INVESTMENT MANAGEMENT

Learning Objectives
Understand the meaning of investment
Understand how investment in real assets
differs from investment in financial assets
Understand the various steps involved in the
process of investment.
 Investment
Current commitment of money or other resources for a
period of time in order to derive future payments that will
compensate the investor for :

the time the funds are committed,

the expected rate of inflation, and
the uncertainty of the future payments.
 Real and Financial Assets
Investors may choose to hold real assets (tangible assets
such as buildings, automobiles) or financial assets.

Financial assets are claims to the income generated by

real assets or claims on income from the government.

Securities are financial assets.

 Real Assets
Real assets are generally less liquid than financial assets.
Liquidity refers to the ease of converting an asset into
money quickly, conveniently and at little exchange cost.
Real assets are less liquid as they are adapted to a specific
use and yield benefits only in cooperation with other
productive factors.
Moreover, returns on real assets are relatively difficult to
measure accurately, due to absence of broad, ready and
active markets.
 Uses of Financial Assets

Shift purchasing power from high- earning periods to low-

earning periods of life.

Risk inherent in real assets can be transferred to those

willing to bear the risk.

Allow separation of ownership from management.

Investment Management Process
Specification of Investment Objectives and Constraints
Selection of Asset Mix
Formulation of Portfolio Strategy
Portfolio Building and Execution
Portfolio Revision
Portfolio Performance Evaluation
 Investment Objectives
Common Investment Goals
Income
Growth
Stability
Income and growth related to investment return
Stability related to containment and elimination of risk
Investment objectives can be stated in terms of return and
risk: target return and risk tolerance
Risk tolerance depends on financial situation and
temperament for risk
 Investment Constraints
For Individual Investors
Liquidity
Investment Horizon
Taxes
Unique circumstances

For Institutional Investors

Client Constraints
Type of Security
Concentration
Regulatory Constraints
 Selection of Asset Mix
How much of the portfolio has to be invested in
Cash equivalents
Stocks
Bonds
Real Estate
Precious Metals

Stocks preferred by Investors with

Greater risk tolerance
Longer investment horizon
Formulation of Portfolio Strategy
Two Broad Portfolio Strategies
Active Strategy
Passive Strategy

An active strategy uses available information and

forecasting techniques (security analysis) to seek a
performance better than a simple diversified portfolio

A passive strategy relies on diversification to match the

performance of some market index
 Active Portfolio Management
Strategies
Active strategies fall into three categories
Fundamental strategies
Technical Strategies
Market anomalies and security
attributes
 Fundamental Strategies
Market Timing: shifting funds between stocks, bonds and
T-bills depending on market forecasts and estimated risk
premiums

Sector Rotation : shifting funds among different equity

sectors and industries (financial stocks, technology stocks,
durable goods, consumer cyclicals), or different investment
styles (large caps, small caps, value stocks, growth stocks)

Stock Picking : find undervalued stocks using DCF or

relative valuation methods or bonds that offer the highest
YTM at low risk
 Security Selection
Security Selection can follow one of the
following two approaches

Top- down (EIC) approach

Bottom-up approach
 Technical Strategies
Technical strategies use past stock price trends to form
equity portfolios.

Technical analyst believe that:

Either the past trend in stock prices will continue (called

Price Momentum Strategy) , or

Past trends in prices will reverse themselves (called

Contrarian Investment Strategy)
 Anomalies and Attributes
Some active equity portfolio management strategies are
based on :

Market anomalies (such as weekend effect, January effect)

Company attributes (such as size, P/E ratio, P/BV ratio)

Investment style (value investing, growth investing)

 Passive Strategies
The goal of a passive portfolio is to match the returns (or
to have minimum tracking error) of a passive index as
closely as possible.
Such passive index may be a published index or a
customized index (e.g. that of dividend paying stocks only)
Three basic techniques of constructing a passive index
portfolio are Full replication, Sampling and Quadratic
programming
Instead of constructing their own passive investment
portfolios, investors can pursue a passive strategy simply
by buying shares in an index mutual fund or an exchange
traded fund (ETF).
 Portfolio Building
Identification of efficient portfolios based on
Expected returns
Variance of returns
Correlation of returns

The approach is called the Mean-Variance Approach

Selection of optimum portfolio is based on risk-return

tradeoff
 Portfolio Revision
Portfolio revision required to maintain the target asset
allocation and the risk-return characteristics of the
portfolio

It involves
Portfolio rebalancing (to maintain target asset allocation)
Portfolio up gradation (selling over-priced securities and
buying under-priced securities)
Portfolio Performance Evaluation
Measurement of performance considering the return and
the risk

Evaluating the performance relative to a benchmark

Performance better than the benchmark does not

necessarily mean that investment objectives are met