HOOFSTUK / CHAPTER

13
PORTEFEULJE BESTUUR / PORTFOLIO
MANAGEMENT

©
 In hierdie leergedeelte / In this study
section
 In staat wees om die  Be able to illustrate the
belangrike elemente van significant elements of
portefeuljebestuur te portfolio management.
illustreer.  Explore the basic
 Die basiese beginsels van principles of the portfolio
die management process.
portefeuljebestuursproses  Understand the objectives
ondersoek. and constraints of
 Die doel en beperkinge portfolio management.
van portefeuljebestuur  Examine the mix of
verstaan. assets of the portfolio
 Die mengsel van bates in in terms of asset
die portefeulje in terme allocation.
van batetoedeling
ondersoek.
 In hierdie leergedeelte / In this study
section
 In staat wees om die  Be able to construct a
portefeulje van bates en portfolio of assets and
meting van die opbrengs measure its return and
en risiko saam te stel. risk.
 Ekwiteitportefeuljebestuur  Understand equity
-strategieë verstaan. portfolio management
 Vaste rentedraende strategies.
effekte portefeuljebestuur  Understand fixed interest-
verstaan. bearing security portfolio
management.
 Introduction
Portfolio is…
the combination/group of individual securities held by an
investor/institution
Portfolio management is…
 making decisions about the asset mix and asset allocation
(investment) and the policy(objectives)
 balancing risk against performances by choosing the optimal
portfolio taking into account its risk-return characteristics. It
requires constant review and monitoring
Two forms of portfolio management: Passive vs active
management…
Advantage of a portfolio:
 A group of securities (portfolio) is more diversified than individual
investments (less diversified) held in isolation
 Thus, it reduce total risk (volatility ) and less correlated, without
sacrificing returns.
Purpose of this chapter…
Illustrate the significant elements of portfolio management (which is
 Investment policy statement
(IPS)
 The firs step is to compile an investment policy
statement (IPS) (see chapter 1)
 Defines objectives and constrains.
 Aim of IPS:
 Guides and controls investment objectives (which is strongly
influenced by the investor’s life cycle)
 Describes strategies that will be used to meet them. This
contains information such as asset allocation, risk tolerance,
investment style and liquidity requirements
 Encourages the investor follow long-term investment
discipline
instead of short-term impulsive approach
 Objectives and constraints
 When an investor needs professional advice,
the financial advisor must gather information
(research) about the investor. This is
summarised in IPS as guideline
 The objectives of each individual is different
and is reliant on but not limited to the
following:
 Age, marital status, living expenses, wealth etc. to
indicate the degree of risk he/she is willing to take
 Objectives and constraints
 Objectives and constraints dictate the
appropriate investment strategies to
be followed.
 Objectives (Financial goals seeking to achieve,
e.g. retirement, education: depending on short-,
medium- and long-term objectives)
 Each investor has a unique combination of goals,
time horizons, liquidity needs, etc.
 Objectives and constraints (continues)
 The 3 objectives are:
Capital preservation
The objective is geared towards maintaining purchasing power
Although the individual wants to maintain a particular quality of life,
they also want their investments to grow – at least at the current level
of inflation. E.g. investments include bonds, money market
instruments.
Capital appreciation
The objective is geared towards yielding returns above the level of
inflation – aggressive objective
Capital appreciation will probably mean that the individual invests in
a shares portfolio
Current income
A current income objective comes from the notion that only income
can be spent and all capital gains should be reinvested. This
objective/portfolio is created for retired individuals to receive a steady
income. Income is generated from bond interest payments and
dividends.
 Objectives and constraints
 Constraints:
 Risk tolerance (An investor’s willingness and need to accept
risk (loss) of and investment) – influence expected returns,
asset types and weight restrictions
 Time horizon (Amount of time available to achieve a
financial goal, e.g. retirement. Time it takes to recover losses)
 Liquidity and marketability (Ability and ease to convert an
asset at its current market price without losing principal)
 Taxes (Consider your personal income tax, estate tax, trust
tax, capital gains tax, after tax returns) – e.g. rare gold coins
 Legal and regulatory factors (Regulations on investments
differ between countries) – Regulation 28
 Unique needs and personal preferences (Limitations that
individuals have on what types of investment are suitable for
their portfolio, e.g. not prefer shares in tobacco companies)
 Life cycle
 In addition to objectives and constraints,
financial advisor uses the life cycle of investor
to show the risk-return preferences from the
investor

 Investment strategies change during the

investor’s lifetime as there is a inverse
relationship between age and risk tolerance

 The life cycle of an individual:

 Accumulation phase
 Accumulating assets such as house, cars, making provision
for short term goals (e.g. car, house deposit) and long term
goals, e.g. (children's education, retirement etc.)
 Taking higher risk because you have a longer life
expectancy when you are young
 Invest heavily in equity
 Life cycle
 Consolidation phase
 Most individual’s debt has been repaid by now, earnings
exceed expenses
 Capital preservation becomes more important since
retirement is closer. Portfolio is based on medium risk
(equity exposure is gradually reduced in favour of fixed
income instruments, e.g. high quality bonds)

 Spending phase
 The focus shift to capital protection (low risk investments,
e.g. treasury bills), only spending interest income
 The individual is financially independent and lives of
investments and retirement portfolios

 Gifting phase
 Excess amounts (accumulated wealth) available in the
portfolio and investor will give it away in the form of
Life cycle
 Asset allocation
 Asset allocation
 Asset allocation can be defined as the process of allocating funds
of a portfolio to classes of assets such as bonds, equities and cash
 Used to reduce risk
 Combines various assets in the same or different asset classes
 3 major asset categories…
 Asset classes generating the most volatility…

 Diversification:
 The main reason for diversification is to reduce risk
 The less correlated assets are, the less risk

 The importance of asset allocation

 According to studies, 90% of a portfolio’s performance depends on asset
allocation
 Determination of the asset mix
 Policy / Strategic asset allocation – Passive approach is followed , i.e.
allocation changes due to investor’s objectives and constrains instead of changes
in the market
 Tactical asset allocation – Active approach (economic forecasting, market
assessments, equity and bond research). i.e. beat the market return by shifting
asset allocation due to changing market conditions
 General portfolio
construction
• In deciding which assets to include in a
portfolio, the most important criteria are
risk and return
• Step 1 :Measuring return
n
k  ki Pi
Expected return i 1

where = expected return

n = number of possible states
ki = rate of return at state i

Pi = prob. of state i occurring

 General portfolio
Example: construction

Step 1: Calculate the expected return for security A

&B
Share A: (probability)(Return: Share B: (probability)(Return:
share A) share B)
= (0.10)(-0.25) + (0.20)(-0.18) + (0.30)= (0.10)(0.06) + (0.20)(0.04) + (0.30)
(0.09) + (0.40)(0.30) (0.01) + (0.40)(-0.03)
= (-0.025) – 0.036 + 0.027 + 0.120 = 0.006 + 0.008 + 0.003 – 0.012
= 0.086 = 0.005
 General portfolio
construction
 Step 2: Measuring risk of single
2
securities n 
 k  k  P
 
n1
 i i
 
ki

 Standard deviation

 where σ = standard deviation

 = expected return
 ki = outcome associated with state i
 Pki = probability associated with state i
 General portfolio construction
Example:

Step 2: Calculate the standard deviation for both

securities A and B
Share A: σ = √ Σ (ki – ki)2 x pki
= √ [0.10(-25% – 8.6%)2 + 0.20(-18% – 8.6%)2 + 0.30(9% - 8.6%)2
+ 0.40(30% – 8.6%)2]
= 20.92%

Share B: σ = √ Σ (ki – ki)2 x pki

= √[0.10(6% - 0.5%)2 + 0.20(4% - 0.5%)2 + 0.30(1% - 0.5%)2 + 0.40(-
3% -0.5%)2]
 General portfolio
construction
 Step 3: Measuring portfolio return of
two asset portfolio
Portfolio return: kp = (WA × kA) + (WB ×
kB)
where kp = expected rate of return on
portfolio
Example: Step 3
W &W
A = weight of shares A and B in the
Assume an allocation of 75% toB security A and 25% to security
portfolio
B. Security A has a rate ofkreturn
kA & of 8.60% and security B has
B = expected rates of return on shares A
a rate of
andreturn
B of 0.5%. Calculate the portfolio return.
kp = (WA × kA) + (WB × kB)

kp = (0.75 x 8.60%) + (0.25 x 0.50%)

kp = 6.45 + (0.125)
 General portfolio
construction
 Measuring portfolio risk of two asset
portfolio

where σi = standard deviation of asset i

σ²i = variance of asset I
ωi = weight associated with state i
ri,j = correlation between asset i and j
 General portfolio
construction
Covariance: It a measure of the directional relationship
between the returns on two risky assets

• The sign of the cov. shows the tendency in the linear

relationship between assets
• + (-) cov. = asset returns move together (inversely) -
similar behaviour (opposite behaviour)
• High cov. = strong linear relationship

The magnitude of the covariance = not easy to predict

Correlation: measure the degree of strength of
relationship or dependence between two variables.
• Numerical value between + 1 and – 1
• + (positive relationship - securities’ returns move up/down together)
• - (negative relationship - securities moves inversely, i.e. return of one share
decreases, the return on the other increases)
• The closer the coefficient is to +1 or -1, the stronger the correlation between
these assets
• Correlation of 0 shows no relationship, the two variables are random
 General portfolio
construction
Step 4: Covariance (A,B):

Step 5: Correlation:
 Correlation (r) = Covariance (A,B) ÷ (σA × σB),
 Where:
 Covariance (A,B) =
 General portfolio
construction

Step 4: Calculate the covariance (1 st) ( of security A & B)

 (1st) Covariance A,B : ∑ probability x (return A– KA)(return B–

KB)
 KA = 8.6%, K B= 0.50%

 COV= 0.10 (-0.25 – 0.086)(0.06 - 0.005) + 0.20 (-0.18 – 0.086)

(0.04 - 0.005%) + 0.30 (0.09- 0.086) (0.01 - 0.005) + 0.40
(0.3- 0.086) (-0.03 - 0.005)
 General portfolio
construction
Step 5 :Calculate Correlation (r) = Covariance (A,B) ÷ (σA × σB)
Correlation (r) : Covariance / individual risk for A x individual risk for
B
= - 0.0067 / (0.2092 x 0.0323) ALTERNATIVELY -67.00/
(20.92% x 3.23%)
= -0.991541
Interpret:
Correlation is very close to -1.0. The closer it is to -1.0 the
more the return on the two securities tend to move exactly
opposite to each other.
 General portfolio
construction

Given the information above, calculate:

Expected return of a portfolio consisting of:
 75% in share A and;
 25% in share B investment proposal
 General portfolio
construction
Portfolio return
Kp = (75% consisting of share A)
(Individual return of share A) + (25%
consisting of share B) (Individual return
of share B)
Kp = (0.75)(8.60%) + (0.25)(0.50%)

kp = 0.0645 + 0.00125

Kp = 0.06575

Kp = 6.58%
General portfolio
construction
 General portfolio
construction
Step 6: Portfolio risk
σp = √(75%2 share A)(Individual risk for A2) + (25% of

share B2)(individual risk for B2) + 2(75% share A) (25%

share B)(correlation)(individual risk for A)(individual risk
for B)
= √(0.752 x 0.20922 )+ (0.252 x 0.03232)+ 2(0.75 x 0.25 x -
0.991541 x 0.2092 x 0.0323)

 = √(0.5625 x 0.043764) + (0.0625 x 0.001044) +

(-0.002509)
 = √0.022174
 General portfolio
construction
Step 7: Optimal asset allocation (see also next slide
for alternative technique)

 Optimal Weight = Factor (A) / [1+Factor (A)]

 Where:
 Factor(A) = (σB² - CovarianceAB) / (σA² - CovarianceAB)

 Factor (A)
 = [(0.0323)2 – (-0.0067)] / [(0.2092)2 – (-0.0067)]
 = 0.153439
Optimal weight = 0.153439/(1 + 0.153439)
Optimal weight =0.133027

Share A: 13.3%

Share B: 86.7% (100 – 13.3)

Interpret: A portfolio composition of 13.3% invested in Security A and

86.7% in Security B will produce the highest return with the lowest portfolio
 General portfolio
construction
Optimal asset allocation (Step 7)

 Alternatively: Minimum-variance allocation:

 σB² - x σA x σB ) / (σA² + σB² - x σA x σB )
 Where
 σi = standard deviation of asset i
 σ²i = variation of asset i
 = correlation between asset i and j
 RECAP: Steps to construct a portfolio
Step 1
Calculate the return of each security (see Ch. 1) (Share A & Share B,
respectively)
Step 2
Calculate the risk of each security (see Ch. 1) (Share A & Share B,
respectively)
Step 3
Calculate the return of the portfolio (using the proposed investment
weights given (A &B, respectively)
Step 4
Calculate the covariance of both securities (A,B)
Step 5
Calculate the correlation of both securities (A,B)
Step 6
Calculate the risk of the portfolio (using the correlation (A,B)
Step 7
Calculate the optimal asset allocation (either using the Factor A
method or minimum variance allocation technique) to determine the
weight of each security (A & B) respectively that must be invested in the
 General portfolio
construction
1. Passive management (long-term horizon)
- No forecasting, market timing or some form of analysis to
select or
pick a particular share.
- Intention is not to outperform the market.
- Tendency to have low trading costs (rebalance not often).
Methods:
 Buy and hold
 Investors buys shares or bonds and hold them for long time
(matching their investment horizon), regardless of market
fluctuations.
 Indexing (e.g. types like full replication vs sampling)
 Invest in a portfolio that will match the performance of a
selected index or index fund or portfolio index. E.g. ETF
(Satrix 40 ETF)
 Fund of funds
 Holding a portfolio of other investment funds rather than
investing directly in shares, bonds or other securities
 General portfolio
construction
2. Active management (short-term horizon)
- Specific shares (or other securities) are selected with the goal of
outperforming some investment benchmark index.
- Use technical and fundamental analysis.
- Market timing is important. Attempts to predict the future
direction
of the market.
- Tendency to have high trading costs (rebalance often).
Methods:
 Momentum strategy
 Investors believe that past ‘winners’ on average will continue to outperform
past ‘losers’. However, the portfolio is rebalanced regularly to establish the
recent ‘winners’ that should be invested in.
 Interest rate anticipation (self study)
 Valuation analysis (self study)
 Credit analysis (self study)
 Yield spread analysis (self study)
 Yield curve strategies (self study)
 Riding the yield curve
 Bond ladders, barbells and bullets (leave out)
 Bonds swaps (leave out)
 General portfolio
construction
Leave out Section 13.7.3 (Matched-funding
techniques), Section 13.7.4 (Contingent
immunization), and Section
13.8 (Financial Technology)
 Self-evaluasie / Self-evaluation
 Verduidelik die  Explain the life cycle
lewensiklusteorie in theory in portfolio
portefeuljebestuur. management.
 Bespreek die doelwitte  Discuss the objectives
en beperkinge van and constraints of
portefeuljebestuur. portfolio management.
 Verduidelik die belang  Explain the importance
van batetoedeling. of asset allocation.
 Verduidelik die konsep  Explain the concept of
van diversifikasie. diversification.
 Onderskei tussen  Distinguish between
beleidsbate toedeling policy asset allocation
en taktiese and tactical asset
batetoedeling. allocation.
 Self-evaluasie / Self-evaluation
 Hoe word risiko en  How is risk and return
opbrengs in die konteks measured in the
van portefeuljebestuur portfolio management
gemeet? context?
 Bespreek die  Discuss the equity
bestuurstrategieë van portfolio management
ekwiteit portefeuljes. strategies.
 Bespreek die  Discuss the fixed
bestuurstrategieë van interest-bearing security
vaste rentedraende portfolio management
effekte portefeuljes. strategies.