What Is Portfolio Management?

Portfolio management is the art and science of selecting and overseeing a group of investments that meet the long-term financial objectives and risk tolerance of a client, a company, or an institution.

Portfolio management requires the ability to weigh strengths and weaknesses, opportunities and threats across the full spectrum of investments. The choices involve trade-offs, from debt versus equity to domestic versus international and growth versus safety.

Understanding Portfolio Management

Professional licensed portfolio managers work on behalf of clients, while individuals may choose to build and manage their own portfolios. In either case, the portfolio manager's ultimate goal is to maximize the investments' expected return within an appropriate level of risk exposure.

Portfolio management may be either passive or active in nature.

  • Passive management is a set-it-and-forget-it long-term strategy. It may involve investing in one or more exchange-traded (ETF) index funds. This is commonly referred to as indexing or index investing. Those who build Indexed portfolios may use modern portfolio theory (MPT) to help optimize the mix.
  • Active management involves attempting to beat the performance of an index by actively buying and selling individual stocks and other assets. Closed-end funds are generally actively managed. Active managers may use any of a wide range of quantitative or qualitative models to aid in their evaluations of potential investments.

Key Takeaways

  • Portfolio management involves building and overseeing a selection of investments that will meet the long-term financial goals and risk tolerance of an investor.
  • Active portfolio management requires strategically buying and selling stocks and other assets in an effort to beat the broader market.
  • Passive portfolio management seeks to match the returns of the market by mimicking the makeup of a particular index or indexes.

Key Elements of Portfolio Management

Asset Allocation

The key to effective portfolio management is the long-term mix of assets. Generally, that means stocks, bonds, and "cash" such as certificates of deposit. There are others, often referred to as alternative investments, such as real estate, commodities, and derivatives.

Asset allocation is based on the understanding that different types of assets do not move in concert, and some are more volatile than others. A mix of assets provides balance and protects against risk.

Rebalancing captures gains and opens new opportunities while keeping the portfolio in line with its original risk/return profile.

Investors with a more aggressive profile weight their portfolios toward more volatile investments such as growth stocks. Investors with a conservative profile weight their portfolios toward stabler investments such as bonds and blue-chip stocks.

Diversification

The only certainty in investing is that it is impossible to consistently predict winners and losers. The prudent approach is to create a basket of investments that provides broad exposure within an asset class.

Diversification is spreading risk and reward within an asset class. Because it is difficult to know which subset of an asset class or sector is likely to outperform another, diversification seeks to capture the returns of all of the sectors over time while reducing volatility at any given time.

Real diversification is made across various classes of securities, sectors of the economy, and geographical regions.

Rebalancing

Rebalancing is used to return a portfolio to its original target allocation at regular intervals, usually annually. This is done to reinstate the original asset mix when the movements of the markets force it out of kilter.

For example, a portfolio that starts out with a 70% equity and 30% fixed-income allocation could, after an extended market rally, shift to an 80/20 allocation. The investor has made a good profit, but the portfolio now has more risk than the investor can tolerate.

Rebalancing generally involves selling high-priced securities and putting that money to work in lower-priced and out-of-favor securities.

The annual exercise of rebalancing allows the investor to capture gains and expand the opportunity for growth in high potential sectors while keeping the portfolio aligned with the original risk/return profile.

Active Portfolio Management

Investors who implement an active management approach use fund managers or brokers to buy and sell stocks in an attempt to outperform a specific index, such as the聽Standard & Poor's 500聽Index or the Russell 1000 Index.

An actively managed investment fund has an individual portfolio聽manager, co-managers, or a team of managers actively making investment decisions for the fund. The success of an actively managed fund depends on a combination of in-depth research, market forecasting, and the expertise of the portfolio manager or management team.

Portfolio managers engaged in active investing pay close attention to market trends, shifts in the economy, changes to the political landscape, and news that affects companies. This data is used to time the purchase or sale of investments in an effort to take advantage of irregularities. Active managers claim that these processes will boost聽the potential for returns higher than those achieved by simply mimicking the holdings on a particular index.

Trying to beat the market inevitably involves additional聽market risk. Indexing eliminates this particular risk, as there is no possibility of human error in terms of stock selection. Index funds are also traded less frequently, which means that they incur lower expense ratios and are more tax-efficient than actively managed funds.

Passive Portfolio Management

Passive portfolio management, also referred to as聽index fund聽management, aims to duplicate the return of a particular聽market index聽or benchmark.聽Managers buy the same stocks that are listed on the index, using the same weighting that they represent in the index.

A passive strategy portfolio can be structured as an exchange-traded fund (ETF), a mutual fund, or a聽unit investment trust. Index funds are branded as passively managed because each has a portfolio manager whose job is to replicate the index rather than select the assets purchased or sold.

The聽management fees聽assessed on passive portfolios or funds are typically far lower than active management strategies.