Portfolio managers are professionals who manage investment portfolios, with the goal of achieving their clients’ investment objectives. In recent years, portfolio manager has become one of the most coveted careers in the financial services industry. In this article we will answer the question, what does a portfolio manager do?
There are two types of portfolio managers, distinguished by the type of clients they serve: individual or institutional. Both types of portfolio manager serve to satisfy the earning goals for their respective clientele.
What Does a Portfolio Manager Do? – Different Investment Styles
The style of investing generally refers to the investment philosophy that a manager employs in their attempts to add value (e.g., beat the market benchmark return). In order to answer the question, “What does a portfolio manager do?”, we have to look at the various investing styles they might use. Some categories of major investing styles include small vs. large, value vs. growth, active vs. passive, and momentum vs. contrarian.
Small vs. large styles refer to the preference for stocks of small-cap (market capitalization) companies or large-cap stocks.
Value vs. growth styles are based on a preference between focusing on current valuation vs. analysis focused on future growth potential.
Active vs. passive investing styles refer to the relative level of active investing that the portfolio manager prefers to engage in. Active portfolio management aims to outperform benchmark indexes, while passive investing aims to match benchmark index performance.
Momentum vs. contrarian style reflects the manager’s preference for trading with, or against, the prevailing market trend.
What Does a Portfolio Manager Do? – The Six-Step Portfolio Management Process
So exactly how do portfolio managers go about achieving their clients’ financial goals? In most cases, portfolio managers conduct the following six steps to add value:
#1 Determine the Client’s Objective
Individual clients typically have smaller investments with shorter, more specific time horizons. In comparison, institutional clients invest larger amounts and typically have longer investment horizons. For this step, managers communicate with each client to determine their respective desired return and risk appetite or tolerance.
#2 Choose the Optimal Asset Classes
Managers then determine the most suitable asset classes (e.g., equities, bonds, real estate, private equity, etc.) based on the client’s investment goals.
#3 Conduct Strategic Asset Allocation (SAA)
Strategic Asset Allocation (SAA) is the process of setting weights for each asset class – for example, 60% equities, 40% bonds – in the client’s portfolio at the beginning of investment periods, so that the portfolio’s risk and return trade-off is compatible with the client’s desire. Portfolios require periodic rebalancing, as asset weights may deviate significantly from the original allocations over the investment horizon due to unexpected returns from various assets.
Both Tactical Asset Allocation (TAA) and Insured Asset Allocation (IAA) refer to different ways of adjusting weights of assets within portfolios during an investment period. The TAA approach makes changes based on capital market opportunities, whereas IAA adjusts asset weights based on the client’s existing wealth at a given point of time.
A portfolio manager may choose to conduct either TAA or IAA, but not both at the same time, as the two approaches reflect contrasting investment philosophies. TAA managers seek to identify and utilize predictor variables that are correlated with future stock returns, and then convert the estimate of expected returns into a stock/bond allocation. IAA managers, on the other hand, strive to offer clients downside protection for their portfolios by working to ensure that portfolio values never drop below the client’s investment floor (i.e., their minimum acceptable portfolio value).
By selecting weights for each asset classes, portfolio managers have control over the amount of 1) security selection risk, 2) style risk, and 3) TAA risk taken by the portfolio.
Security selection risk arises from the manager’s SAA actions. The only way a portfolio manager can avoid security selection risk is to hold a market index directly; this ensures that the manager’s asset class returns are exactly the same as that of the asset class benchmark.
Style risk arises from the manager’s investment style. For instance, “growth” managers frequently beat benchmark returns during bull markets but underperform relative to market indexes during bear markets. Contrarily, “value” managers often struggle to beat benchmark index returns in bull markets, but frequently beat the market average in bear markets.
The manager can only avoid TAA risk by choosing the same systematic risk – beta (β) – as the benchmark index. By not choosing that path, and instead betting on TAA, the manager is exposing the portfolio to higher levels of volatility.
#6 Measure Performance
The performance of portfolios can be measured using the CAPM model. The CAPM performance measures can be derived from a regression of excess portfolio return on excess market return. This yields the systematic risk (β), the portfolio’s value-added expected return (α), and the residual risk. Below are the calculations of the Treynor ratio and Sharpe ratio, as well as the information ratio.
The Treynor ratio, calculated as Tp = (Rp-Rf)/ β, measures the amount of excess return gained by taking on an additional unit of systematic risk.
The Sharpe ratio, calculated as Sp = (Rp-Rf)/σ, where σ = Stdev(Rp-Rf), measures the excess return per unit of total risk.
Comparing the Treynor and Sharpe ratios can tell us if a manager is undertaking a lot of unsystematic, or idiosyncratic, risk. Idiosyncratic risks can be managed by diversification of investments within the portfolio.
The information ratio is calculated as Ip = [(Rp-Rf)- β(Rm-Rf)]/ω = α/ω, where ω represents unsystematic risk. As the numerator is value-added, and the denominator is the risk taken in order to achieve the added value, it is the most useful tool to assess the reward-to-risk of a manager’s value-added.
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