Archive for November, 2007

The Role of Capital Market Expectations in Portfolio Management

When developing an investment strategy, one key element is to develop capital market expectations – forecasts of the long-term risk and return characteristics for various asset classes. These forecasts will be used to select asset allocations that minimize risk for a given level of return or maximize return for a given level of risk.

The capital market expectations influence asset allocation strategy and the frequency at which portfolios will need to be rebalanced. Even in a passive strategy (passive strategies do not react to changing capital market expectations) an initial forecast of long-term expectations is crucial.

Posted on 30th November 2007
Under: Active Management, Asset Allocation, Fundamental Analysis, Investment Returns, Passive Management, Portfolio Management | 1 Comment »

Strengths and Weaknesses of the Residual Income Model

When used to value stocks, the residual income model separates value as the sum of two components:

  • The current book value of equity (BV)
  • The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share.

Strengths of the model include:

  • Less sensitivity to estimated terminal value than other models
  • Rely on readily available accounting data
  • Can be used to value stocks that do not have stable dividends or cash flow
  • Focus on economic, rather than accounting, profitability

Weaknesses include:

  • Relies on accounting data (which can be manipulated)
  • May require adjustments based on accounting methods, particularly in cases of a dirty surplus.

Posted on 30th November 2007
Under: Accounting, Financial Statement Analysis, Investing in Stocks, Valuation | No Comments »

Investment Risk Management Process

Investment portfolios are subject to a wide range of risks at all time. A significant part of the portfolio management process is a strong risk management process, which should entail the following steps:

  1. Identifying the risk exposures faced
  2. Establishing appropriate ranges for such exposures
  3. Continually measuring each exposure
  4. Executing appropriate adjustments whenever a given exposure falls outside the target range

Over time, as more is learned about the various risks it may be necessary to alter the procedures to reflect new policies, preferences and information.

Posted on 29th November 2007
Under: Governance, Portfolio Management, Risk Management | No Comments »

Steps in the Portfolio Management Process

The portfolio management process broadly consists of three steps: Planning, Execution and Feedback.

The planning step begins with identifying the investor’s objectives and constraints.  Once these are established, an investment policy statement can be written to act as a guideline for future investment decisions. Long-term expectations for the capital markets will then be used to create a strategic asset allocation suitable to the objectives and constraints outlined.

The execution step puts the plan into action. Specific assets can be selected, and decisions can be made on how best to implement the strategic plan. The portfolio can be optimized using quantitative tools and at times it may be deemed appropriate to make tactical alterations to the long-term strategic asset allocation.

The feedback step consists of ongoing monitoring of the portfolio and rebalancing to the strategic asset allocation when needed. It also entails an evaluation of the performance – not only how well the portfolio performed but what factors contributed to the performance.

Posted on 29th November 2007
Under: Portfolio Management | No Comments »

Investing in Commodities

Investors wanting exposure to commodity prices in their portfolio can gain exposure either directly or indirectly.

Direct investment in commodities has traditionally taken the form of cash purchase of physical commodities such as metal, oil or agricultural products. The development of derivatives markets has resulted in most of the direct commodity transactions involving futures products. Direct investment obviously provides a direct link to commodity prices, but can require possession, storage, financing, insurance and transaction costs which are either paid directly or through the basis in the futures contract.

Indirect investment in commodities is typically manifest as buying the equities of a commodity producer such as a mining company. It does not provide a direct exposure to the commodity prices, in part because many producers uses hedges to control their own exposure.

Posted on 28th November 2007
Under: Active Management, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Portfolio Management | No Comments »

Types of Real Estate Investments

There are a number of ways to invest in real estate, each of which can provide distinct return and diversification characteristics to a portfolio.

Direct investments involve the purchase of residences, business real estate or land, which is then developed and/or managed. The rental of the properties provides a stable income stream, and property values may also rise over the long term.

Indirect investment in real estate can take a number of forms:

  • The equity of companies engaged in development, ownership or management of real estate. These include homebuilders and real estate operating companies.
  • Real estate investment trusts (REITs), which are public equities representing pooled real estate investments.
  • Separately managed accounts
  • Infrastructure funds, which invest in public infrastructure projects such as schools or airports.

Posted on 27th November 2007
Under: Alternative Assets, Portfolio Management | No Comments »

Types of Alternative Investments

Although many refer to “alternative investments” as though a single asset class, there are actually several categories of alternative investments.

Traditionally, the available alternative investments (alternatives to stocks and bonds) were real estate, private equity and commodities.

“Modern Alternatives” also include hedge funds, managed futures, and distressed securities. These categories are typically more like strategies than distinct asset classes.

Despite the individuality of various types of alternative investments, they do share some common characteristics:

  • Relative illiquidity, for which investors require a higher return
  • Improved diversification benefits compared to a portfolio consisting solely of stocks and bonds
  • High costs for due diligence because of complex investment structures, the need for specific expertise, and a lack of transparency with respect to performance communication
  • Difficulty in establishing appropriate benchmarks and thus in performance appraisal

Alternative assets provide investors with exposure to risk factors they cannot get from traditional investments, exposure to specialized investment strategies, or a combination of the two.

Posted on 26th November 2007
Under: Alternative Assets, Asset Allocation, Investment Returns, Portfolio Management | No Comments »

Optimizing Allocations to a Group of Equity Managers

Investors choosing a group of managers for various portions of their total portfolio should maximize the active return generated for a given level of risk specified through the investor’s aversion to active risk.

This can be done objectively by maximizing the utility of active return of the manager mix, which equals the expected return of the manager mix plus the product of:

  • the investor’s trade-off between active risk and active return and
  • the variance of active return

Posted on 25th November 2007
Under: Active Management, Investing in Stocks, Portfolio Management | No Comments »

Extensions to Classical Bond Immunization Theory

Classical bond immunization is based on duration and assumes that changes in the yield curve will be parallel and that there will be no interim cash inflows or outflows prior to the investment horizon.

Multifunctional duration or key rate duration extends immunization theory to incorporate non-parallel shifts in the yield curve.

Alternative theories relax the assumptions to incorporate parallel shifts and interim cash flows.

Return maximization analyzes the risk and return tradeoff for immunized portfolios.

Contingent immunization provides flexibility to pursue active strategies provided a minimum return is assured. Below that minimum, immunization would be triggered.

Posted on 24th November 2007
Under: Fixed income investments, Investing in bonds, Portfolio Management | No Comments »

Benchmarking a Bond Portfolio

There are a number of appropriate ways to benchmark a bond portfolio.


Some investors have specific liabilities that must be met. These can include leverage taken in order to increase portfolio return, legal promises (such as benefit payments) and ongoing cash flow needs faced by the investor.

In cases such as these, success in investing is determined by whether the liabilities are actually met. The liabilities serve both as an objective and as the benchmark for the portfolio performance.

Bond Index

Other investors do not face specific liabilities. These include, for example, the manager of a fixed-income mutual fund. The lack of a cash flow constraint gives such managers greater freedom to seek investment returns.

Such managers will typically use a diversified bond market index as their benchmark, and their objective will be to match or exceed the return on the bond index.

Posted on 23rd November 2007
Under: Fixed income investments, Portfolio Management | No Comments »