Archive for December, 2007

The Portfolio Management Process

Managing investment portfolios is an ongoing process. It consists of several steps:

  • Identifying and specifying investment objectives and constraints
  • Developing investment strategies
  • Deciding portfolio composition in detail
  • Portfolio managers initiating portfolio decisions
  • Traders implementing portfolio decisions
  • Measuring and evaluating portfolio performance
  • Monitoring investor and market conditions
  • Implementing any necessary rebalancing

Posted on 31st December 2007
Under: FInancial Planning, Portfolio Management | No Comments »

Cash Flow Return on Investment (CFROI)

Cash Flow Return on Investment (CFROI) is an internal rate of return (IRR) type metric measuring the return expected to be generated by a firm’s existing assets throughout their useful lives. CFROI can be calculated in five steps:

  • compute the average life of assets by dividing gross assets by depreciation expense
  • compute gross cash flow by adjusting net income for non-cash charges, financing expenses, operating lease payments and equity reserve accounts
  • compute the gross investment as gross plant and equipment adjusted for reserves, capitalized expenses, restructuring charges, amortization and the present value of operating leases
  • compute the value of any assets that will not depreciate (which will represent the future value)
  • solve for IRR (or CFROI)

Posted on 31st December 2007
Under: Accounting, Adjusting Reported Financial Statements, Valuation | No Comments »

The Role of Strategic Asset Allocation in Portfolio Management

A strategic asset allocation combines the Investment Policy Statement with capital market expectations to determine a target weight (or range) for each asset class. Often the strategic asset allocation takes a single period perspective, in which the investor’s time horizon is the period in question. Though more costly, a multiple period perspective can also be taken, which would address liquidity and tax considerations surrounding portfolio rebalancing and the potential for serial correlation in investment returns.

Posted on 30th December 2007
Under: Asset Allocation, FInancial Planning, Portfolio Management | No Comments »

Best and Worst Situations for Applying Residual Income Models

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.

Like any model, residual income models are more appropriate at some times than others. They are most appropriate when:

  • The subject company is non-dividend paying
  • Free cash flow is unstable or negative over a reasonable forecast horizon
  • Other approaches result in greater sensitivity to terminal value than the investor finds comfortable

The are less appropriate when:

  • the company’s accounting practices result in significant dirty surplus
  • the components of residual income (book value, ROE) are not predictable

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

Risk Governance

Risk governance is a term for specific processes put in place for the purpose of risk management. Risk governance requires senior management to make choices regarding the governance structure, infrastructure needs, reporting requirements and methodology.

A centralized governance structure has the advantage of economies of scale and allows management to consider whether the risks of various business units offset (diversify) each other.

A decentralized governance structure, by contrast, puts risk management in the hands of those most familiar with the specific risks.

Many firms are now adopting more centralized approaches due to the advantages noted above, and also to have more oversight of the risk management process.

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

Investment Objectives

The two main investment objectives – risk and return – are intertwined.

Although it may seem strange to consider risk an objective, investors do have an objective of minimizing the risk taken to achieve a given level of return. Risk can be measured in several ways – volatility, tracking error relative to a benchmark, or the risk of loss. Investor objectives must incorporate the investor’s appetite for risk, as well as the ability to tolerate risk. Risk tolerance is constrained by expected spending needs, targets for ending wealth, potential future obligations and the ability to increase savings if returns fall below those required. Both the willingness and the ability to accept risk influence the final risk objective. Finally, the accepted level of risk must be allocated to specific investment opportunities.

Similarly, the return objective must also be measured. Usually it is expressed in terms of total return, but this could be a nominal or a real return, pre-tax or after-tax. Any return objective should be realistic, and consistent with the stated risk objectives.  If there are specific needs, these can result in specific return requirements. All of these must be incorporated into a measurable (either absolute or relative) return objective.

Posted on 29th December 2007
Under: FInancial Planning, Portfolio Management | 2 Comments »

Commodity Benchmarks

As with any asset class, investments in commodities should be compared with an appropriate benchmark for risk and return. A number of commodity indices are in wide use, which all attempt to replicate the returns available to holding long positions in commodities. The indices can vary widely in terms of composition (which commodities are included), weighting scheme, and purpose. It is important to choose an index that matches the investment practices being used.

Since a futures contract is a zero-sum game (every long position is offset by a corresponding short position) it is not possible to market-weight a futures index. Instead, weighting strategies range from judgment-based methods, to equal-weight, to weightings based on world production levels. The benchmarks typically offer representations of both spot return and total return.

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

Benchmarks for Investments in Real Estate

There are a number of benchmarks available to gauge the relative performance of real estate investments.

The National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index is a useful comparison for direct real estate investments. It is a value-weighted index with data reported quarterly. It measures non-levered return, which may be more representative of private real estate funds. One consideration is that its use of appraisals can lead to stale valuations and the appearance of smoother return performance than is actually realized.

The NAREIT index is a useful benchmark for indirect real estate investments. It provides a real-time, cap-weighted performance measure of levered returns. The inclusion of leverage and more frequent measurement contribute to a higher standard deviation of returns than is observed by the NCREIF index.

Posted on 27th December 2007
Under: Alternative Assets, Institutional Investing, Investing in Real Estate, Portfolio Management | No Comments »

Due Diligence for Alternative Investment Managers

When considering investing with managers of alternative assets, there are a number of questions that should be answered.

  1. What is the market opportunity and why does it exist?
  2. Which managers have the best process for exploiting the opportunity and why?
  3. Do the managers have the organizational structure needed and is the structure stable?
  4. Are the managers and their employees trustworthy?
  5. Are the terms and fee structure fair? Are incentives of managers and investors properly aligned?
  6. Who are the attorneys, accountants and other support providers?
  7. Reading and understanding the prospectus
  8. A formal written recommendation

Posted on 26th December 2007
Under: Active Management, Alternative Assets, Institutional Investing, Portfolio Management | No Comments »

Core-Satellite Approach to Equity Manager Selection

The core-satellite approach typically anchors the overall portfolio using a core portfolio that is typically either indexed or an enhanced index portfolio linked to the overall asset class benchmark.

Around this core portfolio, the investor selects satellite managers for portions of the fund based on the manager’s expertise. The satellite portfolios may have the same benchmark, or constitute specific styles within the benchmark.

Posted on 25th December 2007
Under: Active Management, Asset Allocation, Institutional Investing, Investing in Stocks, Passive Management, Portfolio Management | No Comments »