Portfolio management process

A portfolio manager follows a process, and a distributor who understands that process can tell a disciplined manager from a lucky one. The exam frames this chapter as a sequence: know the client, set objectives and constraints, allocate, select, execute, monitor and rebalance. Learn the sequence and the arithmetic inside it.

Step one: understand the client

Everything starts with an investment policy statement (IPS), written or implied in the agreement, that records who the client is and what the portfolio must do. Objectives are stated as return (what growth or income is needed) and risk (how much variation is acceptable). Constraints are the famous list: time horizon, liquidity needs, taxes, legal and regulatory limits, and unique circumstances such as a concentrated promoter holding, an ethical exclusion or an overseas move.

Risk has three faces. Risk capacity is objective: wealth, income stability, horizon and liabilities. Risk tolerance is behavioural: how the client reacts to a 25% drawdown. Risk required is what the goal demands. The 2020 Regulations expect the manager to profile the client and to place her only in an investment approach that suits that profile; the distributor's recommendation should be built on the same profile. When capacity and tolerance differ, advise on the lower one.

Step two: asset allocation

Strategic asset allocation fixes long-term target weights for equity, debt, gold, cash and alternatives, with permitted ranges. Tactical allocation moves within those ranges on a market view. Dynamic allocation follows a rule, for example cutting equity as valuations rise. The expected return of a portfolio is simply the weighted average of its parts, but its risk is less than the weighted average whenever the parts do not move together.

The weighted average of the two standard deviations would be 12.4%; the actual figure is 11.07% because debt and equity rarely fall together. That gap is the whole reason for diversification across asset classes, and it is why a PMS is placed inside an allocation rather than replacing it.

Many wealthy clients run a core and satellite structure: a low-cost diversified core of index and mutual funds, and satellites such as a concentrated equity PMS, a debt PMS or an AIF that aim to add return or exposure the core lacks. The investment policy statement should say what share of the equity allocation a satellite may take, and the manager's investment approach should be read against that limit rather than in isolation.

Step three: security selection and construction

Within each asset class the manager selects securities using the top-down or bottom-up methods from the equity chapter, and then constructs the portfolio: how many positions, the maximum weight per stock and sector, the liquidity threshold for inclusion, cash limits, and whether derivatives may be used for hedging. These rules are the substance of the investment approach in the disclosure document. A good distributor reads them like a contract: a 25-stock portfolio with a 10% single-stock cap behaves very differently from a 12-stock portfolio with no cap.

Because PMS accounts are built one client at a time, managers run a model portfolio and replicate it, but each client's weights and cost prices differ depending on when money arrived and what the market did on that day. This produces dispersion of returns across clients of the same approach, which is why SEBI requires performance to be reported on an aggregated basis across all clients of the approach rather than from a model.

Step four: execution, monitoring and rebalancing

Execution covers order placement, brokerage, settlement through the custodian and allocation of trades across clients on a fair basis. Monitoring compares the portfolio with its benchmark and its own rules: has a stock grown beyond its cap, has a sector drifted, has a holding's thesis broken? Rebalancing restores the target weights, either on a calendar (quarterly, annually) or when a weight crosses a threshold band.

Rebalancing feels wrong to clients because it sells what has done well, but it is the mechanism that keeps the risk level where the IPS put it. In a PMS it has a cost that mutual fund investors never see: each rebalancing sale is a taxable event in the client's own account. Managers therefore use thresholds, direct fresh inflows to underweight assets, and harvest losses where available before selling winners.

Step five: review and reporting

The cycle closes with the quarterly report and an annual review of the IPS itself. Life changes (sale of a business, retirement, a child's education abroad) change the constraints, and a changed constraint can change the allocation. The distributor's standing value is in this review: noticing that a client whose horizon has shortened is still sitting in a small-cap approach, and raising it before the market does.

Process is what you are really selling. A client who understands the six steps will judge the manager on discipline over a cycle rather than on last quarter's number.