Sunday, June 27, 2010

Portfolio Management

To be a portfolio manager is a much coveted goal for a lot of people struggling in the financial industry. This position is deemed as being at the top of the food chain. Everyone feeds information to the portfolio manager so that he can make the best investment decisions. The portfolio manager is THE Top Dog.

However, the way that the industry had evolved makes the top dog's job rather stupid. In fact the whole fund management industry doesn't really make a lot of sense.

Just look at the whole management fee issue. For most funds that it out there, 1% is taken out of the asset base to be paid out as management fee. Basically for every $100 of unit trust that you buy, $1 is paid to the fund manager which consist of the portfolio manager, the team of analysts and the support staff that manages the fund for you.

Now 1% may not sound big, but since average investment return is usually less than 10% per year, it means that you are paying out 10% or more to these fund managers every year.

Well, we can talk about this atrocity some other day. Let's look at the portfolio manager's job. His job is to manage the fund such that he beats some benchmark. This benchmark is usually some stock index. Say the S&500, the Hang Seng Index or the STI index etc.

Well, statistically they sucked. Less than 20% of all portfolio managers that ever existed beat their indices over a long period of time, like say 10 yrs or more.

Why is portfolio management such a difficult thing? Well to answer that might take a few more posts. But first we can talk about how the top dog goes about doing his job.

We talked about the benchmark. Basically the portfolio manager's job is to beat the benchmark. ie if the benchmark return is 10%, the PM should be delivering 11% return or more.

The most logical way to do this, according to the fund management industry, is to over or underweight stocks in the benchmark. Now what does this mean?

You see the benchmark is basically made up of stocks with different weightage. For e.g. the STI index has 30 stocks. Singtel has a weight of 8%, UOB 5%, SIA 4% etc (btw all weights are arbitrary, I dunno the real weights and they change all the time). So a portfolio manager who needs to beat the STI would consult his analysts and all other information sources and decide ultimately, what stocks to over or underweight.

Eg. after all his research, he decides that Singtel has better prospects, so he overweights Singtel, ie instead of putting 8% in Singtel, he puts 10%. And similarly he has to underweight some other stock, eg SIA, so instead of putting 4% in SIA, he puts just 2%.

If over time, Singtel does better than SIA, like say over 3 years, Singtel delivered 30% return but SIA only 20%, then he made the right decision. And since the portfolio manager has to do perhaps a couple of hundred or more of these decisions over say a 10 year time frame, he earns his existence if the net result is that his portfolio delivers a return that is higher than the benchmark.

This is, in a nutshell, the job of the portfolio manager. In the next issue, we discuss some issues with his job.
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