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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.
- Creating the investment policy statement.
- Forming capital market expectations.
- Creating the strategic asset allocation.
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.
- Changes in investor circumstance.
- Changes in economic and market input factors.
- Changes in asset prices.
- Performance evaluation.
Practice Question 1Which 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 2Rank 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 3Key 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;