Mohamed Safiudeen
University of the West of Scotland, UK
Mohamed.Safiudeen@gmail.com
Mahdi H. Miraz
Xiamen University Malaysia, Malaysia
m.miraz@ieee.org
Abstract — The objective of this paper is to survey the literature from theoretical and the practical perspective of asset allocation and portfolio construction, and the ideal means of performing this mission is through portfolio management process. The efficient financial markets and behavioral finance are two different bases in which investors can evaluate best approach for asset allocation and security selection for a security. The Efficient Markets Hypothesis is believed that market discounts all publicly available information, whereas, behavioral finance and neurosciences disprove because of irrational behavior of retail traders financial market become inefficient. Experts believe that fundamental and technical analysis can help investors to evaluate market price movement of a security. This enables investors to make buy and sell decision that leads to a profitable trade. The portfolio management process decomposed into portfolio planning, portfolio construction, and portfolio evaluation phases. It helps identify what is risk tolerance and ability to take risk of an investors, what is the optimal weight of each security in the portfolio and what is the reasonable expected return based on market conditions.
Keywords: Security Allocation, Asset Valuation, Fundamental Analysis, Technical Analysis, Behavioral Finance, CAPM, Mean-Variance Optimization.
I. Introduction
It is proven that time series can be forecasted for security price prediction.it give the ability to understand they in which a security is being priced. The two important techniques were developed to analyses the price of a security that are fundamental [1] and technical analysis [2]. Here market participants have same objective that is when to buy and sell a security for good profit, despite produce the same results but they differ in which security being analyzed. Intrinsic value [3] of a security is being calculated using fundamental analysis technique. Influence of market anomalies results price fluctuation around intrinsic value while it is being traded in the financial markets. Hence it creates an opportunity to buy at low price and sell at high price. Historical price of a security whereby future price movements are predicted and the technique that market participants use is technical analysis. Price [4] of a security includes all publicly available information so technical analyst believe that fundamental analysis is irrelevant. Most of the market participants use both techniques for security selection and asset allocation strategy.
A successful asset allocation strategy includes top-down and bottom up approach to analyze sector, macroeconomic factors of a security. Portfolio constriction is multifaceted approach in which both fundamental as well as technical analysis are employed to identify diversified asset classes across all industries.
Portfolio management process (PMP) [5] can be classified into three steps: portfolio planning, portfolio construction and portfolio evaluation.
II. Portfolio Management Processes
The three different phases of portfolio management process (PMP) are briefly described in the following subsections:
• portfolio planning phase: deals with analyzing investors objectives and constraints.
• portfolio construction phase: deals with asset allocation and security selection.
• portfolio evaluation phase: deals with portfolio performance analysis and rebalancing.
III. Portfolio planning phase
Portfolio manager analyze client’s requirements and constraints in order to determine investment goal. Setting a clear distinction, at an early stage, between goals of clients and portfolio managers are vital. The aim of constructing a portfolio is to achieve maximum diversification benefit that leads to maximum profit. The investment policy statement (IPS) comprises of two main elements: understanding client’s requirements, assets and asset classes in which they want to invest. Furthermore, portfolio manager gathers data such as investment objectives, time horizon, taxes, and the clients’ risk appetite. Most of all risk tolerance is considered to be the most important factor for selecting the right portfolio for the investor.
A. Understanding the investors
Investors can be classified into retail investors and institutional investors. Retail investors are small scale investor mostly their investments are out of their savings. So mostly they may not use professional portfolio management service. Investing firms are example for institutional investors who can make huge investments and can afford to employ professional portfolio management service to manage their funds.
B. Understanding the market: Types and Source of Information
Types of Financial Markets
Financial markets are classified into five broad asset classes such as equity, fixed income, money market, foreign exchange markets and alternative investments. And capital market also categorized based on how it is being traded.
There are four conventional classifications:
· Equity Market : Primary and Secondary markets,
· debt markets,
· exchange Traded and Over-the-counter (OTC) markets and
· Money markets
C. Market Information Source and Type
Investment strategies are built based on the outcome of individual securities performance so portfolio manager often employ multiple investment strategies by measuring each security’s performance and such as indicators are Sharpe ratio, Treynor ratios and Jensen’s alpha and many more. Macroeconomic indicators capture overall market performances such as unemployment rate, gross domestic products, and foreign exchange reserves. It is one of the drivers of financial market.
D. Investment Policy Statement (IPS)
It is statement that outlines investment objectives and constrains of investors. It primarily describe about client’s risk tolerance, time horizon, asset class selection, benchmark, investment strategies and many more. Portfolio managers carefully evaluate investors profile and decide what investment approach should be considered such as (1) active or passive, (2) systematic or discretionary and (3) long or long-short approach.
E. Active versus passive approach
In the active investment approach, portfolio managers actively monitor portfolio performance with objective of outperforming benchmark index by selling overpriced assets and buying undervalued assets. This asserts that the ideal means of approaching the financial markets for profitable investments. In the passive investment approach, portfolio managers replicate the benchmark index and try to match the performance of the benchmark index. In active investment approach portfolio manager makes cautious decision on selection of securities, asset allocation and diversification in order to produce positive alpha. Positive alpha reflect portfolio managers performance.
F. Systematic and Discretionary approach
This describes the way in which investment manager decides investment strategy. Investment managers most likely choose systematic (rule based) approach for passive investment and discretionary approach for active investment. Benefit is systematic strategy helps us to predict future outcomes in this approach analyst can employ back testing strategies to predict future events such as price of a security. Disadvantage of this approach is after certain point in time profitability of the strategy will be reduced. So portfolio will underperform against its benchmark.
G. Long versus short approach
It expresses investment manager’s view towards the market: either bullish or bearish. Bullish refers to a particular perception of security with regards to its market valuation i.e. when a security price is below its intrinsic value and it is evident that price of the security will increase in the future. The opposite is considered as bearish. In the bullish market, investors go for a buy trade whereas in the bearish market investors go for a sell trade, which is also known as short selling.
IV. Portfolio Construction Phase
This has two stages: asset allocation and security selection. Asset allocation must be in-line with IPS which describes end investor’s risk apatite and risk tolerance. It may restrict investment to some asset classes. In order to obtain diversification benefit, the investors opt for investing multiple asset classes resulting in reduction of overall risk of the portfolio. The asset allocation can further be classified into tactical and strategic. In strategic asset allocation, the investment managers select securities with long term investment perspective. In tactical asset allocation, the investment managers select securities with short term investment perspective. It requires frequent rebalancing of the portfolio based on the market conditions.
A. Asset Allocation and Security Section Strategy in Theory
The concept of asset distribution has a connection with the work of Harry Markowitz (1959) [6]. It states that choosing optimal weight of individual securities it minimizes individual security’s variance when it is in the portfolio because of low correlation among constituent securities. Portfolio expected returns [7] is culmination of individual asset’s rates of return. The objective is to minimize the variance of portfolio.
𝑟𝑝=𝑤1𝑟1+𝑤2𝑟2+⋯+𝑤𝑛𝑟𝑛 (1)
Where
· rp = Portfolio return
· w = weight of an asset
· r= rate of return of an asset
min {w1…wn} = σ𝑝2 (2)
Where
· σ𝑝2= standard deviation
Harry believed that solution to this problem is minimum variance portfolio [8]for a given rate of return. It is plotted against portfolio expected return and standard deviation, so rational less risk seeking investors are likely to choose portfolio with lowest standard deviation i.e. the minimum variance portfolio (MVP) point as shown in Chart 1. The dotted curve is efficient frontier in which the total risk equals to the systematic risk and it produces maximum diversification benefit (unsystematic risk is zero). Minimum variance frontier offers the best available asset with maximum expected return and low volatility. It is the only option for portfolio managers to select optimal mean variance portfolio.
Chart 1: Minimum variance frontier
As illustrated in the Chart 2, in order to select optimal portfolio [9] from the minimum variance frontier, an efficient approach is to add risk free asset so that the minimum variance frontier is linear.
Chart 2: Optimal portfolio selection
The line that connects risk free rate rf and risky asset n touches a point T in the parabolic curve. Since T is the maximum attainable portfolio for any given standard deviation, hence T is the optimal portfolio according to modern portfolio theory. The reason behind adding risk free asset is that the investors can increase their exposure by borrowing money at risk free rate rf and investing in risky asset to construct efficient portfolio.
B. Security Selection in Theory
The capital asset pricing model (CAPM) is a single determinant model to calculate expected return using beta (systematic risk). Capital market theory asserts that the investors are compensated only for accepting systematic risk. There are two key assumptions in CAPM model:
· All investors’ estimate of risk and return are the same
· All investors can lend and borrow money at the risk-free rate. The CAPM posits that there exists a linear relationship [10] between the expected rate of return on asset and market index
E[r]=R𝑓+𝛽𝑖𝑀(Rm-−R𝑓) (3)
Where
· E[r]=expected return
· Rf=risk free rate of return
· 𝛽𝑖𝑀=systematic risk
· Rm =Risk premium
C. Asset Allocation and Security Selection in Practice
In the real world, quantitative method and qualitative methods are suggested for optimal asset allocation. Quantitative analysis is process of evaluating security performance such as optimization and simulation [11]. Sharpe ratio measures expected future return for every unit of risk taken. In order to add new assets in the portfolio, new asset Sharpe ratio must be greater than that of the portfolio multiply with correlation between new asset and portfolio [12].
D. Security Selection in practice
It has two approaches The top-down and the bottom-up approach. Top down approach analyze security in the order of economy, industry and sector, and company whereas bottom up approach goes in the reverse order. Top-down approach is often used in passive investing strategy because portfolio and market are exposed to the same risk in the same proportion. Bottom-up approach produces best results in active investment strategy because it allows identifying securities that are mispriced
E. Fundamental Analysis
It is the valuation method of an asset [13].
· Discounted cash flow (DCF),
· Asset based valuation
· Relative valuation.
The DCF [14] Valuation objective is to arrive at present value of the future cash flow using appropriate discount date. It provides net present value of the company also known as intrinsic value of the company.
𝑉0=𝐶𝐹1/(1+𝑟𝑓1)+𝐶𝐹2/(1+𝑟𝑓2)²+⋯+𝐶𝐹𝑛/(1+𝑟𝑓𝑛)^𝑛, (4)
Where
· CF=Cash flow from asset
· rf= risk free rate
· n = number of periods
F. Technical Analysis
It is tool to forecast time series of the security with historical price data. Technical analyst can be able to analyze price action of a security, stock volume movement for a given period of time. Technical indicators continuously measures price movement of a security any adverse changes in the price movement are sharply captured to make manful decisions. There are a range of technical indicators available such as price patterns, oscillators to identify trends in market data.
V. Portfolio Evaluation
Performance of a portfolio is contribution of individual security’s performance. So portfolio manager at constant time interval evaluate the performance of each security and compare them with benchmark performance in order to take corrective action results rebalancing of portfolio. Underperforming securities are removed from the portfolio and new securities will be added to rebalance the portfolio.
A. Portfolio Performance Measurement tools
Sharpe Ratio
Performance analysis has two components: risk and return. Even though return maximization is an important objective, it is sufficient just to compare portfolio return and benchmark return to arrive measure the performance of an asset. A commonly used measure of performance is the Sharpe ratio, which is defined as the portfolio’s risk premium divided by its total risk. Sharpe ration, denoted by SR, can be calculated by using the following formula:
SR=E(Rp)-Rf/ σ
Where
· E(Rp): Expected Return
· Rf: Risk Free Rate of Return
· σp: Standard deviation of the return of portfolio p
The portfolio with the highest Sharpe ratio has the best risk-adjusted performance, with the lowest Sharpe ratio has the worst risk-adjusted performance, provided that the numerator is always positive. Negative numerator produces incorrect rankings.
Treynor’s Ratio
The Treynor ratio is a simple extension of the Sharpe ratio and resolves the Sharpe ratio’s first limitation by substituting beta (systematic risk) for total risk.
TR=E(Rp)-Rf/ β
Where
· E(Rp): Expected Return
· Rf: Risk Free Rate of Return
· Βp: Beta of portfolio
Jensen’s Alpha
Similar to the Treynor ratio, Jensen’s alpha is based on systematic risk. Beta is a coefficient of market return risk, adjusted return is calculated using beta of the portfolio and CAPM. The difference between actual portfolio return and calculated risk-adjusted return is called Jensen’s alpha. It is a measure of portfolio’s performance, relative to the market portfolio. Jensen’s alpha is also the vertical distance from the Security market line, measuring the excess return for the same risk as that of the market. Jensen’s Alpha, denoted as αp, can be calculated using the following equation:
αp = Rp — {Rf + βp[E(Rm)– Rf]}
Where
· E(Rp): Expected Return
· Rf: Risk Free Rate of Return
· Βp: Beta of portfolio
· Rm: Market Premium.
This is to note that the returns in the equation are all realized, actual returns. The sign of αp indicates whether the portfolio has outperformed the market. If αp is positive, then the portfolio has outperformed the market; if αp is negative, the portfolio has underperformed the market. Jensen’s alpha is commonly used for evaluating the fund managers’ performance.
Just like the Sharpe ratio, the numerators must be positive for the Treynor ratio to give meaningful results. In addition, the Treynor ratio does not work for negative-beta assets — that is, the denominator must also be positive for obtaining correct estimates and rankings.
VI. LIMITATIONS
The following are the limitations identified:
• Exposure to each asset class remains fixed, regardless of’ performance or market conditions [15]
• Performance drag due to performance imbalance between asset classes such as stock and bond both are negatively correlated when stock 1’alls bond will rise [16]
• Maintenance intensive portfolio manager must actively rebalance portfolio weight based on market conditions of each asset classes in the portfolio.
• High management fees because of’ active portfolio management.
VII. CONCLUSION
Security selection and asset allocation are key to portfolio management process. Efficient market hypothesis and behavioral finance advocates views of fundamental and technical analysts. It is evident that none of the approaches are superior hence there is no common formula available There are many factors to consider and therefore, a hybrid model, customized to specific scenarios, is likely to perform better.
Further research can be conducted on the equivalence o1 the static and dynamic asset allocation problems, stock bond correlation and its implication s for asset allocation using machine learning tools like R, Python and MATLAB. Portfolio performance optimization, by allocating optimal weight of each security using genetic algorithms, is also going to be studied.
