The three steps of the portfolio management process

What are the three steps?

Portfolio management is a loop of three steps: plan, execute, and feed back. The results of the last step go back into the first.

Portfolio management processthree steps that repeat

• Planning Memorize know the client first
  • Understand objectives and constraints risk, return, time horizon, liquidity
  • Write the investment policy statement (IPS) includes a benchmark
  • Review the IPS regularly every few years or on a major change
• Execution Memorize build the portfolio
  • Asset allocation weights by asset class
  • Security analysis top-down or bottom-up
  • Portfolio construction weights, risk, trading costs
• Feedback Memorize close the loop
  • Monitoring and rebalancing restore target weights
  • Performance measurement and reporting against the IPS benchmark

Step 1: what happens in planning?

Memorize

The planning step starts with the client. A manager who does not understand the client’s needs, meaning objectives and constraints, is unlikely to achieve appropriate results. The output is the investment policy statement (IPS): a written planning document describing the client’s investment objectives and the constraints on the portfolio.

The IPS may name a benchmark, such as a target rate of return or a market index, that the feedback step uses to judge whether the objectives were met. It is reviewed regularly (for example every three years) and whenever the client’s objectives, constraints or circumstances change in a major way.

Step 2: what happens in execution?

Memorize

In the execution step the manager builds a portfolio that fits the IPS. It has three parts.

1. Asset allocation. Set the target weights of the asset classes, such as equities, fixed income, cash and alternatives, and the sub-asset classes and geographies within them. The asset allocation decision is commonly viewed as having the greatest effect on performance.
2. Security analysis. Analysts use their knowledge of companies and industries to assess the cash flows each security will produce, put a value on it and find preferred investments. The result is security analysis .
3. Portfolio construction. Using the target allocation, the security analysis and the IPS, the manager decides asset class, sector and security weights, keeps the risk within the client’s tolerance, and trades. Portfolio construction aims to capture the benefits of diversification, and trading costs are part of the decision because they reduce returns.

How do top-down and bottom-up analysis differ?

Two approaches feed the process. Top-down analysis begins with macroeconomic conditions (growth, interest rates, inflation), decides which markets and industries should do well, and only then considers specific companies. Bottom-up analysis focuses on company-specific circumstances such as management quality and business prospects, and is less concerned with the broad economic cycle. Many firms combine the two: strategists set the top-down view and analysts add the bottom-up insights.

Security analysis stylesboth feed portfolio construction

• Top-down Use it economy and markets, then sectors, then securities
• Bottom-up Use it companies and industries first, less weight on macro forecasts

Go deeper Two portfolios, two sets of constraints

Allocations reflect the client. A university endowment with a very long horizon and high risk tolerance can put most of its money in equities, private equity, real estate and hedge funds and only a small slice in bonds. A life insurer, with regulated liabilities to pay, holds mostly high-quality bonds, mortgages and loans. Same process, very different outputs, because the planning step produced very different policy statements.

Step 3: how does feedback close the loop?

Memorize

The feedback step keeps the portfolio on track. It has two parts.

• Monitoring and rebalancing. The manager watches for changes in markets and in the client’s circumstances. Market moves push weights away from the targets, and rebalancing trades them back.
• Performance measurement and reporting. The manager compares results with the IPS benchmark and reports to the client. Performance measurement shows whether the return requirement was met, and may lead to changes to the IPS, which returns the process to planning.

$$w_{S,1} = \frac{w_S(1+r_S)}{w_S(1+r_S) + w_B(1+r_B)}$$

Sort each card into planning, execution or feedback. If a card involves trading, ask whether it creates a portfolio (execution) or responds to monitoring (feedback).

Exam tip IPS is planning. Allocation, analysis and construction are execution. Rebalancing is feedback.

Go deeper How often should an IPS be reviewed?

There is no fixed rule, and the curriculum gives every three years as an example. A review is also due whenever something major changes in the client’s objectives, constraints or circumstances. Performance analysis can itself suggest that the objectives need another look, which is how feedback leads back into planning.