Portfolio Management

Theory and Practice

Scott D. Stewart, Christopher D. Piros, Jeffrey C. Heisler

• Publisher: Wiley
• Year: 2019
• Print ISBN: 9781119397410
• eBook ISBN: 9781119397434
• Edition: 1
• Topic: Business
• Subtopic: Wealth Management
• Index: Business

A career's worth of portfolio management knowledge in one thorough, efficient guide

Portfolio Management is an authoritative guide for those who wish to manage money professionally. This invaluable resource presents effective portfolio management practices supported by their underlying theory, providing the tools and instruction required to meet investor objectives and deliver superior performance. Highlighting a practitioner's view of portfolio management, this guide offers real-world perspective on investment processes, portfolio decision making, and the business of managing money for real clients. Real world examples and detailed test cases—supported by sophisticated Excel templates and true client situations—illustrate real investment scenarios and provide insight into the factors separating success from failure. The book is an ideal textbook for courses in advanced investments, portfolio management or applied capital markets finance. It is also a useful tool for practitioners who seek hands-on learning of advanced portfolio techniques.

Managing other people's money is a challenging and ever-evolving business. Investment professionals must keep pace with the current market environment to effectively manage their client's assets while students require a foundation built on the most relevant, up-to-date information and techniques. This invaluable resource allows readers to:

• Learn and apply advanced multi-period portfolio methods to all major asset classes.
• Design, test, and implement investment processes.
• Win and keep client mandates.
• Grasp the theoretical foundations of major investment tools

Teaching and learning aids include:

• Easy-to-use Excel templates with immediately accessible tools.
• Accessible PowerPoint slides, sample exam and quiz questions and sample syllabi
• Video lectures

Proliferation of mathematics in economics, growing sophistication of investors, and rising competition in the industry requires advanced training of investment professionals. Portfolio Management provides expert guidance to this increasingly complex field, covering the important advancements in theory and intricacies of practice.

CHAPTER 1
Introduction

Chapter Outline

1. 1.1 Introduction to the Investment Industry
2. 1.2 What Is a Portfolio Manager?
3. 1.3 What Investment Problems Do Portfolio Managers Seek to Solve?
4. 1.4 Spectrum of Portfolio Managers
5. 1.5 Layout of This Book
   1. Problems
   2. Endnotes

1.1 INTRODUCTION TO THE INVESTMENT INDUSTRY

The investment business offers the potential for an exciting career. The stakes are high and the competition is keen. Investment firms are paid a management fee to invest other people's money and their clients expect expert care and superior performance. Managing other people's money is a serious endeavor. Individuals entrust their life savings and their dreams for attractive homes, their children's educations, and comfortable retirements. Foundations and endowments hand over responsibility for the assets that support their missions. Corporations delegate management of the funds that will pay future pension benefits for their employees. Successful managers and their clients enjoy very substantial financial rewards, but sustained poor performance can undermine the well-being of the client and leave the manager searching for a new career.

Many bright and hard-working people are attracted to this challenging industry. Since their competitors are working so hard, portfolio managers must always be at their best, and continue to improve their skills and knowledge base. For most portfolio managers, investing is a highly stimulating vocation, requiring constant learning and self-improvement. Clients are demanding, especially when results are disappointing. While considered a stressful job by many people, it is not unheard of for professionals to manage money into their eighties or nineties.¹

Portfolio management is becoming increasingly more sophisticated due to the ongoing advancement of theory and the growing complexity of practice, led by a number of trends, including:

1. Advances in modern portfolio theory.
2. More complex instruments.
3. Increased demands for performance.
4. Increased client sophistication.
5. Rising retirement costs, and the growing trend toward individual responsibility for those costs.
6. Dramatic growth in assets under management.

These trends parallel the growing use of mathematics in economics, the improvements in investment education of many savers, and the increasing competitiveness of the industry. Assets controlled by individual investors have grown rapidly. In 2016, just under half of all U.S. households owned stock, but fewer than 14 percent directly owned individual stocks.² By year-end 2017, U.S.-registered investment company assets under management had expanded to $22.5 trillion from $2.8 trillion in 1995, managed over 16,800 funds, and employed an estimated 178,000 people.³ The global money management business has grown in parallel. Exhibit 1.1 shows that worldwide assets under management have expanded over 2.5× from 2005 to 2017.

Source: Based on data from Pension & Investments.

EXHIBIT 1.1 Total Worldwide Assets Under Management

Portfolio management is based on three key variables: the objective for the investment plan, the initial principal of the investment, and the cumulative total return on that principal. The investment plan, or strategy, is tailored to provide a pattern of expected returns consistent with meeting investment objectives within acceptable levels of risk. This investment strategy should be formed by first evaluating the requirements of the client, including their willingness and ability to take risk, their cash-flow needs, and identifying any constraints, such as legal restrictions. Given the cash flow needs and acceptable expected risk-and-return outcomes, the allocation between broad asset classes is set in coordination with funding and spending policies. Once investment vehicles are selected and the plan is implemented, subsequent performance should be analyzed to determine the strategy's level of success. Ongoing review and adjustment of the portfolio is required to ensure that it continues to meet the client's objectives.

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THEORY IN PRACTICE: FAMOUS LAST WORDS—“IT'S DIFFERENT THIS TIME.”

The year 2008 was a terrible one for the markets. The S&P 500 fell nearly 40 percent, high-yield bonds declined over 25 percent, and in December Bernie Madoff admitted to what he claimed was a $50 billion Ponzi scheme. While these numbers are shocking, they are not unprecedented and the reasons behind them are not new. Security values can change drastically, sometimes with surprising speed. Declining values can be a response to peaking long-term market cycles, short-term economic shocks, or the idiosyncratic risk of an individual security.

Market cycles can take months or years to develop and resolve. The dot-com bubble lasted from 1995 to 2001. The March 2000 peak was followed by a 65+ percent multiyear decline in the NASDAQ index as once-lofty earnings growth forecasts failed to materialize. The S&P 500 dropped over 40 percent in 1973 and 1974 as the economy entered a period of stagflation following the boom of the 1960s and the shock of the OPEC oil embargo. Black Monday, October 19, 1987, saw global equity markets fall over 20 percent in the course of a single day. The collapse of Enron destroyed more than $2 billion in employee retirement assets and more than $60 billion in equity market value. While the true cost may never be known, economists at the Federal Reserve of Dallas conservatively estimate the cost of the 2007–09 financial crisis to the U.S. alone was $6–$14 trillion.⁴

Each of these examples had a different cause and a different time horizon, but in each case the potential portfolio losses were significant. To assist investors, this book outlines the basic—and not so basic—principles of sound portfolio management. These techniques should prepare the investor to weather market swings. The broad themes include:

• Creating and following an investment plan to help maintain discipline. Investors often appear driven by fear and greed. The aim should be to avoid panicking when markets sell off suddenly (1974, 1987) and risk missing the potential recovery, or overallocating to hot sectors (the dot-com bubble) or stocks (Enron) and being hurt when the market reverts.
• Focus on total return and not yield or cost.
• Establishing and following a proper risk management discipline. Diversification and rebalancing of positions help avoid outsized exposures to particular systematic or idiosyncratic risks. Performance measurement and attribution provide insight into the risks and the sources of return for an investment strategy.
• Not investing in what you do not understand. In addition to surprisingly good performance that could not be explained, there were additional red flags, such as lack of transparency, in the Enron and Madoff cases.
• Behave ethically and insist others do, too.

Although attractive or even positive returns cannot be guaranteed, following the principles of sound portfolio management can improve the likelihood of achieving the investor's long-range goals.

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This book presents effective portfolio management practice, not simply portfolio theory. The goal is to provide a primer for people who wish to run money professionally. The book includes the information a serious portfolio manager would learn over a 20-year career—grounded in academic rigor, yet reflecting real business practice and presented in an efficient format. Importantly, this book presents tools to help manage portfolios into the future; that is what a portfolio manager is paid to do. Although the book discusses the value of historical data, it guides the reader to think more about its implications for the fut...

Table of contents

• Cover
• About the Authors
• Acknowledgments
• Preface
• CHAPTER 1: Introduction
• CHAPTER 2: Client Objectives for Diversified Portfolios
• CHAPTER 3: Asset Allocation: The Mean - Variance Framework
• CHAPTER 4: Asset Allocation Inputs
• CHAPTER 5: Advanced Topics in Asset Allocation
• CHAPTER 6: The Investment Management Process
• CHAPTER 7: Introduction to Equity Portfolio Investing: The Investor's View
• CHAPTER 8: Equity Portfolio Construction
• CHAPTER 9: Fixed-Income Management
• CHAPTER 10: Global Investing
• CHAPTER 11: Alternative Investment Classes
• CHAPTER 12: Portfolio Management Through Time: Taxes and Transaction Costs
• CHAPTER 13: Performance Measurement and Attribution
• CHAPTER 14: Incentives, Ethics, and Policy
• CHAPTER 15: Investor and Client Behavior
• CHAPTER 16: Managing Client Relations
• Sample Cases
• Jerry W.
• MSSI
• McClain Capital
• The Fairbanks Fund
• Glossary
• References
• Index
• End User License Agreement