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This chapter provides an overview of portfolio theory and management. It discusses the three major steps in the portfolio management process—planning, execution, and feedback—and the key tasks involved in each step. Next the chapter examines modern portfolio theory including such topics as asset pricing models, traditional finance models, behavioral finance, alternative investments, performance evaluation and presentation, and the recent financial crisis. Next the chapter describes the purpose of the book, its distinguishing features, and intended audience. The chapter then discusses the structure of the remaining 29 chapters and provides an abstract of each chapter. The final section offers a summary and conclusions. While the theory and practice of portfolio management have been moving ahead at a dizzying pace, this book enables readers to gain a better understanding of the existing state of knowledge and the challenges remaining in this area.

Though a good problem to have, sovereign wealth funds struggle with how to manage the amount of money entrusted to them. Sovereign wealth funds have competing financial, economic, political, and business mandates. From maximizing risk adjusted returns to promoting economic development and diversification to creating national champions or stable earnings for future generations, sovereign wealth funds face a difficult task in managing the competing expectations. This chapter will focus on the investment challenges and objectives of managing such large amounts of money. Though there is little evidence that sovereign wealth funds are using their investment capital to leverage political foreign policy victories, their success as investors is mixed. Rather than confusing their public policy and investment mandates, sovereign wealth may open up additional opportunities for partner firms through their privileged position though firm performance remains mixed. Sovereign wealth funds appear willing to accept different levels of risk through their asset allocation. Whether holding large amounts of cash or short term fixed income securities or a riskier portfolio of equities and alternative investments, countries reveal divergent risk levels in their portfolios. Though a good problem to have, countries are taking a different approach to managing the new found wealth.

The two largest European sovereign wealth funds are in Norway and Russia. While each gain their sovereign wealth fund capital from natural resource extraction each country targets different investment objectives with divergent management styles and broader macroeconomic framework. Norway operates its fund as a generational fund for the benefit of future citizens while Russia initially established its fund as a type of rainy day account. What distinguishes Norway and Russia from other funds is the level of transparency in their funds. Norway publishes regulations, ethics, investment decisions, capital levels, and annual returns. Russia specifies by law its investments and publishes monthly updates to paid in capital, investment allocation, and annual returns. Though they both have established and transparent frameworks, the similarities end there. Norway manages a diversified portfolio of equity and fixed income securities with benchmark returns, risk budgets, and clear decision making capital withdrawals to fund government budgets. Conversely, Russia maintains a low risk portfolio of bank deposits and high quality primarily short term sovereign and corporate debt. The Russian preference for running large government budget deficits financed by capital withdrawals from their sovereign wealth fund has fueled wasteful spending and large drops in balances. While an ideal national wealth risk management profile may more closely replicate the Russian investment allocation, their economic and political management reveals the temptations facing commodity rich states.

The previous chapter outlined the nature of futures contracts and some of the institutional aspects of the markets in which they are traded; this chapter analyzes the forces that determine the prices of different futures contracts, their relationship to the current market price (known as the spot price), and derives a satisfactory theory of futures prices. Different determinants are explored of the prices of both commodity futures (contracts based on a tangible commodity) and financial futures (those based on another financial instrument or index). After looking at the role of futures in ‘programme trading’ and the realities of so‐called portfolio insurance through the use of futures and options – a concept that was put to the test by the ‘Black Monday’ crash of 1987 – the chapter concludes by discussing futures as an investment. The five sections of the chapter (which is a discussion with respect to the USA) are as follows: Profits and losses on various transactions; Relations among spot and futures prices; Hedgers, speculators, and market equilibrium; The role of expectations; and Futures and portfolio management.

Private equity (PE) does not fit easily into the standard risk-return Markowitz portfolio optimization framework used in the investment portfolios of institutional and other investors. The concepts of return, risk, and correlation in modern portfolio theory cannot be properly defined because no liquid market with daily observable prices exists. Therefore, good portfolio management requires a deep understanding of all the idiosyncrasies of PE investments and how they interfere with standard portfolio management. Alternative frameworks such as behavioral finance and adaptive market hypothesis are discussed. While integrating PE into a wider portfolio is problematic, designing a portfolio on its own is more straightforward. Different approaches are discussed especially on how diversification through various dimensions can be attained.

In the oversight of most funds, the portfolio manager holds the key decision-making power. Often regarded as foundational to the investment process, a few select managers can attract billions of dollars from investors, giving the managers increased prominence, credibility, and compensation. Despite their stature, portfolio managers are not immune to the behavioral biases that other investors exhibit, which can distort the portfolio management process. This chapter offers an overview of portfolio management and compares characteristics of the fund types that portfolio managers oversee. It also reviews several important behavioral biases that portfolio managers display, as well as the consequences that each has on portfolio construction: overconfidence, herd mentality, risk-taking behavior, and disposition effect. The chapter also contrasts the gender differences of portfolio managers and reviews the ramifications for their respective portfolios.

Debt portfolio management has received increasing attention over time as both academics and practitioners have become aware of its unique challenges. This chapter discusses the common risk factors faced by debt portfolio managers and introduces a set of portfolio management strategies that are targeted at addressing major debt portfolio risks in order to achieve common portfolio management goals. These strategies differ in both style and objective. Passive strategies only require investor effort and decision-making at the initial formation of the portfolio, whereas active strategies require frequent restructuring and rebalancing of the portfolio. Some strategies aim at funding liabilities, while others attempt to seek total return. The chapter also provides a discussion of the application of modern portfolio theory within the context of debt portfolio management.

What is best for the asset owner (principal) is usually not best for the delegated fund manager (agent). Principal–agent conflicts can be mitigated by appropriate governance structures and contracts. Poorly designed benchmarks cause agents to work against the asset owner’s goals. Effective boards can advocate for principals’ interests. Boards should build processes for investment decisions rather than making those decisions.

Chapter 4 discusses a particular set of fund managers and analysts, those who follow investment strategies which are based on quantitative research. They might be expected to be more solitary in their practices and less enmeshed in relations to clients and to other intermediaries than their colleagues who rely on more qualitative reasoning. The chapter shows, however, that this is not so. Quantitative managers’ investment ideas often come from others in the investment chain. Brokers and sell-side analysts are one major source; another source of ideas is those occupying similar roles in other firms. The chapter also suggests that basing a quantitative investment strategy around an idea that is already in circulation eases the task of marketing and the communication with clients. However, successful self-presentation to external audiences can cause internal frictions with colleagues within the investment firm, the other topic which the chapter explores in detail.

This chapter uses the Monte Carlo resampling method of Carey (1998) to provide nonparametric empirical evidence about the practical importance to portfolio bad-tail loss rates of several different asset and portfolio characteristics. This bootstrap-like method simulates the likely range of loss experience of a portfolio manager who randomly selects assets from those available for investment, while at the same time causing his portfolio to conform to specified targets and limits. The chapter is organized as follows. Section 6.1 describes the data, and Section 6.2 describes some details of the resampling method. Sections 6.3 through 6.9 report results, while Section 6.10 offers concluding comments. The study shows that credit risk is substantially influenced by the following factors: borrower default ratings, estimates of likely loss given a default, and measures of portfolio size and granularity (the extent to which loans to a few borrowers make up a large fraction of the portfolio). In addition, the linear structure that is inherent in the internal ratings approach seems to produce reasonable estimates of overall credit risk for the bank. A commentary and discussion summary are also included at the end of the chapter.

The rise and fall of photographic industry is analyzed in the light of Product Portfolio Management to indicate the appropriate attitude of a manufacturing company. A photographic company at its golden age was characterized by a strong technical domain, large scale to afford all the necessary research activities including fundamental research with photographic science, analysis of the present state and future possibility of products, disciplined projects for development of new products with quantitative plans, and efficient, precise, and powerful execution of research activities, indicating what a manufacturing company should be. It is also noted that the way to develop new products is quite different from that to look for new seeds that will support a manufacturing company in the future.

This chapter describes how the work of the central office will change from a bureaucracy designed to administer many functions and serve many masters to a more strategic and streamlined agency. The central office's core responsibility is overseeing and managing the district's portfolio of autonomous schools. This involves new duties and the termination of control functions incompatible with school autonomy and performance accountability. The chapter describes how other central office functions would change, including the services that would be performed by independent service providers via contracting by the central office or schools.

Stocks and bonds? Real estate? Hedge funds? Private equity? The conventional way of allocating across asset classes fails to account for the overlapping risks that they represent. Investors must consider the underlying factor risks behind asset class labels, just as eating a healthy diet requires looking through foods to the nutrients that they contain. Factor risks are the hard times that affect all assets, and investors are rewarded for weathering losses during bad times with long-run risk premiums. Optimally harvesting factor risk premiums—on our own or by hiring others—requires identifying our particular set of bad times and exploiting the difference between them and those of the average investor.

This chapter introduces the panel entitled “Managing Risk During Macroeconomic Uncertainty” by making two distinctions between the challenges facing sovereign wealth funds (SWFs) and those facing ordinary investors and ordinary asset managers. The first is that they are long-term investors, and the second is that they represent national interests. The long-term investor point is easy to understand. Long-term investors know that there are certain risks that will occur and that there will be certain business cycles; they may not know when they are going to occur, but they know that there will be, sometime in the future, economic fluctuations. The second point is that they are managing assets that are part of the national wealth. This means that when they look at the management of that asset it has to be seen in the context of all the other assets that are part of the nation's balance sheet.

This chapter provides evidence that practitioner and regulatory use of market value at risk (VaR) measures is not likely to be destabilizing. It specifically presents a review of VaR and herding theories. VaR have become important tools of portfolio management. The VaR-induced herding effect depends on commonalities in the positions in financial institutions. Tests of herding usually focus on portfolio positions for a subgroup of investors. The chapter then addresses the description of the market risk charge. Trading is more profitable, but riskier, than banking activities. Trading by primary dealer subsidiaries has a negative correlation with banking activities. There is no evidence that the post-1998 period has witnessed an increase in volatility. Arguments that bank trading and VaR systems contribute to volatility due to similar positions has no empirical support.

The diverse investment opportunities available in the debt market enable both individual and institutional investors to develop effective passive and active strategies for financial planning and portfolio management. Such strategies suggest a set of purchases, redemptions, and liquidations to meet investor objectives that consider such factors as market risk, expected investment returns, cash flows, liquidity, and investor convenience. Investment strategies can inoculate the portfolio against potential adverse markets events such as wide fluctuations in interest rates or can be executed in anticipation of an event affecting future market conditions such as an announcement by the Federal Reserve or the default of a municipality. This chapter presents different scenarios in which an investor would employ some appropriate strategies involving bonds or other debt-based securities.

This chapter provides background information about commodities. The first section provides an introduction consisting of a discussion of benefits and risk and commodity investment strategies. The next two sections discuss the outlook for commodity performance and the purpose of the book, followed by sections on its distinguishing features and the intended audience. The chapter then outlines the six major sections of the book, including an abstract for each of the remaining 27 chapters. These sections are (1) background, (2) types of commodities, (3) methods to invest in commodities, (4) performance of commodities, (5) strategies and portfolio management, and (6) issues involving commodities. The final section offers a summary and conclusions.

Mutual fund managers are talented, but, on average, none of that skill enriches asset owners. The average mutual fund underperforms the market after fees, investors chase funds with high past returns only to end up with low future returns, and larger mutual funds do worse than smaller funds. While the Investment Company Act of 1940 gives significant protection to ordinary investors, most mutual funds are run for the benefit of mutual fund firms rather than investors.