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Factors affecting Portfolio construction

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1. Factors affecting Portfolio construction:

Fund managers often use different methods to construct their portfolios depending on the type of funds they manage and the style of management they adopt. There are several other external factors which have different influences on the construction of portfolio. This means that the fund manager has to look into his investments from different perspectives and collect as many information and data available on the securities they hold and such information may be sourced from external environments and internal analysis.

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Some of the factors that influence the decision of the fund manager in the portfolio construction are:

1.1 Size of the Firm:

The size of the company in which the investment is proposed to be made influences the decision on such investment. However the decision depends on the prevailing economic condition in that in an economic boom  smaller companies are bound to outperform bigger companies and in a recessionary situation the converse will be true and under such circumstances, the investments are to be made in companies that are considered more resilient because of cash availability or diversification.

1.2 Book Value and Market Value:

In the context of the portfolio construction, the book values and market values play a key role. It is mostly the case that market value is quite different from the book value.

This is because the market value accounts for the growth potential of the securities. “Most investors who use fundamental analysis to pick stocks look at a company’s market value and then determine whether or not the market value is adequate or if it’s undervalued in comparison to it’s book value, net assets or some other measure”. (Investopedia)

1.3 Monday Factor:

Monday tends to be the worst day to invest in stocks. Lawrence Harris (1986) has studied intraday trading and found that the weekend effect tends to occur in the first 45 minutes of trading as prices fall, but on all other days prices rise during the first 45 minutes. This anomaly might be the result of the moods of the people before and after the weekend holidays. Investors should however, keep in mind that the difference is small and virtually impossible to take advantage of because of trading costs.

1.4 January Effect:

Stocks in general and smaller stocks in particular have historically generated abnormally high returns during the month of January. According to Robert Haugen and Philippe Jorion (1996), “the January effect is, perhaps the best-known example of anomalous behavior in security markets throughout the world.” The intriguing fact about January effect is that it has continued for nearly two decades, as theoretically an anomaly should disappear as traders attempt to take advantage of it in advance. It is also argued that some other anomalies also occur in January. This may be due to the rebounding of the small stocks following year-end tax selling. Studies have revealed that there may be other reasons also for such effect other than just the tax effects.

1.5 Price Earnings Ratio:

Being one of the security level indicators, the price earnings ratio guides the investment decision based on the style of investment; whether the ‘value style ‘is followed or a ‘growth style’. The price earnings ratio offers a dynamic measurement for the trends in changing values or changing growth. Depending on the style of investment this measure can be used to guide the construction of portfolio.

1.6 Momentum:

A momentum strategy involves buying past winners and selling past losers. By employing the medium term momentum representing the strategy of buying past winning stocks and selling past losing stocks an above normal performance over a period can me maintained. This way the investment manager can construct a portfolio that will give him an above normal performance over a period.

2. Protection of Portfolio by Short Fall Analysis and Options:

Traditionally “mean variance’ model has been used by the most of the analysts to both theoretically and in the practical world for measuring the performance of the investments and thereby protecting the portfolios. However this model was suffering from several shortcomings the chief among them is that it ignores the occurrence of skew ness or asymmetry of returns from the investments. Susan Arterian explains that “the mean variance model consequently breaks down when applied to portfolios with options, or dynamic, option-replicating trading strategies, which produce highly skewed returns”. Similarly the mean variance model doesn’t take into account the investors’ preferences even for positive returns and provide the opportunity to adjust the portfolio accordingly.

In order to overcome these shortcomings new wave portfolio theorists have found out alternative risk measures like shortfall analysis, semi variance and adjusted beta models to arrive at the optimum return portfolios by measuring the relative performances of the various investments. Shortfall is represented by the returns that couldn’t be achieved against targets. This model allows the investors to express different levels of preference for increased returns and at the same time the investor can specify the limits of negative returns over different time periods and also over different ranges of the overall returns expected from the portfolio. In the shortfall analysis there is the facility for adjusting both the contributions and allocations according to the needs to protect the investments to result in the maximum return.

More often the shortfall analysis is complemented by investments in ‘options’. For example if an investor wants his portfolio to be protected from big losses by expressing his aversion of taking risks, under shortfall analysis it is assumed that that his portfolio can be supported by put options or certain call options to cover the risk involved in investing in risk prone securities. Of course it is but natural that these call and put options investments have to be carried out over a period of time depending on the shortfall of returns against the targets so that the overall performance of the portfolio is maintained.

3. Non-symmetrical Performance:

The portfolio theory normally assumes the assets returns follow a Gaussian distribution in which the returns follow a symmetrical pattern. The assessment models developed by the theorists follow this assumption and have defined the movements of the symmetrical returns by the first two moments namely mean and the variance. But however in the practical world the returns in most cases fall under a non-symmetrical environment and hence follow erratic returns over a period of time. This phenomenon is described as non-symmetrical performance of the investments and is often measured by the third and fourth moments of distribution namely skew ness and kurtosis.

In order to operate under a circumstance of a non-symmetrical performance of the portfolio several indicators have been established by the financial theory. One of the chief approaches is to follow the median model. In contrast to the traditional mean variance model the median can be used as an effective indicator to make an assessment of the probable outcome of an investment. In the median model, the investment manager can find a more concrete and reliable estimation of the outcome of the investments and also the median model is best suited for the assessment of the outcome in a typical non-symmetrical environment. In a non-symmetrical environment 50 percent of the cases would perform better than the median level and in the balance cases the performance may not reach the median level at all.

The next indicator that can be uses to assess the performance under non-symmetrical environment relates to the risk. The model of ‘Value at Risk’ (VaR) is the standard model being mostly used by the portfolio managers for controlling the risk on the investments.

Wojtek Nabialek (2006) describes “To properly talk about VaR it is necessary to specify two numbers. One is a time horizon, which can be merely a number of days in the case of a trading book or more likely a number of years for an investment portfolio, and the other number is a percentage” If one considers the VaR of 95 percent it indicates that “a one-day, 95 per cent VaR is the one-day loss that has a 5 per cent probability of happening (ie we are 95 per cent safe it should not happen).” Wojtek Nabialek (2006)

Researchers have found that the performance of the portfolios have to be analysed using the traditional movements of distribution namely mean and the variance and also using the third and fourth movements since the most of the returns follow non-normal distribution patterns and display the higher moments of distribution. Three methods can be used to for ranking the funds while relying on all the four movements of distribution. That means for measuring the non-symmetrical performance of the investments an equally weighted scoring system across all the four movements of distribution; or a weighted scoring system using all four the movements of distribution and also relative to the other funds in the group; and the third one is a combination of the first two “where funds are classified into quintiles on the basis of their information ratios, skew ness and kurtosis” Ron Bird, David R. Gallagher (2002)

However the investors are more concerned with the investments the returns of which ensure a symmetrical distribution and hence the second and third methods of assessing the non-symmetrical performances are more relevant.

4. Role of trends/techniques (benchmark, technology, return &risk optimisation, derivatives, security selection, strategy) in affecting funds manager, asset consultant, institutional investor

Risk management involves the adoption and use of a variety of trends, tools and techniques that help the funds manger to construct an efficient investment portfolio in which he deploys the funds at his disposal to optimize the return there from. The institutional investors also expect that their funds managers “cultivate a risk-aware leadership and develop dynamic and resilient corporate cultures capable of dealing with all manner of uncertainties.” (Erwin Martens)

4.1 Funds Manger:

The success of an efficient funds manager depends largely on how he creates and optimizes the value for the investment portfolios he is holding. For achieving this objective the funds manager has to understand the risks associated with the investments; both implicit and explicit. This will guide him to identify the areas where he should have as well as should not have exposure and also the extent of exposure. For assessing the implicit and explicit risks he has to make use many a tools, techniques and trends like benchmarking and modern technology available to extrapolate the risk factors. Wherever he finds that he can manage the risks by adopting the policies of dealing in derivatives to mitigate the losses associated with the risks, he chooses to indulge in Hedging or invest in call or put options depending upon the need. Similarly the fund manager’s capability in the selection of the securities in which he proposes to make the investments also tell up on his efficiency in optimizing the return on the investments.

4.2 Asset Consultant:

Though the role and objectives of the asset consultant are the same as that of the funds manager he acts more on an advisory capacity rather than functioning as a decision making authority. However this doesn’t absolve of his responsibility to advise a selection of investments so that the investor gets a maximum return on his investments. For this purpose, he is to have a broader understanding of the movements of the stocks based on their market values. He is also expected to have a fair knowledge of the intrinsic values of at least the major securities trading in the market so that he can make a meaningful suggestion to the potential investor. While exercising this capability the various trends and techniques come handy to the asset consultant and help him improving his worth to the organisation or the individual who is relying on his judgment.

4.3 Institutional Investors:

The trends and techniques have a large role to play in the investment decisions of the institutional investors, as usually the quantum of investments made by the institutions are fairly large and are being made for a longer period of time. Hence a careful selection of investments is at the root of the investment decisions of any institutional investor. Hence is customary for the institutional investor to carefully analyse the trends and historical movements of the stock prices and the returns those stocks have offered to the investor before any investment decisions are taken. In most of the instances the institutional investors rely on the intelligence and ability of their funds managers who make use of the various tools and techniques to arrive at an investment pattern that best suits the institutions.

References:

Erwin Martens The Putnam paradigm http://www.financewise.com/public/edit/riskm/rmforinvestors/rmforinvestors-casestudy.htm

Investopedia Market Value http://www.investopedia.com/terms/m/marketvalue.asp

Lawrence Harris (1986) “A Transaction Data Study of Weekly and Intradaily Patterns in Stock Returns,” Journal of Financial Economics, June 1986

Robert Haugen and Philippe Jorion, (1996)”The January Effect: Still There after All These Years,” Financial Analysts Journal, January-February 1996.

Ron Bird, David R. Gallagher (2002) The Evaluation of Active Manager Returns in a Non-Symmetrical Environment

Journal of Asset Management Date: March 2002 EDHEC – Risk http://www.edhec-risk.com/site_edhecrisk/public/research_news/choice/RISKReview1039087624396703982

Susan Arterian Exploring the New Efficient Frontier http://www.derivativesstrategy.com/magazine/archive/1995-1996/1295fea1.asp

Wojtek Nabialek (2006) How to Get Grips With Risk http://www.ftmandate.com/news/fullstory.php/aid/1117/How_to_get_to_grips_with_risk_.html

Cite this Factors affecting Portfolio construction

Factors affecting Portfolio construction. (2016, Dec 09). Retrieved from https://graduateway.com/factors-affecting-portfolio-construction/

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