Portfolios, Pros, Performance

Constructing a balanced portfolio involves putting together many concepts such as portfolio theory, macro research industry analysis and issue selection. It takes years of experience to get it right. Our Portfolios, Pros, Performance discussion breaks down how the investment industry approaches these concepts.

On this page we will talk about various ways to put these portfolios together. Also, we will discuss about the industry of professionals who do it day in and day our. Finally, we will talk about how we can see how well a portfolio does.

Portfolio Management

The key decision in investing is the asset allocation decision as it relates to your goals. Generally, the mix remains fixed and only changes when your needs change. There should be no attempt to time the market.

Passive management attempts to achieve the track record of an index. Active management sets a goal to earn a total return which exceeds the return of a benchmark index. There is no middle ground.

In this section, discuss the merits of passive versus active approaches to managing portfolios.Then, we will touch on style attribution. And finally, we will wind about with asset allocations strategies.

Passive Management

The mission is to construct a set of assets which closely tracks the benchmark and meets your needs and goals.The challenges include keeping up with index changes and mergers and re-balancing cash flows.

Passive Techniques
  • Replication– all assets in index purchased
  • Sampling– statistics used to hold smaller number of issues which mirror track record
  • Quadratic Optimization– past info on price and inside links used to construct a model

Choosing the correct index is key if you have unique needs.

Active Management

As with passive, choosing the benchmark to beat is key to reaching your goals. The challenge includes working with higher costs and dealing with higher risk.

We have to be consistent in our area of expertise. To meet success we must maintain our philosophy and keep calm while the other guy does not. Low trading levels keep the costs down.

Active Themes
  • Equity Market Timing- between asset classes
  • Sector and Industry Rotation– catch the next hot trend before the herd does
  • Stock-picking- finding cheap stocks

Momentum plans work when the market rewards the firms with steady, above average growth. The intro of computer programs makes discerning these trend easier.

Value versus Growth

Value and growth approaches focus on tangent aspects of the earnings per share segments. A value player compares the intrinsic value to the market value while the growth guy looks for above average growth in earnings.

Value Focus
  • Looks at the price
  • Not worried about current earnings or seeing how the firm ticks
  • Assumes PE is below normal level and market will soon correct
Growth Focus
  • looks at earnings pieces and its econ factors
  • looks for firms with rapid earnings growth
  • assumes PE will remain constant over near term

Grouping the stocks is not straight forward. Detailed firm value models are time-consuming so we rely more on easily found measures such as PE or price to book.

Style Analysis

Looking a style is an attempt to explain the risk in observed returns in terms of a stock’s traits. The goal is to better feel for the way and factors the firm turns it profits.

A simple style grid groups track records among two factors such as firm size and value/growth. Studying these traits makes it easier to choose the right benchmarks.

Style Benchmark Approaches
  • Sharpe- uses combos of asset classes, firm size and foreign exposure
  • BARRA- many stock traits such as past success, trading volume, labor vs. machines and firm size
  • Ibbotson– simple models use asset class, firm size and value/growth

An optimal combo of indexes decides whether a manager has been true to their style. You should be cautious with a manager whose record shows style drift.

Asset Allocation

The stock holdings are part of a balanced holdings. The balanced holdings also contain  fixed income and cash. The manager chooses the proper mix of asset classes in the entire account after a review of the market outlook.

Allocation Strategies
  • Integrated– forms an outlook for future markets and reviews your goals and needs
  • Strategic– sets the long-term asset weights without your feedback loop
  • Tactical- adjusts the asset class mix on the run,while watching changing markets
  • Insured– assumes returns are constant over time while your needs and goals change as wealth level changes

The choice of strategy depends on the needed changes in your goals and needs as well as the link between past and future markets.

Pro Asset Management

Using a pro money manager entails setting up a private account with an advisor or buying shares of an ETF or mutual fund.

In this section, we will go over the structure of professional asset management. Then, we will talk about the various it is presented. AT the end we will cover the ethics of the industry and who is charged to regulate it.

Structure and Evolution

In its most straight forward form, you and big firms can make contracts directly with an advisor for its service. This service can range from handling standard banking chores to advising you on building your own account to actively managing your funds.

A second approach involves the mixing funds from many clients. An investment firm invests pools of funds owned by many clients in a single account.

Advisor firms form a close link with you, getting to know your goals and needs. Conversely, MFs or ETFs mainly form a fund plan and markets it to you without taking stock of your needs..

Investment Companies

They mainly are a corporation which has as its major assets the asset holdings referred to as a fund. A n outside firm is hired by the board of the fund to manage the holdings and handle most of the other admin.

A closed-end fund runs like any other public firm. It shares trade on the normal market.  Supply and demand fixes the market price .

Open-ended funds, or MFs, continue to sell and buy shares after their IPO. They stand ready to sell more shares of the fund at the net asset value (NAV), with or without a sales charge, or to buy back shares of the fund at the NAV.

Types of Funds
  • Common stock– solely common stocks
  • Balanced– stocks and bonds
  • Bonds– Bonds only
  • Money market- short-term assets

The method of sale and goals segments the funds. Foreign funds tend to be closed-ended, not needed to be liquid. This feature requires the sale of stocks in the holdings on an illiquid foreign stock exchange.

Ethics and Regs

The issue of ethics arises anytime one person is hired to perform a service to look after the interest of another person. Therefore, the investment industry is highly regulated which ensures a base level of good practice.

The main goal of regulations ensures firms keep good records. Account info is reported to you in a fair and timely manner.

Principal Security Laws
  • Investment Company Act of 1940– regulates the structure and ops of MFs
  • Securities Act of 1933- requires fed registration of all public offerings
  • Securities Exchange Act of 1934– regulates broker/dealers and requires them to register with the SEC
  • investment Advisers Act of 1940– requires fed registration of all advisors to MFs

A fee based on assets under management rewards advisors. But, they have a reason to reach for risky returns. With soft dollars, a manager commits you to pay a broker commission higher than the simple cost of executing a trade. In exchange, the manager receives added bundled service.

Portfolio Performance

It is both costly and time-consuming to review and select assets in an account.  You or the big firm should decide whether this effort is worth the time and money. It’s key to decide whether the track record covers the cost.

The two major requirements of an advisor are the skill to get above-average returns for a given risk level and to spread the risk to control all unsystematic risk.

In this section, we will go over the measures used to judge the performance of portfolios. Then, we will get into the skills needed to do a good job.Finally, we will go over the requirements for reporting performance.

Performance Measures

At one time, investors judged the track record on the basis of rate of return. Modern concepts have led to measuring risk by grouping accounts into to similar risk classes and comparing rates of return.

Composite Performance Measures
  • Treynor– defines the link between the rates of return for an account over time and the rates of return for the market
  • Sharpe– seeks to measure the total risk of the account by including the SD; rather than counting only the systematic risk
  • Jensen– concerns with the time series of returns for the asset and index for a few time frames
  • Information Ratio– measures the average return in excess of the benchmark return divided by the SD

The accounts should be reviewed and each of the part looked at: return, risk, and measure of diversification. It is expected the best track record is the account with low diversification because they are trying to beat the market by being unique in their picks and timing.

Performance Attributes

Advisors can add value by either picking good stocks or showing good market timing skills by allocating funds to different asset classes or market segments. Attribution analysis attempts to figure out which of these factors is the source of the account’s overall track record.

It compares the total return to the manager’s actual holdings to the return for a benchmark index and breaks down the difference into an allocation effect and a picking effect.

Good timing skill is therefore a matter of putting more money in those market segments which end up yielding greater than average returns. The selection effect measures the manager’s skill to form specific market segment holdings which get good returns relative to the way in which the same market segment holdings are defined by the benchmark index weighted by the actual manager’s segment mix.

Performance Reporting

The returns upon which the performance measures are based must be reported to the investor. The returns for the portfolio must take into consideration contributions, fees and withdrawals of cash during the investment period. Performance presentation standards have been proscribed by the CFA Institute.

The cash flows and returns are computed on a daily basis. These daily returns are then geometrically linked for weekly, monthly, annual and multiple year periods.

Presentation Standard Goals
  • achieve uniformity and compatibility among presentations
  • improve the service offered to clients
  • enhance the professionalism of the industry
  • bolster the notion of self-regulation

Introduced in 1993, the CFA Institute’s Global invest presentation Standards (GIPS) has become the accepted practice within the investment community.

Presentation Principles
  • Total return used when calculating performance
  • Time-weighted returns used
  • Accounts are valued daily and periodic returns are geometrically linked
  • Composite track record contains actual fee-paying accounts including terminated accounts
  • Performance calculated after the deduction of trading costs
  • Taxes on income and realized capital gains recognized in the same period
  • Annual returns for all years presented
  • Track record is disclosed on a  gross or net of fees

Also, it is encouraged to disclose the volatility of the aggregate return and identify benchmarks which parallel the risk or investment style the composite is expected to track.

On this page, we talked about various ways to put these portfolios together. Also, we discussed the industry of professionals who do it day in and day our. Finally, we talked about how we can see how well a portfolio does.

Portfolios, Pros, Performance

Advanced Topics