CHAPTER 7 : Portfolio Management

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 CHAPTER OBJECTIVES

•After completing this unit, students should be able to:

1. Differentiate and explain active and passive portfolio

management.

2. Understand and describe monitoring and revision of

the portfolio.

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INTRODUCTION

 Portfolio management involves a series of decisions

and actions that must be made by every investor
Portfolios must be managed -whether investors follow
a passive approach or active approach to selecting and
holding their financial assets

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7.1 Active and Passive Portfolio Management
Two types of investment portfolio management:
 Active portfolio management
 Passive portfolio management
Passive portfolio management:
The main points for the passive portfolio management:
 Holding securities in the portfolio for the relatively long
periods with small and infrequent changes;
 Investors act as if the security markets are relatively efficient.
 Passive investors do not try out performing their designated
benchmark.
 The reasons when the investors with passive portfolio
management make changes in their portfolios:
 The investor’s preferences change;
 The risk free rate changes; 4
 The consensus forecast about the risk and return of the
benchmark portfolio changes.
The main points for the active portfolio management:
 Active investors believe that from time to time there are
mispriced securities or groups of securities in the market;
 The active investors do not act as if they believe that security
markets are efficient;
• The active investors use deviant predictions – their forecast of
risk and return differ from consensus opinions.
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There are arguments for both active and passive investing though
it is probably a case that a larger percentage of institutional
investors invest passively than do individual investors.
Of course, the active versus passive investment management
decision does not have to be a strictly either/ or choice. One
common investment strategy is to invest:
- Passively in the markets investor considers to be efficient and
- Actively in the markets investor considers inefficient.
•Investors also combine the two by investing part of the portfolio
passively and another part actively.
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 Strategic versus tactical asset allocation
• An asset allocation- focuses on determining the
mixture of asset classes that is most likely to provide a
combination of risk and expected return that is optimal
for the investor.
 Asset allocation - is a bit different from diversification.
It focus is on investment in various asset classes.
 asset allocation refers to the percentage of stocks,
bonds, and cash in your portfolio
 Diversification, in contrast, tends to focus more on
security selection – selecting the specific securities to
be held within an asset class.
 diversification involves spreading your assets across
asset classes within those three buckets. 7
 Cont.

• Asset classes here is understood as groups of securities

with similar characteristics and properties (for
example, common stocks; bonds; derivatives, etc.).
• Asset allocation proceeds other approaches to
investment portfolio management, such as market
timing (buy low, sell high) or selecting the individual
securities which are expected will be the “winners”.

• These activities may be integrated in the asset

allocation process.
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•But the main focus of asset allocation is to find such a
combination of the different asset classes in the investment
portfolio which the best matches with the investor’s goals
expected return on investment and investment risk.

•In fact, studies have shown that as much as 90 % or more of a

portfolio’s return comes from asset allocation.

•Furthermore, researchers have found that asset allocation has a

much greater impact on reducing total risk than does selecting the
best investment vehicle in any single asset category.

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 Two categories in asset allocation are defined:

 Strategic asset allocation;

 Tactical asset allocation.
Strategic asset allocation
• -identifies asset classes and the proportions for those
asset classes that would comprise the normal asset
allocation.
• Strategic asset allocation -is used to derive long-
term asset allocation weights.

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• The fixed-weightings approach in strategic asset allocation is
used.
• Investor using this approach allocates a fixed percentage of the
portfolio to each of the asset classes, of which typically are
three to five. Example of asset allocation in the portfolio might
be as follows:

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 Tactical asset allocation
•Produces temporary asset allocation weights that
occur in response to temporary changes in capital
market conditions.
•The investor’s goals and risk- return preferences are
assumed to remain unchanged as the asset weights are
occasionally revised to help attain the investor’s
constant goals.

•Alternative asset allocations are often related with the

different approaches to risk and return, identifying
conservative, moderate and aggressive asset allocation.

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• The conservative allocation -is focused on providing low
return with low risk;
• The moderate – average return with average risk and
• The aggressive – high return and high risk

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

Portfolio revision -is the process of selling certain assets in

portfolio and purchasing new ones to replace them.
•The main reasons for the necessity of the investment portfolio
revision:
 As the economy changes, certain industries and companies
become either less or more attractive as investments;
 The investor over the time may change his/her investment
objectives and in this way his/ her portfolio isn’t longer
optimal;
 The constant need for diversification of the portfolio. -
Individual securities in the portfolio often change in risk-return
characteristics and their diversification effect may be lessened.

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•Three areas to monitor when implementing investor’s
portfolio monitoring:
1. Changes in market conditions;
2. Changes in investor’s circumstances;
3. Asset mix in the portfolio.
• The need to monitor changes in the market is
obvious.
• Investment decisions are made in dynamic investment
environment, where changes occur permanently.

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• The key macroeconomic indicators- (such as GDP
growth, inflation rate, interest rates, others), as well
as the new information about industries and
companies should be observed by investor on the
regular basis, because these changes can influence
the returns and risk of the investments in the
portfolio
• Investor can monitor these changes using various
sources of information, especially specialized
websites
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•It is important to identify the major changes in the investment environment
and to assess whether these changes should negatively influence investor’s
currently held portfolio. If it so, investor must take an actions to rebalance
his/ her portfolio. When monitoring the changes in the investor’s
circumstances, following aspects must be taken into account:
 Change in wealth
 Change in time horizon
 Change in liquidity requirements
 Change in tax circumstances
 Change in legal considerations
 Change in other circumstances and investor’s needs.

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

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