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Subject 2. The portfolio management process logic

Portfolio management is an ongoing process in which the investment objectives and constraints are identified and specified, investment strategies are developed, the portfolio composition is decided in detail, portfolio decisions are initiated by portfolio managers and implemented by traders, portfolio performance is measured and evaluated, investor and market conditions are monitored, and any necessary rebalancing is implemented.

There are three elements in the portfolio management process: planning, execution, and feedback.

The Planning Step

  • Identifying and specifying the investor's objectives and constraints.

    See subject 3 for details.

  • Creating the investment policy statement.

    See subject 4 for details.

  • Forming capital market expectations.

    Long run forecasts of risk and return characteristics for various asset classes form the basis for choosing portfolios that maximize expected return for given levels of risk or minimize risk for given levels of expected return.

  • Creating the strategic asset allocation.

    The IPS and capital market expectations are combined to determine strategic asset allocation targets or maximal and minimal permissible asset class values as a risk control mechanism. A strategic asset allocation establishes exposures to available major investment opportunity classes in a manner designed to satisfy the client's long run objectives and constraints. The plan reflects the interaction of objectives and constraints with the investor's long run capital market expectations, the expectations concerning the risk and return characteristics of capital market instruments. The investor may seek both single period and multi period perspectives as well.

The Execution Step

In this step, investment strategies are integrated with expectations to build a portfolio. Execution results in an actual portfolio with an actual asset allocation designed to meet the target of the strategic asset allocation.

The focus of portfolio managers is the portfolio selection / composition problem. It is the problem of building a portfolio and often uses portfolio optimization to combine assets efficiently to achieve return and risk objectives. What's equally important is the portfolio implementation. It is the trading desk problem of implementing the portfolio decisions and involves explicit and implicit transaction costs. Poorly managed, transaction costs can reduce performance and negate any advantage an investor may have.

The Feedback Step

  • Monitoring and rebalancing.

    This is an action that uses feedback to manage ongoing exposures to available investment opportunities so that the client's current objectives and constraints continue to be satisfied.

    Why is a portfolio reviewed for change?

    • Changes in investor circumstance.
    • Changes in economic and market input factors.
    • Changes in asset prices.

  • Performance evaluation.

    Investment performance must be periodically evaluated to assess progress toward achievement of investment objectives and to assess portfolio management skill. Performance measurement is the calculation of rates of return for the portfolio. Performance attribution is the analysis of the rates of return to determine the factors explaining how the return was achieved. Performance appraisal determines how good the performance was.

    A portfolio's absolute returns can be decomposed into three sources: the strategic asset allocation, market timing and security selection. The management of portfolios is usually conducted with reference to a benchmark. Therefore, relative portfolio performance evaluation is often of key importance. The ongoing review of the benchmark itself is also important.

Practice Question 1

Which of the following are portfolio manager's responsibilities?

I. to identify the risk and return objectives for the portfolio given the investor's constraints.
II. to develop a well-diversified portfolio with the selected risk level.
III. to reduce transaction costs.
IV. to implement the chosen investment strategy and to review it regularly.

Correct Answer: I, II, III and IV

Practice Question 2

Rank the following Portfolio Management Processes steps in the appropriate order:

A. Prepare policy statement, examine economic conditions, construct the portfolio, monitor and update investor needs.
B. Examine economic conditions, construct the portfolio, prepare the policy statement, and gather feedback.
C. Prepare policy statement, construct the portfolio, monitor investor needs, and examine economic conditions.

Correct Answer: A

The first step requires a development of the policy statement, followed by a close examination of current and projected financial economic, political and social conditions. The third step implements the plan by constructing the portfolio and then afterwards, monitoring and updating is conducted through a feedback loop.

Practice Question 3

Key steps in the dynamic process of portfolio management are:

I. Specification of investor objectives, constraints, and preferences.
II. Asset allocation, portfolio optimization, security selection, implementation, and execution.
III. Determination of capital market expectations.
IV. Measurement of portfolio performance.

The order of these steps in the process is:

A. I, II, III, IV.
B. I, III, II, IV.
C. I, IV, III, II.

Correct Answer: B


Study notes from a previous year's CFA exam:

b. describe the steps of the portfolio management process and the components of those steps;