FM5 -Investment Portfolio

TOPIC NO. 1 – INTRODUCTION TO INVESTMENT PORTFOLIO

MANAGEMENT

A. PORTFOLIO MANAGEMENT
Portfolio management is a key tool for financial growth and is relevant to both individual
investors as well as organizations. Making the most of an investment portfolio involves
developing a focused strategy that can help gauge market risks and maximize returns
successfully. Investors benefit from assistance provided by skilled professionals in
managing their investment portfolio. Let’s dig deeper into what is portfolio management and
how it works.

What Is Portfolio Management?

Portfolio management is the art and science of selecting and overseeing a group
of investments that meet the long-term financial objectives and risk tolerance of
a client, a company, or an institution.

Some individuals do their own investment portfolio management. That requires a

basic understanding of the key elements of portfolio building and maintenance
that make for success, including asset allocation, diversification, and
rebalancing.

In simple terms, portfolio management is the process of choosing and managing a set of
investments to meet the specific financial goals of a company or an individual. There is a
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science behind selecting the right investment mix for a client and perfectly balancing the
risk tolerance.

KEY TAKEAWAYS

 Investment portfolio management involves building and overseeing a

selection of assets such as stocks, bonds, and cash that meet the long-
term financial goals and risk tolerance of an investor.
 Active portfolio management requires strategically buying and selling
stocks and other assets in an effort to beat the performance of the broader
market.
 Passive portfolio management seeks to match the returns of the market by
mimicking the makeup of an index or indexes.
 Investors can implement strategies to aggressively pursue profits,
conservatively attempt to preserve capital, or a blend of both.
 Portfolio management requires clear long-term goals, clarity from the IRS
on tax legislation changes, understanding of investor risk tolerance, and a
willingness to study investment options.

Understanding Portfolio Management

Professional licensed portfolio managers work on behalf of clients, while
individuals may choose to build and manage their own portfolios. In either case,
the portfolio manager's ultimate goal is to maximize the investments' expected
return within an appropriate level of risk exposure.

Portfolio management requires the ability to weigh strengths and weaknesses,

opportunities and threats across the full spectrum of investments. The choices
involve trade-offs, from debt versus equity to domestic versus international, and
growth versus safety.

Examples of Portfolio Management

Let us say an individual is looking to explore multiple investment avenues such as stocks,
bonds, or funds. However, they only possess limited knowledge about the investment
market and know very little about the market forces that can influence returns on these
investments. In such situations, portfolio management plays a key role as it can not only
help enhance returns but also put the right financial strategies into practice.

If this hypothetical investment corpus amounts to $1,000, a portfolio manager will distribute
it across different units like real estate, mutual funds, and shares, for example, to enhance
profitability. This division is generally based on the individual’s financial goals and risk
appetite.
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How Does Portfolio Management Work

There is no one-size-fits-all approach when it comes to portfolio management. Every
individual or organization has a unique investment portfolio that requires a customized and
strategic investment plan. Now that you know what is portfolio management, here is a
breakdown of how it actually works:

Planning

 Identify clients goals: Understand clients needs, long- and short-term goals, define
clear financial objectives in terms of capital appreciation or stable returns
 Factor in limitations: Calculate associated risks, liquidity prospects and expected
returns from different asset combinations
 Develop a strong strategy: Involves strategic and customized asset allocation
based on investment goals and market behavior

Execution

 Invest in profitable revenues: Making investments in the selected portfolio of

securities after thoroughly assessing their fundamentals, liquidity, and credibility
 Minimize risks: Diversifying the investment mix based on budget, timeline and
financial goals

Feedback

 Evaluate efficiency: Monitor and analyze the portfolio’s ratio of risk to return to
determine its effectiveness

Rebalance the composition: Revise the portfolio’s composition based on current market
conditions to maximize earnings

Importance of Portfolio Management

Portfolio management is so much more than just picking profitable investments. It also
involves learning about the investor’s goals, timelines, budget and creating an investment
strategy that is well-diversified and yields high returns. Good portfolio management can
result in greater returns as it takes both long- and short-term financing options over a given
period of time into consideration. This enhances the likelihood of efficient resource
allocation and capital appreciation.

Most investments are far from being a one-and-done deal. They need to be tweaked and
rebalanced from time to time in order to maximize returns. This is also called portfolio
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adjustment. For example, in case of mutual fund investments, fund management may
undergo some changes if it is actively managed. In such cases, a portfolio manager can
take charge and make the required changes to other fund holdings. In this manner, portfolio
management also helps monitor and evaluate financial portfolios on a regular basis.

The Role of the Portfolio Manager

Since we have established what is portfolio management, let’s look at what a portfolio
manager does. A portfolio can have a variety of investments that are held in a single
account or across multiple accounts. This can be a retirement account or even a taxable
investment account. A portfolio manager helps make such decisions with ease.

These are the main responsibilities of a portfolio manager:

 Inform the client about relevant investment tools

 Create and implement customized investment solutions
 Choose the optimal asset class based on investment goals
 Develop and manage financial portfolios
 Evaluate and monitor assets
 Measure performance and manage risk
 Rebalance the portfolio depending on market conditions

In simple terms, a portfolio manager is someone who essentially helps design and
implement the best financial investment plan that is well-diversified and yields high returns.

Portfolio Management: Things to Keep in Mind

Now that you have a detailed understanding of what is portfolio management, it’s time to
find out what really goes into making portfolio management effective and successful. Once
you have the initial strategy in place, here are the key areas to explore:

Asset Allocation

It refers to how your assets are divided across different types of investments. Risk tolerance
plays a crucial role here. A good portfolio manager will help customers make informed
investment choices taking aspects such as age, budget, and goals into account and
recommend the kind of risks they can take when investing.

Diversification

The best way to explain this concept is this: avoid putting all your eggs in one basket. This
ensures that even if a certain investment sinks, the entire portfolio does not get affected. A
good example of asset diversification is investing in funds that offer different securities,
which means more diversification as compared to a single stock.

Rebalancing
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It involves evaluating and adjusting the investment strategy as per market fluctuations and
main financial goals. Rebalancing is an important element of a good portfolio management
strategy.

Tax Considerations

Tax-efficient investing is incredibly important to ensure that a minimum amount of tax is

levied on the customers’ returns.

Portfolio Management: Passive vs. Active

Portfolio management may be either passive or active.

Passive management is the set-it-and-forget-it long-term strategy. It may involve

investing in one or more exchange-traded (ETF) index funds. This is commonly
referred to as indexing or index investing. Those who build indexed portfolios
may use modern portfolio theory (MPT) to help them optimize the mix.

Active management involves attempting to beat the performance of an index by

actively buying and selling individual stocks and other assets. Closed-end
funds are generally actively managed. Active managers may use any of a wide
range of quantitative or qualitative models to aid in their evaluations of potential
investments.

Active Portfolio Management

Investors who implement an active management approach use fund managers

or brokers to buy and sell stocks in an attempt to outperform a specific index,
such as the Standard & Poor's 500 Index or the Russell 1000 Index.

An actively managed investment fund has an individual portfolio manager, co-

managers, or a team of managers actively making investment decisions for the
fund. The success of an actively managed fund depends on a combination of in-
depth research, market forecasting, and the expertise of the portfolio manager or
management team.

Portfolio managers engaged in active investing pay close attention to market

trends, shifts in the economy, changes to the political landscape, and news that
affects companies. This data is used to time the purchase or sale of investments
in an effort to take advantage of irregularities. Active managers claim that these
processes will boost the potential for returns higher than those achieved by
simply mimicking the holdings on a particular index.
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Trying to beat the market inevitably involves additional market risk. Indexing
eliminates this particular risk, as there is no possibility of human error in terms of
stock selection. Index funds are also traded less frequently, which means that
they incur lower expense ratios and are more tax-efficient than actively managed
funds.

Passive Portfolio Management

Passive portfolio management, also referred to as index fund management, aims

to duplicate the return of a particular market index or benchmark. Managers buy
the same stocks that are listed on the index, using the same weighting that they
represent in the index.

A passive strategy portfolio can be structured as an exchange-traded fund

(ETF), a mutual fund, or a unit investment trust. Index funds are branded as
passively managed because each has a portfolio manager whose job is to
replicate the index rather than select the assets purchased or sold.

The management fees assessed on passive portfolios or funds are typically far
lower than active management strategies.

Portfolio Management: Discretionary vs. Non-

Discretionary
Another critical element of portfolio management is the concept
of discretionary and non-discretionary management. This portfolio management
approach dictates what a third-party may be allowed to do relating to your
portfolio.

A discretionary or non-discretionary management style only pertains to if you

have an independent broker managing your portfolio. If you only want the broker
to execute trades that you have explicitly approved, you must opt for a non-
discretionary investment account. The broker may advise on strategy and
suggest investment moves. However, without your approval, the broker is simply
an adviser that must follow your discretion.

On the other hand, some investors would prefer placing all of the decision-
making in the hands of their broker or financial manager. In these situations, the
financial adviser can buy or sell securities without the approval of the investor.
The adviser still has a fiduciary responsibility to act in their client's best interest
when managing their portfolio.
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B. FINANCIAL MARKETS
What Are Financial Markets?
Financial markets refer broadly to any marketplace where securities trading
occurs, including the stock market, bond market, forex market, and derivatives
market. Financial markets are vital to the smooth operation of capitalist
economies.

KEY TAKEAWAYS

 Financial markets refer broadly to any marketplace where the trading of

securities occurs.
 There are many kinds of financial markets, including (but not limited to)
forex, money, stock, and bond markets.
 These markets may include assets or securities that are either listed on
regulated exchanges or trade over-the-counter (OTC).
 Financial markets trade in all types of securities and are critical to the
smooth operation of a capitalist society.
 When financial markets fail, economic disruption, including recession and
rising unemployment, can result.

Understanding the Financial Markets

Financial markets play a vital role in facilitating the smooth operation of capitalist economies by
allocating resources and creating liquidity for businesses and entrepreneurs. The markets make it
easy for buyers and sellers to trade their financial holdings. Financial markets create securities
products that provide a return for those with excess funds (investors/lenders) and make these funds
available to those needing additional money (borrowers).
The stock market is just one type of financial market. Financial markets are created when people
buy and sell financial instruments, including equities, bonds, currencies, and derivatives. Financial
markets rely heavily on informational transparency to ensure that the markets set prices that are
efficient and appropriate.
Some financial markets are small with little activity, and others, like the New York Stock Exchange
(NYSE), trade trillions of dollars in securities daily. The equities (stock) market is a financial market
that enables investors to buy and sell shares of publicly traded companies. The primary stock
market is where new issues of stocks are sold. Any subsequent trading of stocks occurs in the
secondary market, where investors buy and sell securities they already own.
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Types of Financial Markets

There are several different types of markets. Each one focuses on the types and classes of
instruments available on it.
a. Stock Markets
Perhaps the most ubiquitous of financial markets are stock markets. These are venues where
companies list their shares, which are bought and sold by traders and investors. Stock markets, or
equities markets, are used by companies to raise capital and by investors to search for returns.
Stocks may be traded on listed exchanges, such as the New York Stock Exchange
(NYSE), Nasdaq, or the over-the-counter (OTC) market. Most stock trading is done via regulated
exchanges, which plays an important economic role because it is another way for money to flow
through the economy.
Typical participants in a stock market include (both retail and institutional) investors, traders, market
makers (MMs), and specialists who maintain liquidity and provide two-sided markets. Brokers are
third parties that facilitate trades between buyers and sellers but who do not take an actual position
in a stock.
b. Over-the-Counter Markets
An over-the-counter (OTC) market is a decentralized market—meaning it does not have physical
locations, and trading is conducted electronically—in which market participants trade securities
directly (meaning without a broker). While OTC markets may handle trading in certain stocks (e.g.,
smaller or riskier companies that do not meet the listing criteria of exchanges), most stock trading is
done via exchanges. Certain derivatives markets, however, are exclusively OTC, making up an
essential segment of the financial markets. Broadly speaking, OTC markets and the transactions
that occur in them are far less regulated, less liquid, and more opaque.
c. Bond Markets
A bond is a security in which an investor loans money for a defined period at a pre-established
interest rate. You may think of a bond as an agreement between the lender and borrower containing
the loan's details and its payments. Bonds are issued by corporations as well as by municipalities,
states, and sovereign governments to finance projects and operations. For example, the bond
market sells securities such as notes and bills issued by the United States Treasury. The bond
market is also called the debt, credit, or fixed-income market.
d. Money Markets
Typically, the money markets trade in products with highly liquid short-term maturities (less than one
year) and are characterized by a high degree of safety and a relatively lower interest return than
other markets.
At the wholesale level, the money markets involve large-volume trades between institutions and
traders. At the retail level, they include money market mutual funds bought by individual investors
and money market accounts opened by bank customers. Individuals may also invest in the money
markets by purchasing short-term certificates of deposit (CDs), municipal notes, or U.S. Treasury
bills, among other examples.
e. Derivatives Markets
A derivative is a contract between two or more parties whose value is based on an agreed-upon
underlying financial asset (like a security) or set of assets (like an index). Rather than trading stocks
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directly, a derivatives market trades in futures and options contracts and other advanced financial
products that derive their value from underlying instruments like bonds, commodities, currencies,
interest rates, market indexes, and stocks.
Futures markets are where futures contracts are listed and traded. Unlike forwards, which trade
OTC, futures markets utilize standardized contract specifications, are well-regulated, and use
clearinghouses to settle and confirm trades. Options markets, such as the Chicago Board Options
Exchange (Cboe), similarly list and regulate options contracts. Both futures and options exchanges
may list contracts on various asset classes, such as equities, fixed-income securities, commodities,
and so on.
f. Forex Market
The forex (foreign exchange) market is where participants can buy, sell, hedge, and speculate on
the exchange rates between currency pairs. The forex market is the most liquid market in the world,
as cash is the most liquid of assets. The currency market handles more than $7.5 trillion in daily
transactions, more than the futures and equity markets combined.1
As with the OTC markets, the forex market is also decentralized and consists of a global network of
computers and brokers worldwide. The forex market is made up of banks, commercial companies,
central banks, investment management firms, hedge funds, and retail forex brokers and investors.
g. Commodities Markets
Commodities markets are venues where producers and consumers meet to exchange physical
commodities such as agricultural products (e.g., corn, livestock, soybeans), energy products (oil,
gas, carbon credits), precious metals (gold, silver, platinum), or "soft" commodities (such as cotton,
coffee, and sugar). These are known as spot commodity markets, where physical goods are
exchanged for money.
However, the bulk of trading in these commodities takes place on derivatives markets that utilize
spot commodities as the underlying assets. Forwards, futures, and options on commodities are
exchanged both OTC and on listed exchanges around the world, such as the Chicago Mercantile
Exchange (CME) and the Intercontinental Exchange (ICE).
h. Cryptocurrency Markets
Thousands of cryptocurrency tokens are available and traded globally across a patchwork of
independent online crypto exchanges. These exchanges host digital wallets for traders to swap one
cryptocurrency for another or for fiat monies such as dollars or euros.
Because most crypto exchanges are centralized platforms, users are susceptible to hacks or
fraudulent activity. Decentralized exchanges are also available that operate without any central
authority. These exchanges allow direct peer-to-peer (P2P) trading without an actual exchange
authority to facilitate the transactions. Futures and options trading are also available on major
cryptocurrencies.

The Bottom Line

Financial markets provide liquidity, capital, and participation that are essential for economic growth
and stability. Without financial markets, capital could not be allocated efficiently, and economic
activity such as commerce and trade, investments, and growth opportunities would be greatly
diminished.
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Many players make markets an essential part of the economy—firms use stock and bond markets
to raise capital from investors. Speculators look to various asset classes to make directional bets on
future prices. At the same time, hedgers use derivatives markets to mitigate various risks,
and arbitrageurs seek to take advantage of mispricings or anomalies observed across various
markets. Brokers often act as mediators that bring buyers and sellers together, earning a
commission or fee for their services.