There is a generally accepted 5-step
investment process used in professional portfolio management:
1. Investment Policy
Statement (IPS) (click to expand)
The investment policy statement
is both the beginning and the end of the investment process. It documents
the issues to be addressed as well as the conclusions drawn from the
process. It should contain the following elements:
- Purpose of an IPS
- Risk Tolerance Assessment
- Investment Objectives
- Investment Expectations by
Investment, Asset, and Aggregate Portfolio
- Performance Measurement and Control
- Adoption of Plan
2. Capital Markets
Expectations
In order to select and combine the various investments into an effective
portfolio, we must make certain assumptions about the performance
characteristics of each asset class.
Parameters to Estimate
- Returns: What level of returns should
we observe in each asset class?
- Volatility/risk: What is the
distribution of returns that we should observe in each asset class?
- Correlation of returns: How will the
returns be correlated between asset classes?
- Investment time horizon: How long does
the asset need to be held to have a high probability of achieving the
average performance of that asset class?
Asset Classes on Which to Estimate
Parameters
- Inflation
- Cash and equivalents
- Treasury Bills
- CD's
- Money market funds
- Fixed income
- US Government securities
- Foreign government bonds
- Domestic corporate bonds
- Foreign corporate bonds
- Municipal bonds
- Treasury Inflation Protected
Securities (TIPS)
- Long-term vs. short-term instruments
- Preferred stocks (classified as
fixed-income)
- Collateralized Debt Obligations (CDOs)
- Capital appreciation strategies vs.
interest income strategies
- Default premium
- Horizon premium
- Equities
- Capitalization: Large cap, mid cap,
small cap, and micro cap
- Domestic vs. International
- International: developed market vs.
emerging market
- Value vs. growth
- Capital appreciation vs. income
- Performance by economic sector
- Equity risk premium
- Small cap premium
- Exchange rate return and risks
- Real estate
- Debt: Collateralized Mortgage
Obligations (CMOs)
- Equity: Real Estate Investment
Trusts (REITs)
- Alternative investments
- Hedge funds
- Private equity
- Venture capital
- Distressed debt
- Commodities
3. Asset Allocation and
Location (click to expand)
The asset classes appropriate to
the investor's situation are then identified and combined into an
efficient portfolio.
- Asset Selection
- Optimization Process
- Asset Allocation
- Rebalancing Parameters
- Asset Location
- Expected Long-Term Benchmark
Portfolio Results
4. Implementation
(click to expand)
While the asset allocation
process determines what asset exposure the investor needs, the
implementation process determines how that asset exposure is
achieved.
- Active vs. Passive Management
- Strategies
- Action Calendar
5. Performance Monitoring
and Control (click to expand)
The final step is establishing
the process by which all previous activities are monitored and controlled.
- Performance Measurement
- Underperformance Defined
- Communications Required
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