Many investment research analysts frequently turn into portfolio managers over time. After all, the goal of virtually all investment analysis is to make an investment decision or advise someone to make one. Analyzing equities and managing equity portfolios are closely linked: That's why most analysts have a good educational background in both equity analysis and subjects like modern portfolio theory (MPT).

However, in finance—as in many professions—the real-world application of theoretical or academic concepts can involve thinking beyond one's specialty and training. Running a group of stock portfolios involves attention to detail, software skills, and administrative efficiency.

In short, you need to know the mechanics of equity portfolio management to create and handle a group of distinct portfolios, ensuring they not only perform well but that they perform as a homogeneous element.

key takeaways

  • Certain mechanical elements to portfolio management must be learned before actually constructing and running equity portfolios. 
  • Portfolio managers may be constrained by the style, values, and approach of the investment firm they work for.
  • Understanding the tax consequences of portfolio management activity is of primary importance in building and managing portfolios over time.
  •  Portfolio modeling is a good way to apply the analysis and evaluation of a key set of stocks to a set of portfolios in one group or style. 
  • Portfolio modeling can be an efficient link between equity analysis and portfolio management.

Limits on Portfolio Managers

Professional portfolio managers who work for an investment management company do not usually have a choice about the general investment philosophy that governs the portfolios they manage. An investment firm may have strictly-defined parameters for stock selection and asset management. For example, a company may define itself as having a value investment selection style, and it uses certain trading guidelines to follow that style.

Moreover, portfolio managers are usually constrained by market capitalization guidelines. Small-cap managers may be limited to selecting stocks in the $200 million to $3 billion market cap range.

There may also be a "house style" in selection vis-a-vis economic trends. Some portfolio managers use a bottom-up approach in which investment decisions are made by selecting stocks without consideration to sectors or economic forecasts. Others are top-down oriented, using entire sectors or macroeconomic trends as a starting point for analysis and stock selection. Many styles use a combination of these approaches.

Of course, the individual manager's preferences have a role, too. Still, the first step in portfolio management is to understand your particular organization's investment universe and mantra.

Portfolio Managers and Tax Considerations

Understanding the tax consequences of portfolio management activity is
of primary importance in building and running portfolios over time.

Many institutional portfolios, such as those for retirement or pension funds, do not incur taxes every year. Their tax-sheltered status gives their portfolio managers more flexibility than they'd have with taxable portfolios.

Non-taxable portfolios can allow themselves 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, short-term capital gains, capital losses, tax selling, and dividend income generated by their holdings. They may hold themselves to a lower portfolio turnover rate (compared to non-taxable portfolios) to avoid taxable events.

Building a Portfolio Model

Whether a manager is running one portfolio or 1,000 of them in a single 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. Then, individual portfolios are modified to match up against this weighting mix.

Portfolio models are often created using specialized investment management software, though general programs such as Microsoft Excel can work as well.

For example, after doing some mix of company analyses, sector analyses, and macroeconomic analyses, the portfolio manager may decide that it needs a relatively large weight of a particular stock. In this portfolio manager's style, a relatively large weighting is 4% of the total portfolio value. By reducing the weighting of other stocks in the model, or by reducing the overall cash weighting, the portfolio manager would be able to buy enough stocks of a particular company in all the portfolios to match up against the 4% model weight.

All of the portfolios will look like each other, and like the portfolio model, at least in terms of the 4% weighting on that particular stock.

In this way, the portfolio manager can run all the portfolios in a similar or identical fashion given the specific style mandated by that portfolio group. All the portfolios can be expected to generate returns in a standardized way, relative to each other. They also will be 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, not on the individual portfolios.

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 the actual portfolios covered by it.

The Efficiency of Portfolio Modeling

Modeling allows for remarkable analytical efficiency. The portfolio manager only needs to have an understanding of 30 or 40 stocks owned in similar proportions in all portfolios, rather than 100 or 200 stocks owned in various proportions in many accounts.

Changes on these 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 trigger 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 needs to be applied to the change in asset size to build a portfolio that mirrors the portfolio model. Smaller portfolios may be limited by stock board lot constraints, which can affect the portfolio manager's ability to accurately buy or sell to some percentage weightings.