What is Portfolio Management? Need, Objectives, Scope, Example

  • Post last modified:21/02/2022
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What is Portfolio Management?

Portfolio management is an art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance.

Portfolio management in common parlance refers to the selection of securities and their continuous shifting in the portfolio to optimize the returns to suit the objectives of the investor.

Portfolio management includes portfolio planning, selection and construction, review and evaluation of securities. The skill in portfolio management lies in achieving a sound balance between the objectives of safety, liquidity and profitability. Timing is an important aspect of portfolio revision.

Ideally, investors should sell at market tops and buy at market bottoms. Investors may switch from bonds to share in a bullish market and vice-versa in a bearish market.

This however requires financial expertise in selecting the right mix of securities in changing market conditions to get the best out of the stock market.

Portfolio management service is one of the merchant banking activities recognized by Securities and Exchange Board of India (SEBI). The portfolio management service can be rendered either by the SEBI recognized categories I and II merchant bankers or portfolio managers or discretionary portfolio manager as defined in clause (e) and (f) of rule 2 SEBI (portfolio managers) Rules 1993.



What is Portfolio?

A portfolio means a collection of financial assets such as stocks, bonds, debt instruments, mutual fund and cash equivalents etc. A portfolio is planned to stabilize the risk of non-performance of various investment alternatives as they are held directly by investors and managed by financial professionals.

Risk preference is a tendency to choose a risky or less risky option. Utility function or indifference curve are used to represent someone’s else preference. A risk averse decision maker always turns down fair gambles and has a concave utility function.

A risk-neutral decision maker is always indifferent to accepting fair gambles and has a linear utility function. A risk tolerant/risk-seeking decision maker always accepts fair gambles and has a convex utility function.


Understanding Portfolio Management

The modern portfolio theory assumes that the investors are risk averse. This means that given a choice between two assets with equal expected rates of return, risk averse investors will select the asset with the lower level of risk. It also means that a riskier investment has to offer a higher expected return or else nobody will buy it.

For example, Consider Mr. Mahesh has 100,000 and wants to invest his money in the financial market other than real estate investments. Here, the rational objective of the investor (Mr. Mahesh) is to earn a considerable rate of return with less possible risk.

Ideal Recommended portfolio for Mr. Mahesh

Investor’s PortfolioInvestmentPercentageSecurityReturns
Government Bonds25,00025%HighLow
Bank Fixed Deposits15,00015%HighAverage
Shares35,00035%LowHigh
Mutual Funds25,00025%AverageAverage

Thus an investor will take on increased risk only if he is compensated by higher expected returns. Conversely, an investor who wants higher returns must accept more risk. The exact tradeoff between risk and reward differs across investors and is based on individual risk aversion characteristics.

The implication of risk aversion is that a rational investor will not invest in a portfolio if a second portfolio exists which has a more favorable risk-return profile i.e. if for that level of risk an alternative portfolio exists which has better expected returns.

The modern portfolio theory further assumes that only the expected return and the volatility of return matter to the investor. The investor is indifferent to other characteristics of the distribution of returns, such as its skewness. Thus, portfolio management deals with finding an efficient portfolio that maximizes the rate of return for a given level of risk. The return is the weighted return of the securities held in the portfolio. The risk of the portfolio is represented by the standard deviation of the return of the portfolio.

Need for Portfolio Management

  • Portfolio management presents the best investment plan to the individuals as per their income, budget, age and ability to undertake risks.

  • Portfolio management minimizes the risks involved in investing and also increases the chance of making profits.

  • Portfolio managers understand the client’s financial needs and suggest the best and unique investment policy for them with minimum risks involved.

  • Portfolio management enables the portfolio managers to provide customized investment solutions to clients as per their needs and requirements.

Objectives of Portfolio Management

Following are the objectives of portfolio management:

Security of principle investment

Investment safety or minimization of risks is one of the most important objectives of portfolio management. Portfolio management not only involves keeping the investment intact but also contributes towards the growth of its purchasing power over the period.

The motive of a financial portfolio management is to ensure that the investment is absolutely safe. Other factors such as income, growth, etc., are considered only after the safety of investment is ensured.

Consistency of Returns

Portfolio management also ensures to provide the stability of returns by reinvesting the earned returns in profitable and good portfolios. The portfolio helps to yield steady returns. The returns should compensate the opportunity cost of the funds invested.

Capital Growth

Portfolio management guarantees the growth of capital by reinvesting in growth securities or by the purchase of the growth securities. A portfolio shall appreciate in value, in order to safeguard the investor from any erosion in purchasing power due to inflation and other economic factors. A portfolio must consist of those investments, which tend to appreciate in real value after adjusting for inflation.

Marketability

Portfolio management ensures flexibility to the investment portfolio. A portfolio consists of such investment, which can be marketed and traded. Suppose, if your portfolio contains too many unlisted or inactive shares, then there would be problems to do trading like switching from one investment to another. It is always recommended to invest only in those shares and securities which are listed on major stock exchanges, and also, which are actively traded.

Liquidity

Portfolio management is planned in such a way that it facilitates to take maximum advantage of various good opportunities upcoming in the market. The portfolio should always ensure that there are enough funds available at short notice to take care of the investor’s liquidity requirements.

Diversification of Portfolio

Portfolio is purposely designed to reduce the risk of loss of capital and/or income by investing in different types of securities available in a wide range of industries.

Favorable Tax Status

Portfolio management is planned in such a way to increase the effective yield an investor gets from his surplus invested funds. By minimizing the tax burden, yield can be effectively improved. A good portfolio should give a favorable tax shelter to the investors. The portfolio should be evaluated after considering income tax, capital gains tax, and other taxes.


Scope of Portfolio Management

Portfolio Management is a continuous process. It is a dynamic activity. The following are the basic operations of a portfolio:

  • Identification of investor’s objective, constraints and preferences
  • Monitoring the performance of portfolio by incorporating the latest market conditions
  • Making an evaluation of portfolio income (comparison with targets and achievement)
  • Making revision in the portfolio
  • Implementation of the strategies in tune with investment objectives

In India, Portfolio Management is still in its infancy. Barring a few Indian banks, and foreign banks and UTI, no other agency had professional Portfolio management until 1987. After the success of Mutual Funds in Portfolio Management, a number of brokers and Investment Consultants some of whom are also professionally qualified have become Portfolio Managers. They have managed the funds of clients on both discretionary and nondiscretionary basis.

It was found that many of them, including Mutual Funds, have guaranteed a minimum return or capital appreciation and adopted all kinds of incentives which are now prohibited by SEBI. They resorted to speculative over trading and insider trading, discounts, etc., to achieve their targeted returns to the clients, which are also prohibited by SEBI.

The SEBI has imposed strict rules for portfolio managers, which include their registration, a code of conduct and minimum infrastructure, experience and expertise etc. It is no longer possible for any unemployed youth, or retired person or self-styled consultant to engage in Portfolio management without the SEBI’s license. The guidelines of SEBI are in the direction of making Portfolio Management a responsible professional service to be rendered by experts in the field.

Basically Portfolio Management involves

  • A proper investment decision-making of what to buy and sell
  • Proper money management in terms of investment in a basket of assets so as to satisfy the asset preferences of investors
  • Reduce the risk and increase returns.

Constraints of Portfolio Management

The management of customer portfolios is an involved process. Besides assessing a customer’s risk profile, a portfolio manager must also take into account other considerations, such as the tax status of the investor and of the type of investment vehicle, as well as the client’s resources, liquidity needs and time horizon of investment.

Resources

One obvious constraint facing an investor is the amount of resources available for investing. Many investments and investment strategies will have minimum requirements.

For example, setting up a margin account in the USA may require a minimum of a few thousand dollars when it is established. Likewise, investing in a hedge fund may only be possible for individuals who are worth more than one million dollars, with minimum investments of several hundred thousand dollars.

Tax Status

In order to achieve proper financial planning and investment, taxation issues must be considered by both investors and investment managers. In some cases, the funds are not taxed at all. Investors will need to assess any trade-offs between investing in tax-free funds and fully taxable funds.

Investors in a higher tax category will seek investment strategies with favorable tax treatments. Tax-exempt investors will concentrate more on pretax returns.

Liquidity Needs

At times, an investor may wish to invest in an investment product that will allow for easy access to cash if needed. Liquidity considerations must be factored into the decision that determines what types of investment products may be suitable for a particular client.

Highly liquid stocks or fixed-interest instruments can guarantee that a part of the investment portfolio will provide quick access to cash without a significant concession to price should this be required.

Time Horizons

An investor with a longer time horizon for investing can invest in funds with longer- term time horizons and can most likely stand to take higher risks, as poor returns in one year will most probably be cancelled by high returns in future years before the fund expires.

A fund with a very short-term horizon may not be able to take this type of risk, and hence the returns may be lower.

Special Situations

Special situations besides the constraints already mentioned, investors may have special circumstances or requirements that influence their investment universe.

For example, the number of dependants and their needs will vary from investor to investor. An investor may need to plan ahead for school or university fees for one or several children. Certain investment products will be more suited for these investors.

Other investors may want only to invest in socially responsible funds, and still other investors, such as corporate insiders or political officeholders, may be legally restricted regarding their investment choices.


Who is Portfolio Manager?

Portfolio manager means any person who pursuant to contract or arrangement with a client, advises or directs of undertakes on behalf of the client (whether as a discretionary portfolio manager or otherwise) the management or administration of a portfolio of securities or the funds of the client, as the case may be.

A merchant banker acting as a portfolio Manager shall also be bound by the rules and regulations as applicable to the portfolio manager.

SEBI Guidelines for Portfolio Manager

It will thus be seen that Portfolio Management is an art and requires high degree of expertise. The merchant banker has been authorized to do Portfolio Management Services, if they belong to Categories I and II as licensed by the SEBI. This classification of merchant bankers was dropped in 1996 and only the category I merchant bankers is allowed to operate in India.

Others who want to provide such services should have a minimum net worth of Rs. 50 lakhs and expertise, as laid down or changed from time-to-time by the SEBI and would have to register with the SEBI. The SEBI have set out the guidelines in this regard, in which the relations of the client vis-a-vis the Portfolio Manager and the respective rights and duties of both have been set out. The code of conduct for Portfolio Managers has been laid down by the SEBI.

The job of the Portfolio Manager in managing the client’s funds, either on a discretionary or nondiscretionary basis has thus become challenging and difficult due to the multitude of obligations laid on his shoulders by the SEBI, in respect of their operations, accounts, audit etc. It is thus clear that Portfolio Management has become a complex and responsible job which requires in-depth training and expertise.

It is in this context that the regulations of SEBI on Portfolio Management become necessary so that the minimum qualifications and experience are also ensured for those who are registered with SEBI. Nobody can do Portfolio Management without SEBI registration and license.

The SEBI has given permission to Merchant Bankers to do Portfolio Management. As per the guidelines of September, 1991 a separate category of Portfolio Managers is also licensed by SEBI for which guidelines were given in January 1993. A code of conduct was also laid down for this category, as is the case with all categories of capital market players and intermediates.

Portfolio Management Service

As per the SEBI norms, it refers to professional services rendered for management of Portfolio of others, namely, clients or customers with the help of experts in Investment Advisory Services. Investment management on the other hand involves continuing relationship with a client to manage investments with or without discretion for the client as per his requirements.

Who can be a Portfolio Manager?

Only those who are registered and pay the required license fee are eligible to operate as Portfolio Managers. An applicant for this purpose should have necessary infrastructure with minimum two professionally qualified persons with experience in this business and a minimum net worth of Rs. 50 lakhs.

The Certificate once granted is valid for three years. Fees payable for registration are Rs. 2.5 lakhs every year for two years and Rs. 1 lakh for the third year. From the fourth year onwards, renewal fees per annum are Rs. 75,000. These are subject to changes by the SEBI.

The SEBI has imposed a number of obligations and a code of conduct on them. The Portfolio Manager should have a high standard of integrity, honesty and should not have been convicted of any economic offence. He should not resort to rigging up of prices, insider trading or creating false markets etc. Their books of accounts are subject to inspection and audit by SEBI.

The observance of the code of conduct and guidelines given by the SEBI are subject to inspection and penalties for violation are imposed. The Manager has to submit periodical returns and documents as may be required by the SEBI from time-to-time.

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