Portfolio Construction and Analytics

Frank J. Fabozzi, Dessislava A. Pachamanova

• Publisher: Wiley
• Year: 2016
• Print ISBN: 9781118445594
• eBook ISBN: 9781119238140
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

A detailed, multi-disciplinary approach to investment analytics

Portfolio Construction and Analytics provides an up-to-date understanding of the analytic investment process for students and professionals alike. With complete and detailed coverage of portfolio analytics and modeling methods, this book is unique in its multi-disciplinary approach. Investment analytics involves the input of a variety of areas, and this guide provides the perspective of data management, modeling, software resources, and investment strategy to give you a truly comprehensive understanding of how today's firms approach the process. Real-world examples provide insight into analytics performed with vendor software, and references to analytics performed with open source software will prove useful to both students and practitioners.

Portfolio analytics refers to all of the methods used to screen, model, track, and evaluate investments. Big data, regulatory change, and increasing risk is forcing a need for a more coherent approach to all aspects of investment analytics, and this book provides the strong foundation and critical skills you need.

• Master the fundamental modeling concepts and widely used analytics
• Learn the latest trends in risk metrics, modeling, and investment strategies
• Get up to speed on the vendor and open-source software most commonly used
• Gain a multi-angle perspective on portfolio analytics at today's firms

Identifying investment opportunities, keeping portfolios aligned with investment objectives, and monitoring risk and performance are all major functions of an investment firm that relies heavily on analytics output. This reliance will only increase in the face of market changes and increased regulatory pressure, and practitioners need a deep understanding of the latest methods and models used to build a robust investment strategy. Portfolio Construction and Analytics is an invaluable resource for portfolio management in any capacity.

Chapter 1
Introduction to Portfolio Management and Analytics

Portfolio management is the process of managing money. Other terms commonly used to describe this process are investment management, asset management, and money management. Accordingly, the individual who manages a portfolio of investment vehicles is referred to as a portfolio manager, investment manager, asset manager, or money manager. We use these terms interchangeably throughout this book.

In discussing portfolio management, reference is made to the “investor.” The investor is the entity that will receive the benefits from the investment of proceeds that results from managing of the portfolio. Typically, an investor does not make portfolio management decisions. Rather, the investor delegates that responsibility to professional portfolio managers. Professional portfolio managers rely to varying degrees on portfolio analytics for identifying investment opportunities, keeping portfolios aligned with investment objectives, and monitoring portfolio risk and performance.

In this book we review widely used approaches to portfolio analytics and discuss new trends in metrics, modeling approaches, and portfolio analytics system design. This chapter provides an introduction to the portfolio management process. We begin with an overview of asset classes. We then describe the main areas of portfolio management where analytics are used, review trends in systems for portfolio analytics, and explain how the themes in this introduction chapter map to the content of the chapters to follow.

1.1 Asset Classes and the Asset Allocation Decision

An important decision in portfolio management is the allocation of funds among asset classes. This is referred to as the asset allocation decision. The funds are then managed within the asset classes.¹ In most developed countries, the four major asset classes are (1) common stocks, (2) bonds, (3) cash equivalents, and (4) real estate. How do market participants define an asset class? There are several ways to do so. The first is in terms of the investment attributes that the members of an asset class have in common. These investment characteristics include (1) the major economic factors that influence the value of the asset class and, as a result, correlate highly with the returns of each member included in the asset class; (2) similar risk and return characteristics; and (3) a common legal or regulatory structure. Based on this way of defining an asset class, the correlation between the returns of different asset classes should be low.

The four major asset classes above can be extended to create other asset classes. From the perspective of a U.S. investor, for example, the four major asset classes can be expanded by separating foreign securities from U.S. securities: (1) U.S. common stocks, (2) non-U.S. (or foreign) common stocks, (3) U.S. bonds, (4) non-U.S. bonds, (5) cash equivalents, and (6) real estate. Common stock and bonds are commonly further partitioned into sectors, loosely referred to by some practitioners as asset classes. For U.S. common stocks (also referred to as U.S. equities), the following are classified as sectors: market capitalization stocks and value/growth stocks.

A company's market capitalization (or simply market cap) is the total market value of its common stock outstanding. For example, suppose that a corporation has 600 million shares of common stock outstanding and each share has a market value of $100. Then the market capitalization of this company is $60 billion (600 million shares times $100 per share). The convention in the market for classifying companies based on market capital is as follows: mega-cap stocks (greater than $200 billion), large-cap stocks ($10 billion to $200 billion), mid-cap stocks ($1 billion to $10 billion), small-cap stocks ($300 million to $1 billion), micro-cap stocks ($50 million to $300 million), and nano-cap stocks (less than $50 million).

A publicly traded company's market cap is easy to determine given the market price per share and the number of shares outstanding are known. How are “value” and “growth” stocks defined? These definitions are based on the investment style pursued by portfolio managers for stock selection. Specifically, a growth stock manager seeks to perform better than the broad market by buying companies with high-earnings-growth expectations. It is notable that the growth manager terminology emanates from the term “growth company.” There is no analog for the value manager—as in “value company.” Accordingly to value managers, two characteristics of value companies are that they trade at a low multiple relative to earnings and that they trade at a low price relative to their book value.

For U.S. bonds, also referred to as fixed income securities, the following are classified as sectors: (1) U.S. government bonds, (2) corporate bonds, (3) U.S. municipal bonds (i.e., state and local bonds), (4) residential mortgage-backed securities, (5) commercial mortgage-backed securities, and (6) asset-backed securities. In turn, several of these sectors are further segmented by the credit rating of the issuer assigned by commercial firms referred to as credit rating agencies. For example, for corporate bonds, investment-grade (i.e., high credit quality) corporate bonds and noninvestment-grade corporate bonds (i.e., speculative quality) are treated as two sectors.

For non-U.S. stocks and bonds, the following are classified as sectors: (1) developed market foreign stocks, (2) developed market foreign bonds, (3) emerging market foreign stocks, and (4) emerging market foreign bonds. The characteristics that market participants use to describe emerging markets is that the countries in this group:

• Have economies that are in transition but have started implementing political, economic, and financial market reforms in order to participate in the global capital market.
• May expose investors to significant price volatility attributable to political risk and the unstable value of their currency.
• Have a short period over which their financial markets have operated.

Loucks, Penicook, and Schillhorn (2008, 340) describe what is meant by an emerging market as follows:

Emerging market issuers rely on international investors for capital. Emerging markets cannot finance their fiscal deficits domestically because domestic capital markets are poorly developed and local investors are unable or unwilling to lend to the government. Although emerging market issuers differ greatly in terms of credit risk, dependence on foreign capital is the most basic characteristic of the asset class.

With the exception of real estate, all of the asset classes we identified earlier are referred to as traditional asset classes. Real estate and all other asset classes that are not in the list are referred to as nontraditional asset classes or alternative asset classes. The latter include also hedge funds, private equity, and commodities.

1.2 The Portfolio Management Process

Regardless of the asset class being managed, the portfolio management process follows the same integrated activities. These activities can be defined as follows:²

1. The investor's objectives, preferences, and constraints are identified and specified to develop explicit investment policies.
2. Strategies are developed and implemented through the choice of optimal combinations of assets in the marketplace.
3. Portfolio performance evaluation is performed; market conditions, relative asset values, and the investor's circumstances are monitored.
4. Portfolio adjustments are made as appropriate to reflect significant changes in any or all of the relevant variables.

In this book we focus on the second activity of the portfolio management process, developing and implementing a portfolio strategy. Our emphasis is on analytics-based portfolio management.

1.2.1 Setting the Investment Objectives

Setting investment objectives starts with a thorough analysis of the investor's investment objectives. Investors can be classified as individual investors and institutional investors. Within each of these broad classifications is a wide range of investment objectives.

The objectives of an individual investor may be to accumulate funds to purchase a home or other major acquisition, to have sufficient funds to be able to retire at a specified age, or to accumulate funds to pay for college tuition for children. An individual investor may engage the services of a financial advisor/consultant in establishing investment objectives.

The investment objectives of institutional investors fall into one of the following two broad categories: nonliability-driven objectives and liability-driven objectives. Those institutional investors that fall into the first category can manage their assets without regard to satisfying any liabilities. An example of an institutional investor that is not driven by liabilities is a regulated investment company. The second category includes institutional investors that must meet contractually specified liabilities. A liability is a cash outlay that must be made at a specific future date in order to satisfy the contractual terms of an obligation. An institutional investor is concerned with both the amount and timing of liabilities, because its assets must produce the cash flow to meet any payments it has promised to make in a timely way.

Two examples of institutional investors that face liabilities are life insurance companies and defined benefit plans. Life insura...

Table of contents

• Cover
• The Frank J. Fabozzi Series
• Title Page
• Copyright
• Table of Contents
• Dedication
• Preface
• About the Authors
• Acknowledgments
• Chapter 1: Introduction to Portfolio Management and Analytics
• Part One: Statistical Models of Risk and Uncertainty
• Part Two: Simulation and Optimization Modeling
• Part Three: Three Portfolio Theory
• Part Four: Equity Portfolio Management
• Part Five: Fixed Income Portfolio Management
• Part Six: Derivatives and Their Application to Portfolio Management
• Appendix: Basic Linear Algebra Concepts
• References
• Index
• End User License Agreement