Careers in Finance: Portfolio Manager
Portfolio manager: Money may not grow on trees, but sometimes it appears to. Amidst the tailwind of easy Central Bank monetary policies, global assets under management swelled to an astounding $74 trillion by 2015.1 Over $45 trillion (61%) of these funds came from institutions.2
And the money is expected to continue growing. A PwC report estimated that global assets under management could hit $100 trillion by 2020.3 Given the same proportions, that means institutional assets would top $61 trillion.
Assuming a benchmark 1% annual fee, it’s no wonder investment managers all over the world are battling for management duties.
This is a boom for the most common overseer of institutional money, the portfolio manager. It is the job of these managers to make sure that capital is being invested in a prudent, responsible manner that’s consistent with the institution’s predetermined needs.
What is a Portfolio Manager?
A portfolio manager is an experienced financial professional tasked with handling the investments of major institutions including banks, insurance companies, defined benefit pension plans, university endowments, charities and sovereign wealth funds.
Portfolio managers typically oversee a very large investment portfolio of securities with assets including equities, fixed income, commodities, real estate and private capital investments. As such, these asset managers operate quite differently than retail money managers such as financial advisors.
Portfolio managers are further tasked with generating a return on the assets, commensurate with the income and liquidity needs of the institution’s beneficiaries, clients or stakeholders. These beneficiaries might include insurance claimants, retired school teachers or even orphanages.
To gauge whether this is a career in finance you might consider, here is some information on how the portfolio management process works.
Portfolio Management Process
Investment Policy Statement
The portfolio manager begins by creating an investment policy statement after appropriate due diligence. This is a document that identifies and classifies the institution’s unique needs. It will specify the required rate of return, taking into consideration the time horizon, risk tolerance, and income and liquidity needs of the institution’s liabilities.
For example, banks and property and casualty insurers have short-term time horizons and greater liquidity needs. As such, they require ample liquidity to meet depositor withdrawals and policy claims.
Suitable investments for them typically include U.S. Treasury bills and notes, repurchase agreements, commercial paper, money market funds and lower duration, structured settlements and investment-grade corporate debt.
Conversely, a university endowment or charitable foundation will typically have a long time horizon and low liquidity requirements. As such, they can afford to take a significantly higher risk and accept less liquidity with their investments.
A portfolio manager might include allocations to small-cap stocks, junk bonds, private equity stakes, commercial real estate projects or investments in emerging and frontier markets. On a stand-alone basis the investments might be risky but together they actually reduce overall portfolio risk as we’ll cover in the next section.
After creating an investment plan, a portfolio manager begins selecting securities and determines an asset allocation strategy and that complements the client’s requirements.
Portfolio managers work with a team of research analysts who scour thousands of securities that match the return requirements for the client. They identify a variety of fundamental characteristics such as earnings growth rates, sustainable dividend policies or low price to earnings ratios and run screens to produce candidates that meet the selected criteria. Portfolio managers, often former analysts themselves, typically add further insight.
A major concern for portfolio managers is managing volatility and risk. Portfolio managers seek attractive ‘risk-adjusted returns’ or returns per unit of risk. One way financial professionals measure ‘risk’ is with standard deviation- how a security has fluctuated from its average or ‘mean’ in the past.
Volatile stocks will exhibit large price movements (standard deviations) and are considered a greater risk. If you purchased the shares of a volatile security at the wrong point in time, you could quickly experience a large loss.
Assume a manager must select between two railroad stocks for inclusion in a portfolio. The first, Chug-a-Long Railways, has a mean annual return of 11.5%, with a standard deviation of 14.8%. The other, Rocky Mountain Railways, has the same mean return of 11.5% but a standard deviation of 34.2%. This reveals that Rocky Mountain Railway shares have been much more volatile in the past. Since the two securities exhibit the same return, Chug-a-Long would be the more attractive investment because the shares had less volatility, all else equal.
Generally, the portfolio manager wants to smooth out the return profile.
After identifying a number of attractive securities, the portfolio manager assesses not only how the securities moved by themselves, but also how they will affect the portfolio’s overall risk and return profile. The manager will only add securities that will help diversify the portfolio. Diversification is the basic premise of Modern Portfolio Theory.4
This theory was originally created by economist Harry Markowitz who was awarded the Nobel Prize for the discovery.5 The interesting part is that you could add a risky, highly volatile stock to your portfolio and as long as it is not perfectly, positively correlated to (moves in tandem with) other investments, actually reduces the portfolio’s risk. You wouldn’t want to own all cyclical investments (like technology or oil & gas) in case a recession appears.
If you don’t have a balance of non-cyclical, defensive stocks (like utilities or healthcare) the portfolio could endure a large drawdown. While diversification reduces individual security-specific risk, it doesn’t eliminate overall market risk.
To further reduce portfolio risk, the portfolio manager will include a number of different asset classes such as equities, fixed income, commodities, cash, and alternative investments. The manager will further parse these classes by geographic location.
Using the aforementioned strategies, portfolio managers can create “optimal portfolios”, ones that maximize return and minimize risk. While most portfolios have significantly more positions, some believe properly constructed portfolio can include as little as 13 properly correlated securities and still be considered an ‘optimal’ portfolio.
It should be noted that a major flaw in the Modern Portfolio Theory was exposed during both the Financial Crisis and Dotcom boom – a historical risk may not accurately reflect current or future risk levels. We also saw this with the housing crash. On a nationwide basis, there had never been a down year for the housing market. That is, until 2007, when prices plunged not only among the sand states (Florida, Arizona, Nevada, California) but also nationwide.
During the financial crisis, we saw that correlations among formerly negative or uncorrelated asset classes, became positively correlated rather quickly. One reason was due to lack of liquidity, where large asset managers were forced to sell more liquid assets to meet redemptions when they couldn’t sell illiquid securities. In other words, the diversification benefits didn’t hold up during the crisis.
The final task is analyzing and properly attributing manager performance. When investment managers realize returns in excess of their risk-adjusted expected return, it is known as generating ‘alpha’. Achieving alpha is the ‘Holy Grail’ of investments and is at the root of the debate between active and passive management. This is often used to determine performance-driven compensation.
Often, investment consultants must scrutinize fund manager performance to decipher what proportion of return was really attributable to manager skill. Properly calculating alpha is important because it’s not uncommon for funds to incorrectly tout their own accomplishments in marketing materials.
It is also important to make sure an institution, such as a pension fund, selects the best outside manager to run money since the fees charged may be high. The demand for such analysis is in such high demand that the CFA Institute has added another financial designation, Certificate in Investment Performance Measurement (CIPM), in addition to their classic CFA mark.
Compensation for Portfolio Managers
Portfolio managers enjoy some of the highest compensation in the financial industry. According to Payscale, the median portfolio manager earned $82,600 according to a respondent’s survey.6 Indeed pegged the number at $90,305.7 And Glassdoor showed an even higher average salary of $118,752.8 A CNBC article cited a 2014 study, revealing that the average portfolio manager at a hedge fund earned $2.2 million.9 That seems a little high but may be skewed by extreme outliers on the high side.
Hedge fund portfolio managers did seem to earn the most according to reported numbers on Indeed. BlueCrest Capital reported $250,000, Balyasny came in at $227,244 and Tudor Investments was $184,481.10 managers at insurance company Liberty Mutual enjoyed a $131,221 average while PIMCO paid $120,884.11 Looking at broker-dealers, portfolio managers at Bank of America Merrill Lynch received $120,870, JP Morgan Chase averaged $91,156 per year while Morgan Stanley trailed slightly at $86,545.12
How do I Become a Portfolio Manager?
Portfolio managers typically start their careers as investment or research analysts and then move their way up the ladder until they land the coveted portfolio manager position. Most begin as analysts to become well-versed in fundamental analysis. This way, they have built a foundation on how to value and assess securities for portfolio inclusion. Then they learn to see the bigger picture and construct portfolios that meet client objectives.
The experience and academic requirements are extensive to become a portfolio manager. Academically, many have earned their Chartered Financial Analyst (CFA) designation or have learned similar concepts from an MBA in Finance program. If the manager works with alternative investments, they may also have the Chartered Alternative Investment Analyst (CAIA) designation. If you are interested in a well-paying and highly-respected financial career, consider the path towards becoming a portfolio manager.