Investment Management

CHAPTER

1

3

Investment Management

Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of FinanceSchool of Management

Yale University

Harry M. Markowitz, Ph.D.

Consultant

he purpose of this book is to describe the activities associated with

investment management

. Investment management—also referred toas

portfolio management

and

money management

—requires an under-standing of:

1. how investment objectives are determined2. the investment products to which an investor can allocate funds3. the way investment products are valued so that an investor can assess

whether or not a particular investment is fairly priced 4. the investment strategies that can be employed by an investor to real-

ize a specified investment objective 5. the best way to construct a portfolio, given an investment strategy6. the techniques for evaluating the performance of an investor

In this book, the contributors will explain each of these activities. Inthis introductory chapter, we set forth in general terms the

investmentmanagement process

. This process involves the following five steps:

Step 1:

Setting investment objectives

Step 2:

Establishing an investment policy

T

1-Fabozzi/Markowitz Page 3 Thursday, July 25, 2002 12:29 PM

4

FOUNDATIONS OF INVESTMENT MANAGEMENT

Step 3:

Selecting an investment strategy

Step 4:

Selecting the specific assets

Step 5:

Measuring and evaluating investment performance

STEP 1: SETTING INVESTMENT OBJECTIVES

The first step in the investment management process, setting investmentobjectives, begins with a thorough analysis of the investment objectivesof the entity whose funds are being managed. These entities can be clas-sified as

individual investors

and

institutional investors

. Within each ofthese broad classifications is a wide range of investment objectives.

The objectives of an individual investor may be to accumulatefunds to purchase a home or other major acquisition, to have sufficientfunds to be able to retire at a specified age, or to accumulate funds topay for college tuition for children. An individual investor may engagethe services of a financial advisor/consultant in establishing investmentobjectives.

Institutional investors include

�

pension funds

�

depository institutions (commercial banks, savings and loan associa-tions, and credit unions)

�

insurance companies (life companies, property and casualty companies, and health companies)

�

regulated investment companies (mutual funds)

�

endowments and foundations

�

treasury department of corporations, municipal governments, and gov-ernment agencies

In general we can classify institutional investors into two broad cat-egories—those that must meet contractually specified liabilities andthose that do not. We can classify those in the first category as institutionswith “liability-driven objectives” and those in the second category as“non-liability driven objectives.” Some institutions have a wide range ofinvestment products that they offer investors, some of which are liabil-ity driven and others that are non-liability driven. Once the investmentobjective is understand, it will then be possible to (1) establish a “bench-mark” or “bogey” by which to evaluate the performance of the investmentmanager and (2) evaluate alternative investment strategies to assess thepotential for realizing the specified investment objective.

A

liability

is a cash outlay that must be made at a specific time tosatisfy the contractual terms of an issued obligation. An institutional



5

investor is concerned with both the

amount

and

timing

of liabilities,because its assets must produce the cash flow to meet any payments ithas promised to make in a timely way.

STEP 2: ESTABLISHING AN INVESTMENT POLICY

The second step in the investment management process is establishingpolicy guidelines to satisfy the investment objectives. Setting policybegins with the asset allocation decision. That is, a decision must bemade as to how the funds to be invested should be distributed amongthe major classes of assets.

Asset Classes

Throughout this book we refer to certain categories of investment prod-ucts as an “asset class.” From the perspective of a U.S. investor, the con-vention is to refer the following as

traditional asset classes

:

U.S. common stocksNon-U.S. (or foreign) common stocksU.S. bondsNon-U.S. (or foreign) bondsCash equivalentsReal estate

Cash equivalents are defined as short-term debt obligations that havelittle price volatility and are covered in Chapter 16.

Common stock and bonds are further divided into asset classes. ForU.S. common stocks (also referred to as U.S. equities), the following areclassified as asset classes:

Large capitalization stocksMid capitalization stocksSmall capitalization stocksGrowth stocksValue stocks

By “capitalization,” it is meant the market capitalization of the com-pany’s common stock. This is equal to the total market value of all ofthe common stock outstanding for that company. For example, supposethat a company has 100 million shares of common stock outstandingand each share has a market value of $10. Then the capitalization of


6


this company is $1 billion (100 million shares times $10 per share). Themarket capitalization of a company is commonly referred to as the“market cap” or simply “cap.”

While the market cap of a company is easy to determine given the marketprice per share and the number of shares outstanding, how does one define“value” and “growth” stocks? We’ll see how that is done in Chapter 8.

For U.S. bonds, also referred to as fixed-income securities, the fol-lowing are classified as asset classes:

U.S. government bondsInvestment-grade corporate bondsHigh-yield corporate bondsU.S. municipal bonds (i.e., state and local bonds)Mortgage-backed securitiesAsset-backed securities

All of these securities are described in Chapters 16 and 17, where what ismeant by “investment grade” and “high yield” are also explained. Some-times, the first three bond asset classes listed above are further divided into“long term” and “short term.”

For non-U.S. stocks and bonds, the following are classified as assetclasses:

In addition to the traditional asset classes, there are asset classescommonly referred to as

alternative investments

. Two of the more pop-ular ones are hedge funds and private equity. Hedge funds are coveredin Chapter 29 and private equity is the subject of Chapter 30.

How does one define an asset class? One investment manager, MarkKritzman, describes how this is done as follows:

...some investments take on the status of an asset class simplybecause the managers of these assets promote them as an assetclass. They believe that investors will be more inclined to allocatefunds to their products if they are viewed as an asset class ratherthan merely as an investment strategy.

1

He then goes on to propose criteria for determining asset class status.We won’t review the criteria he proposed here. They involve concepts

Developed market foreign stocks Developed market foreign bondsEmerging market foreign stocks Emerging market foreign bonds

1

Mark Kritzman, “Toward Defining an Asset Class,”

The Journal of Alternative In-vestments

(Summer 1999), p. 79.



7

that are explained in later chapters. After these concepts are explained itwill become clear how asset class status is determined. However, itshould not come as any surprise that the criteria proposed by Kritzmaninvolve the risk, return, and the correlation of the return of a potentialasset class with that of other asset classes.

Along with the designation of an investment as an asset class comesa barometer to be able to quantify performance—the risk, return, andthe correlation of the return of the asset class with that of another assetclass. The barometer is called a “benchmark index,” “market index,” orsimply “index.” For example, listed below are the most popular indexesused to represent the various asset classes that fall into the equity area:

For the U.S. fixed income (bond) asset class, the two commonly usedindexes are the Lehman Brothers Aggregate Bond Index and theSalomon Brothers Broad Index.

As other asset classes are described in later chapters, the index usedas a proxy for that asset class will be discussed.

If an investor wants exposure to a particular asset class, an investormust be able to buy a sufficient number of the individual assets compris-ing the asset class. Equivalently, the investor has to buy a sufficientnumber of individual assets comprising the index representing that assetclass. This means that if an investor wants exposure to the U.S. largecap equity market and the S&P 500 is the index (consisting of 500 com-panies) representing that asset class, then the investor can’t simply buythe shares of a handful of companies and hope to acquire the desiredexposure to the large cap equity market. For institutional investors,acquiring a sufficient number of individual assets comprising an assetclass is often not a serious problem and we will see how this can be donein later chapters. However, for individual investors, obtaining exposure

U.S. Equity Wilshire 5000, Frank Russell 3000U.S. Large Cap Equity Standard & Poor’s (S&P) 500U.S. Large Cap Value Frank Russell 1000 Value, S&P/Barra 500 ValueU.S. Large Cap Growth Frank Russell 1000 Growth, S&P/Barra 500 GrowthU.S. Mid Cap Equity Frank Russell Mid CapU.S. Small Cap Equity Frank Russell 2000U.S. Small Cap Value Frank Russell 2000 ValueU.S. Small Cap Growth Frank Russell 2000 GrowthInternational Equity Morgan Stanley Capital International (MSCI) EAFE

Salomon Smith Barney International,MSCI All Country World (ACWI) ex U.S.

Emerging Markets MSCI Emerging Markets


8


to an asset class by buying individual assets is not simple. How can indi-vidual investors accomplish this?

Fortunately, there is an investment vehicle that can be used toobtain exposure to asset classes in a cost effective manner. The vehicle isa regulated investment company, more popularly referred to as a mutualfund. This investment vehicle is the subject of Chapter 26. For now,what is important to understand is that there are mutual funds thatinvest primarily in specific asset classes. Such mutual funds offer aninvestor the opportunity to gain exposure to an asset class without theinvestor having expertise in the management of the individual assets inthat asset class and by investing a sum of money that in the absence of amutual fund would not allow the investor to acquire a sufficient numberof individual assets to obtain the desired exposure.

Constraints

There are some institutional investors that make the asset allocationdecision based purely on their understanding of the risk-return charac-teristics of the various asset classes and expected returns. The asset allo-cation will take into consideration any investment constraints orrestrictions. Asset allocation models are commercially available forassisting those individuals responsible for making this decision. Chapter31 describes one such model.

In the development of an investment policy, the following factorsmust be considered:

�

client constraints

�

regulatory constraints

�

tax and accounting issues

Client-Imposed Constraints

Examples of client-imposed constraints would be restrictions that spec-ify the types of securities in which a manager may invest and concentra-tion limits on how much or little may be invested in a particular assetclass or in a particular issuer. Where the objective is to meet the perfor-mance of a particular market or customized benchmark, there may be arestriction as to the degree to which the manager may deviate fromsome key characteristics of the benchmark.

For example, in later chapters of this book the concepts of the betaof a common stock portfolio and the duration of a bond portfolio willbe discussed. These risk measures provide an estimate of the exposure ofa portfolio to changes in key factors that affect the portfolio’s value—the market overall in the case of a portfolio’s beta and the general level



9

of interest rates in the case of a portfolio’s duration. Typically, a clientwill not set a specific value for the level of risk exposure. Instead, theclient restriction may be in the form of a maximum on the level of therisk exposure or a permissible range for the risk measure relative to thebenchmark. For example, a client may restrict the portfolio’s durationto be +0.5 or

−

0.5 of the client-specified benchmark. Thus, if the dura-tion of the client-imposed benchmark is 4, the manager has the discre-tion of constructing a portfolio with a duration between 3.5 and 4.5.

Regulatory Constraints

There are many types of regulatory constraints. These involve con-straints on the asset classes that are permissible and concentration limitson investments. Moreover, in making the asset allocation decision, con-sideration must be given to any risk-based capital requirements. Fordepository institutions and insurance companies, the amount of statu-tory capital required is related to the quality of the assets in which theinstitution has invested. There are two types of risk-based capitalrequirements: credit risk-based capital requirements and interest rate-risk based capital requirement. The former relates statutory capitalrequirements to the credit-risk associated with the assets in the portfo-lio. The greater the credit risk, the greater the statutory capital required.Interest rate-risk based capital requirements relate the statutory capitalto how sensitive the asset or portfolio is to changes in interest rates. Thegreater the sensitivity, the higher the statutory capital required.

Tax and Accounting Issues

Tax considerations are important for several reasons. First, certain insti-tutional investors such as pension funds, endowments, and foundationsare exempt from federal income taxation. Consequently, the assets inwhich they invest will not be those that are tax-advantaged investments.Second, there are tax factors that must be incorporated into the invest-ment policy. For example, while a pension fund might be tax-exempt,there may be certain assets or the use of some investment vehicles inwhich it invests whose earnings may be taxed.

Generally accepted accounting principles (GAAP) and regulatoryaccounting principles (RAP) are important considerations in developinginvestment policies. An excellent example is a defined benefit plan for acorporation. GAAP specifies that a corporate pension fund’s surplus isequal to the difference between the market value of the assets and thepresent value of the liabilities. If the surplus is negative, the corporatesponsor must record the negative balance as a liability on its balancesheet. Consequently, in establishing its investment policies, recognition


10


must be given to the volatility of the market value of the fund’s portfoliorelative to the volatility of the present value of the liabilities. Considerthis. In 1994 the return on the S&P 500 and the Lehman BrothersAggregate Bond Index was 1.29% and

−

2.92%, respectively. Interestrates rose in 1994. In 1995, the return on the S&P 500 was 37.52% and18.47% on the Lehman Brothers Aggregate as a result of a decline ininterest rates.

2

Most pension plans allocate the bulk of their funds tocommon stocks and bonds. Which was the best year for pension funds?It would seem that 1995 was the best year. Yet, The Pension BenefitGuaranty Corporation stated that underfunding by pension fundsincreased in 1995 but decreased in 1994. The reason is that the declinein interest rates increased the present value of liabilities in 1995 anddecreased liabilities in 1994 due to a rise in interest rates. Thus, it is notjust the performance of the assets that affects the performance of a pen-sion fund but the relative performance of assets versus liabilities.

STEP 3: SELECTING A PORTFOLIO STRATEGY

Selecting a portfolio strategy that is consistent with the investmentobjectives and investment policy guidelines of the client or institution isthe third step in the investment management process. Portfolio strate-gies can be classified as either active or passive.

An

active portfolio strategy

uses available information and forecast-ing techniques to seek a better performance than a portfolio that is sim-ply diversified broadly. Essential to all active strategies are expectationsabout the factors that have been found to influence the performance ofan asset class. For example, with active common stock strategies thismay include forecasts of future earnings, dividends, or price-earningsratios. With bond portfolios that are actively managed, expectationsmay involve forecasts of future interest rates and sector spreads. Activeportfolio strategies involving foreign securities may require forecasts oflocal interest rates and exchange rates.

A

passive portfolio strategy

involves minimal expectational input,and instead relies on diversification to match the performance of somemarket index. In effect, a passive strategy assumes that the marketplacewill reflect all available information in the price paid for securities.Between these extremes of active and passive strategies, several strategieshave sprung up that have elements of both. For example, the core of aportfolio may be passively managed with the balance actively managed.

2

The relationship between changes in interest rates and bond prices will be explainedin Chapter 21.



11

In the bond area, several strategies classified as

structured portfoliostrategies

have been commonly used. A structured portfolio strategy isone in which a portfolio is designed to achieve the performance of somepredetermined liabilities that must be paid out. These strategies are fre-quently used when trying to match the funds received from an invest-ment portfolio to the future liabilities that must be paid.

Given the choice among active and passive management, whichshould be selected? The answer depends on (1) the client’s or moneymanager’s view of how “price-efficient” the market is, (2) the client’srisk tolerance, and (3) the nature of the client’s liabilities. By market-place price efficiency we mean how difficult it would be to earn a greaterreturn than passive management after adjusting for the risk associatedwith a strategy and the transaction costs associated with implementingthat strategy.

STEP 4: SELECTING THE SPECIFIC ASSETS

Once a portfolio strategy is selected, the next step is to select the specificassets to be included in the portfolio. It is in this phase of the investmentmanagement process that the investor attempts to construct an

efficientportfolio

. An efficient portfolio is one that provides the greatestexpected return for a given level of risk, or equivalently, the lowest riskfor a given expected return.

Inputs Required

To construct an efficient portfolio, the investor must be able to quantifyrisk and provide the necessary inputs. As will be explained in the nextchapter, there are three key inputs that are needed: future expectedreturn (or simply expected return), variance of asset returns, and correla-tion (or covariance) of asset returns. All of the investment toolsdescribed in the chapters that follow in this book are intended to providethe investor with information with which to estimate these three inputs.

There are a wide range of approaches to obtain the expected returnof assets. Investors can employ various analytical tools that will be dis-cussed throughout this book to derive the future expected return of anasset. For example, we will see in Chapter 4 that there are various assetpricing models that provide expected return estimates based on factorsthat historically have been found to systematically affect the return onall assets. Investors can use historical average returns as their estimateof future expected returns. Investors can modify historical averagereturns with their judgment of the future to obtain a future expected


12


return. Another approach is for investors to simply to use their intuitionwithout any formal analysis to come up with the future expected return.

In the next chapter, the reason why the variance of asset returnsshould be used as a measure of an asset’s risk will be explained. Thisinput can be obtained for each asset by calculating the historical vari-ance of asset returns. There are sophisticated time series statistical tech-niques that can be used to improve the estimated variance of assetreturns but they are not covered in this book. Some investors calculatethe historical variance of asset returns and adjust them based on theirintuition.

The covariance (or correlation) of returns is a measure of how thereturn of two assets vary together. Typically, investors use historicalcovariances of asset returns as an estimate of future covariances. Butwhy is a covariance of asset returns needed? As well be explained in thenext chapter, the covariance is important because the variance of a port-folio’s return depends on it and the key to diversification is the covari-ance of asset returns.

Approaches to Portfolio Construction

Constructing an efficient portfolio based on the expected return for aportfolio (which depends on the expected return of all the asset returnsin the portfolio) and the variance of the portfolio’s return (whichdepends on the variance of the return of all of the assets in the portfolioand the covariance of returns between all pairs of assets in the portfolio)is referred to as “mean-variance” portfolio management. The term“mean” is use because the expected return is equivalent to the “mean”or “average value” of returns. This approach also allows for the inclu-sion of constraints such as lower and upper bounds on particular assetsor assets in particular industries or sectors. The end result of the analy-sis is a set of efficient portfolios—alternative portfolios from which theinvestor can select that offer the maximum expected portfolio return fora given level of portfolio risk.

There are variations on this approach to portfolio construction.Mean-variance analysis can be employed by estimating risk factors thathistorically have explained the variance of asset returns. The basic princi-ple is that the value of an asset is driven by a number of systematic factors(or, equivalently, risk exposures) plus a component unique to a particularcompany or industry. A set of efficient portfolios can be identified basedon the risk factors and the sensitivity of assets to these risk factors. Thisapproach is referred to the “multi-factor risk approach” to portfolio con-struction and is explained in Chapter 13 for common stock portfoliomanagement and Chapter 24 for fixed-income portfolio management.



13

With either the full mean-variance approach or the multi-factor riskapproach there are two variations. First, the analysis can be performedby investors using individual assets (or securities) or the analysis can beperformed on asset classes. This will be illustrated for the full mean-variance approach in the next chapter.

The second variation is one in which the input used to measure riskis the tracking error of a portfolio relative to a benchmark index, ratherthan the variance of the portfolio return. By a benchmark index it ismeant the benchmark that the investor’s performance is comparedagainst. As explained in Chapter 7, tracking error is the variance of thedifference in the return on the portfolio and the return on the bench-mark index. When this “tracking error multi-factor risk approach” toportfolio construction is applied to individual assets, the investor canidentify the set of efficient portfolios in terms of a portfolio thatmatches the risk profile of the benchmark index for each level of track-ing error. Selecting assets that intentionally cause the portfolio’s riskprofile to differ from that of the benchmark index is the way a manageractively manages a portfolio. In contrast, indexing means matching therisk profile. “Enhanced” indexing basically means that the assetsselected for the portfolio do not cause the risk profile of the portfolioconstructed to depart materially from the risk profile of the benchmark.This tracking error multi-factor risk approach to common stock andfixed-income portfolio construction will be explained and illustrated inChapters 13 and 24, respectively.

At the other extreme of the full mean-variance approach to portfoliomanagement is the assembling of a portfolio in which investors ignore allof the inputs—expected returns, variance of asset returns, and covari-ance of asset returns—and use their intuition to construct a portfolio.We refer to this approach as the “seat-of-the-pants approach” to portfo-lio construction. In a rising stock market, for example, this approach istoo often confused with investment skill. It is not an approach we rec-ommend.

STEP 5: MEASURING AND EVALUATING PERFORMANCE

The measurement and evaluation of investment performance is the laststep in the investment management process. Actually, it is misleading tosay that it is the last step since the investment management process is anongoing process. This step involves measuring the performance of theportfolio and then evaluating that performance relative to some bench-mark.


14


Although a portfolio manager may have performed better than abenchmark, this does not necessarily mean that the portfolio managersatisfied the client’s investment objective. For example, suppose that afinancial institution established as its investment objective the maximi-zation of portfolio return and allocated 75% of its funds to commonstock and the balance to bonds. Suppose further that the managerresponsible for the common stock portfolio realized a 1-year return thatwas 150 basis points greater than the benchmark.

3

Assuming that therisk of the portfolio was similar to that of the benchmark, it wouldappear that the manager outperformed the benchmark. However, sup-pose that in spite of this performance, the financial institution cannotmeet its liabilities. Then the failure was in establishing the investmentobjectives and setting policy, not the failure of the manager.

SUMMARY

The overview of the investment management process described in thischapter should help in understanding the activities that the portfoliomanager faces and the need for the analytical tools that are described inthe chapters that follow in this book.

3

A basis point is equal to 0.0001 or 0.01%. This means that 1% is equal to 100 basispoints.


Investment Management

Documents

Transcript of Investment Management