Chapter 1 Introduction Fabozzi: Investment Management

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Chapter 1IntroductionFabozziInvestment
Management
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Learning Objectives
From this chapter...

• You will learn the steps involved in the
  investment process.
• You will understand the difference between retail
  and institutional investors.
• You will study the factors considered in setting
  investment policy.
• You will be able to explain what is meant by the
  allocation decision.

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Learning Objectives

• You will recognize various general portfolio
  strategies.
• You will be able to define an efficient
  portfolio.
• You will discover the process of evaluating
  portfolio performance.
• You will investigate the structure of the money
  management business.
• You will review the ethical issues in investment
  management.

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Investment Management TermsPortfolio
Management/Money ManagementAn investment
manager runsmoney and uses

• Their understanding of investment vehicles
• valuation
• strategies of selection

to accomplish investment objectives
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Types of Investors
Retail-Individuals like yourself
Institutional- large firms in a variety of
businesses with large inflows of cash
Banks Pension
Funds Endowment Funds
Mutual Funds
As most individual investors employ mutual funds
rather than invest in stocks, there has been an
institutionalization of the financial
markets.There are fewer retail investors and the
markets are moved by purchases of large blocks of
shares, rather than 50 or 100 share blocks.
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Investment Management Process
1. Setting investment objectives
2. Establishing investment policy
3. Selecting a portfolio strategy
4. Selecting the assets
5. Measuring and evaluating performance
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Setting Investment Objectives
Objectives will vary depending on the type of
institution
Pension Fund Generating funds to pay to
beneficiaries in the future and current recipients
Life Insurance Generate profits while meeting
obligations of payments to clients
Banks Realize returns greater than the cost of
funds(interest on accounts)
Mutual Funds Generate profits while providing
strong returns for investors.
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Establishing Investment Policy
How do we satisfy the objectives?
Begin by determining how to allocate
assets among investment vehicles or assets. A
portfolio consists of a group of assets.
Assets can include
Stocks, bonds, real estate, foreign securities,
commodities, gold
Constraints on how funds can be invested
Regulations Amount of ownership in
one asset, tax considerations.
Client Amount of acceptable
risk, diversification needs
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Selecting a Portfolio Strategy
Active- applies information and forecasting
techniques Financial ratios,
historical yield curves, predicting dividend
growth
Passive- diversifies to match a market index
Standard and Poors 500

Structured strategy is used for bond holdings
where funds received from investments match the
value of the liabilities to be disbursed.
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Choosing a Strategy
Use Marketplace Price Efficiency
Defined as how difficult it would be to earn a
greater return than passive management would,
after adjusting for risk and transaction costs
associated with the chosen strategy.
Clients risk tolerance Are they able to sleep
at night while holding a risky asset or are they
more conservative? (Discuss risk tolerance in
daredevil sports or size of a car loan in a
budget.)
Nature of the clients liabilities Does the
client need to access cash quickly or are they
able to effort their lifestyle without drawing on
their investments in an uncontrolled way?
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Selecting the Assets
Active Strategy- identify mispriced securities in
constructing an efficient portfolio (sometimes
called value investing, can discuss the
difference between a value shop and a growth shop)
An efficient portfolio is one that provides the
greatest expected return for a given level of
risk, or the lowest risk for a given expected
return.
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Measuring And Evaluating Performance
Compare portfolio result to a benchmark
A benchmark is the performance of a predetermined
set of securities such as an index. Many money
managers use a customized index to match the
objectives of the investment.
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Structure of the Money Management Process
In-house money managers This is
the process of making money for your own
organization.
Money made in the markets can be used to fund
projects, bonuses, pay down debt or fund an
expansion or acquisition. These money managers
are motivated by their loyalty to their firm and
desire to see it grow and prosper.
It is possible to have both in house and outside
money managers.
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Structure of the Money Management Process
Outside money managers are hired to
make money for various types of organizations.
If they are successful, they will attract more
clients, increase their money under management
and generate more fees for their money management
firm. Organizations include
Financial institutions banks, insurance
companies, investment companies. Non-financial
institutions pension funds and endowment funds.
(Baby boomer generation is putting
billions of dollars into pension funds and mutual
funds to save for retirement. Discuss lack of
confidence in Social Security and subsequent need
to increase personal savings.)
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Structure of the Money Management Process
Who are these outside money management firms?
Bank related trust departments manage funds for
individuals (PNC Asset Management Group)
Insurance related subsidiaries that manage
annuity type investments (Prudential Insurance)
Brokerage firms asset management subsidiaries
(Merill Lynch Asset Management)
Independent money management firms mutual
funds (Fidelity or Putnam)
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Ethics in Investment Management
Money managers and broker/dealers provide
services to clients. However, money managers are
also the clients of broker/dealers. This leads to
conflict interest.
Lines of defense for client Trust
ethics of service provider Industry
wide policies for ethical and professional
behavior.
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Ethics in Investment Management
Violators of regulations set by the Security and
Exchange Commission(SEC) or the national
Association of Securities Dealers(NASD) can

• Be stripped of the right to transact business on
  any exchange.
• Be required to compensate the client for monetary
  damages
• Be required to pay punitive damages

A Chartered Financial Analyst (CFA) can lose
their right to use that designation. (Discuss The
self-study, 3 grueling exams required to become a
CFA and the research jobs that can follow.)
(Discus the genesis of the SEC (1993) from bank
and exchange excesses and fraudulent behavior in
the 1920s.)
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Organization of the Book
Section I Chapters 1 and
2background information and an overview of
market and major asset classes, including
historical performance of stocks and bonds
Section II Chapters 3-5 discuss
modern portfolio theory and capital market theory
leading to how to determine the equilibrium price
of an asset
Section III Chapters 6-10
students will learn about the considerations in
managing the institutions investment portfolio
including client liabilities, tax problems, and
regulatory constraints
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Organization of the Book
Section IV Chapters 11-21 discuss
common stock (equity)portfolio management
including the important idea of pricing
efficiency technical, fundamental and
forecasting analysis techniques industry
environment indexing factor models options and
futures and equity trading
Section V Chapters 22-30 discuss
fixed income portfolio management including
characteristics and analytical tools, yields,
active bond strategies and indexing, and futures
and contracts
Section VI Chapters 31-33 show
the student the mathematical models used to make
asset allocation decisions, and how to measure
and evaluate the performance of a money manager
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Organization of the Book
Appendix A reviews the fundamental concepts of
probability and statistics
Appendix B reviews of the income statement and
balance sheet