Question

1. state and explain the traditional portfolio objectives?

2. Explain the six steps of portfolio management?

Answer 1

1.

If we look traditional portfolio than following are objectives of such portfolios:

• Stability of principal – this simply means that our capital should remain stable and there should not be any loss to principal amount
• Income objective – This means that whatever capital we have invested our main motive is to earn income from such investment
• Growth of income – this means that our main capital or principal should grow over the period of time
• Capital appreciation – By capital appreciation objective means the investment is in assets which will grow in value. This objective is most closely associated with the purchase of common stock, which offer low dividend yields but great opportunity for increase in value/capital appreciation. Common stock generally ranks among the most variable of investments as their return likely depends on what will happen in an unpredictable future.

2.

The Six-Step Portfolio Management Process - so exactly how do portfolio managers go about achieving their clients’ financial goals, in most cases, portfolio managers conduct the following six steps to add value:

#1 Determine the Client’s Objective

Individual clients typically have smaller investments with shorter, more specific time horizons. In comparison, institutional clients invest larger amounts and typically have longer investment horizons. For this step, managers communicate with each client to determine their respective desired return and risk appetite or tolerance.

#2 Choose the Optimal Asset Classes

Managers then determine the most suitable asset classes (e.g., equities, bonds, real estate, private equity, etc.) based on the client’s investment goals.

#3 Conduct Strategic Asset Allocation (SAA)

Strategic Asset Allocation (SAA) is the process of setting weights for each asset class – for example, 60% equities, 40% bonds – in the client’s portfolio at the beginning of investment periods, so that the portfolio’s risk and return trade-off is compatible with the client’s desire. Portfolios require periodic rebalancing, as asset weights may deviate significantly from the original allocations over the investment horizon due to unexpected returns from various assets.

#4 Conduct Tactical Asset Allocation (TAA) or Insured Asset Allocation (IAA)

Both Tactical Asset Allocation (TAA) and Insured Asset Allocation (IAA) refer to different ways of adjusting weights of assets within portfolios during an investment period. The TAA approach makes changes based on capital market opportunities, whereas IAA adjusts asset weights based on the client’s existing wealth at a given point of time.

A portfolio manager may choose to conduct either TAA or IAA, but not both at the same time, as the two approaches reflect contrasting investment philosophies. TAA managers seek to identify and utilize predictor variables that are correlated with future stock returns, and then convert the estimate of expected returns into a stock/bond allocation. IAA managers, on the other hand, strive to offer clients downside protection for their portfolios by working to ensure that portfolio values never drop below the client’s investment floor (i.e., their minimum acceptable portfolio value).

#5 Manage Risk

By selecting weights for each asset classes, portfolio managers have control over the amount of 1) security selection risk, 2) style risk, and 3) TAA risk taken by the portfolio.

Security selection risk arises from the manager’s SAA actions. The only way a portfolio manager can avoid security selection risk is to hold a market index directly; this ensures that the manager’s asset class returns are exactly the same as that of the asset class benchmark.

Style risk arises from the manager’s investment style. For instance, “growth” managers frequently beat benchmark returns during bull markets but underperform relative to market indexes during bear markets. Contrarily, “value” managers often struggle to beat benchmark index returns in bull markets, but frequently beat the market average in bear markets.

The manager can only avoid TAA risk by choosing the same systematic risk – beta (β) – as the benchmark index. By not choosing that path, and instead betting on TAA, the manager is exposing the portfolio to higher levels of volatility.

#6 Measure Performance

The performance of portfolios can be measured using the CAPM model. The CAPM performance measures can be derived from a regression of excess portfolio return on excess market return. This yields the systematic risk (β), the portfolio’s value-added expected return (α), and the residual risk.