Mastering Portfolio Construction | CFA Level I Portfolio Management

Introduction to Portfolio Construction

In this lesson, we’ll dive deeper into the second stage of the portfolio management process – the construction or execution stage.

Think of yourself as a football coach and your client as the club owner. Your job is to win the game for the owner. Forming capital market expectations is like studying the competition. Strategic asset allocation is like crafting the game strategy, and tactical asset allocation is like adjusting the strategy during the game. Finally, security selection is like choosing specific players for each role. Now, let’s break down the process step-by-step.

Capital Market Expectations

Capital market expectations refer to the investor’s outlook on the risk and return prospects of asset classes. These asset classes can be divided into:

• Equities: domestic or foreign, large or small, developed or emerging markets.
• Bonds: domestic or foreign, developed or emerging markets, investment grade or high yield.
• Alternative Investments: hedge funds, private equity funds, commodities, and real estate.

As a portfolio manager, you’ll collect data on the long-term expected returns, standard deviation of returns, and correlations of returns with other asset classes. These correlations are presented in a correlation matrix.

Strategic Asset Allocation

Using the expected returns, standard deviation of returns, and correlations of returns, you can construct an efficient frontier and identify the optimal risky portfolio for your client. The asset allocation for this optimal portfolio is the strategic asset allocation for the client’s portfolio.

Active Management

If you maintain the strategic asset allocation without deviation, you are a passive manager. If you deviate from the strategic allocation to take advantage of short-term opportunities, you are pursuing an active strategy. Active management can include tactical asset allocation and security selection.

Tactical Asset Allocation

Tactical asset allocation is a dynamic investment strategy that involves actively adjusting a portfolio’s asset mix to take advantage of short-term market opportunities. Instead of strictly adhering to a strategic asset allocation, which is designed for the long term, tactical asset allocation allows investors to capitalize on perceived market inefficiencies, mispricing, or changes in market conditions.

For example, an investor may temporarily underweight stocks and overweight bonds if they believe stocks are overvalued relative to bonds. While this active strategy may generate higher returns, it also introduces additional risks compared to a passive portfolio that maintains a fixed asset allocation. It’s important for investors using tactical asset allocation to carefully manage and monitor their risk exposure to ensure it stays within acceptable limits.

Security Selection

Security selection is the process of choosing individual securities within an asset class to include in a portfolio. This step involves analyzing and evaluating specific stocks, bonds, or other investments to determine their suitability based on the investor’s risk tolerance, return objectives, and overall investment strategy. Through careful security selection, investors aim to identify undervalued or high-potential securities that can help them outperform their benchmark or achieve their investment goals. This active management approach can potentially lead to higher returns but may also increase portfolio risk compared to a passive strategy that follows an index.

Risk Budgeting

While active strategies may produce higher returns, they also increase the portfolio’s risk compared to a passive portfolio. To manage this risk, risk budgeting sets an overall risk limit and allocates it to the systematic risk, tactical asset allocation risk, and security selection risk.

Issues with Active Management

Active portfolio management can face challenges, such as offsetting active positions and unnecessary trading. One way to address these issues is through a core-satellite approach, which combines passively-managed core portfolios and actively-managed satellite portfolios.

ESG Integration in Portfolio Planning and Construction

ESG integration is the inclusion of environmental, social, and governance factors throughout the portfolio management process. Approaches to ESG integration include:

• Negative screening
• Positive screening
• Thematic investing
• Impact investing
• Engagement or active ownership

Benchmarking can be a challenge in ESG investing, as traditional broad market indexes may not be appropriate. Shareholder engagement is another key aspect, involving investors communicating with companies to promote positive change.

Ultimately, the goal of ESG investing is to create a positive impact on society and the environment while still generating financial returns. ESG integration is now widely adopted across mainstream funds due to investor demands.

Conclusion

And that wraps up our discussion on portfolio planning and construction. Remember, the process involves forming capital market expectations, strategic asset allocation, tactical asset allocation, and security selection. ESG integration is also a growing trend in portfolio management.