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LM03 Portfolio Management Overview 2025 Level I Notes © IFT. All rights reserved 1 LM03 Portfolio Management: An Overview 1. Introduction ...................................................................................................................................................... 2 2. Portfolio Perspective: Diversification and Risk Reduction ............................................................. 2 3. Portfolio Perspective: Risk-Return Trade off, Downside Protection, Modern Portfolio Theory ...................................................................................................................................................................... 2 4. Steps in the Portfolio Management Process ......................................................................................... 3 5. Types of Investors ........................................................................................................................................... 4 6. The Asset Management Industry .............................................................................................................. 5 7. Pooled Interest - Mutual Funds ................................................................................................................. 6 7.1 Mutual Funds ............................................................................................................................................. 6 8. Pooled Interest - Types of Mutual Funds ............................................................................................... 8 9. Pooled Interest – Other Investment Products ..................................................................................... 8 9.1 Exchange Traded Funds ........................................................................................................................ 9 9.2 Hedge Funds ............................................................................................................................................... 9 9.3 Private Equity and Venture Capital Funds ..................................................................................10 Summary ..............................................................................................................................................................11 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM03 Portfolio Management Overview 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction In this reading, we will see the importance of the portfolio approach to investing, investment needs of different types of investors, steps in the portfolio management process, and how to compare various types of pooled investments. 2. Portfolio Perspective: Diversification and Risk Reduction The portfolio approach means evaluating individual investments based on their contribution to the investment characteristics of the portfolio. Assume an investor’s portfolio has three stocks A, B, and C. He is evaluating whether to add another stock, D, to the portfolio. In a portfolio approach, the investor will analyze what will happen to the risk and return of the portfolio with and without stock D; whereas, in an isolated approach, he will only look at the merits and demerits of the stock D. Diversification helps investors avoid disastrous outcomes. For instance, many Enron employees held all of their retirement funds in Enron shares. When the share tumbled from $90 to zero between January 2001 and 2002, it completely ruined their financial wealth; this example emphasizes the need to diversify one’s portfolio. Instead, if the Enron employees had held shares of other companies or other products, the consequence would not have been as bad. Diversification also helps investors reduce risk without compromising their expected rate of return. A simple measure of diversification risk is the diversification ratio. Let us take the example of the same portfolio consisting of three stocks: A, B, and C with each stock belonging to a different industry. There is a high probability that the movements of A, B, and C are not correlated with each other, i.e., when A moves up, B may move down or C may move down. The benefit of diversification is that the movements of individual stocks cancel each other out to some extent. The benefits of diversification in risk reduction for an equally weighted portfolio is measured by diversification ratio. Diversification ratio = Risk of equally weighted portfolio of n securities Risk of single security selected at random 3. Portfolio Perspective: Risk-Return Trade off, Downside Protection, Modern Portfolio Theory The composition of the portfolios also matters for the risk-return trade-off. The table below shows two portfolios with different compositions of A, B, and C. Two portfolios with same stocks but different compositions Weight of each stock Portfolio Stock A Stock B Stock C Expected Return Standard Deviation Portfolio 1 33% 33% 33% 11% 13.1%
LM03 Portfolio Management Overview 2025 Level I Notes © IFT. All rights reserved 3 Portfolio 2 50% 25% 25% 11% 14% As you can see both the portfolios have the same expected return, but Portfolio 1 has a better risk-return trade-off than Portfolio 2 as the risk assumed is lower for the same return. However, an important point to note is that portfolios do not provide guaranteed downside protection. Although portfolio diversification reduces risk, the level of risk reduction is not the same at times of financial crises. The benefits of risk reduction from diversification are best seen under normal market conditions. 4. Steps in the Portfolio Management Process The three steps in the portfolio management process are planning, execution, and feedback. Step One: The Planning Step In this step, the portfolio manager needs to understand a client’s needs and develop an investment policy statement (IPS). IPS is a written document that states the client’s objectives and constraints. Objectives are return and risk objectives which may be stated in absolute terms or relative terms. Constraints may include liquidity, unique circumstances, time horizon, legal, and taxes. Step Two: The Execution Step Based on the IPS, a portfolio is constructed in this step. Under execution, the first activity is asset allocation. Here the portfolio manager decides what asset classes must be included in the client’s portfolio and in what proportion. Stocks, bonds, and alternative investments are examples of different asset classes. As an example, a client’s asset allocation may consist of 60% equities, 30% fixed-income securities and 10% alternative investments. Asset allocation is followed by security selection which is the analysis and selection of individual securities. In other words, the specific securities to be purchased are identified. For example, if 60% is allocated to equities, the analyst will identify what specific stocks to purchase. Once the securities are selected, they are purchased through a broker or dealer. This is called portfolio construction. Step Three: The Feedback Step A portfolio manager’s responsibility does not end with constructing a portfolio. The portfolio also needs to be monitored and rebalanced at regular intervals. For example, if the stock market performs very well in a particular period, the asset allocation drifts away from the intended levels. In this case the portfolio needs to be rebalanced. The frequency at which performance is measured is pre-decided – for instance, it could be on a monthly or quarterly basis. The feedback step also involves performance measurement and reporting. Analysis must include how the portfolio performed over time, were the objectives met, what assets attributed to the good/poor performance, how the portfolio performed against the
LM03 Portfolio Management Overview 2025 Level I Notes © IFT. All rights reserved 4 benchmark, and so on. 5. Types of Investors The investment needs of different client types are given in the following table: Investment Horizon Risk Tolerance Income Needs Liquidity Needs Individual Investors Depends on individual goals. Depends on the ability and willingness to take risk. Depends on rationale behind investment. Depends on the individual. Banks Short Low Pay interest on deposits. High, to meet the daily withdrawals. DB pension plans Long, depends on the employee profile. High for longer investment horizon. High for mature funds (payouts are closer), low for growing funds. Low Endowments and foundations Long High Meet spending obligations. Low Insurance Companies (P&C) Short Low Low High Insurance Companies (Life) Long Low (because of high liquidity needs). Low High Mutual Funds Varies by fund. Varies by fund. Varies by fund. High, to meet redemptions. Instructor’s Note: The two types of pension plans are: Defined Contribution Plan: Company contributes an agreed-upon amount to the plan. The agreed-upon amount is recognized as a pension expense on the income statement and the contributed amount is treated as an operating cash outflow. In DC plan, the investment and inflation risk is borne by the employee. Defined Benefit Plan: A company makes promises of future benefits to be paid to the employees. Since the employee’s future benefits are defined, the employer assumes the investment risk. 6. The Asset Management Industry The asset management industry is an integral component of the global financial services