A Guide to the Principles, Processes, and Players in Investment Management
The core principle of portfolio management is to evaluate individual investments not in isolation, but in the context of the overall portfolio. This "portfolio perspective" recognizes that the risk and return of an individual asset affects the risk and return of the entire portfolio.
According to Modern Portfolio Theory (MPT), diversification is the key to optimizing a portfolio. By combining assets that are not perfectly correlated, an investor can reduce the total risk of the portfolio, often without sacrificing expected return.
Portfolio management is a dynamic and continuous cycle consisting of three main steps.
This involves understanding the client's needs, objectives, and constraints. The outcome is the Investment Policy Statement (IPS), a formal document that guides all future investment decisions.
This is where the portfolio is constructed. It involves asset allocation (deciding how to distribute investments across different asset classes) and security selection (choosing specific securities within each asset class).
This involves monitoring the portfolio, measuring its performance against a benchmark, and rebalancing it periodically to ensure it remains aligned with the IPS. This step feeds back into the planning step, making the process a continuous loop.
Different types of investors have different investment needs, which are reflected in their time horizons, risk tolerances, and income and liquidity requirements.
| Client Type | Time Horizon | Risk Tolerance | Primary Need |
|---|---|---|---|
| Individual Investors | Varies | Varies | Varies (e.g., retirement, education) |
| Defined Benefit Pension Plans | Long-term | Typically high | Fund future liabilities |
| Endowments & Foundations | Very long-term | Typically high | Meet spending commitments in perpetuity |
| Banks | Short-term | Low | Manage assets against liabilities |
| Insurance Companies | Varies (short or long) | Low | Pay future claims |
| Investment Companies | Varies by fund | Varies by fund | Meet fund objectives |
Aim to outperform a specific benchmark through security selection and market timing.
Aim to replicate the returns of a specific benchmark (e.g., an index fund that tracks the S&P 500).
Focus on long-only strategies in public markets (stocks and bonds).
Focus on strategies involving private equity, hedge funds, and other non-traditional assets.
Pooled investment vehicles allow investors to combine their capital and gain access to a diversified portfolio managed by a professional.
Can be open-end (shares are bought and redeemed at NAV) or closed-end (shares trade on an exchange like a stock). They come in various types, including money market, bond, and stock funds.
A basket of securities that trades on an exchange like a single stock. They combine the diversification of a mutual fund with the trading flexibility of a stock.
A private portfolio owned by a single investor but managed by a professional manager. Offers more customization than a mutual fund.
Private investment funds that use complex strategies and leverage to generate high returns. They are typically open only to qualified, wealthy investors.
Funds that invest in private companies (not publicly traded), often taking an active role in their management.