This document discusses the key steps and concepts in portfolio management, including: 1) Identifying investment objectives like risk tolerance and return targets as well as constraints like time horizon and liquidity needs through creating an investment policy statement. 2) Developing strategic asset allocation by considering capital market expectations and the investment policy statement. 3) Implementing the portfolio through selection of specific assets and ongoing monitoring including performance evaluation and rebalancing.

1. Chapter 1
The Portfolio Management Process – Overview
 Major learning objectives: To understand
1. the importance of the portfolio perspective
2. the steps of the portfolio management process
3. the types of investment objectives
4. the types of investment constraints
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2. Specific Learning Outcomes
 The role of the investment policy statement in the portfolio
management process
 The client’s
 risk objective
 return objective
 time horizon, liquidity and other constraints
 Passive, active and semi-active approaches to investing
 The role of capital market expectations in the portfolio
management process
 The role of strategic asset allocation in the portfolio
management process
 Portfolio implementation in the portfolio management process
 The role of performance evaluation
 The purpose of monitoring and rebalancing
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3. 1. The Importance of the Portfolio
Perspective
 Asset returns are correlated. Analyzing assets in isolation
ignores the interrelationships among assets → can lead to
misunderstanding of the risk and return prospects for the
investor’s total position
 Idea dates back to Markowitz
 Avoid the behavioural bias of mental accounting
 Should care about overall portfolio’s risk and return, tax
efficiency, liquidity … etc.
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4. 2. Steps in the Portfolio Management
Process
 Planning
 Identify and specify the investor’s objectives and
constraints
 Create the investment policy statement (IPS)
 Form capital market expectations
 Create the strategic asset allocation
 Execution
 Select specific assets and implement decisions
 Determine need for tactical asset allocation
 Feedback
 Monitoring and rebalancing
 Performance evaluation
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5. Planning: Types of Investment
Objectives
 Risk objective
 How to measure? Volatility, tracking error, downside risk?
 Investor appetite for risk
 Investor ability to take risk – spending needs, wealth
targets, obligations, ability to increase savings
 How much risk is investor both willing and able to bear?
 Specific risk objective
 How should risk be allocated to specific investments?
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6. Planning: Types of Investment
Objectives
 Return objective
 How to measure return – total return, nominal, real, pre-
tax or after-tax?
 Return desired – is it realistic and consistent with risk
objective?
 Return needed – Specific objectives for ending wealth
require specific returns in order to be met.
 Specific return objective – incorporates above points into
measurable annual return objective that could be
absolute (i.e. 10%) or relative (i.e. greater than inflation
or a benchmark return.)
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7. Planning: Investment Policy
Statement (IPS)
 Outlines investor objectives and constraints, as well as
manager requirements for reporting, rebalancing, fees,
investment strategy and style, performance benchmarks
 Ensures that all future investment decisions are consistent
with outlined objectives and constraints
 In Canada, it is called the Statement of Investment Policies
and Procedures (SIP&P)
 Required by law for pension plans in most jurisdictions
 Examples: York University’s pension fund SIP&P
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8. Planning: Approaches to Investing
 Passive approach does not react to changes in capital market
expectations
 Indexing – holds a portfolio designed to replicate the return of a
benchmark index
 Strict buy and hold
 Active approach responds to changing conditions
 Holdings differ from benchmark according to management’s
assessment of each holding
 Goal is to produce excess return (alpha) relative to the benchmark
 Semi-active, risk-controlled active or enhanced index
approach seeks positive alpha while tightly controlling risk
factors
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9. Planning: Capital Market
Expectations
 Managers should form long-term forecasts of the risk
and return characteristics of asset classes
 Forms the basis for choosing portfolios that minimize
risk relative to return or maximize return relative to risk
 Influences asset allocation strategy and frequency of
rebalancing
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10. Planning: Strategic Asset Allocation
 Optimal asset mix for a specific investor/plan
 Combine IPS with capital market expectations to
determine target weight for each asset class (possibly
maximum and minimum weight range)
 Single period perspective simplest
 Multiple period perspective (dynamic asset allocation),
taking into account say, serial correlations in returns
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11. Execution: Portfolio Selection,
Composition and Implementation
 Portfolio Selection/Composition Decision
 Managers initiate portfolio decisions based on analysts’
input
 May involve a quantitative optimization process
 Portfolio Implementation Decision
 Trading desk implements decision
 Must incorporate transaction costs, including explicit
(commissions, fees and taxes) and implicit costs (bid-ask
spread, market impact, and opportunity costs when orders
are unable to be filled or are filled slowly)
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12. Monitoring: Elements of
Performance Evaluation
 Performance evaluation is needed to monitor investor
progress toward goals and measure manager skill
 Skill assessment has three components
 Performance measurement – rate of return
 Performance attribution – sources of return include
strategic allocation (asset mix), sector and security
selection
 Performance appraisal – to benchmark returns
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13. Monitoring: Rebalancing Portfolios
 Changes in investor circumstances or in market and
economic conditions provide feedback to the portfolio
management process
 Changing economic and market conditions cause assets
to drift away from target weight and necessitate
rebalancing portfolio to ensure client objectives and
constraints remain satisfied
 Issues with rebalancing: Frequency, timing, capital
gains/losses
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14. Further Discussion: Formulating a Risk
Objective
 Risk objective will largely determine the return objective
(no free lunch plans)
 How to measure risk?
 Variance, Standard deviation
 Tracking error relative to benchmark
 Downside risk, Value at risk
 Investor’s ability to take risk
 How much volatility would inconvenience investor
 Wealth targets and achievability
 Liabilities
 Financial strength outside portfolio (income, ability to save)
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15. Further Discussion: Formulating a Risk
Objective
 Risk tolerance/aversion – how much is investor
both willing and able to bear
 May translate “low risk tolerance” into “loss in any
given year should not exceed x%” or “portfolio
standard deviation of x%”.
 Risk budgeting – how should the desired level of
risk be allocated among various assets?
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16. Further Discussion: Formulating an
Investment Return Objective
 Must be consistent with risk objective
 How to measure?
 Total return
 Real or nominal
 Before or after tax
 How much is desired
 How much is required in order to meet objectives
 Specific objective – “average annual return in excess
of 5% after tax.”
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17. Further Discussion: Types of Investment
Constraints
 Liquidity requirements
 Investment time horizon
 Tax
 Legal/Regulatory
 Others
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18. Liquidity Requirements
 Liquidity requirements are needs for cash that exceed
contributions or savings
 Stem from liquidity events
 Planned – buying a house in 2 years
 Unplanned – house damaged in hurricane
 Requires allocation to assets that can be readily converted
into cash without impacting value
 May also be met using insurance or derivative strategies
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19. Investment Time Horizon
 Time period associated with investment objective –
short term or long-term (> 10 years)
 Affects ability to assume risk
 Can lead to different asset allocation
 Must consider investor tolerance for temporary risks
 Longer time horizon typically allows:
 higher risk tolerance → higher allocation to risky assets
 Target–date funds
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20. Other Constraints
 Tax
 Different tax rates applied to income/dividends/gains
 Tax advantaged savings vehicles
 Legal and Regulatory
 Limits on allocations to certain assets
 Limits on investments in tax-advantaged accounts
 Pension laws and acts (e.g., ERISA in the U.S.)
 Other considerations
 Social concerns → Socially Responsible Investing (SRI)
 (For individual investors: Health needs, dependents,
bequests, estate taxes … etc.)
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