What Is Portfolio Management?

Portfolio management is the art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance. Portfolio management is all about determining strengths, weaknesses, opportunities and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other trade-offs encountered in the attempt to maximize return at a given appetite for risk.

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Portfolio Management

Understanding Portfolio Management

Although it is common to use the terms "portfolio management" and "financial planning" as synonyms, these staples of the financial services industry are not the same. Portfolio management is the act of creating and maintaining an investment account, while financial planning is the process of developing financial goals and creating a plan of action to achieve them. Professional licensed portfolio managers are responsible for portfolio management on behalf of others, while individuals may choose to self-direct their own investments and build their own portfolio. Portfolio management's ultimate goal is to maximize the investments' expected return given an appropriate level of risk exposure.

Portfolio management, in general, can by either passive or active in nature.. Passive management is a set-it-and-forget-it long-term strategy that often involves simply tracking a broad market index (or group of indexes), commonly referred to as indexing or index investing.

Active management instead involves a single manager, co-managers or a team of managers who attempt to beat the market return by actively managing a fund's portfolio through investment decisions based on research and decisions on individual holdings. Closed-end funds are generally actively managed.

Key Takeaways

  • Portfolio management is the act of building and maintaining an appropriate investment mix for a given risk tolerance.
  • The key factors for any portfolio management strategy involve asset allocation, diversification, and rebalancing rules.
  • Active portfolio management seeks to 'beat the market' through identifying undervalued assets, often through short-term trades and market timing.
  • Passive (indexed) portfolio management seeks to replicate the broader market while keeping costs and fees to a minimum.

The Key Elements of Portfolio Management

Asset Allocation: The key to effective portfolio management is the long-term mix of assets. Asset allocation is based on the understanding that different types of assets do not move in concert, and some are more volatile than others. Asset allocation seeks to optimize the risk/return profile of an investor by investing in a mix of assets that have low correlation to each other. Investors with a more aggressive profile can weight their portfolio toward more volatile investments. Investors with a more conservative profile can weight their portfolio toward more stable investments. Indexed portfolios may employ modern portfolio theory (MPT) to aid in building an optimized portfolio, while active managers may use any number of quantitative and/or qualitative models.

Diversification: The only certainty in investing is it is impossible to consistently predict the winners and losers, so the prudent approach is to create a basket of investments that provide broad exposure within an asset class. Diversification is the spreading of risk and reward within an asset class. Because it is difficult to know which particular subset of an asset class or sector is likely to outperform another, diversification seeks to capture the returns of all of the sectors over time but with less volatility at any one time. Proper diversification takes place across different classes of securities, sectors of the economy and geographical regions.

Rebalancing is a method used to return a portfolio to its original target allocation at annual intervals. It is important for retaining the asset mix that best reflects an investor’s risk/return profile. Otherwise, the movements of the markets could expose the portfolio to greater risk or reduced return opportunities. For example, a portfolio that starts out with a 70% equity and 30% fixed-income allocation could, through an extended market rally, shift to an 80/20 allocation that exposes the portfolio to more risk than the investor can tolerate. Rebalancing almost always entails the sale of high-priced/low-value securities and the redeployment of the proceeds into low-priced/high-value or out-of-favor securities. The annual iteration of rebalancing enables investors to capture gains and expand the opportunity for growth in high potential sectors while keeping the portfolio aligned with the investor’s risk/return profile.

Active Portfolio Management

Investors who implement an active management approach use fund managers or brokers to buy and sell stocks in an attempt to outperform a specific index, such as the Standard & Poor's 500 Index or the Russell 1000 Index.

An actively managed investment fund has an individual portfolio manager, co-managers, or a team of managers actively making investment decisions for the fund. The success of an actively managed fund depends on combining in-depth research, market forecasting, and the experience and expertise of the portfolio manager or management team.

Portfolio managers engaged in active investing pay close attention to market trends, shifts in the economy, changes to the political landscape, and factors that may affect specific companies. This data is used to time the purchase or sale of investments in an effort to take advantage of irregularities. Active managers claim that these processes will boost the potential for returns higher than those achieved by simply mimicking the stocks or other securities listed on a particular index.

Since the objective of a portfolio manager in an actively managed fund is to beat the market, he or she must take on additional market risk to obtain the returns necessary to achieve this end. Indexing eliminates this, as there is no risk of human error in terms of stock selection. Index funds are also traded less frequently, which means that they incur lower expense ratios and are more tax-efficient than actively managed funds.

Active management traditionally charges high fees, and recent research has cast doubts on managers' ability to consistently outperform the market.

Passive Portfolio Management

Passive management, also referred to as index fund management, involves the creation of a portfolio intended to track the returns of a particular market index or benchmark as closely as possible. Managers select stocks and other securities listed on an index and apply the same weighting. The purpose of passive portfolio management is to generate a return that is the same as the chosen index instead of outperforming it.

A passive strategy does not have a management team making investment decisions and can be structured as an exchange-traded fund (ETF), a mutual fund, or a unit investment trust. Index funds are branded as passively managed because each has a portfolio manager replicating the index, rather than trading securities based on his or her knowledge of the risk and reward characteristics of various securities. Because this investment strategy is not proactive, the management fees assessed on passive portfolios or funds are often far lower than active management strategies.

Index mutual funds are easy to understand and offer a relatively safe approach to investing in broad segments of the market. (For related reading, see "Passive vs. Active Portfolio Management: What's the Difference?")