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Reading 51: Portfolio Management (Investor types (Endowments (High risk…
Reading 51: Portfolio Management
Portfolio perspective
Adding a risky asset can actually reduce portfolio risk
Evaluate investments based on their contribution to risk and return of a portfolio
Diversification ratio:
= \( \frac{Std.dev. Of. Equally.Weighted.Portfolio.Return}{Average.Std.Dev.Of.Return.On.Portfolio.Assets} \)
Investor types
Individual investor
Varied risk tolerance
Varied Investment Horizon
Varied Liquidity needs
Varied income needs
Bank
Low risk tolerance
Short Investment Horizon
High Liquidity needs
Income needs: to pay interest
Endowments
High risk tolerance
Low Liquidity needs
Low income needs
Long Investment Horizon
To provide perpetual financial support to some causes
Insurance
Low risk tolerance
Investment Horizon: Long (life insurance), Short (Property & Casualty Insurance)
High Liquidity needs
Low income needs
Mutual funds
Varied risk tolerance
Varied Investment Horizon
High Liquidity needs
Varied income needs
Defined benefit pension
High risk tolerance
Long Investment Horizon
Low Liquidity needs
Varied income needs (depends on age)
Sovereign Wealth Funds
Varied investment goal
Invest for future generations
Manage foreign exchange reserves
Manage government assets
Pension Plans
Defined Contribution plans
Employer contributes a certain sum each period to the employee's retirement account
Employee assume all of the investment risk.
no promise regarding the future value of the plan assets
Defined benefit plans
Employer promise to make periodic payment to employee after retirement
As employees' future benefits are defined,
Employer assumes all investment risk
Portfolio management process
Step 1: Planning
Understand client needs and circumstances (including client's return objectives, risk tolerance, constraints, and preferences).
Create Investment Policy Statement (IPS)
Develop a strategy consistent with IPS
Specify performance benchmark
Step 2: Execution
Analyze risk and return characteristics of asset classes
Analyze market conditions to identify attractive asset classes
Identify attractive securities within asset classes
Portfolio construction: target/strategic asset allocations, individual securities weightings, risk management
Step 3: Feedback
Monitor and update investor's needs
Monitor and update market conditions
Rebalance portfolio as needed
Measure and report performance
Asset Management Industry
Pooled investments
Mutual Funds
Classification
Open-ended vs. Close-ended
Open-ended fund:
shares can be bought or sold at will at Net Asset Value (NAV)
No. Shares changes with purchases and redemptions
Fee (%) for on-going management
Load funds: Up-front changes, redemption charges, or both
No-load funds: neither type of charge
Close-ended fund:
Has a fixed number of shares that are traded at a price determined by the market.
Issued as an IPO
Trade like shares of stock, commission and spread, and margin and shorting
Fee (%) for ongoing management
Market prices can (do) differ from NAV
Do not need to hold cash or sell shares to meet redemptions as open-end funds do
Type by investment objective
Money market funds
Bond funds: high yield, global, domestic, government, corporate, long-term, short-term, tax-exempt, etc.
Stock funds: actively managed funds, index funds
Balanced funds
Definitions
Mutual fund combines funds from many investor into a single portfolio that is invested in a specified class of securities to match a specific index.
Exchange-traded fund
similar to mutual funds
Low management fees; may have brokerage costs.
Typically index funds
Trade like shares of closed-end funds
Can be shorted or margined
Dividend typically paid out
In-kind purchase and redemptions keep market price close to NAV
May have tax advantages over open-end index funds
No capital-gain distribution
Separately managed accounts (Wrap accounts)
are the portfolio managed for individual investors who have substantial assets in exchange for annual fee based on assets.
Minimum investment $100-500K
Hedge Fund
Not registered or offered to the public
Small number of accredited investor
High minimum investment, high leverage, derivatives
Many strategies are used (e.g., long/short, global macro, event driven)
Venture Capital Funds
Provide start-up / early-stage financing
Expected failures but with some big successes
Active in management of portfolio firms
Private Equity Funds
Portfolio of privately held companies
May use high leverage
Hope to restructure, improve cash flow, and resell as an IPO at a profit
consist of buy-side firms that manage investment for clients
Full-service: Variety of styles and asset classes
Specialist: Focus on a style or asset class
Multi-boutique: Holding company for specialist
May focus on traditional or alternative asset classes or both
Management method
Active Management:
Use manager skill to attempt to outperform a benchmark
Passive Management:
Smart beta: focus on exposure to a specific market risk factor
Replicate performance of a benchmark
Notable trends:
Market share for passive management has increased to about 20% of AUM
Information technology investment to capitalize on Big Data
Emergence of robo-advisors