Model Portfolio

Copyright: emevil / 123RF Stock Photo

A model portfolio is a theoretical portfolio that fund managers construct so that all investment accounts invest in the same market will follow the same investment decision in the model portfolio.

Listed below is an example of a small model portfolio:

Model Portfolio A
Stock	Quote	%
Amazon	AMZN	20.0%
Apple	APPL	28.5%
Facebook	FB	15.0%
Google	GOOG	15.0%
Intel	INTC	10.0%
Microsoft	MSTF	10.0%
Cash		1.5%
		100.0%

Please note that cash component is included because you need to maintain some cash level to facilitate trading.  

Most institutional investors restrict the upper limit of the cash level so that the investment account can be fully invested. However, most institutional investors do not allow negative cash or overdraft. The fund manager needs to cover any interest charges for any overdraft. It is prudent to maintain some cash level especially if the investment account is actively traded.

Model Portfolio for Multiple Markets

Constructing a model portfolio for multiple markets is quite different from single market. If an investment firm uses both top down and bottom up investment approach, they will construct their model portfolio at the market/country level.

When you construct a model portfolio for multiple markets, you do not add cash component at the country level. Therefore, each country has 100% allocation, as shown:

US
Stock	Quote	Price	%
Amazon	AMZN	$346.38	20.0%
Apple	APPL	$  98.97	30.0%
Facebook	FB	$  77.60	15.0%
Google	GOOG	$586.08	15.0%
Intel	INTC	$  35.00	10.0%
Microsoft	MSTF	$  45.91	10.0%
			100.0%
UK
HSBC	HSBA.L	$760.00	30.0%
BP	BP.L	$445.00	30.0%
Prudential Plc	PRU.L	$952.00	20.0%
Lloyds Banking	LLOY.L	$  54.63	20.0%
			100.0%
German XETRA
Bayer AG	BAYN.DE	$  69.29	45.0%
Deutsche Bank AG	DBK.DE	$  36.10	45.0%
Commerzbank	CBK.DE	$     1.53	10.0%
			100.0%

Portfolio B

If a portfolio has an investment mandate of 50% US and 50% UK stocks with 2% cash holdings, you need to compute the resulting allocation as follows:

Effective Allocation
US	49.00%
UK	49.00%
Cash	2.00%
	100.00%

The formula for effective allocation is: US/UK Allocation * (1 – Cash) = 0.5 * 0.98 = 49%

The allocation for each individual country would be:

US
Stock	Quote	Price	%	New %
Amazon	AMZN	$    258.70	20.0%	9.800%
Apple	APPL	$    467.90	30.0%	14.700%
Facebook	FB	$      27.37	15.0%	7.350%
Google	GOOG	$    780.70	15.0%	7.350%
Intel	INTC	$      21.19	10.0%	4.900%
Microsoft	MSTF	$      27.88	10.0%	4.900%
			100.0%	49.000%
UK
HSBC	HSBA.L	$    660.40	30.0%	14.700%
BP	BP.L	$    466.80	30.0%	14.700%
Prudential Plc	PRU.L	$  1422.00	20.0%	9.800%
Lloyds Banking	LLOY.L	$      74.00	20.0%	9.800%
			100.0%	49.000%

The formula for effective allocation of each individual stock is: Amazon Stock Allocation * US/UK Effective Allocation = 20% * 49% = 9.8%

Portfolio C

Let’s consider another portfolio (Portfolio C) which has an investment mandate of 50% US and 50% Europe with cash of 1%. In this case the fund manager has the sole discretion of allocating 60% UK and 40% XETRA (German market).

Effective Allocation
US	49.50%
UK	29.70%
XETRA	19.80%
Cash	1.00%
	100.00%

The formula for US stocks is:

Effective allocation US = US Allocation(%) * (1 – Cash(%)) = 0.5 * 0.99 = 49.5%

The formula for European stocks is:

Effective allocation UK = UK Allocation(%) * [Europe Allocation(%) * (1 – Cash (%))] = 0.6 * (0.5 * 0.99) = 29.70%

Effective allocation XETRA = XETRA Allocation(%) * [Europe Allocation(%) * (1 – Cash (%))] = 0.4 * (0.5 * 0.99) = 19.80%

US	Quote	Price	%	New %
Amazon	AMZN	$   346.38	20.0%	9.900%
Apple	APPL	$     98.97	30.0%	14.850%
Facebook	FB	$     77.60	15.0%	7.425%
Google	GOOG	$   586.08	15.0%	7.425%
Intel	INTC	$     35.00	10.0%	4.950%
Microsoft	MSTF	$     45.91	10.0%	4.950%
			100.0%	49.500%
UK
HSBC	HSBA.L	$   660.40	30.0%	8.910%
BP	BP.L	$   466.80	30.0%	8.910%
Prudential Plc	PRU.L	$1,422.00	20.0%	5.940%
Lloyds Banking	LLOY.L	$     74.00	20.0%	5.940%
			100.0%	29.700%
German XETRA
Bayer AG	BAYN.DE	$   105.60	45.0%	8.910%
Deutsche Bank AG	DBK.DE	$     27.05	45.0%	8.910%
Commerzbank	CBK.DE	$     12.67	10.0%	1.980%
			100.0%	19.800%

The formula for effective allocation of each individual stock is: Stock Allocation * Effective Allocation .

For multiple market allocation, fund managers will focus on asset allocation within a country and they will allocation funds between countries if they have the discretion to do so like in Portfolio C.  After which the computation of the exact allocation is depend on the system and fund management support staff.

*****

Portfolio Implementation

Copyright: cetex / 123RF Stock Photo

What is portfolio implementation? Portfolio implementation is an exercise when a portfolio or a group of portfolios are being actively traded in order to achieve the desired holdings.

There are many ways of implementing a portfolio. For a smaller setup, fund managers made the investment decision by themselves and contact brokers to execute the trade. They will then fill up the trade ticket and hand it over to the settlement department. 

Most fund managers construct a model portfolio so that various similar investment accounts can follow the same investment decision.

The basic principle of portfolio implementation is to ensure that all clients having similar investment mandate will be treated equally. Therefore, portfolio implementation must be performed together for a group of similar investment accounts. All the buy orders will go to the traders at the same time regardless of the size of your investment account. This is to ensure equal treatment of your various investment accounts without favouring any particular client. Most institutional investor will require fund managers to have a portfolio implementation policy in place.

Portfolio implementation basically involves portfolio re-balancing, cash management and pre-trade compliance.

We will discuss the details of constructing model protfolio, re-balancing, cash management and pre-trade compliance in separate articles:

• Model Portfolio
• Portfolio Re-Balancing
• Cash Management
• Pre-Trade Compliance

*****

Structure & Organization of an Investment Firm

The main function of an investment firm is to investment money for clients. Therefore, fund managers play the most essential roles in the firm. A new investment firm usually starts with two or three fund managers and gradually additional functions and roles are added as the company grows.

In an investment firm, besides fund management, other key business functions include trading, marketing, compliance and trade settlement. As the firm grow larger, additional business function are added including fund accounting, customer service, IT and Administration.

An organisation structure of a typical small size investment firm

An organisation structure of a typical medium size investment firm

Let’s discuss each business functions in details:

Management Office

The CEO, President or Managing Director of an investment firm is usually the main partner / owner of an investment firm. Most of them are experienced fund manager themselves and they usually also act as Chief Investment Officer overseeing the front office or fund management department.

Some of the investment firm were founded by experienced bankers and they usually partner with an experienced fund manager to manage the investment while they bring in the money. In some cases, the owner will take up the role of Chief Investment Officer and hired an experienced banker or business manager to run the company.

Chief Investment Officer (CIO)

For smaller investment firm, this role is also taken by the CEO. In the case where the CEO is an experienced banker, this role will be given to someone with experienced in managing investment.

CIO usually oversees the management of the investment portfolios. He or she will also be responsible for formulating the firm’s investment strategy as well as managing the investment team.

Investment Team

Fund Managers / Investment Managers

Fund managers are responsible for managing the investment portfolio. They have to make decision on stock selection, asset allocation and sector allocation. For smaller setup, fund managers will perform other operational task such as portfolio implementation, cash management and trading. For most countries, fund managers are required to be licensed.

Analyst

Analysts are responsible for analyzing individual stock and bonds. They also perform industry analysis. Some analyst team may include an economist to analyze the economy. They will make recommendations to the Chief Investment Officer and fund managers. For some countries, analysts are required to be licensed.

Fund Management Support

Fund management support (aka Front Office Support) would assist the fund managers in portfolio implementations and cash management. Sometimes, they would place the orders with the approval of fund managers. In some organization, fund management support reports to the Chief Operating Officer.

Traders

The primary responsibility of traders is to execute orders from the fund management team. Since these traders are not members of the exchange, the traders would in turn place trading order with some primary brokers. The secondary responsibility for traders is to manage different brokers during trade execution. After the trade is done, it is the trader’s responsibility to ensure that all portfolios are allocated with the correct amount of stocks.

Some larger trading team includes foreign exchange traders and a team of support staff that would assist the principal traders in order execution.

Operations

The operations division usually includes Middle Office, Back Office, IT and Administration. In a larger organization, the operations division is usually managed by Chief Operating Officer.

Middle Office

Middle office usually includes risk management team and performance measurement team. However, the use of the term is not always the same. Some company consider fund management support as middle office whereas some company consider their trading support staff as middle office. In a smaller firm, risk management and performance analysis are usually perform by the same team.

Risk Management

Risk management team involves in computation of the investment portfolio’s investment risk against the market or benchmark. They focus on tracking error, VAR, information ratio and standard deviation.

Performance Measurement

Performance measurement team involves in computation of the investment portfolio’s returns and performance attribution.

 

Back office

Back office usually consists of trade settlement and fund accounting department, although smaller firm combined both function into a single department.

Trade Settlement

Trade settlement department involves in processing trades after trade have been made by the trading team. The usual task involves order matching, order confirmation, sending settlement instruction and transfer of money for trade settlement.

Fund Accounting

Fund accounting involves in taking care of subscription and redemption of the fund. The team also need to accrue any fees and expense including income receivables.

Information Technology

The IT department is responsible for the IT infrastructure of the firm. An IT department usually consist of the system group and the application group.

System Group

The system group is responsible for the network infrastructure, the servers and the desktop PC of the company. System group also provides user support for the desktop PC.

Application Group

The application group is responsible for developing, maintain and support the core business application of the company. For smaller investment firm which could not afford to develop the core business application in-house, the company will buy readymade investment application from the outside. Such company will have only a few application support staff.

Support Office / Administration

The support office or administration department is responsible for all other administrative matters necessary while conducting a business.

*****