INSTITUTIONAL INVESTMENT MANAGEMENT CFI 4203

THE PORTFOLIO MANAGEMENT PROCESS

 Investors know that risk drives return hence the practice of managing and investing
funds should focus on managing risk rather than returns.
 Maintaining a reasonable and disciplined approach to investing will increase the
likelihood of investment success over time.

Step 1

Investors short term and long term needs, expectations, familiarity with the markets, history, risk
tolerance, financial distress, risk tolerance, constraints investment strategy, objectives.

Step 2

Examine current and projected financial, political, economic, and social conditions. These help in
constructing the portfolio and these conditions jointly determine the investment strategy.

Step 3

Implement the plan by constructing the portfolio. Meet the investors needs at minimum level of risk

Step 4

Monitor and update investment needs, environmental conditions, evaluate portfolio performance.

This can be a continuous process especially when the environment and investor needs are changing
rapidly.

STATEMENT OF INVESTMENT POLICY

IMPORTANCE

1. Help investors to understand and articulate realistic investor goals, example of a bad
goal ‘to make a lot of money’. Disadvantages of such a goal;

It may not be appropriate for the investor

It is too open ended to provide guidance for specific investments and time frames

It helps investors to understand their needs, objectives and investment constraints and
financial markets and the risks of investing.
A process of communicating; which helps the manager.

2. Standards for evaluating Portfolio Performance

It provides an objective standard too measure performance. The performance should be

measured against guidelines specified in the statement, not on the portfolio’s overall returns.

3. Protect the client against inappropriate and unethical behaviour

4. Helps other managers to take over in the event of dismissal or promotion of the current
manager, thus it prevents costly delays and misunderstandings.

INVESTMENT OBJECTIVES
These should be expressed in terms of risk and return.

They help to avoid such high risk investment strategies or ‘Account Churning’ –which involves
moving quickly in and out of investment in an attempt to buy low and sell high.

Risk tolerance is affected by current insurance coverage, cash reserves, family situation, age
and net worth.

1. Capital Preservation

Minimize the risk of loss in real terms

This seeks to maintain the purchasing power of investments e.g return should be greater than
the rate of inflation.

Generally it’s a strategy for strongly risk averse investors/ for funds needed in the short term
e.g tuition fees or down payment for a house.

2. Capital Appreciation

The portfolio should grow in real terms to meet future needs.

Growth occurs mainly thru capital gains

This is an aggressive strategy for investors willing to take on the risk (risk lovers).

Appropriate for long term investors seeking to save for retirement /education (young people).

3. Current Income

The portfolio should generate income than capital gains

Usually for supplementing earnings to meet living expenses e.g retirees

4. Total Return

The investor wants the portfolio to grow over time to meet a future need.

It seeks to achieve appreciation thru both capital gains and re-investing current income.

Risk exposure lies between current income and capital appreciation.

INVESTMENT CONSTRAINTS
1. Liquidity needs

Investors can have liquidity needs that the investment plan should consider.

Near term goal might require available funds.

Wealthy individuals with huge tax obligations need adequate liquidity to pay taxes, some
retirees’ need cash for daily expenses, eg a 25 year old investor might not need/ need little
liquidity since his focus is on long term retirement fund.

Unemployment, honeymoon expenses, house down payment may need cash.

2. Time Horizon

There exist a close r/ship between liquidity and time horizon and ability to handle risk.

Investors with long term horizon require less liquidity and can tolerate risk (typical young
investor).

Short term investors require less risky assets with a higher degree of liquidity because losses
are harder to overcome in a short period horizon.

3. Tax Concerns

Taxable income from Income, Dividends and rents is taxable at the investors marginal tax rate .

Capital gains are taxed differently from income tax , capital gains …capital gains is paid only
when the asset is sold.

Some sources of investment income are exempt from taxes eg income on federal securities,
TBs, notes and bonds.

High Taxed individuals have a high propensity to purchase tax exempt investments.
 4. Legal and Regulatory Factors

These can constrain the investment strategies e.g penalties paid upon early withdrawal – this
can be a constraint to an investor with substantial needs.

Insider trading, Prescribed assets, IPEC Limits.

5. Unique needs and preferences.

These are idiosyncratic concerns

No firms that manufacture tobacco,

alcohol, pornography or environmentally harmful products….?

Some use social responsibility criteria

Time and expertise of the investor to manage his portfolio.

ASSET ALLOCATION
Though a policy statement does not indicate which specific securities to purchase and when
they should be sold, it should provide guidelines as to the asset classes to include and the
relative proportions of the investors funds to invest in each asset class.

AA is the process of dividing funds into different asset classes.

It is advisable to present it in ranges than strict numbers to allow the manager some freedom
based on his forecast of market trends.

It constitutes the decisions like;

 What asset classes should be considered for investment ;

 What policy weights should be assigned to each eligible class

Ibbotson and Kaplan (2000), Brinson, Hood and Beebower (1986) and Brinson, Singer and
Beebower (1991) examined the effect of normal policy weights on investment performance
using data from pension funds and mutual funds from 1970-1990s . They found that about 90%
of a fund’s returns over time can be explained by its target asset allocation policy.

Also across a set of different funds, about 40% of the difference in fund returns is explained by
the difference in asset allocation policy.
Also due to market efficiency, fund managers practicing market timing and security selection on
average, have difficulty surpassing passively invested index returns after taking into account the
expenses and fees. Is this true for our financial market???

STRATEGIC ASSET ALLOCATION

Represent the optimal combination of various asset classes in an efficient market.

It is basically an indexed portfolio which would actually be held if a passive, pure investment
strategy is to be employed.

It is the measure against which portfolio returns will be measured against to find out whether
speculative strategies are adding value.

TACTICAL ASSET ALLOCATION

Are speculative transactions i.e timing and selection decisions carried out with the belief that
such transactions generate excess risk adjusted returns.

Timing decisions over- or underweight various asset classes, industries or economic sectors
from the SAA.

Selection deal with securities within a given asset class, industry, sector and attempt to
determine which securities should be over/underweight.

RISK MANAGEMENT VIEW

AA is a risk management strategy that can help reduce the effects of market fluctuations by
recognizing and balancing the different characteristics of stocks, bonds and cash in relation to
your goals and tolerance of risk.

REDUCE VOLATILITY OVER TIME

AA can help improve chances of achieving a desired total return over the long term by
understanding the different ways stocks, bonds and cash have performed historically.

The assets don’t usually gain/lose value concurrently so they can assist in reducing volatility
over time.

AA is a decision affected by investment goal, horizon and tolerance of risk.

If there are more than one investment goal, then there should be different levels of risk and
achieve goals.
Diversifying within an asset class can help spread the risk in that category, so that overall
portfolio results will not be largely affected by the performance of any one investment.

Equity diversification includes holding stocks from different sectors and industries within
different market caps i.e large and small caps and different styles such as growth and value or
even international component.

Fixed income diversification include bonds with staggered maturities i.e laddering or holding
bonds from various sectors and varying credit quality.

Cash…..CDs, TBs and money funds

CLIENT UTILITY AND RISK TOLERANCE

Risk averse investors are willing to only consider only a Rf or speculative prospects with positive
risk premium.

They penalize the E(R) of a risky portfolio by a certain % to account for risk involved.

The greater the risk, the larger the penalty

Each investor assign a welfare/utility score to competing investments based on E(R) and δ

The utility can be used to rank portfolios, and higher utilities are assigned to portfolios with
more attractive risk return profiles i.e high E(R) and lower δ.

U = E(R)-0.005Aδ2

U = utility, E(R) = expected return, A = index of risk aversion, 0.005 is a scaling factor that allow
us to express the E(r) and δ as a %.

The U provided by a Rf portfolio is simply the rate of return on the portfolio because there is no
penalisation of risk.

CHOICE BETWEEN ASSETS

E(r) =22%, Rf =5%, δ =34%, Aversion =3

U =22-0.005(3)(342)

=4.66%
Though risk premium is 17% (large) (22-5), the utility is less than the Rf rate.

The penalty for risk adjust E(R) from 22% to 4.66% by a factor of 17.34%.

If the investor is more risk tolerant i.e A=2 then the E(R) will be adjusted by only 11.56% and the
utility level become 10.44% wc is higher than the Rf rate. Accept the project.

EXERCISE

E(R) =20%, δ =20%, TB rate =7%. Which investment alternative will be chosen by an investor
where A =4? What if A =8?

We can call the investor’s utility value the Certainty Equivalent Rate which is described as the
rate that risk free investments would need to offer with certainty to be considered equally
attractive as the risky portfolio.

PASSIVE AND ACTIVE STRATEGIES

Passive strategists believe that the market is efficient hence all the securities are correctly
priced. If ever there is mispricing, then it will be a small portion which can quickly correct or
pursuing it will be made useless by the transaction costs involved in buying and selling.

They contend that the risk created by buying and selling is not worth it since securities are
properly priced, so no excess risk adjusted returns can be generated. They believe in indexed
portfolios (replicate the performance of a given index) and buy and hold strategy i.e what
Buffet called Buy and Switch off the market.

In bonds, their aim becomes to manage Interest rate risk, say, through immunization technique.

Active strategists believe markets are not efficient hence there is room for making above
market returns through buying and selling of mispriced securities. In the bond markets, they try
to anticipate interest rates movements and their impact on asset prices.

They generate abnormal returns if and only if the analyst’s information or sight is superior to
that of the market. You cannot profit from the info that rates are about to fall if it is already
reflected in the asset prices.

These believe in Fundamental and Technical Analysis.

BOND PORTFOLIO MANAGEMENT STRATEGIES
Different strategies are viable for certain portfolios with different needs and risk profile.

PASSIVE MANAGEMENT STRATEGIES

1. BUY AND HOLD STRATEGY

It involves collecting bonds with desired quality, coupon levels, and term to maturity and
indenture provisions i.e call features. This does not attempt to generate above the market
returns but rather takes asset prices as fair and only concentrate on managing interest rate risk
of their portfolio. Many successful investors follow a modified buy and hold strategy which
involves investing with the intention of holding the asset up to the end of the investment
horizon but still actively look for opportunities to trade into more desirable positions.

Aggressive buy and hold investors also incorporate timing considerations by using their
knowledge of market rates and expectations, BUT there is still diversifiable risk because you are
not holding all assets.

2. INDEXING STRATEGY

Though empirical studies show that many managers have not been able to match the risk
return performance of common stock on bond indexes, they still try to index part of their
portfolios. The intention is to match the performance of a selected bond market index e.g
Merill Lynch Index, Gvt Bond Index, Lehman Brothers Index.

The manager is judged not by the return and risk but by how closely the portfolio tracks the
chosen index. It involves examining the tracking error i.e the difference between the rate of
return for the portfolio and the rate of return on the bond market index.

Problems;

1. Indexes include more than 5000 securities making it difficult to purchase each security
in the index in proportion to its market value.
2. Many bonds are thinly traded; it’s difficult to identify their owners and purchasing the
securities at a fair market price.
3. Portfolio rebalancing because maturing bonds are dropped from the index and new
bonds also issued hence constant rebalancing is needed hence at times stratified
sampling is used.
ACTIVE MANAGEMENT STRATEGIES

INTEREST RATE ANTICIPATION

It relies on uncertain forecast of future interest rates, hence the riskiest. It preserves capital
when interest rates are anticipated to increase and achieve capital gains when interests are
expected to decline. This is done by altering the duration (maturity) of the portfolio i.e reduce
the portfolio duration when rates are expected to rise and increase duration when a decline is
anticipated. When maturities are shortened, to preserve capital, substantial income could be
sacrificed and the opportunity for capital gains could be lost if interest rates decline rather than
rise.

If anticipating a fall in interest rates, we move into longer term bonds because they are more
sensitive to interest rates, hence gain in capital but it also involves a decrease in current income
due to lower coupons on longer duration bonds. It also exposes the portfolio to interest rate
fluctuations if interest move in the opposite direction.

If you anticipate an increase in interest, you move into high yielding short term TBs –high yield
to cover for the reduced horizon and also benefit from high income.

N.B The high the credit quality of the bond, the more sensitive it is to interest rates.

VALUATION ANALYSIS

It involves determining a bond’s intrinsic value based on its characteristics and the value of
these in the market e.g bond rating, maturity (longer maturity might be worth more basis
points ,maturity spread, call provision might have high yields, sinking fund might mean lower
yields. Given these characteristics and the normal cost of these characteristics in terms of yield,
you determine the bond’s required yield i.e its implied intrinsic yield. Compare the derived
value and the market value to determine undervalued or overvalued bonds.

CREDIT ANALYSIS

Involves detailed credit analysis of the bond issuer to determine expected changes in its default
risk. During periods of strong economic expansion, even financially weak firms may survive and
prosper and during severe economic contractions normally strong firms may find it very difficult
to meet financial obligations. Hence there is a cyclical pattern in which downgrades increase
during economic contraction and decline during economic expansions.
The idea is to predict rating changes before they are announced by agencies. The strategy
becomes to acquire bonds that are expected to experience upgrading and sell /avoid those
bond issues expected to be downgraded.

CREDIT ANALYSIS OF HIGH YIELD (JUNK) BONDS

Substantial rates of return can be derived by investing in high yield bonds if you do the credit
analysis required to avoid defaults which occur with these bonds at substantially higher rates
than the overall bond market.

YIELD SPREAD ANALYSIS (BID-ASK)

Aims to identify anomalies between bonds in different sectors .Spreads widen during periods of
economic uncertainty and recession because investors require large risk premium (large
spreads) and the spread will decline during periods of economic confidence and expansion.

BOND SWAPS

Swapping bonds with similar characteristics improves return. It intends to increase current
yield, YTM, take advantage of shifts in Interest rates or realignment of yield spreads, and
improve quality of portfolio or for tax purposes. The risks involves the market moving against
you , yield spreads may fail to move in the anticipated direction or the new issues may not be
perfect substitutes.

E.g Pure Yield Pickup Swap which involves swapping out of a low coupon bond into a
comparable high coupon bond to realize an automatic and instantaneous increase in current
yield and yield to maturity.

SUBSTITUTION SWAP…

A GLOBAL FIXED INVESTMENT STRATEGY

The global AA should consider the following factors that have a bearing on portfolio
performance;

1. The local economy in each country that include the effects of domestic and international
demand.
 2. The impact of this total demand and domestic monetary policy on inflation and interest
rates.

3. The effect of the economy, inflation and interest rates on the exchange rate among
countries.

A manager must decide the relative weight for each country, then within each country
allocation can be among government, municipal and corporate bonds.

MATCHED-FUNDING TECHNIQUES

DEDICATED PORTFOLIO

This refers to a bond portfolio that is dedicated to service a given set of liabilities. It needs to
create a set of streams of cash flows that will extinguish the liability or maturities. What
weakness comes from this strategy?

a) PURE CASH-MATCHED STRATEGY

The coupons, sinking funds and maturity principal should exactly match the specified liabilities.
It is mainly a conservation strategy and it can involve investing in zero coupon TBs that will
exactly offset the liabilities i.e Total Passive.

b) DEDICATION WITH RE-INVESTMENT

The cash flows will not exactly match the liability but any inflows that are not used currently
can be re-invested at a reasonable conservative rate.

IMMUNISATION STRATEGY

It aims to immunize the portfolio from the rate changes. It aims to derive a specified return for
given horizon usually close to market return through managing the impact of interest rates.
Interest rate risk can be eliminated by matching the term to maturity of the asset and the
investor‘s horizon. If the duration of assets and liabilities are matched, price and re-investment
risk will cancel out and for a, duration equal to investment horizon also price and re-investment
risk exactly cancel out.

CONTINGENT PROCEDURES

It involves pursuing the highest possible returns through active strategies while relying on
classical bond immunization techniques to ensure a given minimal return over the horizon.
IMPLICATION OF CAPITAL MARKET THEORY AND EFFICIENT MARKET
HYPOTHESIS
BONDS AND TOTAL PORTFOLIO THEORY

Bonds offer significant diversification benefits and in an efficient market they should be mixed
with stocks to provide superior risk adjusted return compared to either one taken alone.

Since the correlation between bonds and stocks is around 0.30, the combination provide good
return per unit of risk.

The stocks offer superior returns to bond yields, they are also risky and since stocks are more
responsive to business cycles and their cash flows are volatile and not predetermined like that
of bonds, including bonds in such a portfolio reduces the level of risk

BONDS AND CAPITAL MARKET THEORY

It states there should be an upward sloping market line which depicts that higher returns
should be accompanied by higher risk.

Bonds should be found at the lower end of the market line because they are low risky
securities.

Reilly and Wright examined 36 classes of long term securities and the basic findings of the study
show that government and high grade corporate bonds were at the low end of the risk
spectrum.

BOND PRICES AND CAPM

Interest rate risk for investment-quality bonds is non-diversifiable since it is market wide. Also
some evidence exist that default risk is largely non-diversifiable because default experience is
closely related to business cycles.

Therefore, because major bond risk is non diversifiable, we should be able to define bond
returns in the context of CAPM.

Evidence that high grade bond risk is almost all systematic risk is found in the Reilly and Wright
study, which shows that the returns among these investment–grade bonds of sector (gvt,
corporate, mortgages) or rating were 0.90 to 0.99.

The correlation between high yield bonds and investment grade bonds is lower than the strong
correlation between high yield bonds and common stocks, which is because both have
substantial unsystematic risk.