Portfolio Management Process

1Modern portfolio theory

"Don't put all your eggs in one basket" was common wisdom long before 1950, but nobody could quantify the benefit of diversification.

• Harry Markowitz, "Portfolio Selection", Journal of Finance, 1952. He won the Nobel Prize in 1990.
• MPT provides a framework for building and selecting portfolios from expected returns and the investor's risk appetite.
• It quantified diversification using covariance and correlation, showed that variance of return is a meaningful measure of risk, and derived the portfolio variance formula.

Remember

• Markowitz: 1952 paper, 1990 Nobel.

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2Assumptions of MPT

• Investors want the highest return for a given risk. Between two assets with equal returns, they choose the less risky one.
• Each investment is seen as a probability distribution of returns over a holding period.
• Investors maximise one-period expected utility.
• Utility curves show diminishing marginal utility of wealth.
• Risk is judged from the variability of expected returns.
• Decisions depend only on expected return and variance (or standard deviation).

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3Risk-averse, risk-neutral and risk-seeking investors

Where risk exists, more than one outcome is possible, and investors demand a risk premium for bearing it. A prospect with a zero risk premium is a fair game.

Utility scores: portfolios with higher expected return score higher; portfolios with more risk score lower.

Certainty equivalent rate (CER): the risk-free return that would be just as attractive as a given risky portfolio.

Remember

• Risk-averse investors reject fair games; risk seekers accept them.
• For a risk-neutral investor, CER = expected return.

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4Calculating return and risk

Expected return of a security = Σ (probability × return) across scenarios.

• Expected return of A = 0.3×15 + 0.5×10 + 0.2×2 = 9.9%
• Expected return of B = 0.3×25 + 0.5×20 + 0.2×1 = 17.7%

Risk = variability of returns. It is measured by variance and its square root, the standard deviation. A larger value means wider dispersion and higher risk.

Sample standard deviation from historical returns

1. List the returns.
2. Find the mean.
3. Subtract the mean from each return.
4. Square each deviation.
5. Add the squares.
6. Divide by (n − 1) to get the variance.
7. Take the square root to get the standard deviation.

Portfolio expected return = the weighted average of the individual expected returns.

Example Weights 0.2, 0.1, 0.3 and 0.4 in assets returning 9%, 12%, 15% and 18%: 0.018 + 0.012 + 0.045 + 0.072 = 14.7%.

Portfolio risk is not a simple weighted average. It also depends on how the assets move together.

Formula σ²p = w₁²σ₁² + w₂²σ₂² + 2·w₁·w₂·ρ₁₂·σ₁·σ₂

Example Two assets, each with return 15% and SD 5%, weights 50:50, correlation 0.5. σ²p = 0.25×0.0025 + 0.25×0.0025 + 2×0.5×0.5×0.5×0.05×0.05 = 0.001875, so σp ≈ 4.33%. That is below 5% even though both assets have 5% risk: this is diversification at work.

Number of terms

• A two-asset portfolio has 3 terms (2 variances, 1 covariance). A three-asset portfolio has 6 (3 variances, 3 covariances).
• With n assets there are n variances and (n² − n) ÷ 2 covariances. For 50 assets that is 1,225 covariances.

Remember

• Portfolio return is a weighted average; portfolio risk is not.
• Covariance terms = (n² − n) ÷ 2.

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5Two-asset risk–return graph

If two assets are perfectly positively correlated (ρ = +1), both portfolio return and portfolio SD are weighted averages. All their combinations lie on a straight line between the two assets, and there is no diversification benefit. The lower the correlation, the more the curve bends to the left, meaning less risk for the same return.

Exam trap With correlation of +1, combining two assets does not reduce risk. Diversification benefits require correlation below +1.

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6The efficient frontier

Plot every possible combination of securities and you get a cloud of portfolios. Its upper-left edge is an umbrella-shaped curve: the efficient frontier.

• It is the set of portfolios with the highest return for each level of risk, or the lowest risk for each level of return.
• Portfolios below it are sub-optimal because they give too little return for their risk.
• Portfolios to the right of it are sub-optimal because they carry too much risk for their return.

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7Portfolio optimisation

To use MPT, the manager estimates for every asset in the investment universe:

1. expected return;
2. standard deviation;
3. correlations with every other asset.

The investor's constraints are added. From the feasible portfolios, the manager selects the one that meets the investor's objectives.

Remember

• Inputs: expected returns, standard deviations, correlations, plus constraints.

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8Estimation issues

The output is only as good as the inputs. A 50-security universe needs 1,225 correlation estimates, and errors in any of these estimates are called estimation risk. Larger portfolios use a variance–covariance matrix, built in a spreadsheet or code.

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9Why asset allocation matters

Asset allocation is how an investor's wealth is divided among asset classes. An asset class is a group of securities with similar characteristics and risk–return behaviour, such as bonds, equities and cash. Each class splits into sub-classes: bonds into Treasury, corporate and junk; equity into large, mid and small cap.

Asset allocation is the starting point of portfolio management and, in the long run, the main influence on portfolio performance. Picking individual products within a class matters, but it contributes less than the overall mix.

Remember

• Asset allocation drives most of a portfolio's long-run result.

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10Correlation across asset classes

Correlation measures the strength and direction of the relationship between two variables. It ranges from −1 to +1.

• +1 means a perfect positive relationship: the two move together.
• −1 means a perfect negative relationship: they move in opposite directions.

Assets within one class respond to the same factors, so they are highly correlated. Different classes usually have low correlation. Correlation is the most important factor in diversification.

Correlations change over time and across economic regimes, so don't rely only on past correlations.

Exam trap Diversification works best with low or negative correlation, and past correlations may not hold in future.

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11Steps in the portfolio management process

1. Policy statement (IPS): set out risk appetite, objectives, goals and constraints.
2. Study current conditions and forecast trends.
3. Construct the portfolio, then monitor and rebalance it.
4. Measure and evaluate performance.
5. Review periodically: check that the portfolio still fits the objectives and any changes in the investor's circumstances.

The process runs plan → execute → feedback.

The IPS is the road map for the process. The investor or the adviser drafts it, setting out:

• goals with priorities;
• objectives with time horizons;
• the risk–return profile;
• liquidity needs;
• asset classes to use or avoid;
• a review process.

The IPS must be updated periodically and is the basis for strategic asset allocation.

Four purposes of the IPS

1. Sets realistic return expectations.
2. Helps the manager make decisions that fit the investor's objectives.
3. Provides a framework for evaluating the manager.
4. Protects the investor against inappropriate or unethical decisions by the manager.

Remember

• The IPS is the road map and the basis for strategic asset allocation.

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12Investment objectives

Objectives are framed in terms of risk, return and liquidity.

• Risk and return usually move together.
• Liquidity and return move inversely: illiquid assets earn an illiquidity premium.

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13Investment constraints

Liquidity

• The young usually need less liquidity than the old. Health needs, fees and weddings raise it.
• Three kinds of need:
  1. Emergency cash: usually 2–3 months' spending, more if income is uncertain or volatile.
  2. Near-term goals: money needed within a year belongs in liquid, low-risk assets.
  3. Investment flexibility: cash to take advantage of market opportunities.
• Too much liquidity drags on returns. Too little forces untimely sales. Specify it in the IPS.

Regulatory

• Individuals face few regulatory limits, but they include:
  • LRS: resident individuals, including minors, may remit up to US$250,000 per financial year. The scheme started on 4 February 2004 with a US$25,000 limit.
  • Insider trading rules: no trading on unpublished price-sensitive information.

Tax

• Income (interest, dividends, rent) and capital gains are taxed differently, and the same return taxes differently across tax brackets. The IPS should reflect the investor's tax position.

Remember

• Emergency fund: 2–3 months' spending. LRS: US$250,000 a year.

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14Exposure limits

Under the SEBI PMS Regulations, 2020, the client agreement must state the investment approach: the types of securities and instruments the manager may use and the proportion of exposure to each.

Limits on sectors, entities and asset classes are set from the investor's objectives, risk appetite, liquidity, tax and regulatory position, and horizon. Their purpose is to avoid concentration risk, and the manager must keep within them.

15Unique needs: sustainable and ethical investing

Investors may have personal, social, ethical or cultural preferences, for example avoiding polluting companies, or being reluctant to sell an employer's shares out of loyalty. These belong in the IPS, along with reporting, rebalancing schedules, communication frequency and investment style.

Sustainable (ESG) investing looks for financial return and positive impact, judged on three sets of factors:

• Environmental: pollution, water use, clean technology.
• Social: workplace safety, community development, human rights.
• Governance: board independence, board diversity, executive pay.

Many believe ESG focus also helps performance.

Ethical investing makes moral principles the primary filter. It is more personal than sustainable investing, which uses a broad set of screening guidelines. It typically avoids "sin" sectors: gambling, alcohol, tobacco and firearms.

Remember

• Ethical investing is personal and values-led; ESG investing uses broad screens.

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16Assessing goals

List each goal with its priority (high, moderate, low), time frame and amount needed.

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17The investor's financial position

Prepare personal financial statements:

• Net worth statement: assets at market value (home, car, investments, savings, jewellery) minus liabilities (home, car, personal and education loans, credit cards). Update it at least yearly.
• Income–expense statement, usually monthly, shows the surplus available to invest.

18Psychographic analysis: the BB&K model

Psychographic analysis bridges standard finance (investors as rational) and behavioural finance (investors as normal people with biases).

The Bailard, Biehl & Kaiser (BB&K) model uses two axes:

• confidence vs anxiety;
• careful vs impetuous.

Investors can shift type for a while: a winning streak makes a guardian act more like an adventurer, and volatility makes most investors more guardian-like. Each type needs a different management approach.

Remember

• Adventurer: confident + impetuous. Guardian: anxious + careful.
• Celebrity: the hardest client. Individualist: contrarian.

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19Life cycle analysis

The boundaries between phases are fuzzy.

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20Forecasting and benchmarking

Portfolio management combines two sets of information:

• the investor's profile: objectives, goals, personality, life stage and constraints;
• capital market forecasts of the risk and return of each asset class. Historical risk and return are a starting point.

Benchmarks. The IPS should name a benchmark that matches the portfolio ("apples with apples"):

• large-cap equity against the Sensex or Nifty 50;
• mid-cap equity against a mid-cap index;
• long-term bonds against a bond index of similar maturity and credit.

A wrong benchmark gives a misleading picture.

• Use multiple or hybrid benchmarks for mixed portfolios: either a separate index for each part, or a blended index when the mix is stable.
• Review the benchmark when the portfolio or the index composition changes.

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21Asset allocation and construction principles

The asset mix comes from combining the investor's profile with the market forecasts, aiming to optimise after-tax returns.

• Equity: large caps give stability; mid and small caps give growth with volatility. Dividend stocks add cash flow, but capital appreciation is the main source of equity return. How much equity depends on the goals and the time available.
• Debt: match maturity to the horizon; use short-term instruments for short-term goals and for parking money. Credit risk tolerance shapes medium- and long-term holdings.
• Hybrid: stability plus upside. Often used as a long-term goal approaches, for a smooth change in allocation.
• Other assets: gold, precious metals and alternatives for diversification and extra return.

22Strategic vs tactical allocation

Evidence

• Brinson, Hood and Beebower (1986): target asset allocation explained most of the variability in returns of diversified portfolios.
• Ibbotson and Kaplan (2000) confirmed it. Across funds, asset allocation explains about 40% of the variation in returns between funds, and about 90% of a single fund's return variability over time.

Remember

• SAA = time in the market; TAA = timing the market.
• Asset allocation explains about 90% of a fund's return variability over time.

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23Rebalancing

Why rebalance: different returns across assets cause drift from the target mix, which changes the portfolio's risk. Changes in the investor's goals or risk tolerance can also require it. The IPS should set a rebalancing policy: how often and how much deviation is tolerated.

The trade-off: the cost of rebalancing versus the cost of not rebalancing.

• Transaction costs: research, brokerage and time. They are high for illiquid assets (private equity, real estate) and low for listed equity and G-secs.
• Tax costs: rebalancing usually means selling winners and buying laggards, which triggers capital gains tax.
• Opportunity cost: an asset that is sold may keep rising.

Remember

• Rebalancing costs: transaction, tax and opportunity cost.

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24Investment approaches in PMS

Every PMS product is described as an investment approach: a documented strategy that SEBI requires to be disclosed uniformly in the disclosure document and marketing material. It sets out:

• the investment objective;
• the types of securities used (for example, listed large-cap equity);
• the basis for selecting securities and the intended portfolio allocation;
• the benchmark used to compare performance;
• the indicative tenure or investment horizon;
• the risks of the approach.

A distributor should recommend an investment approach, not just a "PMS", because two approaches from the same manager can carry very different risks.

Remember

• Investment approach = objective, securities, allocation, benchmark, horizon, risks.

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25Model portfolios and customisation

In a discretionary PMS, most managers run a model portfolio for each investment approach and replicate it in every client's account. Client portfolios can still differ because of:

• the date of entry (prices differ when each client invests);
• securities brought in by the client when joining;
• client-specific restrictions, for example excluding certain sectors or group companies;
• the timing of additions and withdrawals.

That is why two clients in the same approach can earn different returns, and why SEBI requires performance to be reported on the actual client portfolio using TWRR.

Concentration: PMS portfolios are often concentrated (perhaps 15–30 stocks), which can lead to higher returns or higher losses than a diversified mutual fund. This concentration risk must be explained to clients.

Remember

• Same approach, different client returns: entry date, stocks brought in, restrictions, flows.
• PMS portfolios are often concentrated: higher risk.

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26Rebalancing and cash in a PMS

• Rebalancing brings the portfolio back to the model or target allocation after markets move or the manager changes views.
• In PMS, every sale during rebalancing is a taxable event for the client (chapter 11), so rebalancing has a direct tax cost. Good managers weigh that cost against the benefit.
• Cash may be held while the manager finds opportunities or to meet expenses. Too much cash creates cash drag, which lowers returns in rising markets.

Remember

• Rebalancing in PMS = taxable sales in the client's hands.
• Excess cash = cash drag.

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