About the lecturer

• Nguyen Thi Hoang Anh, PhD, CFA, FRM

• Email: nguyenthihoanganh.cs2@ftu.edu.vn

PORTFOLIO MANAGEMENT
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About the lecturer About the lecturer

• Courses: Money and Banking, Corporate Finance,

Portfolio Management, Financial Economics

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Course Introduction Why Portolio Management?

Course Tittle: Portfolio Management

Lecturer: Nguyen Thi Hoang Anh, PhD, CFA, FRM
Email: nguyenthihoanganh.cs2@ftu.edu.vn
Course website: www.schoology.com
Assessment: One exam, one group assignment, quizzes and
class participation score.
Textbook:
Frank K. Reilly, Keith C. Brown, and Sanford J. Leeds, 2020,
Investment Analysis and Portfolio Management, 11th ed.,
Cengage
Bodie, Kane, Marcus, 2018, Investment, 11th Edition,
McGraw-Hill
CFA Level 1, 2, 3 5 1-6

Course Introduction Portfolio Management

• Portfolio management is both an art and a science.

• The objective of this class is to blend theory and
practice to achieve a consistent portfolio management
process. This dynamic process is designed to be
applied in a comprehensive and logical fashion to
variety of objectives and constraints in an
increasingly more volatile and global capital markets.
• The objective of this course is to develop key
concepts in investment theory from the perspective of
a portfolio manager, and to apply such concepts using
real financial data.
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Course Structure
Lecture Session Topics covered Readings and Activities
1 1 Portfolio Management: An Overview RBL Chapter 2
CFA 2022 L1 Reading 48
2 2-3 Application: Portfolio Optimisation
CFA 2022 L1 Reading 51
3 4-5 Portfolio Planning and Asset Allocation
CFA 2020 L3 Reading 12
RBL Chapter 11
4 6-7 Equity Portfolio Management CFA 2020 L3, Readings
22-24
5 7 Professional Portfolio Management RBL Chapter 17
RBL Chapter 18
6 8-9 Portfolio Performance Evaluation CFA 2020 Level 3,
Reading 35
7 10 Application: Portfolio Style

8 11 - 12 Private Wealth Management

CFA 2020 L3, Reading 28 Lecture 1: Portfolio Management:
Group work submission
13 Group presentation An Overview
14 Exercises
9 1-10
15 Review Sessions

Learning outcomes Portfolio Perspective

 Diversification and Risk reduction
 A simple measure of the value of diversification is calculated
as the ratio of the standard deviation of the equally weighted
portfolio to the standard deviation of the randomly selected
security. This ratio may be referred to as the diversification
ratio.

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Portfolio Perspective Portfolio Perspective
 Diversification and Risk reduction  Diversification and Risk reduction

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Portfolio Perspective Portfolio Perspective

 Risk-Return Trade-off, Downside Protection, Modern  Risk-Return Trade-off, Downside Protection, Modern
Portfolio Theory Portfolio Theory

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Steps in the portfolio management process Steps in the portfolio management process

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Steps in the portfolio management process Steps in the portfolio management process

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Steps in the portfolio management process Steps in the portfolio management process

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Steps in the portfolio management process Steps in the portfolio management process
Types of Investors
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Institutional Investors
 Banks are financial intermediaries that accept deposits
and make loans.
 Banks often have excess reserves that are invested in
relatively conservative and very short-duration fixed-income
investments, with a goal of earning an excess return above
interest obligations due to depositors.
 Liquidity is a paramount concern for banks that stand ready
to meet depositor requests for withdrawals.
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Institutional Investors
 Institutional investors primarily include defined benefit
pension plans, endowments and foundations, banks,
insurance companies, investment companies, and
sovereign wealth funds.
 Each of these has unique goals, asset allocation
preferences, and investment strategy needs.
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Institutional Investors
 Insurance companies:
 Receive and invest premiums from the policyholders with
the objective of funding customer claims as they occur.
 Broadly categorized into life insurers and property and
casualty insurers
 Life insurance companies have a relatively long-term
investment horizon, while property and casualty (P&C)
insurers have a shorter investment horizon because claims are
expected to arise sooner than for life insurers.
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Institutional Investors Institutional Investors
 Endowments are funds of non-profit institutions that
help the institutions provide designated services. For
example, in the United States, many universities have large
endowment funds to support their programs.
 A foundation is a fund established for charitable
purposes to support specific types of activities or to fund
research related to a particular disease.
 Endowments and foundations typically allocate a sizable
portion of their assets in alternative investments. This
large allocation to alternative investments primarily
reflects the typically long time horizon of endowments and
foundations.

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Institutional Investors Institutional Investors

 Defined contribution pension plans (DC plans) are
retirement plans in the employee’s name usually funded by
both the employee and the employer. The key to a DC plan
is that the employee accepts the investment and inflation
risk and is responsible for ensuring that there are enough
assets in the plan to meet their needs upon retirement.
 Defined benefit pension plans (DB plans) are company-
sponsored plans that offer employees a predefined benefit
on retirement
 An ongoing trend is that plan sponsors increasingly favor
CC plans over DB plans because DC plans typically have
lower costs/risk to the company. As a result, DB plans have
been losing market share of pension assets to DC plans.
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Institutional Investors
 Investment companies manage the pooled funds of many
investors.
 Mutual funds manage these pooled funds in particular
styles (e.g., index investing, growth investing, bond
investing) and restrict their investments to particular
subcategories of investments (e.g., large-firm stocks,
energy stocks, speculative bonds) or particular regions
(emerging market stocks, international bonds, Asian-firm
stocks).
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Institutional Investors
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Institutional Investors
 Sovereign wealth funds (SWFs) are state-owned
investment funds or entities that invest in financial or real
assets. SWFs do not typically manage specific liability
obligations, such as pensions, and have varying investment
horizons and objectives based on funding the government’s
goals (for example, budget stabilization or future
development projects).
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The Asset Management Industry The Asset Management Industry
 The asset management industry consists of firms that manage
assets of their clients:
 Specialist asset managers may focus on a specific asset class (e.g.,
emerging market equities) or style (e.g., quantitative investing),
 “full service” managers typically offer a wide variety of asset
classes and styles.
 a “multi-boutique,” in which a holding company owns several asset
management firms that typically have specialized investment
strategies.
 An asset manager can be:
 a buy-side firm given that it uses (buys) the services of sell-side
firms.
 A sell-side firm: a broker/dealer that sells securities and provides
independent investment research and recommendations to their
1-37 clients (i.e., buy-side firms). 1-38

The Asset Management Industry The Asset Management Industry

 Active versus Passive Management

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The Asset Management Industry The Asset Management Industry
 Traditional versus Alternative Asset Managers
 Traditional managers generally focus on long-only equity,
fixed-income, and multi-asset investment strategies,
generating most of their revenues from asset-based
management fees.
 Alternative asset managers, however, focus on hedge fund,
private equity, and venture capital strategies, among others,
while generating revenue from both management and
performance fees (or “carried interest

The Asset Management Industry Pooled Interest – Mutual Funds

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Pooled Interest – Mutual Funds
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Pooled Interest – Mutual Funds
 All mutual funds charge a fee for the ongoing management
of the portfolio assets, which is expressed as a percentage
of the net asset value of the fund.
 No-load funds do not charge additional fees for
purchasing shares (up-front fees) or for redeeming shares
(redemption fees).
 Load funds charge either up-front fees, redemption fees,
or both.
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Pooled Interest – Mutual Funds
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Types of Mutual Funds
 Money market funds invest in short-term debt securities
and provide interest income with very low risk of changes
in share value. Fund NAVs are typically set to one
currency unit.
 Bond mutual funds invest in fixed-income securities.
They are differentiated by bond maturities, credit ratings,
issuers, and types. Examples include government bond
funds, tax-exempt bond funds, high-yield (lower rated
corporat
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Types of Mutual Funds
 Stock mutual funds:
 Index funds are passively managed; that is, the portfolio is
constructed to match the performance of a particular index,
such as the Standard & Poor’s 500 Index.
 Actively managed funds refer to funds where the
management selects individual securities with the goal of
producing returns greater than those of their benchmark
indexese) bond funds, and global bond funds.
 Exchange-traded funds (ETFs)
 A separately managed account
 Hedge funds
 Private equity and venture capital
Review: Mean–Variance Optimization
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Mean–Variance Optimization Mean–Variance Optimization

 Financial assets are generally described by their risk and return
characteristics
 Financial assets normally generate two types of return for
investor: periodic income (dividends or interest payments) and
price change (capital gain/loss)
 Gross and net return
 A gross return is the return earned by an asset manager prior to deductions
for management expenses, custodial fees, taxes, or any other expenses
that are not directly related to the generation of returns but rather related
to the management and administration of an investment
 Net return is a measure of what the investment vehicle has earned for the
investor. Net return deducts all managerial and administrative expenses
that reduce an investor’s return
 Pre-tax and after-tax nominal return
 Real return 1-51
 Risk is defined as the uncertainty over the amount or timing of
future cash flows from an investment, or the variability of returns
from those that are expected
 The risk of a security can be considered in isolation, or on a
portfolio basis; this distinction is critical for portfolio theory
 Some investments are risk free, e.g., a default free T-bond.
 Most investments, however, are risky. Consider an investment in a
stock, which offers a return in the form of a dividend and capital
gain; the return that the investor receives is risky, since both the
dividend and the future sale price of the stock is uncertain
 Other risky investments include government bonds to be sold
before maturity, corporate bonds, derivatives, commodities, real
estate, a firm’s physical assets, human capital
 The most common risk measure is the standard deviation 1-52
Mean–Variance Optimization Mean–Variance Optimization
 Portfolio theory assumes that investors are risk averse,
meaning that given a choice between two assets with
equal rates of return, they will select the asset with the
lowest level of risk
 Most people may be risk loving over small investments (such as
the cost of a weekly lottery ticket), but risk averse over larger
investments (such as the value of their house or car)
 It is reasonable to assume that investors are generally risk
averse over the typical size of investments made in capital
markets; this is borne out by empirical evidence
 Many investors purchase insurance for: Life, Automobile,
Health, and Disability Income.
1-53  Yield on bonds increases with risk classifications 1-54

Mean–Variance Optimization Mean–Variance Optimization

 The risk-return trade-off refers to the positive relationship
between expected risk and return. In other words, a higher
return is not possible to attain in efficient markets and over
long periods of time without accepting higher risk
 Rate of return on T-bills is essentially risk-free
 Investing in stocks is risky, but there are compensations
 The difference between the return on T-bills and stocks is the
risk premium for investing in stocks
 Coefficient of variation is the ratio of the standard deviation
of a distribution to the mean of that distribution. This is the
measure of relative risk

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Mean–Variance Optimization
 In this lecture, we consider what happens when we combine
individual assets into a portfolio
 The model that we use to do this is known as Markowitz
portfolio theory, which was developed in the 1950s
 Markowitz mean–variance portfolio theory makes certain
assumptions and then from these, derives the optimal
combination of risky assets given their characteristics
 Markowitz portfolio theory, the oldest and perhaps most
accepted part of modern portfolio theory, provides the
theoretical foundation for examining the roles of risk and
return in portfolio selection
 Markowitz portfolio theory forms the basis of virtually all
professional fund management today
The definition of a portfolio
Mean–Variance Optimization
 In this lecture, we consider what happens when we combine
individual assets into a portfolio
 The model that we use to do this is known as Markowitz
portfolio theory, which was developed in the 1950s
 Markowitz mean–variance portfolio theory makes certain
assumptions and then from these, derives the optimal
combination of risky assets given their characteristics
 Markowitz portfolio theory, the oldest and perhaps most
accepted part of modern portfolio theory, provides the
theoretical foundation for examining the roles of risk and
return in portfolio selection
 Markowitz portfolio theory forms the basis of virtually all
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professional fund management today 1-58
The definition of a portfolio
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The return, expected return and variance of a portfolio
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The return, expected return and variance of a portfolio
 Consider a portfolio of 40% invested in IBM and 60%
invested in FB
 We can calculated the mean, variance and the standard
deviation of this portfolio
 Portfolio risk is generally smaller than the average of the
assets’ risk
 But what is the optimal combination of assets in a
portfolio?
 This is the subject of portfolio theory
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The return, expected return and variance of a portfolio
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The assumptions of portfolio theory
 Investors consider each investment alternative as being
represented by a probability distribution of returns over
some holding period (one year, say)
 Investors maximise one-period expected utility, and their
utility curves demonstrate diminishing marginal utility of
wealth (i.e. the more money you have, the less utility on
additional dollar of wealth gives you)
 Investors estimate the risk of the portfolio on the basis of
the variance (or, equivalently, standard deviation) of
returns
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The assumptions of portfolio theory
The assumptions of portfolio theory
 Lambda captures each individual investor’s preference for
trading off risk and return. If you look closely at the
formula, you’ll see that higher expected return for the same
level of risk will increase the investor’s utility, while a
higher risk for the same level of return will decrease the
investor’s utility. This is consistent with a risk-averse
investor, as it imposes a “penalty” for risk. U is also
referred to as the certainty-equivalent return.
 Lambda is unique to each individual and is based on the
investor’s willingness and capacity to take on risk. A risk-
neutral investor will have a lambda of 0, although in
practice it is typically assumed to be between 1 and 10
with an average level of 4
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The assumptions of portfolio theory The feasible set of two risky assets
 Investors consider each investment alternative as being
represented by a probability distribution of returns over
some holding period (one year, say)
 Expected returns for all assets are known.
 The variances and covariances of all asset returns are
known.
 Investors need only know the expected returns, variances,
and covariances of returns to determine optimal portfolios.
They can ignore skewness, kurtosis, and other attributes of
a distribution.
 There are no transaction costs or taxes

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The feasible set of two risky assets The efficient frontier

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The efficient frontier The optimal portfolio

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Adding a risk free asset to the feasible set Adding a risk free asset to the feasible set

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Adding a risk free asset to the feasible set

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Mean–Variance Optimization
 The most common constraint in MVO is called the budget
constraint or the utility constraint, which means the asset
weights must add up to 100%.
 The next most common constraint used in MVO is the
nonnegativity constraint, which means all weights in the
portfolio are positive and between 0% and 100% (there are
no short positions in the SAA).
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Criticisms of the mean-variance analysis
 Ignores liabilities: MVO also does not account for the fact that
investors create portfolios as a source of cash to pay for
something in the future: individual investors are looking to fund
their consumption spending in retirement, for example, while
pension funds are focused on funding the pension liability and
repaying employees the retirement benefits promised to them. A
more robust approach needs to account for the factors that affect
these liabilities and the correlations between changes in value of
the liabilities and returns on the asset portfolio.
 Single-period framework: MVO is a single-period framework
that does not take into account interim cash flows or the serial
correlation of asset returns from one time period to the next. This
means it ignores the potential costs and benefits of rebalancing a
portfolio as capital market conditions change and asset allocations
drift away from their optimal starting point 1-79
Criticisms of the mean-variance analysis
 GIGO: The quality of the output from the MVO (portfolio
allocations) is highly sensitive to the quality of the inputs
(i.e., expected returns, variances, and correlations). In
other settings, this is often called the “garbage-in-garbage-
out” (GIGO) problem. Although all three inputs are a
source of estimation error in MVO, expected returns are
particularly problematic, so we focus here on addressing
the quality of the expected return inputs.
 Concentrated asset class allocations: MVO often
identifies efficient portfolios that are highly concentrated
in a subset of asset classes, with zero allocation to others;
in other words, lowest calculated standard deviation is not
the same thing as practical diversification.
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Criticisms of the mean-variance analysis
 Skewness and kurtosis: MVO analysis, by definition,
only looks at the first two moments of the return
distribution: expected return and variance; it does not take
into account skewness or kurtosis. But empirical evidence
suggests quite strongly that asset returns are not normally
distributed: there is significant skewness and kurtosis in
actual returns.
 Risk diversification: MVO identifies an asset allocation
diversified across asset classes but not necessarily the
sources of risk. For example, equities and fixed-income
securities are two different asset classes, but they are
driven by some common risk factors, and diversifying
across the two classes won’t necessarily diversify those
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Practical issues in mean-variance analysis
 Markowitz optimisation treats expected returns,
variances and covariances as deterministic. However,
in practice, these moments of returns are unobservable
and must be estimated.
 We now discuss practical issues that arise in the
application of mean–variance analysis in choosing
portfolios. The two areas of focus are:
 estimating inputs for mean–variance optimization, and
 the instability of the minimum-variance frontier, which
results from the optimisation process’s sensitivity to the
inputs.
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Portfolio management: The shortcomings of
portfolio optimisation
 A problem with portfolio management is that implementation of the
mean-variance optimisation can lead to estimation of optimal
portfolios with extreme weights
 This is because we do not know the true inputs to the portfolio
optimisation procedure, but must instead estimate them on the basis of
historical data
 Under-estimating expected returns for some stocks will lead to large
negative portfolio weights; this is compounded by the fact that if the
correlations between the assets are high (as they commonly are in
practice), optimisation will favour low expected return assets that have
lower correlations
 The problem is so bad that in practice, naïve equally weighted
portfolios of assets will in many cases outperform those based on
portfolio optimisation. Note that it is not the theory at fault; it is
simply that it is very difficult to estimate the inputs that the theory
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requires
Practical issues in mean-variance analysis
 Relative to the first area, we must ask two principal
questions concerning the prediction of expected
returns, variances, and correlations.
 First, which methods are feasible?
 Second, which are most accurate?

 Relative to sensitivity of the optimisation process, we
need to ask:
 What is the source of the problem, and
 What corrective measures are available to address it.
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Portfolio management: The shortcomings of
portfolio optimisation
 A problem with portfolio management is that implementation of the
mean-variance optimisation can lead to estimation of optimal
portfolios with extreme weights
 This is because we do not know the true inputs to the portfolio
optimisation procedure, but must instead estimate them on the basis of
historical data
 Under-estimating expected returns for some stocks will lead to large
negative portfolio weights; this is compounded by the fact that if the
correlations between the assets are high (as they commonly are in
practice), optimisation will favour low expected return assets that have
lower correlations
 The problem is so bad that in practice, naïve equally weighted
portfolios of assets will in many cases outperform those based on
portfolio optimisation. Note that it is not the theory at fault; it is
simply that it is very difficult to estimate the inputs that the theory
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requires
Portfolio management: The shortcomings of
portfolio optimisation
 For example, suppose that we have collected five years of
monthly data for ten stocks in order to estimate the optimal
portfolio; these stocks are recorded in the spreadsheet
below, together with their market capitalisation
Portfolio management: The shortcomings of
portfolio optimisation
 Now we estimate the expected return vector and variance-
covariance matrix for the ten stocks

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Portfolio management: The shortcomings of Portfolio management: The shortcomings of

portfolio optimisation portfolio optimisation
 We derive the optimal portfolio with a risk free asset; we  The reason of this odd ‘optimised
use a risk free rate of 4.83% per annum (i.e. 0.40% per portfolio’ can be explained as:
month)  A number of the historical mean
 We assume that short selling is allowed although the returns are negative; if we ignore
resulting portfolio should, by construction, comprise only the effects of correlations, a
negative expected return should
long positions (to the extent that it is representative of the
imply a short position in the stock
market portfolio whose weights are all positive)
 The correlations between asset
 The resulting portfolio is clearly impracticable: most returns are in some cases very
mutual funds are not allowed to short sell stocks, and even large; large correlations for a
funds that can short sell stocks will find it difficult to short particular stock can lead us to
sell 17.63 times the fund value in AXP or 9.19 times the prefer other stock with smaller
fund value in MMM; the enormous long positions that returns but more moderate
result from these short-sale positions are similarly correlations
impracticable 1-87 1-88
Portfolio management: The shortcomings of
portfolio optimisation Reverse optimization
 Here we highlight the stocks with negative historical
returns and stocks whose correlations are greater than 0.5

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Reverse optimization The Black-Litterman model

 The Black-Litterman model is an extension of reverse
optimization in which the implied returns (actually implied
excess returns) from a reverse optimization are subsequently
adjusted to reflect the investor’s unique views of future
returns.
 A solution was proposed to the portfolio optimisation
problem by Fischer Black and Robert Litterman of Goldman
Sachs

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The Black-Litterman model The Black-Litterman model
 The Black-Litterman model is composed of two parts:
 Step 1: What does the market think about expected returns? It
assumes that the market portfolio (or benchmark portfolio) is optimal
and derives the expected returns of each asset under this assumption
 Step 2: Incorporating investor opinions about expected returns.
Suppose the investor has divergent opinions from the market-based
expected returns; the Black-Litterman model incorporates these
opinions into the optimisation procedure
 To implement the Black-Litterman model, we therefore start by
seeing what the weights of the market portfolio imply for the
expected returns of the stocks in the market portfolio; in other
words, given the variance-covariance matrix of the stocks and the
risk free rate, what expected returns would have yielded the
market portfolio that we observe in practice
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The Black-Litterman model The Black-Litterman model

 To estimate we assume that the expected return of the optimal is
12% per annum (i.e. 1.00% per month); note that we can’t
simply use the historical mean portfolio return as it is only a
very noisy estimate of the true expected return – in our case, it’s
actually lower than the risk free rate
 We can then compute the expected returns implied by the
market portfolio
 Note that by construction, if we applied the standard
optimisation approach using the Black- Litterman expected
returns, our estimated variance-covariance matrix and the
risk free rate, we would simply obtain the weights of the
benchmark portfolio

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The Black-Litterman model The Black-Litterman model
Step 2: Incorporating investor opinions
 Suppose a fund manager disagrees with the market opinion
that the expected return for GM will be 0.96%, and instead
thinks it will be 1.10%
 We set up a new parameter vector called to show fund
manager’s opinion difference from the market-implied
expected return; all of the values are initially zero except for
GM, for which the value is the difference between 1.10%
and 0.96%
 Importantly, however, if we believe that the GM expected
return will be higher than the market-implied expected
return, we implicitly believe that the expected returns for
other stocks will also be different because we know that they
1-97 are correlated with GM 1-98

The Black-Litterman model The Black-Litterman model

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100
The Black-Litterman model
 We can then apply the standard optimisation approach
using the adjusted expected returns, to yield the optimal
active portfolio that reflects the fund manager’s opinion
about GM
 Note that the fund manager’s opinion significantly changes
the weights of the benchmark portfolio
 The fund manager’s positive opinion about GM returns
has, predictably, increased the proportion of GM in the
portfolio
 But it has also affected the weights for the other nine
stocks
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101
Adding More Constraints
 Adding constraints beyond the budget and nonnegativity
constraint can be used to address the GIGO and highly
concentrated allocation issues. These constraints are
usually intended to make the asset allocation more
acceptable to an investor’s desires to include or exclude (in
total or in part) certain asset classes.
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103
The Black-Litterman model
 The previous slides provide an introduction to the more
advanced methods of portfolio management; however, we
have only considered the most basic case where a fund
manager has an opinion about a single asset
 In practice, an active fund manager would have opinions
about a number of assets
 The Black-Litterman model allows for this, but the
solution is more complicated
 We can also allow for differing degrees of confidence
about our opinions of the expected returns of individual
assets; we may strongly believe that the expected return of
GM is 1.1% but only weakly believe that the expected
return in HD is 1.05%
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Adding More Constraints
 Typical examples of additional constraints include:
 Specifying a fixed allocation to one or more assets, often
human capital or other nontradable assets.
 Setting an asset allocation range for an asset class (e.g., 10%
to 15% for global REITs).
 Setting an upper limit on the asset allocation to an asset class
to address liquidity issues (e.g., no more than 10% to private
equity).
 Specifying a relative allocation between two or more classes
(e.g., the allocation to Asia bonds must be less than Asia
equities).
 In a liability-relative setting, including a constraint to require
an allocation to assets that hedge the liability.
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