts in recent years, greatly expanding horizons over the past. This text is probably the one with the most new material for the seasoned professional who is not a fixed-income specialist. The application of option and derivative technology to the once staid province of fixed income has helped contribute to an explosion of thought in this area. And not only does that challenge the professional to stay up to speed with credit derivatives, swaptions, collateralized mortgage securities, mortgage backs, and others, but it also puts a strain on the world’s central banks to provide oversight and the risk of a correlated event. Armed with a thorough grasp of the new exposures, the professional investor is much better able to anticipate and understand the challenges our central bankers and markets face.

I hope you find this new series helpful in your efforts to grow your investment knowledge, whether you are a relatively new entrant or a grizzled veteran ethically bound to keep up to date in the ever-changing market environment. CFA Institute, as a long-term committed participant of the investment profession and a not-for-profit association, is pleased to give you this opportunity.

JEFF DIERMEIER, CFA

President and Chief Executive Officer

CFA Institute

September 2006

CHAPTER 1

THE PORTFOLIO MANAGEMENT PROCESS AND THE INVESTMENT POLICY STATEMENT

John L. Maginn, CFA

Maginn Associates, Inc.

Omaha, Nebraska

Donald L. Tuttle, CFA

CFA Institute

Charlottesville, Virginia

Dennis W. McLeavey, CFA

CFA Institute

Charlottesville, Virginia

Jerald E. Pinto, CFA

CFA Institute

Charlottesville, Virginia

1 . INTRODUCTION

This chapter introduces a book on managing investment portfolios, written by and for investment practitioners. In setting out to master the concepts and tools of portfolio management, we first need a coherent description of the portfolio management process. The portfolio management process is an integrated set of steps undertaken in a consistent manner to create and maintain an appropriate portfolio (combination of assets) to meet clients’ stated goals. The process we present in this chapter is a distillation of the shared elements of current practice.

Because it serves as the foundation for the process, we also introduce the investment policy statement through a discussion of its main components. An investment policy statement (IPS) is a 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.

The portfolio management process moves from planning, through execution, and then to feedback. In the planning step, investment objectives and policies are formulated, capital market expectations are formed, and strategic asset allocations are established. In the execution step, the portfolio manager constructs the portfolio. In the feedback step, the manager monitors and evaluates the portfolio compared with the plan. Any changes suggested by the feedback must be examined carefully to ensure that they represent long-run considerations.

The IPS provides the foundation of the portfolio management process. In creating an IPS, the manager writes down the client’s special characteristics and needs. The IPS must clearly communicate the client’s objectives and constraints. The IPS thereby becomes a plan that can be executed by any adviser or portfolio manager the client might subsequently hire. A properly developed IPS disciplines the portfolio management process and helps ensure against ad hoc revisions in strategy.

When combined with capital market expectations, the IPS forms the basis for a strategic asset allocation. Capital market expectations concern the risk and return characteristics of capital market instruments such as stocks and bonds. The strategic asset allocation establishes acceptable exposures to IPS-permissible asset classes to achieve the client’s long-run objectives and constraints.

The portfolio perspective underlies the portfolio management process and IPS. The next sections illustrate this perspective.

2 . INVESTMENT MANAGEMENT

Investment management is the service of professionally investing money. As a profession, investment management has its roots in the activities of European investment bankers in managing the fortunes created by the Industrial Revolution. By the beginning of the twenty-first century, investment management had become an important part of the financial services sector of all developed economies. By the end of 2003, the United States alone had approximately 15,000 money managers (registered investment advisers) responsible for investing more than $23 trillion, according to Standard & Poor’s Directory of Registered Investment Advisors (2004). No worldwide count of investment advisers is available, but looking at another familiar professionally managed investment, the number of mutual funds stood at about 54,000 at year-end 2003; of these funds, only 15 percent were U.S. based.¹

The economics of investment management are relatively simple. An investment manager’s revenue is fee driven; primarily, fees are based on a percentage of the average amount of assets under management and the type of investment program run for the client, as spelled out in detail in the investment management contract or other governing document. Consequently, an investment management firm’s size is judged by the amount of assets under management, which is thus directly related to manager’s revenue, another measure of size. Traditionally, the value of an investment management business (or a first estimate of value) is determined as a multiple of its annual fee income.

To understand an investment management firm or product beyond its size, we need to know not only its investment disciplines but also the type or types of investor it primarily serves. Broadly speaking, investors can be described as institutional or individual. Institutional investors, described in more detail in Chapter 3, are entities such as pension funds, foundations and endowments, insurance companies, and banks that ultimately serve as financial intermediaries between individuals and financial markets. The investment policy decisions of institutional investors are typically made by investment committees or trustees, with at least some members having a professional background in finance. The committee members or trustees frequently also bear a fiduciary relationship to the funds for which they have investment responsibility. Such a relationship, if it is present, imposes some legal standards regarding processes and decisions, which is reflected in the processes of the investment managers who serve that market segment.

Beginning in the second half of the twentieth century, the tremendous growth of institutional investors, especially defined-benefit (DB) pension plans, spurred a tremendous expansion in investment management firms or investment units of other entities (such as bank trust divisions) to service their needs.² As the potentially onerous financial responsibilities imposed on the sponsors by such plans became more evident, however, the 1980s and 1990s saw trends to other types of retirement schemes focused on participant responsibility for investment decisions and results. In addition, a long-lasting worldwide economic expansion created a great amount of individual wealth. As a result, investment advisers oriented to serving high-net-worth individuals as well as mutual funds (which serve the individual and, to a lesser extent, the smaller institutional market) gained in relative importance.

Such individual investor - oriented advisers may incorporate a heavy personal financial planning emphasis in their services. Many wealthy families establish family offices to serve as trusted managers of their finances. Family offices are entities, typically organized and owned by a family, that assume responsibility for services such as financial planning, estate planning, and asset management, as well as a range of practical matters from tax return preparation to bill paying. Some family offices evolve such depth in professional staff that they open access to their services to other families (multifamily offices). In contrast to family offices, some investment management businesses service both individual and institutional markets, sometimes in separate divisions or corporate units, sometimes worldwide, and sometimes as part of a financial giant (American Express and Citigroup are examples of such financial supermarkets). In such cases, wrap-fee accounts packaging the services of outside investment managers may vie for the client’s business with in-house, separately managed accounts, as well as in-house mutual funds, external mutual funds, and other offerings marketed by a brokerage arm of the business.

Investment management companies employ portfolio managers, analysts, and traders, as well as marketing and support personnel. Portfolio managers may use both outside research produced by sell-side analysts (analysts employed by brokerages) and research generated by in-house analysts—so-called buy-side analysts (analysts employed by an investment manager or institutional investor). The staffing of in-house research departments depends on the size of the investment management firm, the variety of investment offerings, and the investment disciplines employed. An example may illustrate the variety of talent employed: The research department of one money manager with $30 billion in assets under management employs 34 equity analysts, 23 credit analysts, 3 hedge fund analysts, 12 quantitative analysts, 4 risk management professionals, 1 economist, and 1 economic analyst. That same company has a trading department with 8 equity and 8 bond traders and many support personnel. CFA charterholders can be found in all of these functions.

3 . THE PORTFOLIO PERSPECTIVE

The portfolio perspective is this book’s focus on the aggregate of all the investor’s holdings: the portfolio. Because economic fundamentals influence the average returns of many assets, the risk associated with one asset’s returns is generally related to the risk associated with other assets’ returns. If we evaluate the prospects of each asset in isolation and ignore their interrelationships, we will likely misunderstand the risk and return prospects of the investor’s total investment position—our most basic concern.

The historical roots of this portfolio perspective date to the work of Nobel laureate Harry Markowitz (1952). Markowitz and subsequent researchers, such as Jack Treynor and Nobel laureate William Sharpe, established the field of modern portfolio theory (MPT)—the analysis of rational portfolio choices based on the efficient use of risk. Modern portfolio theory revolutionized investment management. First, professional investment practice began to recognize the importance of the portfolio perspective in achieving investment objectives. Second, MPT helped spread the knowledge and use of quantitative methods in portfolio management. Today, quantitative and qualitative concepts complement each other in investment management practice.

In developing his theory of portfolio choice, Markowitz began with the perspective of investing for a single period. Others, including Nobel laureate Robert Merton, explored the dynamics of portfolio choice in a multiperiod setting. These subsequent contributions have greatly enriched the content of MPT.

If Markowitz, Merton, and other researchers created the supply, three developments in the investment community created demand for the portfolio perspective. First, institutional investing emerged worldwide to play an increasingly dominant role in financial markets. Measuring and controlling the risk of large pools of money became imperative. The second development was the increasing availability of ever-cheaper computer processing power and communications possibilities. As a result, a broader range of techniques for implementing MPT portfolio concepts became feasible. The third related development was the professionalization of the investment management field. This professionalization has been reflected in the worldwide growth of the professional accreditation program leading to the Chartered Financial Analyst (CFA®) designation.

4 . PORTFOLIO MANAGEMENT AS A PROCESS

The unified presentation of portfolio management as a process represented an important advance in the investment management literature. Prior to the introduction of this concept in the first edition of this book, much of the traditional literature reflected an approach of selecting individual securities without an overall plan. Through the eyes of the professional, however, portfolio management is a process, an integrated set of activities that combine in a logical, orderly manner to produce a desired product. The process view is a dynamic and flexible concept that applies to all types of portfolio investments—bonds, stocks, real estate, gold, collectibles; to various organizational types—trust companies, investment counsel firms, insurance companies, mutual funds; to a full range of investors—individuals, pension plans, endowments, foundations, insurance companies, banks; and is independent of manager, location, investment philosophy, style, or approach. Portfolio management is a continuous and systematic process complete with feedback loops for monitoring and rebalancing. The process can be as loose or as disciplined, as quantitative or as qualitative, and as simple or as complex as its operators desire.

The portfolio management process is the same in every application: an integrated set of steps undertaken in a consistent manner to create and maintain appropriate combinations of investment assets. In the next sections, we explore the main features of this process.

5 . THE PORTFOLIO MANAGEMENT PROCESS LOGIC

Three elements in managing any business process are planning, execution, and feedback. These same elements form the basis for the portfolio management process as depicted in Exhibit 1-1.

5.1. The Planning Step

The planning step is described in the four leftmost boxes in Exhibit 1-1. The top two boxes represent investor-related input factors, while the bottom two factors represent economic and market input.

5.1.1. Identifying and Specifying the Investor’s Objectives and Constraints The first task in investment planning is to identify and specify the investor’s objectives and constraints. Investment objectives are desired investment outcomes. In investments, objectives chiefly pertain to return and risk. Constraints are limitations on the investor’s ability to take full or partial advantage of particular investments. For example, an investor may face constraints related to the concentration of holdings as a result of government regulation, or restrictions in a governing legal document. Constraints are either internal, such as a client’s specific liquidity needs, time horizon, and unique circumstances, or external, such as tax issues and legal and regulatory requirements. In Section 6, we examine the objective and constraint specification process.

5.1.2. Creating the Investment Policy Statement Once a client has specified a set of objectives and constraints, the manager’s next task is to formulate the investment policy statement. The IPS serves as the governing document for all investment decision making. In addition to objectives and constraints, the IPS may also cover a variety of other issues. For example, the IPS generally details reporting requirements, rebalancing guidelines, frequency and format of investment communication, manager fees, investment strategy, and the desired investment style or styles of investment managers. A typical IPS includes the following elements:

A brief client description.

The purpose of establishing policies and guidelines.

EXHIBIT 1-1The Portfolio Construction, Monitoring, and Revision Process

The duties and investment responsibilities of parties involved, particularly those relating to fiduciary duties, communication, operational efficiency, and accountability. Parties involved include the client, any investment committee, the investment manager, and the bank custodian.

The statement of investment goals, objectives, and constraints.

The schedule for review of investment performance as well as the IPS itself.

Performance measures and benchmarks to be used in performance evaluation.

Any considerations to be taken into account in developing the strategic asset allocation.

Investment strategies and investment style(s).

Guidelines for rebalancing the portfolio based on feedback.

The IPS forms the basis for the strategic asset allocation, which reflects the interaction of objectives and constraints with the investor’s long-run capital market expectations. When experienced professionals include the policy allocation as part of the IPS, they are implicitly forming capital market expectations and also examining the interaction of objectives and constraints with long-run capital market expectations. In practice, one may see IPSs that include strategic asset allocations, but we will maintain a distinction between the two types.

The planning process involves the concrete elaboration of an investment strategy—that is, the manager’s approach to investment analysis and security selection. A clearly formulated investment strategy organizes and clarifies the basis for investment decisions. It also guides those decisions toward achieving investment objectives. In the broadest sense, investment strategies are passive, active, or semiactive.

In a passive investment approach, portfolio composition does not react to changes in capital market expectations (passive means not reacting). For example, a portfolio indexed to the Morgan Stanley Capital International (MSCI)-Europe Index, an index representing European equity markets, might add or drop a holding in response to a change in the index composition but not in response to changes in capital market expectations concerning the security’s investment value. Indexing, a common passive approach to investing, refers to holding a portfolio of securities designed to replicate the returns on a specified index of securities. A second type of passive investing is a strict buy-and-hold strategy, such as a fixed, but nonindexed, portfolio of bonds to be held to maturity.

In contrast, with an active investment approach, a portfolio manager will respond to changing capital market expectations. Active management of a portfolio means that its holdings differ from the portfolio’s benchmark or comparison portfolio in an attempt to produce positive excess risk-adjusted returns, also known as positive alpha. Securities held in different-from-benchmark weights reflect expectations of the portfolio manager that differ from consensus expectations. If the portfolio manager’s differential expectations are also on average correct, active portfolio management may add value.

A third category, the semiactive, risk-controlled active, or enhanced index approach, seeks positive alpha while keeping tight control over risk relative to the portfolio’s benchmark. As an example, an index-tilt strategy seeks to track closely the risk of a securities index while adding a targeted amount of incremental value by tilting portfolio weightings in some direction that the manager expects to be profitable.

Active investment approaches encompass a very wide range of disciplines. To organize this diversity, investment analysts appeal to the concept of investment style. Following Brown and Goetzmann (1997), we can define an investment style (such as an emphasis on growth stocks or value stocks) as a natural grouping of investment disciplines that has some predictive power in explaining the future dispersion in returns across portfolios. We will take up the discussion of investment strategies and styles in greater detail in subsequent chapters.

5.1.3. Forming Capital Market Expectations The manager’s third task in the planning process is to form capital market expectations. Long-run forecasts of risk and return characteristics for various asset classes form the basis for choosing portfolios that maximize expected return for given levels of risk, or minimize risk for given levels of expected return.

5.1.4. Creating the Strategic Asset Allocation The fourth and final task in the planning process is determining the strategic asset allocation. Here, the manager combines the IPS and capital market expectations to determine target asset class weights; maximum and minimum permissible asset class weights are often also specified as a risk-control mechanism. The investor may seek both single-period and multiperiod perspectives in the return and risk characteristics of asset allocations under consideration. A single-period perspective has the advantage of simplicity. A multiperiod perspective can address the liquidity and tax considerations that arise from rebalancing portfolios over time, as well as serial correlation (long- and short-term dependencies) in returns, but is more costly to implement.

This chapter focuses on the creation of an IPS in the planning step and thereby lays the groundwork for the discussion in later chapters of tailoring the IPS to individual and institutional investors’ needs. The execution and feedback steps in the portfolio management process are as important as the planning step and will receive more attention in subsequent chapters. For now, we merely outline how these steps fit in the portfolio management process.

5.2. The Execution Step

The execution step is represented by the portfolio construction and revision box in Exhibit 1-1. In the execution step, the manager integrates investment strategies with capital market expectations to select the specific assets for the portfolio (the portfolio selection/composition decision). Portfolio managers initiate portfolio decisions based on analysts’ inputs, and trading desks then implement these decisions (portfolio implementation decision). Subsequently, the portfolio is revised as investor circumstances or capital market expectations change; thus, the execution step interacts constantly with the feedback step.

In making the portfolio selection/composition decision, portfolio managers may use the techniques of portfolio optimization. Portfolio optimization—quantitative tools for combining assets efficiently to achieve a set of return and risk objectives—plays a key role in the integration of strategies with expectations and appears in Exhibit 1-1 in the portfolio construction and revision box.

At times, a portfolio’s actual asset allocation may purposefully and temporarily differ from the strategic asset allocation. For example, the asset allocation might change to reflect an investor’s current circumstances that are different from normal. The temporary allocation may remain in place until circumstances return to those described in the IPS and reflected in the strategic asset allocation. If the changed circumstances become permanent, the manager must update the investor’s IPS, and the temporary asset allocation plan will effectively become the new strategic asset allocation. A strategy known as tactical asset allocation also results in differences from the strategic asset allocation. Tactical asset allocation responds to changes in short-term capital market expectations rather than to investor circumstances.

The portfolio implementation decision is as important as the portfolio selection/ composition decision. Poorly managed executions result in transaction costs that reduce performance. Transaction costs include all costs of trading, including explicit transaction costs, implicit transaction costs, and missed trade opportunity costs. Explicit transaction costs include commissions paid to brokers, fees paid to exchanges, and taxes. Implicit transaction costs include bid-ask spreads, the market price impacts of large trades, missed trade opportunity costs arising from price changes that prevent trades from being filled, and delay costs arising from the inability to complete desired trades immediately due to order size or market liquidity.

In sum, in the execution step, plans are turned into reality—with all the attendant real-world challenges.

5.3. The Feedback Step

In any business endeavor, feedback and control are essential elements in reaching a goal. In portfolio management, this step has two components: monitoring and rebalancing, and performance evaluation.

5.3.1. Monitoring and Rebalancing Monitoring and rebalancing involve the use of feedback to manage ongoing exposures to available investment opportunities so that the client’s current objectives and constraints continue to be satisfied. Two types of factors are monitored: investor-related factors such as the investor’s circumstances, and economic and market input factors.

One impetus for portfolio revision is a change in investment objectives or constraints because of changes in investor circumstances. Portfolio managers need a process in place to stay informed of changes in clients’ circumstances. The termination of a pension plan or death of a spouse may trigger an abrupt change in a client’s time horizon and tax concerns, and the IPS should list the occurrence of such changes as a basis for appropriate portfolio revision.

More predictably, changes in economic and market input factors give rise to the regular need for portfolio revision. Again, portfolio managers need to systematically review the risk attributes of assets as well as economic and capital market factors (the chapter on capital market expectations describes the range of factors to consider in more detail). A change in expectations may trigger portfolio revision. When asset price changes occur, however, revisions can be required even without changes in expectations. The actual timing and magnitude of rebalancing may be triggered by review periods or by specific rules governing the management of the portfolio and deviation from the tolerances or ranges specified in the strategic asset allocation, or the timing and magnitude may be at the discretion of the manager. For example, suppose the policy allocation calls for an initial portfolio with a 70 percent weighting to stocks and a 30 percent weighting to bonds. Suppose the value of the stock holdings then grows by 40 percent, while the value of the bond holdings grows by 10 percent. The new weighting is roughly 75 percent in stocks and 25 percent in bonds. To bring the portfolio back into compliance with investment policy, it must be rebalanced back to the long-term policy weights. In any event, the rebalancing decision is a crucial one that must take into account many factors, such as transaction costs and taxes (for taxable investors). Disciplined rebalancing will have a major impact on the attainment of investment objectives. Rebalancing takes us back to the issues of execution, as is appropriate in a feedback process.

5.3.2. Performance Evaluation Investment performance must periodically be evaluated by the investor to assess progress toward the achievement of investment objectives as well as to assess portfolio management skill.

The assessment of portfolio management skill has three components. Performance measurement involves the calculation 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 is the evaluation of whether the manager is doing a good job based on how the portfolio did relative to a benchmark (a comparison portfolio).

Often, we can examine a portfolio’s performance, in terms of total returns, as coming from three sources: decisions regarding the strategic asset allocation, market timing (returns attributable to shorter-term tactical deviations from the strategic asset allocation), and security selection (skill in selecting individual securities within an asset class). However, portfolio management is frequently conducted with reference to a benchmark, or for some entities, with reference to a stream of projected liabilities or a specified target rate of return. As a result, relative portfolio performance evaluation, in addition to absolute performance measurement, is often of key importance.

With respect to relative performance we may ask questions such as, Relative to the investment manager’s benchmark, what economic sectors were underweighted or overweighted? or What was the manager’s rationale for these decisions and how successful were they? Portfolio evaluation may also be conducted with respect to specific risk models, such as multifactor models, which attempt to explain asset returns in terms of exposures to a set of risk factors.

Concurrent with evaluation of the manager is the ongoing review of the benchmark to establish its continuing suitability. For some benchmarks, this review would include a thorough understanding of how economic sectors and subsectors are determined in the benchmark, the classification of securities within them, and how frequently the classifications change. For any benchmark, one would review whether the benchmark continues to be a fair measuring stick given the manager’s mandate.

As with other parts of the portfolio management process, performance evaluation is critical and is covered in a separate chapter. In addition, performance presentation is covered by the chapter on Global Investment Performance Standards (GIPS®). These topics play a central role in the portfolio management process.

5.4. A Definition of Portfolio Management

In sum, the process logic is incorporated in the following definition, which is the cornerstone for this book. Portfolio management is an ongoing process in which:

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.

Any necessary rebalancing is implemented.

Although we have provided general insights into the portfolio management process, this book makes no judgments and voices no opinions about how the process should be organized, who should make which decisions, or any other process operating matter. How well the process works is a critical component of investment success. In a survey of pension fund chief operating officers, Ambachtsheer, Capelle, and Scheibelhut (1998) found that 98 percent of the respondents cited a poor portfolio management process as a barrier to achieving excellence in organizational performance. The organization of the portfolio management process of any investment management company should be the result of careful planning.

6 . INVESTMENT OBJECTIVES AND CONSTRAINTS

As previously discussed, the IPS is the cornerstone of the portfolio management process. Because of the IPS’s fundamental importance, we introduce its main components in this chapter. In subsequent chapters, we will create actual IPSs for individual and institutional investors. In this section, we return to the tasks of identifying and specifying the investor’s objectives and constraints that initiate the planning step.

Although we discuss objectives first and then constraints, the actual process of delineating these for any investor may appropriately start with an examination of investor constraints. For example, a short time horizon affects the investor’s ability to take risk.

6.1. Objectives

The two objectives in this framework, risk and return, are interdependent—one cannot be discussed without reference to the other. The risk objective limits how high the investor can set the return objective.

6.1.1. Risk Objective The first element of the risk-return framework is the risk objective because it will largely determine the return objective. A 10 percent standard deviation risk objective, for example, implies a different asset allocation than a 15 percent standard deviation risk objective, because expected asset risk is generally positively correlated with expected asset return. In formulating a risk objective, the investor must address the following six questions:

How do I measure risk? Risk measurement is a key issue in investments, and several approaches exist for measuring risk. In practice, risk may be measured in absolute terms or in relative terms with reference to various risk concepts. Examples of absolute risk objectives are a specified level of standard deviation or variance of total return. The variance of a random variable is the expected value of squared deviations from the random variable’s mean. Variance is often referred to as volatility. Standard deviation is the positive square root of variance. An example of a relative risk objective is a specified level of tracking risk. Tracking risk is the standard deviation of the differences between a portfolio’s and the benchmark’s total returns.

Downside risk concepts, such as value at risk (VaR), may also be important to an investor. Value at risk is a probability-based measure of the loss that one anticipates will be exceeded only a specified small fraction of the time over a given horizon—for example, in 5 percent of all monthly holding periods. Besides statistical measures of risk, other risk exposures, such as exposures to specific economic sectors, or risk with respect to a factor model of returns, may be relevant as well.

What is the investor’s willingness to take risk? The investor’s stated willingness to take risk is often very different for institutional versus individual investors. Managers should try to understand the behavioral and, for individuals, the personality factors behind an investor’s willingness to take risk. In the chapter on individual investors, we explore behavioral issues in reference to the investor’s willingness to take risk.

What is the investor’s ability to take risk? Even if an investor is eager to bear risk, practical or financial limitations often limit the amount of risk that can be prudently assumed. For the sake of illustration, in the following discussion we talk about risk in terms of the volatility of asset values:

In terms of spending needs, how much volatility would inconvenience an investor who depends on investments (such as a university in relationship to its endowment fund)? Or how much volatility would inconvenience an investor who otherwise cannot afford to incur substantial short-term losses? Investors with high levels of wealth relative to probable worst-case short-term loss scenarios can take more risk.

In terms of long-term wealth targets or obligations, how much volatility might prevent the investor from reaching these goals? Investors with high levels of wealth relative to long-term wealth targets or obligations can take more risk.

What are the investor’s liabilities or pseudo liabilities? An institution may face legally promised future payments to beneficiaries (liabilities) and an individual may face future retirement spending needs (pseudo 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? More financial strength means more risk can be taken.

How much risk is the investor both willing and able to bear? The answer to this question defines the investor’s risk tolerance. Risk tolerance, the capacity to accept risk, is a function of both an investor’s willingness and ability to do so. Risk tolerance can also be described in terms of risk aversion, the degree of an investor’s inability and unwillingness to take risk. The investor’s specific risk objectives are formulated with that investor’s level of risk tolerance in mind. Importantly, any assessment of risk tolerance must consider both an investor’s willingness and that investor’s ability to take risk. When a mismatch exists between the two, determining risk tolerance requires educating the client on the dangers of excess risk taking or of ignoring inflation risk, depending on the case. In our presentation in this book, we assume that such education has taken place and that we are providing an appropriate risk objective in the IPS proposed to the client. When an investor’s willingness to accept risk exceeds ability to do so, ability prudently places a limit on the amount of risk the investor should assume. When ability exceeds willingness, the investor may fall short of the return objective because willingness would be the limiting factor. These interactions are shown in Exhibit 1-2.

An investor with an above-average ability to assume risk may have legitimate reasons for choosing a lower-risk strategy. In addition, an investor may face the pleasant situation of having an excess of wealth to meet financial needs for a long period of time. In these cases, the investor needs to have a clear understanding of the eventual consequences of the decision to effectively spend down excess wealth over time. As with any strategy, such a decision must be reevaluated periodically. In the case of a high-net-worth investor who has earned substantial wealth from entrepreneurial risk taking, such an investor may now simply not want to lose wealth and may desire only liquidity to spend in order to maintain her current lifestyle.

What are the specific risk objective(s)? Just as risk may be measured either absolutely or relatively, we may specify both absolute risk and relative risk objectives. In practice, investors often find that quantitative risk objectives are easier to specify in relative than in absolute terms. Possibly as a consequence, absolute risk objectives in particular are frequently specified in qualitative rather than quantitative terms.

What distinguishes the risk objective from risk tolerance is the level of specificity. For example, the statement that a person has a lower-than-average risk tolerance might be converted operationally into "the loss in any one year is not to exceed x percent of portfolio value or annual volatility of the portfolio is not to exceed y percent." Often, clients—particularly individual investors—do not understand or appreciate this level of specificity, and more general risk-tolerance statements substitute for a quantitative risk objective.

How should the investor allocate risk? This is how some investors frame capital allocation decisions today, particularly when active strategies will play a role in the portfolio. The question may concern the portfolio as a whole or some part of it. Risk budgeting disciplines address the above question most directly. After the investor has determined the measure of risk of concern to him (e.g., VaR or tracking risk) and the desired total quantity of risk (the overall risk budget), an investor using risk budgeting would allocate the overall risk budget to specific investments so as to maximize expected overall risk-adjusted return. The resulting optimal risk budgets for the investments would translate to specific allocations of capital to them.

EXHIBIT 1-2 Risk Tolerance

6.1.2. Return Objective The second element of the investment policy framework is the return objective, which must be consistent with the risk objective. Just as tension may exist between willingness and ability in setting the risk objective, so the return objective requires a resolution of return desires versus the risk objective. In formulating a return objective, the investor must address the following four questions:

How is return measured? The usual measure is total return, the sum of the return from price appreciation and the return from investment income. Return may be stated as an absolute amount, such as 10 percent a year, or as a return relative to the benchmark’s return, such as benchmark return plus 2 percent a year. Nominal returns must be distinguished from real returns. Nominal returns are unadjusted for inflation. Real returns are adjusted for inflation and sometimes simply called inflation-adjusted returns. Also, pretax returns must be distinguished from post-tax returns. Pretax returns are returns before taxes, and post-tax returns are returns after taxes are paid on investment income and realized capital gains.

How much return does the investor say she wants? This amount is the stated return desire. These wants or desires may be realistic or unrealistic. For example, an investor may have higher-than-average return desires to meet high consumption desires or a high ending wealth target; for instance, I want a 20 percent annual return. The adviser or portfolio manager must continually evaluate the desire for high returns in light of the investor’s ability to assume risk and the reasonableness of the stated return desire, especially relative to capital market expectations.

How much return does the investor need to achieve, on average? This amount is the required return or return requirement. Requirements are more stringent than desires because investors with requirements typically must achieve those returns, at least on average. An example of a return requirement is the average return a pension fund projects it must earn to fund liabilities to current and future pensioners, based on actuarial calculations. The compound rate of return that an individual investor must earn to attain the asset base needed for retirement is another example of a return requirement. A third example would be the return that a retired investor must earn on his investment portfolio to cover his annual living expenses. We illustrate these last two cases.

Suppose that a married couple needs £2 million in 18 years to fund retirement. Their current investable assets total £1.2 million. The projected future need (£2 million) incorporates expected inflation. The couple would need to earn (£2 million/£1.2 million)¹/¹⁸ − 1.0 = 2.88% per year after tax to achieve their goal. Every cash flow needs to be accounted for in such calculations. If the couple needed to liquidate £25,000 from the portfolio at the end of each year (keeping all other facts unchanged), they would need to earn 4.55 percent per year on an after-tax basis to have £2 million in 18 years (a financial calculator is needed to confirm this result). If all investment returns were taxed at 35 percent, 4.55 percent after tax would correspond to a 7 percent pretax required return [4.55/(1 − 0.35) = 7%].

A retiree may depend on his investment portfolio for some or all of his living expenses. That need defines a return requirement. Suppose that a retiree must achieve a 4 percent after-tax return on his current investment portfolio to meet his current annual living expenses. Thus, his return requirement on a real, after-tax basis is 4 percent per year. If he expects inflation to be 2 percent per year and a 40 percent tax rate applies to investment returns from any source, we could estimate his pretax nominal return requirement as (After-tax real return requirement + Expected inflation rate)/(1 − Tax rate) = (4% + 2%)/(1 − 0.40) = 10%.

In contrast to desired returns, which can be reduced if incongruent with risk objectives, large required returns are an important source of potential conflict between return and risk objectives. Other required return issues that are relevant to specific situations include the following:

What are the needs and desires for current spending versus ending wealth?

How do nominal total return requirements relate to expected rates of price inflation? If assets fund obligations subject to inflation, the return requirements should reflect expected rates of inflation.

What are the specific return objectives? The return objective incorporates the required return, the stated return desire, and the risk objective into a measurable annual total return specification. For example, an investor with a 5 percent after-tax, required, inflation-adjusted annual rate of return but above-average risk tolerance might reasonably set a higher than 5 percent after-tax, inflation-adjusted annual rate of return objective to maximize expected wealth.

An investor’s return objective should be consistent with that investor’s risk objective. A high return objective may suggest an asset allocation with an expected level of risk that is too great in relation to the risk objective, for example. In addition, the anticipated return from the portfolio should be sufficient to meet wealth objectives or liabilities that the portfolio must fund.

For investors with current investment income needs, the return objective should be sufficient to meet spending needs from capital appreciation and investment income: When a well-considered return objective is not consistent with risk tolerance, other adjustments may need to take place, such as increasing savings or modifying wealth objectives.

An investor delegating portfolio management to an investment manager will communicate a mandate—a set of instructions detailing the investment manager’s task and how his performance will be evaluated—that includes a specification of the manager’s benchmark. Because the manager’s performance will be evaluated against the benchmark, the benchmark’s total return is an effective return objective for the investment manager. These instructions may be part of the investment policy statement or, in the case of a portfolio with multiple managers, outlined in separate instructions for each mandate to each manager.

Although an absolute return objective (one independent of a reference return) is sometimes set (e.g., 8 percent), investors often specify a relative return objective. A relative return objective is stated as a return relative to the portfolio benchmark’s total return (e.g., 1 percent higher than the benchmark).

Exhibit 1-3 illustrates the variation in return requirement and risk tolerance among various categories of investors—a subject we explore in detail in Chapters 2 and 3.

6.2. Constraints

The investor’s risk and return objectives are set within the context of several constraints: liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances. Although all of these factors influence portfolio choice, the first two constraints bear directly on the investor’s ability to take risk and thus constrain both risk and return objectives.

6.2.1. Liquidity A liquidity requirement is a need for cash in excess of new contributions (e.g., for pension plans and endowments) or savings (for individuals) at a specified point in time. Such needs may be anticipated or unanticipated, but either way they stem from liquidity events. An example of a liquidity event is planned construction of a building in one year.

EXHIBIT 1-3 Return Requirements and Risk Tolerances of Various Investors

The liquidity requirement may reflect nonrecurring needs or the desire to hold cash against unanticipated needs (a safety or reserve fund). This requirement may be met by holding cash or cash equivalents in the portfolio or by converting other assets into cash equivalents. Any risk of economic loss because of the need to sell relatively less liquid assets to meet liquidity requirements is liquidity risk. (An asset that can be converted into cash only at relatively high total cost is said to be relatively less liquid.) Liquidity risk, therefore, arises for two reasons: an asset-side reason (asset liquidity) and a liability-side reason (liquidity requirements). Portfolio managers control asset selection but not liquidity requirements; as a result, in practice, managers use asset selection to manage liquidity risk. If the portfolio’s asset and income base are large relative to its potential liquidity requirements, relatively less liquid assets can be held. A distinct consideration is liquidity requirements in relation to price risk of the asset—the risk of fluctuations in market price. Assets with high price risk are frequently less liquid, especially during market downturns. If the timing of an investor’s liquidity requirements is significantly correlated with market downturns, these requirements can influence asset selection in favor of less risky assets. In many cases, therefore, consideration of both liquidity risk and price risk means that an investor will choose to hold some part of the portfolio in highly liquid and low-price-risk assets in anticipation of future liquidity requirements. Investors may also modify the payoff structure of a risky portfolio to address liquidity requirements using derivative strategies, although such modifications often incur costs. (Derivatives are contracts whose payoffs depend on the value of another asset, often called the underlying asset.)

6.2.2. Time Horizon Time horizon most often refers to the time period associated with an investment objective. Investment objectives and associated time horizons may be short term, long term, or a combination of the two. (A time horizon of 10 years or more is often considered to be long term. Investment performance over the long term should average results over several market and business cycles.) A multistage horizon is a combination of shorter-term and longer-term horizons. An example of a multistage horizon is the case of funding children’s education shorter term and the investor’s retirement longer term.

Other constraints, such as a unique circumstance or a specific liquidity requirement, can also affect an investor’s time horizon. For example, an individual investor’s temporary family living arrangement can dictate that his time horizon constraint be stated in multistage terms. Similarly, an institutional investor’s need to make an imminent substantial disbursement of funds for a capital project can necessitate a multistage approach to the time horizon constraint.

In general, relevant time horizon questions include the following:

How does the length of the time horizon modify the investor’s ability to take risk? The longer the time horizon, the more risk the investor can take. The longer the time horizon, the greater the investor’s ability to replenish investment resources by increasing savings. A long-term investor’s labor income may also be an asset sufficiently stable to support a higher level of portfolio risk.³ Cash may be safe for a short-term investor but risky for a long-term investor who will be faced with continuously reinvesting.

How does the length of the time horizon modify the investor’s asset allocation? Many investors allocate a greater proportion of funds to risky assets when they address long-term as opposed to short-term investment objectives. Decreased risk-taking ability with shorter horizons can thus constrain portfolio choice.

How does the investor’s willingness and ability to bear fluctuations in portfolio value modify the asset allocation? With a focus on risk, even an investor with a long-term objective may limit risk taking because of sensitivity to the possibility of substantial interim losses. The chance of unanticipated liquidity needs may increase during market downturns, for instance, because a market downturn may be linked to a decline in economic activity affecting income or other sources of wealth. An investor that often faces unanticipated short-term liquidity needs will usually favor investments with a shorter time horizon so as to limit the risk of loss of value.

How does a multistage time horizon constrain the