How Equity Portfolio Management Works

The goal of virtually all investment analysis is to make an investment decision or advise someone else to make one. That is the inextricable link between equity analysis and equity portfolio management.

College finance programs and the CFA Institute's Chartered Financial Analyst program acknowledge this link by teaching the two concepts side by side. That's why most analysts have a good educational background in both equity analysis and portfolio management subjects like modern portfolio theory (MPT).

It also explains why analysts frequently turn into portfolio managers over time.

Even with a good understanding of equity analysis and MPT, there are certain mechanical elements to portfolio management that must be learned before actually constructing and running equity portfolios.

As with many professions, the real-world application of theoretical investment concepts can involve thinking beyond one's specialty and training. Running a group of portfolios involves attention to detail, software skills, and administrative efficiency.

You need to know the mechanics of equity portfolio management to create a group of distinct portfolios that perform as a homogeneous element.

Professional portfolio managers who work for an investment management company do not usually have a choice about the general investment philosophy that governs the portfolios they manage. An investment firm may have strictly defined parameters for stock selection and investment management.

An example would be a firm that defines itself as having a value investment selection style and uses certain trading guidelines to follow that style.

Moreover, portfolio managers are usually constrained by market capitalization guidelines. Small-cap managers may be limited to selecting stocks in the $200 million to $3 billion market cap range.

Of course, the individual manager's preferences have a role, too. Still, the first step in portfolio management is to understand the universe from which investments may be selected.

Another consideration is the analytical approach for the portfolio in question.

Some portfolio managers use a bottom-up approach in which investment decisions are made by selecting stocks without consideration to sectors or economic forecasts. Others are top-down oriented, using entire sectors or macroeconomic trends as a starting point for analysis and stock selection. Many styles use a combination of these approaches.

Many institutional equity portfolios such as pension funds are not taxable. This gives their portfolio managers more flexibility than a taxable portfolio permits.

Non-taxable portfolios may require greater exposure to dividend income and short-term capital gains than their taxable counterparts. Managers of taxable portfolios may need to pay special attention to stock holding periods, tax lots, capital losses, tax selling, and dividend income generated by portfolios.

Taxable portfolios may be more effective by definition, with a lower portfolio turnover rate relative to non-taxable portfolios.

Understanding the tax consequences of portfolio management activity is of primary importance in building and managing portfolios over time.

Whether a manager is running one portfolio or 1,000 of them in a single equity investment product or style, building and maintaining a portfolio model is a common aspect of equity portfolio management.

A portfolio model is a standard against which individual portfolios are matched. Generally, portfolio managers will assign a percentage weighting to every stock in the portfolio model, and then individual portfolios are modified to match up against this weighting mix.

Portfolio models are created using software such as Microsoft Excel or a specific portfolio management package. These make it easier to build a model and then maintain it across many individual portfolios.

For example, after doing some mix of company analyses, sector analyses, and macroeconomic analyses, the portfolio manager may decide that it needs a relatively large weight of a particular stock. In this portfolio manager's style, a relatively large weighting is 4% of the total portfolio value. By reducing the weighting of other stocks in the model, or by reducing the overall cash weighting, the portfolio manager would be able to buy enough stocks of a particular company in all the portfolios to match up against the 4% model weight.

All of the portfolios will look like each other, and like the portfolio model, at least in terms of the 4% weighting on that particular stock.

In this way, the portfolio manager can run all the portfolios in a similar or identical fashion given the specific style mandated by that portfolio group. All the portfolios can be expected to generate returns in a standardized way, relative to each other. They also will be similar to each other in terms of the risk/reward profile. In effect, all of the analytical and security evaluation that the portfolio manager does is run on a model, not on the individual portfolios.

Modeling allows for remarkable analytical efficiency. The portfolio manager only needs to have an understanding of 30 or 40 stocks owned in similar proportions in all portfolios, rather than 100 or 200 stocks owned in various proportions in many accounts.

Changes on these 30 or 40 stocks can be applied to all portfolios easily by changing model weights in the portfolio model over time. As the outlook on individual stocks changes over time, the portfolio manager only needs to change his or her model weightings to trigger the investment decision in all portfolios simultaneously.

The portfolio model can also be used to handle all day-to-day transactions at the individual portfolio level. New accounts can be set up quickly and efficiently by simply buying against the model. Cash deposits and withdrawals can be handled in a similar way.

If the portfolio is large enough, the model only needs to be applied to the change in asset size to build a portfolio that mirrors the portfolio model. Smaller portfolios may be limited by stock board lot constraints, which can affect the portfolio manager's ability to accurately buy or sell to some percentage weightings.

Portfolio modeling is a good way to apply analysis and evaluation of a key set of stocks to a set of portfolios in one group or style. Modeling can be an efficient link between equity analysis and portfolio management.

As the outlook for individual stocks improves or deteriorates over time, the portfolio manager only needs to change the weightings of those stocks in the portfolio model to optimize the return of all portfolios in the group or style. As long as the individual portfolio accounts are traded efficiently, the group will perform as a homogeneous element.