ADM 3351 Lecture Notes - Lecture 11: Financial Institution, Volatility Risk, S&P 500 Index
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This chapter and the two that follow discuss bond portfolio management
strategies. We begin with an overview of the investment management
process and the factors to consider in the selection of a portfolio strategy,
distinguishing between active portfolio strategies and structured portfolio
strategies. Active strategies are discussed in this chapter, and structured
portfolio strategies are the subject of the next two chapters.
OVERVIEW OF THE INVESTMENT MANAGEMENT PROCESS
Regardless of the type of financial institution, the investment management
process involves the following five steps: (i) setting investment objectives,
(ii) establishing investment policy, (iii) selecting a portfolio strategy, (iv)
selecting assets, and (v) measuring and evaluating performance
Setting Investment Objectives
The first step in the investment management process is setting investment
objectives. The investment objective will vary by type of financial
Establishing Investment Policy
The second step in investment management is establishing policy guidelines
for meeting the investment objectives. Setting policy begins with the asset
allocation decision; that is, there must be a decision as to how the funds of
the institution should be distributed among the major classes of investments
(cash equivalents, equities, fixed-income securities, real estate, and foreign
Selecting a Portfolio Strategy
Selecting a portfolio strategy that is consistent with the objectives and policy
guidelines of the client or institution is the third step in the investment
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management process. Portfolio strategies can be classified as either active
strategies or passive strategies. Essential to all active strategies is
specification of expectations about the factors that influence the performance
of an asset class. Passive strategies involve minimal expectational input.
Between the extremes of active and passive strategies have sprung up
strategies that have elements of both. For example, the core of a portfolio
may be indexed, with the balance managed actively. Or a portfolio may be
primarily indexed but employ low-risk strategies to enhance the indexed
portfolio’s return. This strategy is commonly referred to as enhanced
indexing or indexing plus.
In the bond area, several strategies classified as structured portfolio
strategies have commonly been used. A structured portfolio strategy calls
for design of a portfolio to achieve the performance of a predetermined
benchmark. Such strategies are frequently followed when funding liabilities.
When the predetermined benchmark is the generation of sufficient funds to
satisfy a single liability, regardless of the course of future interest rates, a
strategy known as immunization is often used. When the predetermined
benchmark requires funding multiple future liabilities regardless of how
interest rates change, strategies such as immunization, cash flow matching
(or dedication), or horizon matching can be employed.
Given the choice among active, structured, or passive management, the
selection depends on (i) the client or money manager’s view of the pricing
efficiency of the market, and (ii) the nature of the liabilities to be satisfied.
After a portfolio strategy is specified, the next step is to select the specific
assets to be included in the portfolio, which requires an evaluation of
individual securities. It is in this phase that the investment manager attempts
to construct an efficient portfolio.
Measuring and Evaluating Performance
The measurement and evaluation of investment performance is the last step
in the investment management process. This step involves measuring the
performance of the portfolio, then evaluating that performance relative to
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