Introduction To Portfolio Management

9 min read

By Mario Pisa Peña

A definitive read about Portfolio Management, this blog serves as an introductory article and your guide. It explains all that you need to know about Portfolio Management like techniques, types, derivatives, and much more.

Here's what we cover in this article:

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What is Portfolio Management?

Portfolio management is a very generic term used to refer to the manager’s style of managing a portfolio of assets.

In the financial markets, there are many assets available, such as stocks and corporate bonds, treasury bills, commodities, currencies, indices, options, REIT and much more. It is, therefore, necessary to apply management techniques to manage portfolios of assets that can delimit some key aspects such as risk and expected return.

Unfortunately, we can not get infinite returns with zero risks, as one depends on the other and if we want to increase the portfolio return, it will usually be at the expense of taking more risk.

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Definition of Portfolio Management

As the definition goes,

“An efficient portfolio is defined as a portfolio with minimal risk for a given return, or, equivalently, as the portfolio with the highest return for a given level of risk.”

On the NYSE alone, there are more than 2,800 listed companies and in the U.S. derivatives market, CME, there are thousands of contracts available too. If we also consider the international markets, the number of choices is really overwhelming.

Therefore, regardless of whether we are managing the capital of $100,000 or one of billions of dollars, it is convenient to have tools that facilitate the task of selecting the appropriate instruments, or what is the same, to build a portfolio that allows to contain the assigned risk and maximize the return. That is, to use portfolio management techniques.

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What are Portfolio Management techniques?

Portfolio management techniques allow us, at least not to assume unnecessary risks, to limit the risk assumed in each individual investment and the portfolio as a whole.

It helps to improve performance where possible and to be able to analyze and compare with other portfolios that use the same management style. They also allow us to make a hypothesis about the future and answer the question, “what if?”.

Although portfolio management is not an exact science because it deals with the uncertainty of the future, it allows us to have an adequate framework in which to make investment decisions.

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Types of Portfolio Management

We, therefore, see that a classification of management styles is necessary, which can be divided, for example, into the following groups:

  • Passive Management Portfolio: Normally the managers of passive portfolios consider that it is practically impossible to obtain more performance than the market itself and therefore they limit themselves to tracking it.

  • Active Management Portfolio: These portfolio managers consider that if it is possible to obtain a higher return than the market and therefore with more active portfolio management, in theory, they are able to obtain Alpha (Alpha is the excess return with respect to the market). For comparative purposes, it is also interesting to know the Beta of the portfolio, as this indicates the deviation it has had with respect to the market.

  • Aggressive Management Portfolio: They are portfolio managers capable of finding and exploiting market inefficiencies who speculate with market biases.

It is also necessary to classify the different types of assets into manageable groups, for this we have already mentioned some possible groups of assets, but they can also be classified by risk, capitalization, country, sector, value or growth and so on.

Faced with such a variety of styles and assets, portfolio management techniques allow us to standardize management techniques and have adequate measures of performance and risk and, therefore, create different portfolios suitable for each type of investor.

Since any portfolio is made up of assets, let’s try to define some of the most common assets we can find in a portfolio.

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Assets classes in Portfolio Management

The classic components of a portfolio are:

  • Stocks or Equities
  • Bonds
  • Cash

Stocks or Equities: These assets are considered high risk and therefore offer opportunities for high returns. They can also be subclassified by country, sector and/or by the asset of value or growth, the former tend to offer dividends, while the latter tend not to offer dividends but the return is usually higher than the market. In addition, they offer rights at shareholders’ meetings, since in fact, the shareholders own the company. (Sometimes there are exceptions with class A and class B shares where the latter do not offer voting rights.)

Bonds: These assets are considered low risk and therefore offer moderate returns, the advantage is that from the beginning, the investment return is known. These assets are loans that are made to governments and companies, the maturity date and fixed return or coupon payment at a certain frequency is pre-fixed. They can also be subclassified as corporate or government bonds, maturity date, rating, etc.

Cash: We must foresee the money of our portfolio because it will not always be invested 100% and sometimes the cash can be used to make operations in the money market, the risk can vary from very low to very high, depending on the chosen currency.

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Derivatives and Portfolio Management

On the other hand, there are derivative products which, as their name implies, the value (and therefore the return) is derived from an underlying product.

Some of the best-known derivatives are:

  • Futures
  • Options

Futures

A future is a contract between two parties, where one party buys/sells an asset with a certain future delivery date and the other party sells/buys the asset. This contract is guaranteed by the clearinghouse. 

At maturity, both parties are obliged, one to deliver the good, regardless of the current market price, and the other is obliged to receive the good, regardless of the current market price, as the price was fixed at the transaction time.

Although it should be made clear that traders do not usually leave the contract open until the maturity date as they generally have speculative positions.

The future price is derived from an underlying asset such as a stock index, commodities, etc.

Here we can find:

  • Indices (Dow Jones, S&P 500, Nasdaq, Russell 2000, etc.)
  • Precious metals (Gold, platinum, etc.)
  • Industrial metals (copper, lead, etc.)
  • Energy (Oil, Natural Gas, Ethanol, etc.)
  • Agriculture (soybeans, beans, corn, wheat, etc.)
  • Soft (meat, live cattle, orange juice, sugar, cotton, etc.)

Note that you can also gain exposure to these products through ETFs as if they were stocks, although ETFs deserve a separate study.

Options

Options are instruments where one party buys the right to buy/sell an asset at a fixed price on a certain date and the other party sells that right committing to it, this operation is guaranteed by the clearinghouse. The option price is derived from an underlying asset such as stocks, stock index, commodities, etc.
Finally, there are other less common investment instruments but which, depending on the portfolio being designed may be attractive for diversification, these instruments maybe

  • REIT (Real Estate Investment Trusts),
  • OTC (Over the Counter) operations like
    • warrants,
    • venture capital companies, and
    • ad-hoc products that may be created for specific clients, etc.

As you may suppose, this list is neither complete nor exhaustive, but it contains the most popular instruments commonly found in portfolio management.

We have also seen that instruments can be classified in different ways in order to help you select the instruments that best suit your management strategy.

In addition to the enormous variety of financial instruments available, other factors must be taken into account when deciding on one or the other instrument, such as volatility, liquidity, information availability and transaction costs.

With all these elements, it seems clear that we need a framework that facilitates portfolio management and helps us select the best assets for a given moment, delimiting the level of risk to be supported, as well as establishing a return objective.

From the industry’s point of view, it is also important to have established standard indicators that allow the performance of a portfolio to be compared with the rest of the industry.

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Traditional approaches for Portfolio Management

A portfolio is composed of assets and it is the responsibility of the portfolio manager to decide which assets to incorporate into the portfolio. For this, there are two traditional approaches

  • the bottom-up approach
  • top-down approach

The bottom-up approach

This approach makes asset selection based on criteria defined by the analyst as P/E, relative strength, by sectors and so on. This technique is usually known as stock-picking.

The top-down approach

In the top-down approach where the analyst divides the task of selecting actions into filters that, quantitatively, reduce the number of options available for inclusion in the portfolio.

For example, an analysis can be made to decide on which markets or countries we want to invest, then the sectors are decided and finally, stock-picking is done based on some criterion of, for example, relative strength.

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Tools to measure Portfolio returns

Other tools, simple but yet powerful, are to measure the return, among these tools we can find:

  • Arithmetic return: The exact return on an asset can be measured by the price in time 't', minus price in time 't-1' plus dividends (if any) divided by price in 'time-1'.

  • Logarithmic return: The return on an asset can be measured as “ln” which is the price in time 't' plus dividends (if any) divided by price in 'time-1'. This measure is aggregated and allows us to compute any return length simply by adding simple periods.

  • Geometric return: Or the compound geometric rate of return, to compute the real growth rate of the investment over the whole period.

  • Portfolio return: Here there are several approaches since the portfolio can have simple or complex management and the assets that compose it can offer dividends, payment in shares, splits, capital flow, leverage, etc. although we can use the arithmetic return measure to calculate portfolio performance over a given period. We would take the initial value of the portfolio in time t minus the value of the portfolio in time 't-1' added to dividends (if any) and divided by the value of the portfolio in time 't-1'.

  • Relative return: Knowing the performance of a portfolio is an indicator that by itself, only offers a data on the manager’s ability to generate a return, but this data becomes much more relevant if we put it into perspective with respect to other returns of the same kind. For example, if our portfolio is made up of NYSE shares we can compare the performance against the S&P 500 index or we can compare it with the performance of other managers with portfolios and styles with similar characteristics.

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Variance on return in a Portfolio

Finally, the simplest tool to measure the risk on an asset is the variance on return which gives us an idea of the dispersion with respect to the average, but certainly, the assets in the portfolio are subject to other risks that need to be quantified.

One of the first studies on risk and its characterization was carried out by Markowitz who developed the modern portfolio theory and demonstrates the benefit of diversification although he assumes that returns follow a normal distribution which, as we shall see, is not the real behaviour of the market.

This study serves as a basis for other models that we will see in this series of posts such as the Capital Asset Pricing Management (CAPM).

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Conclusion

In the post series on portfolio management, we will look at some of the theories and strategies for the construction of portfolios such as the Capital Asset Pricing Management (CAPM), Fama-French Three-Factor Model or multi-strategy portfolios.

There would be no management if we had not controlled the risk/benefit of the portfolio, we will see posts in this series that will tell us about the analysis of the risk/benefit.

When we have the portfolio built and we have the risk/benefit analysis, we can use optimization techniques that help us maximize performance such as Monte Carlo analysis or ML techniques. Finally, we will look at ML and intraday risk portfolio management techniques.

One can learn about constructing portfolios and managing risks using various quantitative techniques in this course on Quantitative Portfolio Management.

References

Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.