Portfolio Management Process — from the client to the portfolio

The big idea

A portfolio is not a pile of good stocks. It is the answer to a question about a person — what they need, what they can bear, and when they need the money.

This chapter walks through how a portfolio manager gets from that person to a portfolio. The workbook's thread is simple: know the investor, forecast the markets, then decide the asset mix.

9.1 Asset allocation comes first

Asset allocation is the process of deciding how to distribute an investor's wealth among different asset classes.

An asset class is a collection of securities with similar characteristics, attributes and risk/return relationships. Examples: bonds, equities, cash and cash-like securities. A broad class can be split into sub-asset classes:

• Bonds → treasury bonds, corporate bonds, junk bonds
• Equity → large cap, mid cap, small cap

Professional experience suggests that in the long run, the asset allocation decision majorly influences portfolio performance. And it is not an isolated decision — it is one part of the portfolio management process.

9.2 Correlation: why mixing assets works

Correlation measures the strength and direction of the relationship between two variables. The correlation coefficient runs from −1 to +1.

Assets in the same class respond to the same economic factors, so their correlation is expected to be high. Assets in different classes are expected to have low correlation.

That is why diversifying across asset classes cuts risk. The workbook calls correlation the most relevant factor in reaping the benefits of diversification.

But there is a catch. These assumptions hold in normal times. In distress — the workbook names the COVID-19 pandemic — fear and uncertainty hit all asset classes in a similar way. The relationship reverses once normalcy returns.

So: correlations change over time and across economic situations. Future correlations may differ from past ones. Do not rely solely on past correlation figures.

9.3 The four steps of portfolio management

The process is a set of integrated activities undertaken in a logical, orderly and consistent manner to create and maintain an optimum portfolio. Its elements are planning, execution and evaluation.

1. Develop the policy statement. The road map: risk appetite, objectives, goals, constraints.
2. Study current financial conditions and forecast future trends.
3. Construct the portfolio, using the policy statement and market forecast. Because both change, the portfolio needs continuous monitoring and rebalancing.
4. Measure and evaluate performance.

The process moves from planning, through execution, to feedback.

9.3.1–9.3.2 The Investment Policy Statement (IPS)

The IPS is the key step. It is the road map that guides the investment process. The investor or their adviser drafts it, setting out objectives, goals, constraints, preferences and the risks they will take.

Because needs change, the IPS must be updated periodically. It also forms the basis for strategic asset allocation.

Preparing an IPS builds discipline and reduces the chance of inappropriate decisions. It serves four purposes:

1. Gives the investor realistic return expectations
2. Helps the portfolio manager make effective decisions
3. Provides a framework for evaluating the portfolio manager
4. Protects the investor against the manager's inappropriate decisions or unethical behaviour

9.3.3 What goes into it — starting with risk profiling

The investor must be upfront about finances and temperament. The manager must show utmost patience in understanding the investor.

Under current SEBI PMS Regulations, PMS providers must risk-profile investors before investing, using a risk questionnaire. It covers the same six items as the account opening form: investment experience; indicative share of total portfolio with the PM (optional); overall goals; risk tolerance — low, medium or high; time period (same as the term of the agreement); and systematic withdrawal provisions.

9.3.4 Investment objectives

Objectives are stated in terms of risk, return and liquidity.

• Risk is the variability in expected returns.
• Return is what the investor earns over the initial investment, expressed as a percentage per annum.
• Liquidity is the ability to turn an investment into cash quickly without much loss in value. It needs a stable, vibrant market with buyers and sellers always ready.

Objectives can be absolute or relative:

• Absolute: "generate 15% p.a. for the next n years" — standalone, no comparison.
• Relative: "generate 5% p.a. more than NIFTY 50 each year for the next n years".

Two relationships to remember:

• Risk and return: positive. Higher risk, higher expected return.
• Liquidity and return (as a discount rate): inverse. Higher liquidity, lower discount — the gap between quoted and realised price is small.

The three common goals are preservation of capital, regular income and capital appreciation. Tax saving also happens, but tax saving is not appreciated as the sole motto of investment.

9.3.5 Investment constraints

Constraints are limits on what the investor can take exposure to.

Liquidity. Younger people usually need less liquidity than older people. Needs fall into three categories:

• Emergency cash — usually two to three months' spending, more if income is at risk or volatile
• Near-term goals — goals due within a year belong in fairly liquid assets
• Investment flexibility — liquidity to seize opportunities as assets become over- or undervalued

Too much liquidity hurts returns. Too little forces untimely selling. The IPS must specify the liquidity constraint clearly.

Regulatory. Individuals face few, but they exist. Under RBI's Liberalised Remittance Scheme (LRS), a resident individual can invest up to USD 2,50,000 per financial year overseas. LRS was introduced on February 4, 2004 with a limit of USD 25,000, and revised in stages since. Insider trading — dealing on information not publicly known — is another regulatory limit.

Tax. Different incomes (interest, dividend, rent versus capital appreciation) are taxed differently, and the same income can be taxed differently depending on the recipient's bracket. The IPS needs a thorough understanding of the applicable tax code.

Exposure limits. The PMS agreement must include the investment approach and the type of instruments and proportion of exposure. Limits by sector, entity and asset class avoid concentration risk, and the manager must adhere to them.

Unique needs and preferences. Some investors will not hold companies selling environmentally harmful products. Some cannot bring themselves to sell their employer's shares out of emotional attachment. Write these into the IPS.

An IPS may also include reporting requirements, rebalancing schedules, frequency of performance communication, and strategy and style.

9.3.6 Goals and priorities

Investors list goals with priority, time period and amount needed on a goal sheet (Exhibit 9.1).

9.3.7 Financial position

Build personal financial statements: a net worth statement (balance sheet) and an income-expense statement.

Net worth = assets at estimated market value − liabilities. Assets include the house, car, stocks, bonds, mutual funds, savings balances and jewellery. Liabilities include car loan, credit card dues, home loan, personal and education loans.

Calculate net worth periodically, at least once a year. The income-expense statement can be monthly. Income minus spending is what is available for investment.

9.3.8 Psychographic analysis — the BB&K model

Standard finance treats investors as rational. Behavioural finance sees them as normal people with biases and cognitive errors. Psychographic analysis bridges the gap — it accepts investors are normal and prone to irrational behaviour.

The workbook illustrates with Bailard, Biehl & Kaiser (BB&K). It uses two axes:

• Confidence ↔ anxiety — how the investor approaches life, career and money
• Careful ↔ impetuous — whether they are methodical and analytical

That produces five personalities:

Types are not fixed. Recent experience moves people: a Guardian on a winning streak can act like an Adventurer, and most investors become more Guardian-like after heightened volatility. Each type needs a different approach to portfolio management.

9.3.9 Life cycle analysis

Younger earners sit on the higher risk-return side; older people move increasingly to the lower side. The workbook names four phases:

The boundaries between phases are fuzzy on the time scale.

9.3.10–9.3.11 Forecasts and benchmarks

Portfolio management integrates two sets of information: everything about the investor (above), and capital market forecasts of risk and return. Historical risk-return is a good starting point for forecasting.

The IPS must give a framework for evaluating performance — usually a benchmark that matches the portfolio's composition. Compare "apple with apple": BSE 30 or NIFTY 50 for large-cap equity; a bond index of similar maturity and credit profile for long-term bonds.

SEBI's performance benchmarking rules for PMS:

• An investment approach (IA) is the documented investment philosophy for managing client funds.
• On top sits a layer of four strategies: equity, debt, hybrid and multi-asset.
• Each IA is tagged to one and only one strategy, at the PM's discretion.
• APMI prescribes a maximum of three benchmarks per strategy, reflecting its core philosophy. The PM picks one of them for each IA.
• The PM's Board ensures appropriate selection.
• Changing a tag is allowed only after offering subscribers an exit without exit load. The old track record cannot be used for performance reporting. Changes are recorded with justification and verified in the annual audit under Regulation 30.

9.4–9.5 The asset allocation decision: SAA and TAA

Put the two sets of information together and you get the asset allocation decision — the mix that maximises after-tax returns for the investor.

Strategic Asset Allocation (SAA) comes from the investor's characteristics. It is the target policy portfolio — the IPS translated into asset weights. It is long-term.

Tactical Asset Allocation (TAA) is the dynamic, short-term layer, decided more frequently. When conditions favour one class, the manager temporarily shifts money to exploit the discrepancy — for example, cutting equity and adding debt when stocks look overvalued and debt undervalued. After booking gains, the portfolio is rebalanced back to target.

The evidence. Brinson, Hood and Beebower (1986) found a portfolio's target asset allocation explained the majority of a diversified portfolio's return variability over time. Ibbotson and Kaplan (2000) confirmed that investment policy is an important contributor. The figures: across all portfolios, asset allocation explains an average of 40% of the variation in fund returns; for a single fund, 90% of its variation over time.

9.6 Rebalancing

Prices move, asset classes return different amounts, and the mix drifts. Rebalancing restores the original risk-return character. It may also be needed when goals or risk tolerance change.

The IPS should state the rebalancing policy: how often (periodicity) and how much (tolerance for deviation from target).

The trade-off: the cost of rebalancing versus the cost of not rebalancing. If the target is optimal, any drift is undesirable — but rebalancing costs money. Two costs:

• Transaction cost — time and money: research, brokerage
• Tax cost — rebalancing usually sells appreciated assets, which creates tax

Illiquid assets like private equity and real estate are hard to rebalance because transaction costs are higher. Liquid assets like listed equities and government bonds are easier.