Portfolio management

Overview
Portfolio prospective on investing
1- Portfolio diversification helps investors avoid disastrous investment outcomes
2- Portfolio reduce risk as it generally offer equivalent expected returns with lower
overall volatility
3- Portfolio affects risk more than returns
4- Portfolio composition improves trade-off between risk and return because lower level of risk
achieved for the same level of returns
5- Portfolios are not necessary downside protection
6- Modern portfolio theory is the analysis of rational portfolio choices based on the efficient
use of risk, the main conclusion of MPT is that investors should not only hold portfolios but
should also focus on correlation between individual securities

Investment clients
1- Individual investors
2- Institutional investors
 Defined benefit pension plans
 Endowments and foundations
 Banks
 Insurance companies
 Investment companies
 Sovereign wealth funds

Portfolio management process

1) The Planning Step

 Understanding the client’s needs
 Preparation of an investment policy statement (IPS)

2) The Execution Step

 Asset allocation

 Security analysis

 Portfolio construction

3) The Feedback Step

  Portfolio monitoring and re-balancing

 Performance measurement and reporting

Pooled investments
Mutual funds
The value of the mutual funds is referred to as the net asset value which is computed on a daily basis
based on the closing price of securities in the portfolio

Open-end fund: a mutual fund that accepts new investment money by issuing additional shares at
the net asset value of the fund at the time of investment

Closed-end fund: a mutual fund which is no new investment money is accepted, new investors invest
by buying existing shares and existing investors can liquidate by selling their shares

No load fund: a mutual fund in which there is no fee for investing or redeeming fund shares,
although there is an annual fee based on percentage of net asset value

Load funds: a mutual fund in which a percentage fee is charged to new investments or redemptions
in addition to the annual fee

Types of mutual funds based on type of assets:

1. Money market funds: Although money market funds have been a substitute for bank savings
accounts since the early 1980s, they are not insured in the same way as bank deposits. In the
United States, there are two basic types of money market funds: taxable and tax-free.
Taxable money market funds invest in high-quality, short-term corporate debt and federal
government debt. Tax-free money market funds invest in short-term state and local
government debt.
2. Bond mutual funds: it is an investment fund consisting of a portfolio of individual bonds and,
occasionally, preferred shares. The net asset value of the fund is the sum of the value of
each bond in the portfolio divided by the number of shares
3. Stock mutual funds: There are two types of stock mutual funds. The first is an actively
managed fund in which the portfolio manager seeks outstanding performance through the
selection of the appropriate stocks to be included in the portfolio. Passive management is
followed by index funds that are very different from actively managed funds. Their goal is to
match or track the performance of different indices.
4. Hybrid/balance funds: Hybrid or balanced funds are mutual funds that invest in both bonds
and shares.

Exchange traded funds: Exchange traded funds (ETFs) combine features of closed-end and
open-end mutual funds.
Separately managed accounts: An SMA is an investment portfolio managed exclusively for
the benefit of an individual or institution.
Hedge funds: private investment that typically use leverage, derivatives and long and short
investment strategies such as:
  Convertible Arbitrage: Buying securities as convertible bonds.
 Dedicated Short Bias: Taking more short positions than long positions.
 Emerging Markets: Investing in companies in emerging markets
 Equity Market Neutral: Attempting to eliminate the overall market movement by selling
overvalued securities and buying undervalued securities.
 Event Driven: Attempting to take advantage of specific company events.
 Fixed-Income Arbitrage: Attempting to profit from arbitrage opportunities in interest
rate securities. Take advantage of small price discrepancies
 Global Macro: Trying to capture shifts between global economies, usually using
derivatives on currencies or interest rates.
 Long/Short: Buying long equities that are expected to increase in value and selling short
equities that are expected to decrease in value. Unlike the equity market neutral
strategy, this strategy attempts to profit from market movements, not just from
identifying overvalued and undervalued equities.

Buyout funds: a fund that buys all shares of a public company so that the company becomes
private

Venture capital finds: finance companies in their start-up phase, play a very active role in the
management beyond just providing money, they provide close oversight and advice, make the
investment with the intent to exit in three to five years. These funds make a large number of small
investments with the expectation that only a small number will pay off. The assumption is that the
one that does pay off pays off big enough to compensate for the ones that do not pay off.
Portfolio risk and return – part 1
Construction of an optimal portfolio is an important objective of an investor

Investment characteristics of assets

Financial assets are generally defined by their return & risk characteristics

1- Return
Two types of return for investors:
1- Periodic income through cash dividends or interest payments.
2- Capital gain or loss as price of a financial asset can increase or decrease.
Measurements:

Holding period return: Total return from holding an asset for a single period

HPR = Pt – P0 + D / P0
Total holding period return for three years holding period return with three different annual returns:

HPR N years = [(1 + R1) × (1 + R2) × (1 + R3)] – 1

Averaging methods:

Aggregating returns across several holding periods

Arithmetic or mean return:

R = R1 + R2 + R3.... / N
Geometric mean return:

Rg = {(1+R1) (1+R2) … (1+RN)} 1/N - 1

Money weighted return or IRR:

The internal rate of return on a portfolio, taking account of all cash flows

Annualized returns:

Rannual = (1 + Rperiodic) c – 1
Where C = is the number of periods per year

Portfolio return (two assets):

Rportfolio = W1 R1 + W2 R2
Other major return measures
A gross return: Total return earned by an asset manager prior to direct fees & expenses deductions

A net return: Total return earned by an asset manager after direct fees & expenses deductions

Pre-tax nominal returns: refers to return prior to paying taxes

After-tax nominal returns: refers to return after taxes deduction

Real returns: refers to nominal returns adjusted for inflation

(1+Rreal) = (1+Rnominal) / (1+Rinflation) - 1

After-tax real return: is what the investor receives as compensation for postponing consumption and
assuming risk after paying taxes on investment returns. As a result, the after-tax real return becomes
a reliable benchmark for making investment decisions. Although it is a measure of an investor’s
benchmark return
Leveraged return: return on leverage positions by margins or by borrowing, Note that both the gains
and losses are amplified by a factor of 10.

Historical return: actually returns earned in the past, whereas expected return is what investor
expect to earn in the future based on risk free rate + risk premium + expected inflation

Because investment is risky, there is no guarantee that the actual return will be equal expected
return

2- Variance and covariance of returns

Variance of one asset: Variance of returns is a measure of the volatility of the dispersion of returns

σ2 = ∑ (R − μ) 2 / N
s2 = ∑ (R−Ṝ) 2 / N−1
Standard deviation is the square root of its variance

Portfolio’s variance (two assets):

σ2P = w12σ12 + w22σ22 + 2 w1 w2 Cov (R1, R2)

σ2P = w12σ12 + w22σ22 + 2 w1 w2 (ρ) σ1σ2
Standard deviation of a portfolio is the square root of its variance

Correlation is a measure of the consistency or tendency for two investments to act in a similar way.

 ρ = +1: Returns of the two assets move in same direction

 ρ = –1: Returns of the two assets move in opposite directions
 ρ = 0: no linear relationship
Portfolio risk becomes smaller as correlation coefficient among investments decrease

5- Other investment characteristics

In evaluating investments using mean (expected return) and variance (risk), we make two
important assumptions.
1- We assume that the returns are normally distributed because a normal distribution
can be fully characterized by its mean and variance.
2- We assume that markets are informationally & operationally efficient.
There is also certain operation limitations of the market that affects the choice of
investments, one is liquidity, second is the cost of trading which has mainly three
components: brokerage commission, bid-ask spread and price impact

Portfolio selection
1- Risk aversion
Risk aversion is the degree of an investor’s inability or unwillingness to take risk, risk aversion three
types are:

 Risk seeking: if investor chooses the gambling, negative aversion

 Risk neutral: if investor is indifferent about the gamble or guaranteed outcome, 0 aversion
 Risk averse: if investor chooses the guaranteed outcome, positive aversion

We will assume that investor is a risk-averse. This assumption is the standard approach taken in the
investment industry globally.
Risk tolerance: refer to the amount of risk an investor is willing to take to achieve investment goal, it
is negatively related to risk aversion, the higher risk tolerance, the greater the willingness to take risk

2- Utility theory
Utility is a measure of satisfaction an investor derives from different portfolios.

U = E(r) – ½ A σ2
Where U is utility, A is risk aversion which is the marginal reward required to accept additional risk

Several conclusions:

 Higher returns …… higher utility

 Higher variance …… lower utility
 Higher aversion …….. lower utility
 Utility can be highly positive or negative
 Utility can always be increased by getting higher returns or lower risk
 Utility does not measure satisfaction, it can be useful only in ranking various investments
 3- Indifference curves
A curve that representing all combinations of two attributes such that customer is entirely
indifferent among them, because all investors prefer more utility than less, investors want to move
to the upper left (northwest) to the indifference curve with the highest utility

4- Capital allocation line

Two fund separation theory states that all investors optimal portfolios will be made up of
combination of risk-free asset and an optimal portfolio if risky assets

Capital allocation line is a line that represents this combination

Capital allocation line equation is as follows:

E (R p) = R free + {(E (R risky) – R free) /σ risky} σ Portfolio

Where σ Portfolio = W risky x σ risky
Capital allocation line has an Intercept of Rf and slope of {(E (R risky) – R f) / σ risky}

The capital allocation line consists of the set of feasible portfolios. Indifference curve under the
capital allocation line may be attainable but are not preferred by any investor because the investor
can get a higher return for the same risk by moving up to the capital allocation line. Indifference
curve above the capital allocation line are desirable but not achievable with available assets
Less averse investors will go far from the y-axis

5- Portfolio selection
Utility gives us the indifference curves for an individual and the capital allocation line gives us the set
of feasible investments. Tangency of each individual’s indifference curves on the capital allocation
line will provide us with the optimal portfolio for different investors.
Less averse investors will go far from the y-axis

6- The power of diversification

Correlation among assets is the primary determinant of portfolio risk

 No reduction in risk when correlation is +1

 Risk can be reduced to zero when correlation is -1

Avenues for diversification:

 Diversify with asset classes.

 Diversify with index funds.
 Diversification among countries
 Diversify by not owning your employer’s stock.
 Evaluate each asset before adding to a portfolio.
 Buy insurance for risky portfolios.
Efficient frontier & optimal portfolio
Investment opportunity set: it is a set of all the attainable portfolios by the combination of one or
more of the investable assets, it is a set points on and to the right of the efficient frontier curve

Minimum-variance portfolio: portfolio with minimum variance for each given level of expected
return

Minimum variance frontier: the entire collection of these minimum variance portfolios

Global minimum-variance portfolio: the portfolio on the minimum-variance frontier with the
smallest variance of return

Markowitz efficient frontier: the set of portfolios that give maximum return with same risk that
investors will choose, they are above the global minimum variance portfolio

A risk free asset and many risky assets: The addition of a risk-free asset makes the investment
opportunity set much richer than the investment opportunity set consisting only of risky assets.

Two-fund separation theorem: states that all investors regardless of taste, risk preferences, and
initial wealth will hold a combination of two portfolios or funds: a risk-free asset and an optimal
portfolio of risky assets.

Optimal portfolio is the point in which indifference curve is tangent to capital allocation line

Optimal risky portfolio is the point in which capital allocation line is tangent to the efficient
frontier

The location of an optimal investor portfolio depends on the investor’s risk preferences, moving
from the risk-free asset along the capital allocation line, we encounter investors who are willing to
accept more risk. At tangency Point, the investor is 100 percent invested in the optimal risky
portfolio. Beyond tangency Point, the investor accepts even more risk by borrowing money and
investing in the optimal risky portfolio.
Portfolio risk and return – part 2
Capital market theory
If investors have different valuations of assets, then the construction of a unique optimal risky
portfolio is not possible. If we make a simplifying assumption of homogeneity in investor
expectations, we will have a single optimal risky portfolio
A capital allocation line includes all possible combinations of the risk-free asset and any risky
portfolio. The capital market line is the capital allocation line under the assumption of homogeneity
where the risky portfolio is the market portfolio, graphically return on y-axis & risk on x-axis and the
market portfolio is a point where the capital market line is tanged to the Markowitz efficient frontier

E(RP) = RF + {(RM – RF) / σM} σP

The y-intercept is the risk-free rate, and the slope of the line referred to as the market price of risk is
{(Rm − Rf)/ σm}. The CML has a positive slope because the market’s risky return is larger than the risk-
free return.
Leverage portfolios: As one moves further to the right on the capital market line, an increasing
amount of borrowed money is being invested in the market. This means that there is negative
investment in the risk-free asset, which is referred to as a leveraged position in the risky portfolio.

With different lending and borrowing rates, the CML will no longer be a single straight line, it will be
kinked line
 The line will have a slope of [E(Rm) – Rf]/σm between Market portfolio & y-axis, where
borrowing is at Risk free rate
 The line will have a smaller slope at points beyond Market portfolio point, where borrowing
will be higher than risk free rate
Investment in the risk-free asset may be positive (lending), zero (no lending or borrowing), or
negative (borrowing). Leverage allows less risk-averse investors to increase the amount of risk they
take by borrowing money and investing more than 100 percent in the passive portfolio.

Pricing of risk
Systematic & nonsystematic risk

Total risk = systematic variance + nonsystematic variance Systematic risk:

risk that affects the entire market or economy, it is non-diversifiable and cannot be avoided such as
interest rates, inflation, economic cycles, political uncertainty and natural disasters

Nonsystematic risk: unique risk that is limited to a particular asset or industry, it is diversifiable, such
as major oil discoveries or airline crashes

Pricing of risk: we can assume that in an efficient market, systematic risk is priced and investors are
compensated for holding assets or portfolios based only on it, investors do not receive any return for
accepting nonsystematic risk.
Return generating models:
It is a model that can provide an estimate of the expected return of a security given certain
parameters, it can be built using different kind of factors such as:

1. Macroeconomic factors: use economic factors that are correlated with security returns such
as economic growth, interest rates, productivity, employment, and consumer confidence
2. Fundamental factors: use relationships between security returns and company’s underlying
fundamentals such as earnings, earnings growth, cash flow generation, investment in
research, advertising, and number of patents
3. Statistical factors: use historical and cross-sectional data to identify factors that explain
variance and covariance in observed returns

Types of models
 Multi factor model: allows more than one variable to be considered in estimating returns and
can be built using different kinds of factors such as
1- Fama & French: three factors are used, firm size, firm book value to market value ratio &
return on market portfolio less risk-free rate
2- Carhart suggest a forth factor to fama & frensh: price momentum using prior period
returns
 Single factor model:

The single index model is the simplest:

E(R) - RF = β {E (RM) – RF}

On implementation of a single-index model, a regression that specifies a linear relationship between
return on a security and the return on a broad market index with R f is the intercept & beta is the
slope

The market model: a simplified form of single index model in which it is easier to work with and is
normally used in estimating beta risk and computing abnormal returns

E(R) = α + β RM + e
The intercept α Where α = RF (1 – β) and beta is the slope
Estimating Beta: beta a measure of how sensitive an asset’s or portfolio’s return is to the market as a
whole, it can be estimated by calculations or regression analysis

1- Calculating beta: it is a measure of systematic risk that is based on the covariance of an

asset’s or portfolio’s return with return of the overall market

β = Cov (RI, RM) / σM2

= (ρ x σI) / σM
The variances and correlations used to calculate beta usually based on historical returns
 2- Regression analysis: An alternative and more practical approach is to estimate beta
directly by using regression analysis & the market model, which is a statistical
process that evaluates the relationship between a given variable and one or more
other variables.
It is necessary to recognize that estimates of beta may or may not represent current or
future levels of an asset’s systematic risk.

CAPM - The capital asset pricing model:

It is one of the most significant innovations in portfolio theory, the model is simple, yet powerful; is
intuitive, yet profound; and uses only one factor, yet is broadly applicable

The model provides a linear expected return–beta relationship that precisely determines the
expected return given the beta of an asset. In doing so, it makes the transition from total risk to
systematic risk, the primary determinant of expected return.

E (RP) = RF + β {E (RM) – RF}

Assumptions of the CAPM

 Investors are risk-averse, utility-maximizing, rational individuals.

 Markets are frictionless, including no transaction costs and no taxes.

 Investors plan for the same single holding period.

 Investors have homogeneous expectations or beliefs.

 All investments are infinitely divisible.

 Investors are price takers.

CAPM, with all its limitations and weaknesses, provides a benchmark for comparison and for
generating initial return estimates.
Security market line (SML) is a graphical representation of the CAPM with beta on the x-axis and
expected return on the y-axis, the SML intercept the risk-free rate of return, and the slope of this
line is the market risk premium, (Rm – Rf)

Portfolio’s beta: βP= ∑ w β

Portfolio performance evaluation: four ratios are commonly used in performance evaluation

 Sharpe ratio: defined as the portfolio’s risk premium per unit of total portfolio risk
RP – RF / σP
Limitations:
 1- It uses total risk as a measure of risk when only systematic risk is priced.
2- The ratio itself is not informative. To rank portfolios, the Sharpe ratio of one portfolio must
be compared with the Sharpe ratio of another portfolio. Nonetheless, the ease of
computation makes Sharpe ratio a popular tool.

 M-squared ratio: it produces the same portfolio rankings as sharp ratio but is stated in
percentage terms, M2 can be expressed as follows:
M2 = {(σ M / σ P) (RP − RF)} − (Rm − RF)

 Trey nor ratio: excess return as per unit of Beta, it is a simple extension of Sharpe ratio by
replacing total risk with beta
RP – RF / β P
 Jensen’s alpha: The difference between the actual portfolio return and the calculated risk-
adjusted return is a measure of the portfolio’s performance relative to the market portfolio
and is called Jensen’s alpha. By definition, αm of the market is zero. Jensen’s alpha is also the
vertical distance from the SML measuring the excess return for the same risk as that of the
market and is given by

α P = RP – [RF + βP (RM – RF)]

Security characteristic line: a graph with excess return of a security on y-axis and the excess return of
the market on x-axis, Jensen’s alpha is the intercept and beta is the slope

Security selection:

The CAPM-calculated price is the current market price because it reflects the beliefs of all other
investors in the market. If the investor-estimated current price is higher (lower) than the market
price, the asset is considered undervalued (overvalued). Therefore, the CAPM is an effective tool for
determining whether an asset is undervalued or overvalued and whether an investor should buy or
sell the asset.

Construction a portfolio: much of the nonsystematic risk can be diversified away in as few as 30
securities. These securities, however, should be randomly selected and represent different asset
classes for the portfolio to effectively diversify risk. Otherwise, one may be better off using an index
(e.g., the S&P 500 for a diversified large-cap equity portfolio and other indices for other asset
classes).

Limitations of the CAPM:

Theoretical Limitations of the CAPM

 Single-factor model: Only systematic risk or beta risk is priced in the CAPM.
 Single-period model: The CAPM is a single-period model that does not consider multi-period
implications or investment objectives of future periods
Practical Limitations of the CAPM
 Market portfolio: The true market portfolio according to the CAPM includes all assets, which
means that it also includes many assets that are not investable
 Proxy for a market portfolio: In the absence of a true market portfolio, market participants
generally use proxies.
 Estimation of beta risk: A long history of returns is required to estimate beta risk.
  The CAPM is a poor predictor of returns
 Homogeneity in investor expectations

 Theoretical models: arbitrage pricing theory which is based on the same principle as the CAPM
but expand the number of risk factors
 Practical models: four factor model which is based on the relationship between past returns and
a variety of different factors, this additional three factors are relative size, relative book to
market value, and beta of the assets with addition of relative past stock returns
Basics of portfolio planning and
construction
1-Portfolio planning
Portfolio planning defined as a program developed in advance of constructing a portfolio that is
expected to satisfy the client’s investment objectives, the written document that governing this
process is the investment policy statement (IPS)

IPS:
The IPS is the starting point of the portfolio management process

The IPS can take a variety of forms. A typical format will include the client’s investment objectives
and the constraints that apply to the client’s portfolio.

Client’s investment objectives are specified in terms of risk tolerance and return requirements.
These must be consistent with each other: a client is unlikely to be able to find a portfolio that offers
a relatively high expected return without taking on a relatively high level of risk.

Constraints section covers factors that need to be taken into account when constructing a portfolio
for the client that meets the objectives. The typical constraint categories including liquidity, time
horizon, regulatory requirements, tax status, and unique needs. The constraints may be internal (i.e.,
set by the client), or external (i.e., set by law or regulation).
The IPS should be reviewed on a regular basis to ensure that it remains consistent with the client’s
circumstances and requirements.
Major components of IPS:

There is no single standard format for an IPS. Many IPS include the following sections:

 Introduction. This section describes the client.

 Statement of Purpose. This section states the purpose of the IPS.
 Statement of Duties and Responsibilities. This section details the duties and responsibilities
of the client, the custodian of the client’s assets, and the investment managers.
 Procedures. This section explains the steps to take to keep the IPS current and the
procedures to follow to respond to various contingencies.
 Investment Objectives. This section explains the client’s objectives in investing.
 Investment Constraints. This section presents the factors that constrain the client in seeking
to achieve the investment objectives.
 Investment Guidelines. This section provides information about how policy should be
executed (e.g., on the permissible use of leverage and derivatives) and on specific types of
assets excluded from investment, if any.
 Evaluation and Review. This section provides guidance on obtaining feedback on investment
results.
  Appendices: (A) Strategic Asset Allocation (B) Rebalancing Policy. Many investors specify a
strategic asset allocation (SAA)

Risk objectives: When constructing a portfolio for a client, it is important to ensure that the risk of
the portfolio is suitable for the client. The IPS should state clearly the risk tolerance of the client.

Quantitative risk objectives can be absolute or relative or a combination of the two.

A Five-Item Risk Assessment Instrument
1. Investing is too difficult to understand.
a. Strongly agree
b. Tend to agree
c. Tend to disagree
d. Strongly disagree
2. I am more comfortable putting my money in a bank account than in the stock market.
a. Strongly agree
b. Tend to agree
c. Tend to disagree
d. Strongly disagree
3. When I think of the word “risk” the term “loss” comes to mind immediately.
a. Strongly agree
b. Tend to agree
c. Tend to disagree
d. Strongly disagree
4. Making money in stocks and bonds is based on luck.
a. Strongly agree
b. Tend to agree
c. Tend to disagree
d. Strongly disagree
5. In terms of investing, safety is more important than returns.
a. Strongly agree
b. Tend to agree
c. Tend to disagree
d. Strongly disagree

There would be a conflict between ability and willingness to take risk

Return objectives: return objectives may be stated on an absolute or a relative basis

Constraints:

Liquidity: The IPS should state what the likely requirements are to withdraw funds from the
portfolio.

Time horizon: The IPS should state the time horizon over which the investor is investing. It may be
the period over which the portfolio is accumulating before any assets need to be withdrawn; it could
also be the period until the client’s circumstances are likely to change.

Tax concerns: the portfolio should reflect the tax status of the client. For example, a taxable
investor may wish to hold a portfolio that emphasizes capital gains and receives little income. A
taxable investor based in the United States is also likely to consider including US municipal bonds
(“munis”) in his or her portfolio because interest income from munis, unlike from treasuries and
corporate bonds, is exempt from taxes. A tax-exempt investor, such as a pension fund, will be
relatively indifferent to the form of returns.
Legal and regulatory factors: The IPS should state any legal and regulatory restrictions that constrain
how the portfolio is invested.

Unique circumstances: This section of the IPS should cover any other aspect of the client’s
circumstances that is likely to have a material impact on the composition of the portfolio. A client
may have considerations derived from his or her religion or ethical values that could constrain
investment choices.

Gathering client information: Good record keeping is very important, and may be crucial in a case in
which any aspect of the client relationship comes into dispute at a later stage.

2-Portfolio construction
Once the IPS has been compiled, the investment manager can construct a suitable portfolio.
Strategic asset allocation is a traditional focus of the first steps in portfolio construction. The
strategic asset allocation is stated in terms of percent allocations to asset classes.
The process of formulating a strategic asset allocation is based on the IPS and capital market
expectations

Capital market expectations:

An investor’s expectations concerning the risk and return prospects of asset classes

Traditionally, capital market expectations are quantified in terms of asset class expected returns,
standard deviation of returns, and correlations among pairs of asset classes. Formally, the expected
return of an asset class consists of the risk-free rate and one or more risk premium(s) associated
with the asset class. Expected returns are in practice developed in a variety of ways, including the
use of historical estimates, economic analysis, and various kinds of valuation models. Standard
deviations and correlation estimates are frequently based on historical data.

Strategic asset allocation:

Traditionally, investors have distinguished cash, equities, bonds, and real estate as the major asset
classes. In recent years, this list has been expanded with private equity, hedge funds, and
commodities. In addition, such assets as art and intellectual property rights may be considered asset
classes for those investors prepared to take a more innovative approach and to accept some
illiquidity. Combining such new asset classes as well as hedge funds and private equity under the
header “alternative investments” has become accepted practice.

Steps toward an actual portfolio:

The strategic asset allocation in itself does not yet represent an actual investment portfolio. It is the
first step in implementing an investment strategy. For quantitatively oriented portfolio managers,
the next step is often risk budgeting.
Risk budgeting is the process of deciding on the amount of risk to assume in a portfolio (the overall
risk budget), and subdividing that risk over the sources of investment return (e.g., strategic asset
allocation, tactical asset allocation, and security selection). Because the decision about the amount
of risk to be taken is made in constructing the IPS, at this stage we are concerned about the
subdivision of that risk.