Sunday, December 1, 2013

How does modern portfolio management work?

Decide on Strategic Asset Allocation (Benchmark/SAA)
Investment Committee (IC) defines an Asset Allocation for the various Risk Profiles the bank wants to offer their clients. Risk in this sense means, the maximal possible loss. Usually a bank offers at least 15 risk profiles, from bonds only to stocks only (eg. Fixed Income, Yield, Balanced, Growth, Equity in the common reference currencies USD, EUR, CHF). These asset allocations consist of various Asset Classes. The common asset classes are Equity, Bonds, Cash. Since around the year 2000 the asset class alternative investments and a bid later commodities became more popular. This asset allocation is optimized (Diversification) in order to achieve the maximal return with the risk taken. The strategic asset allocation remains unchanged over years. Changes happen when due to longterm market outlook a new asset class is seen to be favorable as for example the asset class “alternative investments”.

Decide on Tactical Asset Allocation (TAA)
Investment Committee reviews the current tactical asset allocation usually several times per month and decides if an adjustment is needed. A change happens several times per year. The bet is taken against the strategic asset allocation. That means because of the current market outlook the Investment Committee meight underweight or overweight TAA against SAA in order to achieve a higher return. Since the tactical/strategic asset allocation (usually) is static, but the asset asset allocations of client portfolios change because of market movementsa decision is needed, when to rebalance back to the static asset allocation. Depending on the banks organization this is made in the Investment Committee or by the portfolio management unit itself.

Within the limitation of the tactical asset allocation specialists from the portfolio management unit decide, which investment products to by or sell. Adjustments are made when the TAA changes, but changes are also made when market conditions and company outlook favor a switch from one instrument into an other. An example: IC decides to overweight stocks US against strategic asset allocation. Tactical asset allocation is increased from 20% to 26%. As as result the PM specialist for US stocks needs to find two US stock investments for 3% each.