The goal of virtually all investment analyses is to make investment decisions or advise others in making their own investment decisions. Therefore, there is an inextricable link between the art and science of equity analysis and equity portfolio management. College finance programs and the CFA Institute's Chartered Financial Analyst® program embody this link by teaching the two concepts side by side. As a result, most analysts have a good educational background in both equity analysis and portfolio management subjects like modern portfolio theory (MPT) early in their careers. Analysts frequently turn into portfolio managers over time. (For related reading, see Preparing For A Career As A Portfolio Manager and Modern Portfolio Theory: An Overview.)
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Even with a good understanding of equity analysis and MPT, there are certain mechanical elements to portfolio management that must be addressed before actually constructing and running equity portfolios. As is the case with many professions, the real-world application of theoretical investment concepts can involve thinking beyond one's specialty and training. Running a group of portfolios involves extensive attention to detail, computerization and the need for administrative efficiency. In this article, we'll explain the mechanics of equity portfolio management, and how this system can create a group of different portfolios that perform as a homogeneous element. (To learn more, see Portfolio Management For The Under-30 Crowd.)
Investment Philosophy and the Investment Universe
Professional portfolio managers who work for an investment management company generally do not have a choice about the general investment philosophy used to govern the portfolios they manage. An investment firm may have strictly defined parameters for stock selection and investment management. An example would be a firm defining a value investment selection style using certain trading guidelines. Furthermore, portfolio managers are also usually constrained by market capitalization guidelines. For example, small-cap managers may be limited to selecting stocks in the $200 million to $3 billion market cap range. Therefore, the first step in portfolio management is to understand the universe from which investments may be selected. (For related reading, see Determining What Market Cap Suits Your Style.)
Another philosophical consideration is the analytical approach for the portfolio in question. Some firms or portfolios use a bottom-up approach, where investment decisions are made primarily by selecting stocks without consideration to sector selection or economic forecasts. Other styles may be top-down oriented and portfolio managers pay primary attention to analyzing entire sectors or macroeconomic trends as a starting point for analysis and stock selection. Many styles use a combination of these approaches. (For related reading, see A Top-Down Approach To Investing and Where Top Down Meets Bottom Up.)
A lot of institutional equity portfolios, such as pension funds, are not taxable. This gives portfolio managers more managerial flexibility than taxable portfolios. Non-taxable portfolios may use greater exposure to dividend income and short-term capital gains than their taxable counterparts. Managers of taxable portfolios may need to pay special attention to stock holding periods, tax lots, capital losses, tax selling and dividend income generated by portfolios. Taxable portfolios may be more effective with a lower portfolio turnover rate, relative to non-taxable portfolios. Understanding the tax consequences of - or lack thereof - portfolio management activity is of primary importance in building and managing portfolios over time. (To learn more, see Your Dividend Payout: Can You Count On It?)
Building the Portfolio Model
Whether running one portfolio or a thousand portfolios in one equity investment product or style, building and maintaining a portfolio model is a common aspect of equity portfolio management. A portfolio model is a standard against which individual portfolios are matched. Generally, portfolio managers will assign a percentage weighting to every stock in the portfolio model, and then individual portfolios are modified to match up against this weighting mix. Portfolio models are usually computerized using software such as Microsoft Excel or specific portfolio management software tools. (To learn more, see Microsoft Excel Features For The Financially Literate.)
For example, after doing some mix of company analyses, sector analyses and macroeconomic analyses, the portfolio manager may decide that he or she wants to own a relatively large weight of a particular stock. Perhaps in the portfolio manager's style, a relatively large weighting is 4% of the total portfolio value. By reducing the weighting of other stocks in the portfolio model, or by reducing the overall cash weighting, the portfolio manager would buy enough stocks of a particular company in each portfolio to match up against the 4% model weight. All of the portfolios will look like each other (and the portfolio model), at least in terms of the 4% weighting on that particular stock. (For related reading, check out A Guide To Portfolio Construction.)
In this way, the portfolio manager runs all portfolios in a similar or identical fashion given the specific style mandated by that portfolio group. He or she would expect all portfolios in the group to generate returns in a standardized way, relative to each other. All of the portfolios will also be very similar to each other in terms of the risk/reward profile. In effect, all of the analytical and security evaluation that the portfolio manager does is run on a model, and not on the individual portfolios.
Achieving Portfolio Efficiency
Running all of his or her portfolios in a similar way, allows a portfolio manager to achieve a remarkable analytical efficiency. The portfolio manager only needs to have an understanding of perhaps 30 or 40 stocks owned in similar proportions in all portfolios, rather than 100 or 200 stocks owned in various proportions in 1,000 different portfolio accounts. Analysis on the 30 or 40 stocks can be applied to all portfolios easily by changing model weights in the portfolio model over time. As the outlook on individual stocks changes over time, the portfolio manager only needs to change his or her model weightings to reflect the investment decision in all portfolios simultaneously.
The portfolio model can also be used to handle all day-to-day transactions at the individual portfolio level. New accounts can be set up quickly and efficiently by simply "buying against the model." Cash deposits and withdrawals can be handled in a similar way. If the portfolio is large enough, the model only really needs to be applied to the change in asset size to build a portfolio that looks just like the portfolio model. Smaller portfolios may be limited by stock board lot constraints, which may affect the portfolio manager's ability to accurately buy or sell to certain percentage weightings. (To learn more, see What's the smallest number of shares of stock that I can buy?)
Portfolio modeling is a good way to apply analysis and evaluation of a key set of stocks - those that the portfolio manager wants to own - to a set of portfolios in one group or style. Portfolio modeling is an efficient link between equity analysis and portfolio management. As the outlook for individual stocks improves or deteriorates over time, the portfolio manager only needs to change the weightings of those stocks in the portfolio model to optimize the return of all portfolios in the group or style. As long as the individual portfolio accounts are traded efficiently, the group will perform as a homogeneous element.
To read related career articles, see Becoming A Financial Analyst.
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