PM 3 Portfolio Management: An Overview

Managing a client’s money follows a repeatable sequence built around three stages: planning, execution, and feedback. Each stage contains specific tasks.

The planning step

The process begins by understanding the client’s objectives and constraints and writing them into an investment policy statement (IPS). Without that prior understanding, a manager is unlikely to serve the client well. The IPS is a written document setting out the client’s investment objectives together with the constraints that bind the portfolio. It often names a benchmark, such as a target rate of return or the performance of a market index, that the feedback stage later uses to judge whether goals were met. The IPS should be reviewed and refreshed on a regular schedule, for example every three years or whenever the client’s objectives, constraints, or circumstances change materially.

The execution step

Next the manager builds a portfolio consistent with the IPS. Execution starts with a target asset allocation, which fixes the weighting of asset classes, and then moves to analyzing, selecting, and buying individual securities.

Asset allocation. The manager forms economic and capital-market expectations and proposes a mix of asset classes suited to the client. Decisions cover the split among equities, fixed income, and cash; sub-classes such as corporate versus government bonds; geographic weightings; and any alternative assets, among them commodities, real estate, private equity, and hedge funds. Two analytical directions feed this work. A top-down analysis starts from the macroeconomic outlook, then narrows to attractive markets and industries, and finally to specific companies. A bottom-up analysis instead starts from company-specific facts, such as management quality and business prospects, paying less attention to the broad economic cycle.

Security analysis. The top-down picture combines with the bottom-up work of security analysts who cover particular sectors. Using detailed knowledge of the firms and industries they follow, they assess the size and risk of each security’s cash flows, assign a valuation, and flag preferred holdings.

Portfolio construction. The manager then assembles the portfolio using the target allocation, the security analysis, and the IPS. A central aim is diversification, again the refusal to hold everything in one basket. Decisions include asset-class weights, sector weights within a class, and the selection and sizing of individual holdings. Although every decision affects performance, the asset allocation choice is generally viewed as the most influential. Endowments illustrate how allocation reflects risk tolerance.

These endowments lean heavily on alternatives, namely private equity, real estate, and hedge funds, and they are relatively risk tolerant, with Yale holding under 5 percent in fixed income. Contrast that with an insurer: the Massachusetts Mutual Life Insurance Company portfolio held roughly 80 percent in bonds, mortgages, loans, and cash at the end of 2017, with bonds alone at 56 percent. The difference reflects risk tolerance and regulation, since life insurers face investment constraints. Once holdings are chosen, they must be traded; in many firms the manager passes orders to a buy-side trader who deals with a broker or dealer to execute them.

The feedback step

Feedback keeps the portfolio aligned as conditions change. Under portfolio monitoring and rebalancing, the manager reviews the portfolio as prices and fundamentals move; when weights drift from their intended levels because of market movements, rebalancing restores them, and the portfolio is revised if the client’s needs shift. Under performance evaluation and reporting, the manager assesses whether objectives were met, whether the return requirement was achieved, and how the portfolio fared against any benchmark. Weak results may prompt a review of objectives and changes to the IPS.

The same process serves many kinds of clients, split broadly into individual (retail) and institutional investors. Each group has distinctive needs.

Individual investors

Individuals invest for varied reasons. Short-term goals include funding a child’s education, saving for a large purchase such as a car or home, or starting a business. The dominant goal for most is retirement income. Many people fund retirement using defined contribution pension plans (DC plans), which are held in the worker’s own name and usually paid into by both employee and employer. Familiar examples are the US 401(k), the group personal pension scheme in the United Kingdom, and Australian superannuation. What defines a DC plan is that the employee, not the employer, carries the investment and inflation risk and must accumulate enough to retire on. Some individuals invest for growth and seek assets with capital-gain potential; others, such as retirees, want income and tilt toward fixed income and dividend-paying shares. Needs also depend on wider circumstances, such as job security and home ownership, and many people first build a cash reserve and buy suitable insurance before making longer-term investments. Managers reach individuals either directly or by way of intermediaries, for instance financial advisers and retirement plan providers, and the distribution channel differs from region to region. Wealth managers often target high-net-worth clients, who tend to want customized solutions alongside tax and estate planning.

Institutional investors

This category takes in banks, insurers, sovereign wealth funds, defined benefit pension plans, endowments and foundations, and investment companies. Each has its own goals, allocation preferences, and strategy needs.

Defined benefit pension plans

A defined benefit pension plan (DB plan) is a company-sponsored plan promising employees a predefined retirement benefit. The benefit is defined because the sponsor must specify the retirement income owed to participants. Employers generally make the contributions and bear the risk of funding the promised benefits, so plan managers must ensure enough assets will be available to pay pensions when due. A plan may have an indefinitely long horizon if it keeps admitting new members, or a finite horizon if closed to new entrants. Managers sometimes match assets to liabilities, for example by holding bonds whose cash flows line up with expected pension payments. A long-running trend favors DC plans over DB plans because they cost the company less and carry less risk, so DB plans have been losing share of pension assets. Even so, DB plans remain large. Global pension assets came to more than US$41 trillion at year-end 2017, with the United States, United Kingdom, and Japan jointly accounting for over 76 percent of that sum.

The mix of DB and DC also varies by geography. The United States and Australia hold a higher share of pension assets in DC plans, while in Canada, Japan, the Netherlands, and the United Kingdom the balance still tilts toward DB plans.

Endowments and foundations

An endowment is a fund held by a non-profit institution to support the specific services it provides, whereas a foundation exists to make grants. Together they hold an estimated US$1.6 trillion of assets within the United States, which is the leading market for both. They typically allocate a sizable share to alternative investments, reflecting their long, often perpetual, time horizons and the influence of the endowment model developed at Yale University by David Swensen and Dean Takahashi.

A typical objective is to preserve the real, inflation-adjusted value of the fund while producing income for the institution’s needs. Spending rules make this concrete. Yale sets a target spending rate of 5.25 percent and applies a smoothing rule: spending in a year equals 80 percent of the prior year’s spending plus 20 percent of the target rate applied to the market value two years earlier. The Wellcome Trust in the United Kingdom targets a 4.5 percent real return across a long horizon so as to balance current and future beneficiaries. Objectives and constraints also shape the holdings, for instance a medical endowment excluding tobacco.

Banks, insurers, and sovereign wealth funds

Banks accept deposits and lend, and they invest excess reserves conservatively in very short-duration fixed income, aiming to earn more than they owe depositors. Liquidity is paramount because they must meet withdrawals on demand. Insurance companies collect premiums and must invest them so claims can be paid. They fall into two broad camps, life insurers and property and casualty (P&C) insurers. Premiums form the general account, which regulation keeps conservatively invested in a diverse set of fixed-income securities; allocations differ across insurer types because of differing liability durations and liquidity needs, with life insurers holding longer-term assets than P&C insurers. The surplus account, the excess of assets over liabilities, targets a higher return and can hold less conservative assets such as public and private equity, real estate, infrastructure, and hedge funds. Sovereign wealth funds (SWFs) are government-owned pools that put money into financial or real assets. They usually carry no specific liabilities such as pensions, and their horizons and objectives follow government goals such as budget stabilization or future development. Assets held by SWFs grew to over twice their earlier size between 2007 and March 2018, passing US$7.6 trillion, and the largest, such as Norway’s Government Pension Fund Global, China Investment Corporation, and the Abu Dhabi Investment Authority, cluster in Asia and in resource-rich states.

Both the management process just described and the investor groups above operate inside the asset management industry, a core part of global financial services. By the close of 2017 this business oversaw upward of US$79 trillion of assets belonging to institutional and individual owners. Roughly 80 percent of professionally managed money sits in North America and Europe, while the quickest growth is coming from Asia and Latin America.

The industry is highly competitive and broad, ranging from pure-play independent managers to diversified banks, insurers, and brokerages that add asset management to their core business. An asset manager is called a buy-side firm because it uses the services of sell-side firms, which are broker-dealers that sell securities and supply investment research to their buy-side clients. Managers vary in scope: specialists focus on one asset class or style, full-service managers offer many, and a multi-boutique is a holding company owning several specialized firms that keep their own investment cultures and often equity stakes while sharing centralized services such as technology, sales, operations, and legal support.

Active versus passive management

At the end of 2017 active management far exceeded passive management in both assets and revenue, though passive was growing quickly. Active managers use fundamental research, quantitative research, or both to try to beat a benchmark such as the S&P 500, or a blend of benchmarks for multi-asset portfolios. Passive managers instead aim to replicate a market index. Because passive fees are low, passive holds a fifth of assets but only 6 percent of industry revenue.

Between these poles are strategies known as smart beta, which use simple, transparent, rules-based tilts toward factors such as size, value, momentum, or dividends. Smart beta typically charges somewhat higher fees and turns over more than plain market-cap-weighted passive strategies.

Traditional versus alternative managers

Managers are also grouped as traditional or alternative. Traditional managers concentrate on long-only equity, fixed-income, and blended multi-asset mandates, drawing the bulk of revenue from asset-based fees. Alternative managers focus on hedge funds, private equity, and venture capital, earning both management fees and performance fees, also called carried interest. Alternatives hold a small share of total assets but generate a disproportionately large share of revenue. The line between the two has blurred: traditional firms have added higher-margin alternative products, while alternative firms have launched retail liquid alternatives, typically inside regulated pooled vehicles such as mutual funds, carrying lower leverage, no performance fee, and holdings that are easier to sell.

Ownership structure

Ownership matters for retaining and motivating key staff, and managers who invest personal capital alongside clients are often viewed favorably for the alignment it signals. Most asset managers are privately owned, typically by the people who founded or run them, and usually take the legal form of a limited liability company or a limited partnership. Publicly traded managers are less common but hold substantial assets, and a widespread form is the asset management division of a large, diversified financial services company that also offers insurance and banking.

Industry trends

Three trends stand out. The first is the growth of passive investing. Passive assets are concentrated among a small group of managers and tilted toward equity strategies; the top three providers control 70 percent of the industry’s passive assets. Low cost is a key driver, since index fund fees are often a fraction of active fees, as is the trouble active managers have producing alpha where prices are already efficient, for example large-cap US equities.

The second trend is the use of big data. In 2013 IBM estimated that 90 percent of the world’s data had been created in the prior two years, and cheaper storage and greater computing power keep expanding the sources available. Managers apply advanced statistics and machine learning to structured inputs, order-book records and security returns among them, as well as to unstructured material generated by internet activity. Computers can read earnings and economic releases faster than people and trade on them. Popular new sources include social media data, which can signal market sentiment and product trends, and imagery and sensor data from satellites and geolocation devices that track economic activity such as weather, shipping patterns, and retail traffic. The challenge is finding data with predictive value faster than rivals, an information arms race requiring heavy investment in specialists and technology.

The third trend is the rise of robo-advisers, technology platforms that use automation and algorithms to deliver services such as investment planning, asset allocation, tax loss harvesting, and strategy selection, usually shaped by an investor questionnaire on goals and risk tolerance. They range from purely digital to hybrid models with human advisers. At the close of 2017 these platforms oversaw roughly US$180 billion, a figure widely expected to climb. Drivers include rising demand from mass affluent and younger investors, who have been underserved; lower fees, since a US financial adviser might charge about 1 percent a year while robo-advisers average around 0.20 percent and lean on low-cost index funds and ETFs; and new entrants, as large wealth managers, insurers, asset managers, and even technology firms build robo solutions to serve new segments and monetize their access to user data.

A recurring challenge for every investor is finding the right products. Options range from a simple brokerage account, where the individual assembles securities alone, to pooled vehicles run by professional managers. The principal pooled vehicles are mutual funds, exchange-traded funds, separately managed accounts, hedge funds, plus private equity and venture capital funds.

Mutual funds

A mutual fund is a comingled pool in which each investor holds a pro-rata claim on the fund’s income and value. Its value is the net asset value, computed daily from the closing prices of the securities held.

Mutual funds are a primary product for individuals worldwide; the International Investment Funds Association put worldwide regulated open-end fund assets at US$50 trillion in the first quarter of 2018. Their appeal lies in modest minimum investments, ready diversification, liquidity each day, and standardized reporting of performance and tax.

An open-end fund accepts new money and issues new shares at net asset value, and it redeems shares at net asset value, so its share count changes constantly. A closed-end fund accepts no new money after launch; investors buy from and sell to one another, so the share count is fixed. Because of that fixed base, closed-end fund shares can change hands above or below net asset value, at a premium or discount set by demand for them. Each structure has trade-offs. Open-end funds grow easily but pressure the manager to handle inflows and outflows, often keeping some cash for redemptions and sometimes selling assets at inconvenient times, so they tend not to be fully invested. Closed-end funds avoid that but grow only with difficulty; of the roughly US$19 trillion in US mutual fund assets at the end of 2017, only about 1 percent were closed-end. Funds are also classed as load or no-load: a no-load fund charges no purchase or redemption fee, only an annual fee based on net asset value, while a load fund adds a sales charge to buy or redeem and is often sold through brokers who take part of the upfront fee. Load funds have declined in importance over time.

Types of mutual funds

Funds are commonly grouped by the assets they hold. Money market funds invest in short-term instruments, among them certificates of deposit, commercial paper, and treasury bills, seeking safety of principal, high liquidity, and returns near money-market rates. Many keep a constant net asset value at 1 unit of currency, while others use a variable net asset value. In the United States they are either taxable, holding high-quality short-term corporate and federal debt, or tax-free, holding short-term state and local debt. They have served as an alternative to bank deposit accounts since the early 1980s, yet they carry no deposit insurance. Bond mutual funds hold a portfolio of bonds and occasionally preferred shares, with the net asset value equal to the total value of the bonds divided by the shares. The key difference from a money market fund is maturity: money market holdings run from overnight to rarely beyond 90 days, whereas bond fund holdings span one year to 30 years or more.

Stock (equity) funds have historically been the largest category by assets. They come in two forms. An actively managed fund selects stocks in pursuit of superior performance, while an index fund passively tracks a benchmark; the first index fund was launched in 1976 by the Vanguard Group. Active funds charge higher fees to pay for research, trade far more, and, because funds usually must distribute realized income and gains, tend to generate more taxable capital gains than an index fund’s buy-and-hold approach. Hybrid or balanced funds hold both bonds and stocks. They are a small share of US mutual fund assets but more common in Europe, and they have grown with lifecycle or target date funds, which manage the asset mix around a chosen retirement date. For example, an investor aged 40 in 2019 who plans to retire at 67 could buy a 2046 target date fund; it might start near 90 percent shares and 10 percent bonds and gradually shift toward bonds over the following 27 years.

Other pooled products

A separately managed account (SMA), also called a managed, wrap, or individually managed account, is run solely for one individual or one institution. In contrast to a mutual fund, the client holds the underlying assets directly. The drawback is a much higher minimum investment, so large institutions are the main users. SMAs let managers tailor a strategy to specific objectives, constraints, and tax situations; a public pension plan might, for instance, exclude tobacco and defense while adding companies favored on other environmental, social, and governance grounds.

Exchange-traded funds (ETFs) list on exchanges and change hands like ordinary stocks, and most are built as open-end funds. They are among the fastest-growing products, with global assets rising from US$428 billion in 2005 to US$4.9 trillion by June 2018. Because they trade on exchanges, ETFs are priced intraday, and investors buy from and sell to other investors, can short the shares, and can buy on margin. Mutual funds, by contrast, usually transact once a day at net asset value, with no short sales or margin, and investors deal directly with the fund. In practice an ETF’s market price stays close to the net asset value of its holdings. ETFs also tend to pay dividends out to shareholders rather than reinvest them, as mutual funds usually do, and often carry a smaller minimum investment.

Hedge funds are private vehicles that commonly use leverage, derivatives, and both long and short positions. The industry traces to a 1949 fund run by A.W. Jones & Co., and global hedge fund assets reached US$3.3 trillion by May 2017. Strategies range from narrow niches to global multi-strategy approaches, so hedge funds are often used for diversification. Shared traits include short selling, whether direct or synthetic through derivatives; a focus on absolute return in all market conditions; the use of financial or implicit leverage; historically low correlation with traditional asset classes; and a two-part fee, a management fee plus an incentive fee on realized gains, traditionally 2 percent and up to 20 percent, though competition has pressured both. Hedge funds are not open to all investors, typically requiring a high minimum and restricting liquidity to periodic withdrawals or long lock-ups.

Private equity and venture capital funds seek to buy, improve, and eventually sell portfolio companies for profit. Private equity assets under management reached US$3.1 trillion in December 2017, and most funds run about 7 to 10 years, subject to extensions. Unlike managers of public securities, these firms take a hands-on role through financial engineering, installing management and board members, and shaping business strategy, then exit or harvest by selling a portfolio company via merger, acquisition, or initial public offering. Most funds are limited partnerships between the fund manager, the general partner (GP), and the investors, the limited partners (LPs). They earn revenue through management fees, typically 1 to 3 percent of committed capital and sometimes stepping down over time; transaction fees paid by portfolio companies, often partly shared with LPs; carried interest, which is the general partner’s cut of the gains, usually around 20 percent and generally collected only once the LPs have recouped their capital; and investment income on the GP’s own capital.