Portfolio Management 101: Definition, Types, Process and Approaches


What is Portfolio?

A portfolio is a collection of similar or different financial assets such as stocks, cash, mutual-funds or MFs, bonds, ETFs (Exchange-traded-funds), commodities and other kind of financial assets.

What is Portfolio Management?

Portfolio Management can be understood as the management of set of various activities such as analysis and allocation of financial assets, evaluation of portfolio, rebalancing and monitoring the portfolio according to the investor's Investment Policy Statement (IPS), measuring and reporting the performance of portfolio to have transparency and sustaining the satisfaction or reliability from the investor's side.

Portfolio Approach of Investing

Within portfolio management, we always think of some basic or common portfolio approaches of investing such as diversification, minimum risk, composition rules and downside protection. Let's discuss about each approach one by one.

  1. Portfolio Diversification: The advantages or benefits of a diversified portfolio can be understood from a well-known quote and that is "Don't put all your eggs in only one basket", which is frequently used by a number of investors or portfolio managers including one of the world's richest persons; Mr. Warren Buffet.
  2. Reducing Risk: Usually, a diversified portfolio shows lower portfolio risk or volatility (which is measured by standard deviation) than anyone individual financial security or asset. Within a diversified portfolio, the individual security positions show correlations between each-other, for example A security A goes 1.5 times higher with compare to market and security within the same portfolio goes down by 0.3 with compare to market. And similarly, we have other securities which show correlation with other included securities within the portfolio.
  3. Composition Matters: As we get to know that portfolio is nothing but a collection of securities within their various compositions, and each individual security contains its own historic risk-return profile on the basis of its past market-prices. When we do allocation of these securities within the portfolio, and when we provide different percentages to different securities within the portfolio to make a better risk-return profile portfolio (maximum profit at minimum risk).

Types of Portfolio Management

On the basis of activity

  1. Active Portfolio Management: It is one of the type of Portfolio Management in which Portfolio Managers or PMs actively do frequent buying and selling in an effort to outperform a specific benchmark or index. They also take some charge percentages for AUM (Assets Under Management).
  2. Passive Portfolio Management: In Passive Management, Portfolio Managers keep a strategy which aims to mimic broader market indices. PMs allocate financial securities with such a composition in a portfolio so that the portfolio can be treated as broader market index. And that's why it become so easier to track and monitor investors' portfolios.

On the basis of Discretionary

  1. Discretionary Portfolio Management: Within Discretionary-Portfolio-Management, the whole responsibility of investor's cash is given to Portfolio Manager. Portfolio Manager do investments or speculation according to his or her own perspective.
  2. Non-Discretionary Portfolio Management: While on the extra hand, within non-discretionary management, financial advisor acquires the responsibilities of investment over Portfolio Managers. And that's how, in this case, the role of PM reduces due to financial advisors.

Portfolio Management Process

  1. Investment Policy Building and Asset Allocation
  2. Investment Vehicles Analysis and Evaluation
  3. Diversified Portfolio Construction
  4. Portfolio Reconfirmation
  5. Portfolio Monitoring and Rebalancing
  6. Performance Measurement and Reporting

Investment Policy Building and Asset allocation

This is the initial stage within portfolio management, this stage can be split-up into two main tasks:

  • Investment Policy Statement (IPS): An IPS is a document which involves several components such as investment objectives, investment constraints (Time Horizon, Tax Concerns, Liquidity Requirements, Legal and Regulatory, and unique circumstances), procedures, risk-return objectives, risk tolerance (ability to take risk) and other relevant information.
  • Asset Allocation: It is the process of allocation of different securities with different compositions on the basis of capital market expectations, risk and return, objectives and constraints. Where securities refer to various financial and physical assets such as bonds, stocks, commodities, Exchange Traded Funds, Real-estate and other remaining securities.

Investment Vehicles Analysis and Evaluation

We select those investment vehicles which satisfies the compatibility or which provide the best balance of diversification at a low cost. Here, Investment Vehicles have mainly 4 types such as

  • stocks
  • bonds
  • real-estate
  • cash

But out of all these, Individual Stocks, Bonds, Mutual-Funds, ETFs and Index-Funds are the most satisfactory investment vehicles. Here, each type of security has its own techniques of analyzing and evaluation. For example: Stocks are analyzed and evaluated on the basis of Fundamental and Technical Analysis techniques. While Bonds and Fixed-Income-Securities are analyzed and evaluated on the basis credits, YTM (yield-to-maturity) and other mathematical techniques used under finance.

Diversified Portfolio Construction

Later on, Portfolio Manager introduces a new concept within the portfolio formation or construction which follows the Modern Portfolio Theory (MPT).

  • MPT helps investors to make a portfolio having minimum risk based on a given expected return.
  • With the help of MPT, risk-averse investors can construct portfolios to maximize expected return based on a given level of market risk.
  • MPT uses diversification techniques which includes various investment vehicles having different expected risk and return, and correlation with other investment vehicles. These can be different stocks of different industries, corporate bonds or government bonds, different exchange-traded-funds and mutual funds with different risks and returns.

Portfolio Reconfirmation

After building a diversified portfolio on the basis of given IPS document, Portfolio manager meets investor and show him the diversified portfolio of various investment vehicles. Then investor either give permission to the portfolio manager to do investment according to built portfolio, or if investor finds any problem within the portfolio, investor ask portfolio manager to do some editing.

Portfolio Monitoring and Rebalancing

Portfolio Manager do investments according to the diversified portfolio, and then portfolio manager do monitoring those investment vehicles which are included within portfolio, and if he finds deviation in form of risk-return defined in IPS, he do rebalancing with the investment vehicles.

Performance Measurement and Reporting

The Portfolio Manager measures the inputs and outputs of portfolio, and provides Portfolio Performance Report to the investors.

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