Portfolio Management Notes

Portfolio
Management: An
Overview
Reading 41
IFT Notes for the 2015 Level 1 CFA exam
Portfolio Management: An Overview
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Contents
1. Introduction ................................................................................................................................. 3
2. A Portfolio Perspective on Investing .......................................................................................... 3
3. Investment Clients ...................................................................................................................... 5
4. Steps in the Portfolio Management Process................................................................................ 7
5. Pooled Investments ..................................................................................................................... 8
Appendix ....................................................................................................................................... 16
Summary ....................................................................................................................................... 17
Next Steps ..................................................................................................................................... 17
This document should be read in conjunction with the corresponding reading in the 2015 Level I
CFA Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality
of the products or services offered by Irfanullah Financial Training. CFA Institute, CFA, and
Chartered Financial Analyst are trademarks owned by CFA Institute.
Copyright Irfanullah Financial Training. All rights reserved.
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1. Introduction
In this reading, we will see the importance of portfolio approach to investing, the different types
of investors and their financial needs, steps in the portfolio management process and different
types of pooled investments like mutual funds.
2. A Portfolio Perspective on Investing

What is portfolio approach?
Portfolio approach means evaluating individual investments by their contribution to risk and return
of an investors portfolio. Assume an investors portfolio has three stocks A, B, and C. He is
evaluating whether to add another stock D to the portfolio or not. In a portfolio approach, the
investor will analyze what will happen to the risk and return of the portfolio with and without stock
D; whereas, in an isolated approach, he will only look at the merits (risk/return) of the stock.
2.1 Portfolio Diversification

Diversification helps investors avoid disastrous outcomes. The curriculum cites the example of
many Enron employees who held all of their retirement funds in Enron shares. When the Enron
share tumbled from $90 to zero between January 2001 and 2002, it completely ruined their
financial wealth; this emphasizes the need to diversify ones portfolio. Instead, if the Enron
employees had held shares of other companies or other products, the consequence would not have
been as bad.
Diversification also helps investors reduce risk without compromising their expected rate of return.
A simple measure of diversification risk is the diversification ratio. Lets take the example of the
same portfolio consisting of three stocks: A, B and C with each stock belonging to a different
industry. There is a high probability that the movements of A, B, and C are not correlated with
each other i.e. when A moves up, B may move down or C may move down. The benefit of
diversification is that the movements of individual stocks cancel each other out to some extent.
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If the amount invested in each of these three shares were the same, then it is an equally weighted
portfolio. The returns on the equally weighted portfolio are just the average returns of the
individual shares.
Equation 1:
Diversification ratio =
risk of equally weighted portfolio of n securities

risk of single security selected at random
Lower the ratio, better is the diversification
Now, if we use standard deviation of returns as a measure of risk, will the standard deviation of
the portfolio be the average of the standard deviation of the individual shares? Assume the standard
deviation of each of the stocks is 20%. But, the standard deviation of the portfolio is 15% and not
20%. The standard deviation of returns of an equally weighted portfolio is lower than the average
of the individual standard deviations due to diversification. In this case, the diversification ratio is
15/20 = 0.75 = 75%. This means that the equally weighted portfolios standard deviation is 75
percent of one of the three stocks selected at random. A lower value for diversification ratio is
better as benefits from risk reduction are higher.
2.2 Composition Matters for the Risk-Return Trade-Off

This concept is addressed in detail in the next reading. We will look at it briefly here. Assume
there are two portfolios with stocks A, B and C. The table below shows two portfolios with
different compositions of A, B and C.
Two portfolios with same stocks but different compositions

Weight of each stock
Portfolio
Stock A
Stock B
Stock C
Expected
Standard
Return
Deviation
Portfolio 1
33%
33%
33%
11%
13.1%
Portfolio 2
50%
25%
25%
11%
14%
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As you can see both the portfolios have the same expected return, but portfolio 1 has a better riskreturn trade-off than portfolio 2 as the risk assumed is lower for the same return.
2.3 Portfolios do not provide guaranteed downside protection

The underlying concept here is that although portfolio diversification reduces risk, the level of risk
reduction is not the same at times of financial crises. In recent times, the degree to which individual
markets tend to move together has increased. For example, following the Euro credit crisis that
began in 2010, most world markets experienced a significant downturn in 2011-2012. Their
movements were highly correlated on a daily basis and even diversification offered minimal
downside protection. The benefits of risk reduction from diversification are best seen under normal
market conditions.
3. Investment Clients
At a high level investors can be categorized as individual investors and institutional investors. A
simplified version of the investment motives of individual investors are presented below:
One avenue of saving for retirement for individuals is the defined contribution (DC) plan. In a DC
plan the contribution amount is defined. Part of the amount is contributed by employees and part
by the employer. The investment risk and responsibility to ensure there are enough funds for a
regular income in retirement is borne by the employee. Example: 401(k) plan in the United States.
There are several types of institutional investors:
Defined Benefit pension plan: obligation to pay a specified amount to employees in

retirement (future benefit)
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University endowments: provide financial support to university and students
Charitable foundations: manage funds to meet foundations objectives
Banks: accept deposits, give loans, and invest excess reserves
Insurance Companies: receive premiums for policies written. Invest premiums to earn a
return and pay claims
Investment Companies: companies that manage mutual funds
Sovereign wealth funds: large government-owned investment funds. Ex: $627 billion Abu
Dhabi Investment authority
Exhibit 14 in the curriculum covers the investment needs by client type. A snapshot of this exhibit
is given below:
Time Horizon
Risk Tolerance
Income Needs
Liquidity Needs
Individual
Depends on time
Depends on the
Depends on the
Depends on the
Investors
left for goal
ability and
amount of the
need for extra
willingness to take
income that a
funds
risk; generally if
client needs from
time horizon is
the investment
long the risk

tolerance is low
DB pension
Generally long
High risk
High if pension
plans
term but depends
tolerance if time
benefits are to be
on the amount of
horizon is long
paid immediately
time left for
term
(mature funds);
Endowments
employees to
low for growing
retire
funds
Very long term
High
Typically low
commitments
and foundations
Banks
Meet spending
Low
Short
Low
Low (pay interest
High (repayment
on deposits)
of deposits)
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Insurance
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Time Horizon
Risk Tolerance
Income Needs
Liquidity Needs
Short
Low
Low
High (to meet

claims)
Companies
(P&C)
Insurance
Long
Low-despite a
Companies
long time horizon,
(Life)
the reason for low
Low
High
Varies by fund
High to meet
risk tolerance is
the high liquidity
need
Investment
Varies by fund
Varies by fund
Companies
redemptions
Note: One easy way to remember is that generally if the time horizon is long, then the risk tolerance
is high. In the case of institutional investors, liquidity needs are low only for DB plans, endowments
and foundations.
4. Steps in the Portfolio Management Process

The three steps in the portfolio management process are: planning, execution and feedback.
1. The Planning Step: In this step, the portfolio manager needs to understand a clients needs
and develop an investment policy statement (IPS). IPS is a written document that states the
clients objectives and constraints. Objectives are return and risk objectives which may be
stated in absolute terms or relative terms. Constraints may include liquidity, unique
circumstances, time horizon, legal, and taxes.
2. The Execution Step: Based on the IPS, a portfolio is constructed in this step. Under
execution, the first activity is asset allocation. Here the portfolio manager decides what
asset classes must be included in the clients portfolio and in what proportion. Stocks,
bonds and alternative investments are examples of different asset classes. As an example,
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a clients asset allocation may consist of 60% equities, 30% fixed-income securities and
10% alternative investments.
Asset allocation is followed by security section which is the analysis and selection of
individual securities. In other words, the specific securities to be purchased are identified.
For example, if 60% is allocated to equities, the analyst will identify what specific stocks
to purchase.
Once the securities are selected they are purchased through a broker or dealer. This is called
portfolio construction.
3. The Feedback Step: A portfolio managers responsibility does not end with constructing
a portfolio. The portfolio also needs to be monitored and rebalanced at regular intervals.
For example, if the stock market performs very well in a particular period, the asset
allocation drifts away from the intended levels. In this case the portfolio needs to be
rebalanced. The frequency at which performance is measured is pre-decided for instance,
it could be on a monthly or quarterly basis.
The feedback step also involves performance measurement and reporting. Analysis must
include how the portfolio performed over time, were the objectives met, what assets
attributed to the good/poor performance, how the portfolio performed against the
benchmark, and so on.
5. Pooled Investments
Pooled investments are where money is collected from several individual investors to be invested
in a large portfolio. As the name implies, it is pooling money together for an investment. The funds
where this collected money is invested could range from mutual funds to private equity depending
on the risk, capital required, strategy, and how it is managed. The different types of investment
products are listed on the following page.
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Investment Products by Minimum Investment

Investment Product
Minimum Investment
Mutual Funds
$50 +
Exchange Traded Funds (ETFs)
$50 +
Separately Managed Accounts
$100,000 +
Hedge Funds
$1,000,000 +
Private Equity Funds
$1,000,000 +
In the rest of this section we understand what a mutual fund is, the different types of mutual funds
and how the other investment products are different from mutual funds.
5.1 Mutual Funds

What is a mutual fund? A mutual fund is a comingled investment pool in which each investor
has a pro-rata claim on the income and value of the fund.
Consider the following example: An investment firms raises $100,000 for a stock-based mutual
fund from five investors and issues 10,000 shares. Each share has a value of $10. There are three
individual investors and two institutional investors. The number of shares is based on the amount
invested relative to the total amount.
Investor
Amount Invested
% of Total
Number of Shares
John
4,000
4%
400
Jill
6,000
6%
600
Joe
10,000
10%
1,000
Jones Co.
50,000
50%
5,000
Widget Co.
30,000
30%
3,000
Assume the $100,000 is invested in various stocks and it grows to $150,000. The value of each
share goes up by 50% to $15. The advantage of this structure is that the investment firm can have
one or two managers managing this entire pool of money and each individual investor need not
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hire a manager to manage his relatively small amount of money. This is a cost effective way of
managing money.
5.2 More on Mutual Funds

In the context of mutual funds it is important to understand the following terms:
Net asset value: Net asset value = value of assets liabilities. The value of a mutual fund
is called the net asset value. It is calculated on a daily basis based on the closing price of
the stocks held in the funds portfolio. The NAV per share is calculate as: NAV/number
of total shares. The NAV per share in our previous example was 100,000/10,000 = $10 per
share
Open-end fund: A mutual fund with no restrictions on when new shares can be issued or
when funds can be withdrawn. The fund accepts new investment money and issues
additional shares at a price equal to the net asset value at the time of investment. Similarly,
when an investor redeems shares, the fund sells the underlying assets/securities to retire so
many shares at the current net asset value. Because of this, an open-end fund trades close
to NAV. NAV is based on closing prices. They can be bought/sold only once during the
day. They are also called evergreen funds.
Closed-end fund: Unlike open-ended fund, in a closed-end fund, no new investment

money is accepted. A new investor may invest in the fund if an existing investor is willing
to sell his shares. So, the outstanding shares stay the same. Since there is no liquidation of
underlying assets and the share base is unchanged, the NAV may trade either at a premium
or discount to net asset value based on the demand for shares. The units issued by closedend funds trade like regular shares they can be bought or sold on margin, shorted etc.
No-load fund: Most mutual funds have an annual fee for managing the fund, which is a
percentage of the funds net asset value. In a no-load fund, only an annual fee is charged
but there is no fee for investing or redemption.
Load fund, a percentage is charged for investing and redemption (called entry and exit
load) in addition to the annual fee.
Funds can be categorized based on types of assets they invest in:

- Money market taxable or non-taxable
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- Bond mutual funds taxable or non-taxable

- Stock mutual funds domestic or international
- Index funds
- Hybrid/balanced funds
Funds can be categorized as actively management or passively managed

- With actively managed funds the manager tries to identify securities which will
outperform the market; these funds have high fees relative to passively managed
funds
- With passively managed funds the manager purchases the same securities as a
benchmark index. This helps ensure that the performance of the fund is similar to
the performance of the benchmark.
5.3 Exchange Traded Funds

Like mutual funds, ETFs are a pooled investment vehicle, often based on an index. With index
mutual funds, investors buy shares directly from the fund. With ETFs, investors buy shares from
other investors.
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The diagram above gives a snapshot of how ETFs work. A fund manager creates the ETF by
determining what assets the ETF will hold. Once the securities are decided, the fund sponsor
contacts an institutional investor who owns those securities. The institutional investor deposits the
basket of securities with the fund sponsor (held through a custodian), and in return, receives
creation units for the deposited securities. The creation units typically represent 50,000 to100, 000
ETF shares.
It is important to note that the weight of securities deposited is often in the proportion of what it is
trying to represent. For example, the weight of Athena Health in iShares Russell 2000 Growth
Index Fund is 0.61%, and it is roughly the same as in Russell 2000 Growth Index. The
institutional investor then sells the creation units as ETF shares to the public; investors buy shares
from other investors, so it works like a closed mutual fund. The institutional investor may redeem
the original securities by returning the ETF creation units.
How ETFs are Similar to Mutual Funds

ETFs combine features of close-end and open-end funds:
Trade like closed-end mutual funds; can be shorted and bought on margin.
Because of unique redemption procedure, their prices are close to net asset value like openend funds.
Expenses tend to be low relative to mutual funds but brokerage fee needs to be paid.
Unlike mutual funds, ETFs do not have capital gains distributions.
Types of ETFs
Exhibit 23 in the curriculum lists these major types of ETFs traded based on the asset class:
Broad-based equity: large-cap, mid-cap
Sector: commodities, real estate, natural resources, technology, utilities, gold etc.
Global: global, international, regional, emerging markets, single country
Hybrid
Bond: government, municipal, corporate, and international
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Differences between Index Mutual Funds and ETFs
How shares are bought
Short sales and margin
Index Mutual Funds
Index ETFs
Investors buy shares directly from
Investors buy shares from other
the fund
investors (like in closed-end fund)
Generally not possible
Can be shorted or bought on margin
A little higher than ETFs
Expenses are lower than mutual
trading
Expenses
funds. There is a brokerage cost on

every transaction unlike mutual
funds.
Purchases and redemptions once
Trading takes place throughout the
at the close of business at the
day like shares at the prevailing
same price.
market price.
Dividends
Dividends are usually reinvested
Dividends paid to shareholders
Minimum investment
Usually higher than ETFs
Usually much smaller than mutual
Trading
funds
Mutual funds generate more
Taxes
Beneficial from a tax perspective
taxable capital gains because of

money flowing into and out of
funds. There is a capital gain
because of liquidation of assets to
meet redemptions on which taxes
are paid.
5.4 Other Pooled Investments

Separately Managed Accounts
A separately managed account is an investment portfolio managed privately for an

individual or institution by a brokerage firm or individual investment professional
(financial advisor).
The investment must be substantial to qualify as a separately managed account, usually

between $100,000 and $500,000.
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The advantage is that the portfolio is managed exclusively to meet the clients needs with
respect to objectives, risk tolerance, and constraints.
Also called managed account, wrap account and individually managed account.
How SMA differs from a mutual fund:
In a SMA, the investor owns the individual underlying share whereas in a mutual fund, the
investor owns a unit/share in a pool of underlying securities which are owned by the mutual
fund.
Since the investor owns the shares, he has more control over when the securities are bought
and sold, and their timing.
Tax implications are considered when buying or selling as it meets the specific needs of
the investor.
Hedge Funds
Started out as a hedge against long-only stock positions i.e. creating a portfolio of short
positions to offset the long positions in stocks. The industry has grown considerably since
the 1940s and now encompasses several strategies.
They tend to use high leverage which leads to high risk.
Most hedge funds are exempt from reporting requirements of a typical public investment
company. For instance, in U.S. they do not have to register with SEC if there are 100 or
less investors.
The curriculum lists a few strategies used by hedge funds. These are discussed in detail at
Level III.
Note: Though not highly testable, you may go through the strategies once without getting into the
details.
Name of Strategy
What does the strategy involve
Convertible arbitrage
Buy convertible bonds that can converted in to shares while

simultaneously selling stocks short.
Dedicated short bias
More short positions than long positions.
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Name of Strategy
What does the strategy involve
Emerging markets
Purchasing sovereign or corporate securities of companies in

emerging markets.
Equity market neutral
Eliminates effect of market movement by going long on

undervalued securities and short on overvalued securities.
Event Driven
Taking advantage of company specific events like earnings

announcements, or one-time events like a merger announcement,
or FDA approval for a drug.
Fixed-Income Arbitrage
Trading on price differences in interest-rate securities.
Global Macro
Trading on global economies using derivatives on currencies or

interest rates.
Long/Short
Going long on equities expected to perform well and short on

equities expected to underperform. The difference from equity
market neutral strategy is that it tries to profit from market
movements.
Buyout Funds and Venture Capital funds are collectively referred to as Private Equity
As the name implies, these are privately held and actively managed equity positions. With
a private equity investment, a firm makes an investment in a company and then is actively
involved in the management of that company.
The equity they hold is private and not traded in public markets. The intention is to exit out
of the investment in a few years.
Buyout Funds
- Make a few large investments in established private companies with the goal of
increasing cash flow. Idea is to buy public companies, make them private,
restructure and then sell it or take it public.
- In leveraged buyout, the level of debt is high (75%) which is paid off by the cash
flows generated from the restructured companys operations.
- Finite investment horizon: usually three to five years through IPO or sale to another
company.
- Buyout(s) make a few large investments.
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Venture Capital Funds

- VC funds make small investments in startup companies unlike buyout funds that
invest in established companies.
- Finite investment horizon: usually three to five years.
- Active participation in the invested business providing advice; closely monitor the
operations.
- Make several small investments as the belief is that a small number will succeed.
Appendix
This reading introduces the following terms which a Level I candidate should be familiar with:
top-down analysis, bottom-up analysis, bottom-up analysis, buy-side firms and sell-side firms.
Top-down analysis: While doing asset allocation, analysts may select securities either based on
top-down analysis or bottom-up analysis. In a top-down analysis, macroeconomic conditions (for
different countries) are analyzed first followed by industry and markets, and then specific
companies within the industry. For example, consider this top-down analysis in early 2010.
Analysts may have forecasted the Australian economy to grow above a certain rate, the mining
industry to do particularly well in Australia, and within mining selected Rio Tinto plc.
Bottom-up: In a bottom-up analysis, the focus is exclusively on the company-specific

circumstances, and not from an economy or industry perspective.
Buy-side firms: Investment management companies like mutual funds that use the services of
sell-side firms.
Sell-side firms: A broker or dealer that sells securities to and provides investment research and
recommendations to investment management companies.
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Summary
Note: This summary has been adapted from the CFA Program curriculum.
In this reading we have discussed how a portfolio approach to investing could be preferable to
simply investing in individual securities.
The problem with focusing on individual securities is that this approach may lead to the
investor putting all her eggs in one basket.
Portfolios provide important diversification benefits, allowing risk to be reduced without

necessarily affecting or compromising return.
We have outlined the differing investment needs of various types of individual and
institutional investors. Institutional clients include defined benefit pension plans,
endowments and foundations, banks, insurance companies, investment companies, and
sovereign wealth funds.
Understanding the needs of your client and creating an investment policy statement represent
the first steps of the portfolio management process. Those steps are followed by security
analysis, portfolio construction, monitoring, and performance measurement stages.
We also discussed the different types of investment products that investors can use to create
their portfolio. These range from mutual funds, to exchange traded funds, to hedge funds, to
private equity funds.
Next Steps
Solve the practice problems in the curriculum.
Solve the IFT Practice Questions associated with this reading.
Review the learning outcomes presented in the curriculum. Make sure that you can perform
the implied actions.
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Portfolio

IFT Notes for the 2015 Level 1 CFA exam

Portfolio Management: An Overview

Copyright Irfanullah Financial Training. All rights reserved.

Portfolio Management: An Overview

2. A Portfolio Perspective on Investing

2.1 Portfolio Diversification

Copyright Irfanullah Financial Training. All rights reserved.

Portfolio Management: An Overview

risk of equally weighted portfolio of n securities

Lower the ratio, better is the diversification

2.2 Composition Matters for the Risk-Return Trade-Off

Two portfolios with same stocks but different compositions

Copyright Irfanullah Financial Training. All rights reserved.

Portfolio Management: An Overview

2.3 Portfolios do not provide guaranteed downside protection

There are several types of institutional investors:

Defined Benefit pension plan: obligation to pay a specified amount to employees in

Copyright Irfanullah Financial Training. All rights reserved.

Portfolio Management: An Overview

University endowments: provide financial support to university and students

Charitable foundations: manage funds to meet foundations objectives

Banks: accept deposits, give loans, and invest excess reserves

Investment Companies: companies that manage mutual funds

left for goal

need for extra

client needs from

long the risk

term but depends

time left for

low for growing

Very long term

Copyright Irfanullah Financial Training. All rights reserved.

Low (pay interest

Portfolio Management: An Overview

High (to meet

long time horizon,

the reason for low

4. Steps in the Portfolio Management Process

Copyright Irfanullah Financial Training. All rights reserved.

Portfolio Management: An Overview

Copyright Irfanullah Financial Training. All rights reserved.

Portfolio Management: An Overview

Investment Products by Minimum Investment

Exchange Traded Funds (ETFs)

Separately Managed Accounts

Private Equity Funds

5.1 Mutual Funds

Portfolio Management: An Overview

5.2 More on Mutual Funds

Closed-end fund: Unlike open-ended fund, in a closed-end fund, no new investment

Funds can be categorized based on types of assets they invest in:

Copyright Irfanullah Financial Training. All rights reserved.

Portfolio Management: An Overview

- Bond mutual funds taxable or non-taxable

Funds can be categorized as actively management or passively managed

5.3 Exchange Traded Funds

Copyright Irfanullah Financial Training. All rights reserved.

Portfolio Management: An Overview

How ETFs are Similar to Mutual Funds

Unlike mutual funds, ETFs do not have capital gains distributions.

Broad-based equity: large-cap, mid-cap

Global: global, international, regional, emerging markets, single country