In the last video of this lesson, we continue with our discussion of active management. Irina Topa-Serry will go deeper in the day-to-day management of an investment portfolio. Irina completed a masters degree in economics, and has more than 15 years of experience in the asset management industry. She is a portfolio manager in emerging market equity at AXA Investment Managers. Enjoy! Let's stay for a chapter more in the exciting world of active fund management. In the previous section, Pierre-François showed you ways of building a robust investment process, such as combining top-down and bottom-up analyses on a specific asset class, while taking into account valuation metrics, sentiment indicators and technical factors. We will now take a step further in the life of a portfolio; more specifically, into the portfolio construction, and its day-to-day management. So, let's assume that the objectives of precise investment strategy for a particular portfolio are well-articulated, and the investment process agreed upon. The fund manager has to make this strategy alive in the fund. In the day-to-day life of the portfolio, this means facing market volatility, sector, style rotations, short-term shocks and many others. In order to best serve the client's objectives, the fund manager needs to build a robust portfolio, that can best weather these inerrant adversities, while extracting a benefit for the performance. Portfolio construction plays thus a major role in the implementation of investment management decisions. You saw in module 2, a form of optimal allocation derived from expected returns, volatilities and correlations. But it is often hard to translate one's own views into these parameters. Not all investors use quantitative allocation methodologies. Sometimes they may not be feasible at all. Then how do we allocate between each of the security that we think are going to perform well? A simple solution would be to rely on a naive approach: it seems that some 1600 years ago, one rabbi said that one should put a third in land, a third in merchandise and a third in cash. This has the merit of being simple to implement and to use: in terms of portfolio construction, you can indeed decide to hold an equally weighted portfolio. However, you may obtain a portfolio that makes little economic sense, and you may quickly run into capacity issues for your strategy. For example in a U. S equity portfolio, equally weighted would mean that you would hold as much in Apple shares, whose market capitalization stands at around 600 billion dollars, as you would hold in Nike, whose market cap is just about 100 billion, or XEROX at 10 billion market cap. Doesn't sound quite right. Obviously, the market capitalization weighted portfolio doesn't have this problem, as each company has a weight proportional to its market capitalization. But it does not incorporate your discretionary views on the upside potential of the different assets. You wouldn't want to be invested in Apple just because it's market capitalization is big, or because the stock is liquid. You would want your savings to be invested in securities, whose price you think will go up. The price of each security doesn't always reflect its true potential: some are overvalued, some are undervalued. To start with, a portfolio manager cannot perfectly assess the mispricing of each and every asset within a given universe. The solution could be to overweight or underweight assets, with respect to their weighting in the market portfolio, following the portfolio's manager's views. The portfolio tilts that you adopt, may be based on different methodologies. A mix of market capitalization weighted and equally weighted portfolios, weigh assets by their volatility, while emphasizing the manager's expectations on the company fundamentals, like the evolution of revenues, earnings, free cash flow, net debt, or dividends. In real life, this optimal allocation per security is a moving objective, as markets are in constant motion, the flow of information driving price moves is permanent, and thus the manager's views are as well permanently challenged. This is when we get to the next question, about market timing: when do you review and amend the allocation of your portfolio? In an equity portfolio, when the price of a security moves sharply up or down, would you still stay invested in that stock? Were there some particular assumptions that have materialized, or on the contrary, being put into doubt? Does the absolute or relative valuation of that security still make sense? In a fixed income portfolio, when the Federal Reserve in the United States announces a rate hike, do you sell immediately the U. S. treasuries you are holding? Do you reallocate your positions towards European bonds? Not changing anything in an allocation, is an active decision in itself, that will have repercussions on the performance. The manager needs to have the discipline to sell that stock or bond, or add more to that stock or bond, that is to say, to stick to this precise investment strategy. It can be done by determining stop losses, target levels. But definitely the timing of buying and selling a security is critical for delivering performance. This is what we call market timing. We are now getting to another crucial question: how does the news flow affect your securities? All of us are starting our day at work with a thorough review of the latest market events, most of the times with the morning meeting, where strategists and economists comment on the past news and upcoming releases. During the day, any unexpected event or news can lead to market movements. We need to be there, to react in case of extreme events, analyzing the impact on the markets. During the European sovereign crisis that started in 2010, political elections and each and every statement by the Greek authorities or the IMF had an impact on the markets, as portfolio managers constantly assessed the risks of contagion to other countries within Europe, and even to some extent to the overall equilibrium of global markets, in the form of systemic risk. All portfolio managers are in close contact to their markets and equity portfolio will meet company CEOs and CFOs to better understand their business models. A fixed-income portfolio manager will regularly need the debt management offices, to better understand their issuance programs and financing needs, to have a deep understanding of the events, that will have an influence on market prices. A real asset portfolio manager will visit the real estate properties he invests in. Finally, it is important to understand that a given information can have a number of interpretations and psychology plays a strong role in financial markets. The ability of a manager to correctly assess the evolution of the economic environment, and translate it at best into a certain positioning in the portfolio, will generate a better return than the overall market index, and deliver the alpha. Quick question: which of the following options is not a problem of relying on an equally weighted portfolio: a) Putting as much weight in small companies and in large companies. b) Relying on an optimized allocation. c) Running into capacity constraints. The answer is b, the multitude of assessments of market participants create the market liquidity, as for every security, at a given time, there is a buyer and a seller at that particular price. You will learn more about these aspects in the next session. Stay tuned.