The Portfolio Management Process
The portfolio management process is the cornerstone to investing. As seen by the chart, the process is an ongoing process by which:
I. An investor's goals, preferences and constraints are identified and specified to develop explicit investment policies.
II. Strategies are developed and implemented through the selection of optimal combinations of assets in the marketplace.
III. Expectations are derived and the investment environment is defined.
IV. Market conditions, relative asset values and the investor's circumstances are monitored; and
V. Portfolio adjustments are made as appropriate to reflect significant change in any or all of the relevant variables.
Specification & Quantification of Investor Objectives, Constraints & Preferences
Prior to implementing an investment program, careful consideration must be given to the investor's specific objective and constraints. Each investor's investment program objectives are goals that are generally defined in terms of return requirements and risk tolerance. The constraints are the investors limitations, such as liquidity, time horizon, taxes and legal matters, imposed on the portfolio manager within which the investor or his advisor must operate to achieve the program's objectives. The investor's individual preferences are constraints that are self-imposed and may be unique to the investor.
At Delta Capital Management, we believe that when we combine objectives and constraints we are able to develop a set of investment policies that are specific to our individual investors. In other words, behind all investment portfolios lay flesh-and-blood investors, each of whom is unique. We attempt to use this uniqueness along with a strict portfolio discipline to tailor your investments to your needs. Many portfolio investment considerations are qualitative, but all lead to a quantification of risk and return and ultimately to the development of an efficient portfolio geared to the specific needs and objectives of the investor.
Portfolio Types and Portfolio Construction
Four Primary Types of Portfolios
Delta Capital Management manages assets under four primary portfolio shells. The following are a list of the types and a brief description of their characteristics:
- Income – Income portfolio policies arise from the traditional notion that only income can be spent and capital gains must be reinvested. Portfolios resulting from this notion can range from safe, high yields in bonds and money market instruments (though with some inflation risk) to a portfolio having some high-yielding stocks (such as utilities) and real estate (such as real estate investment trusts), in which the potential risk (dividends or other payment cuts) and reward (growth in income) can be greater.
- Income & Growth – Income and growth portfolio policies generally refer to both fixed-income and equity portions of the portfolios. However, because of the "income" component, the stock portions of the portfolio tend to have a conservative income bias. The thinking behind this policy is that investors who want to spend only income but who have a long time horizon can have a blend of usable income and still have the potential for modest growth in income or assets (as opposed to a more fixed-income orientation that seeks only to maximize current yield).
- Balanced Portfolio - The balanced portfolio is suited for investors seeking relatively stable growth offset by a moderate level of income. The investor will have a longer time horizon and a higher risk tolerance, willing to accept limited volatility in exchange for moderate wealth enhancement. Balanced portfolios are mixed with 50% of the allocation in bonds and fixed income equivalents and 50% in growth (stock) investments.
- Growth & Income – Growth & Income oriented policies tend to show fixed income as a smaller factor in the portfolio, and focus instead on growth instruments including foreign stocks, and real estate. These are typically favored by younger or wealthier investors who do not need income, and therefore have a longer-term horizon and are able to weather the setbacks of bear markets. Historically, most studies suggest that such equity oriented policies offer the highest return in the long run, but also involve more risk, or standard deviation of return.
- Growth – Growth policies are simply a higher risk, potentially higher return variant of a growth and income policy. They are appropriate for those investors most emotionally able to endure risk and volatility of return. Such portfolios are built on some combination of high beta, aggressive equity-based positions.
*Please note that all forms of traditional policy approaches will offer diversification within the chosen asset class in order to reduce the potential for specific or unsystematic risk.
Portfolio Construction – The "Planet and Satellite" approach
The portfolio construction process at Delta Capital Management is defined by what is termed the "Planet and Satellite" approach to asset management. This particular style is a hybrid approach which takes aspects of the traditional passive investment management (the planet) and combines it with a more active style (the satellites).
The "Planet" portion of the portfolio refers to the long-term cornerstone of the portfolio. This particular area of the portfolio will consist of mostly established core holdings, whether equity or debt instruments. We look to this particular part of our portfolio as the unchanging quality in the market. We anticipate holding onto this core group of stock well into the future and feel that the securities used in this particular portion of the portfolio come from the highest quality companies in the world.
There are five broad criteria that we use when qualifying our core securities. Please keep in mind that a company meeting all of these criteria is not in any way assured of being used as a core position. These are simply criteria that give us a foundation, or starting point, from which to pick the cream for our portfolios. The criteria are:
- Ownership – The size of the float available to the public is our first criteria. We attempt to ensure that a sufficient amount of stock is available to investors and that the stock is not likely to be manipulated by one or two institutions. In most cases, this will remove small-cap issues from consideration. However, we can gain small-cap exposure thru the active portion of the portfolio.
- Fundamental Analysis – We use proprietary fundamental analysis criteria to set fundamental minimums for our core issues. As an example, we will only take companies with a certain level of earnings consistency and profitability. As a note, when analyzing our companies we will use net income on an operating basis.
- Market Capitalization – Our market capitalization cutoff is around $2 billion. This is not a set in stone number. However, when analyzing companies, we are looking for leading companies in leading U.S. industries. Traditionally, you won't find small-cap or even mid-cap issues leading an industry or sector. Again, we are not slighting small- and mid-cap stocks. However, the core portion of our portfolios, we believe, should be proven stable leaders.
- Sector Representation – A final criterion is the economic sector in which the stock is classified. We attempt to keep the weight of each sector in our core portion in line with the weightings of the general domestic economic picture.
- Leadership – This is a very subjective area but probably the most crucial. We only want companies that have respectable and forthright leaders. Companies whose management is constantly working in the grey area and finagling their earnings to make the quarter don't qualify. We only take forthright leadership as part of our core portfolio
Think of this portion of the portfolio as the more active portion of the investment. This particular section of the portfolio allows us to use our day to day knowledge of the market and proprietary techniques to add value to the portfolio. There are three primary ways we add value to the investment portfolio:
- Market Measure – This is the decision to move money in or out of the market in an attempt to enhance returns or limit our downside risk. Understand, we are not a market timing firm nor do we attempt to second guess what we believe are fairly efficient markets. However, under certain economic and market conditions, we may make a decision to have more or less cash in the portfolios.
- Theme Selection – On the domestic equity front, this could be choosing to emphasize small capitalization rather than large capitalization stocks, to over or underweight specific industry groups or to emphasize factors such as growth or yield. For fixed income portfolios, a good example of theme selection would be the choice to use preferred stocks as opposed to debt instruments.
- Selection of Individual Securities – This is one of the areas in which we feel we are value added. Through proprietary research and market knowledge, we feel we are able to ferret out the highest quality issues in the debt and equity markets.
Market Expectations and the Macro Environment
Investing requires forming expectations about the risks and rewards associated with the outlay of capital. In fact, the most important macro decision an advisor makes, whether or not to invest at all, requires weighing the expected benefits of investing against the risks of investing. Two key aspects of economic expectations involve the importance of investor expectations and the macro market variables that produce those expectations.
We believe there are two distinct and different needs for expectations in the investing process. The first involves the needs of the investment manager, whose job it is to correctly evaluate the return and the risk potential of the individual securities as well as the risk/reward position for the market as a whole. The traditional investor has concentrated on returns. Their typical thought is, "How much can I make in this stock or this market". We believe this line of thought to be incorrect. Risk should always be the main concern in any type of investing. Any investment we make will always be evaluated first from the risk side. If the risk is not acceptable, the investment will not be made.
The second involves the needs of the individual investor, whose job it is to be educated in investing and understand the inter-workings of the market. Often, investors have unrealistic expectations of the markets and are only in search of the "fountain of youth". Make no mistake about it; the domestic markets are among the strongest in the world and we feel offer exceptional promise at any given time. But, the markets are also long-term in nature and apt to go thru somewhat drastic fluctuations. At Delta Capital Management we do a great deal to educate our clients. We realize that you have a full time life and that's why you've entrusted us with investing on your behalf. However, we also want you to be fully aware of what's happening in the portfolios and the markets. Our goal is to not only investor for you but to also educate you in the process.
Monitoring and Rebalancing the Portfolio
Even carefully crafted portfolios can't run themselves. We are investing in ever-changing capital markets, thus changes will be made. Investment managers are not architects, who erect a structure then leave its denizens to their own devices. Instead, they reside with the client, making revisions when circumstances demand it. Change is the only true constant, working inexorably to alter client circumstances, market risk attributes, and securities' return prospects. The continual charge of Delta Capital Management is to monitor these changes and respond by rebalancing portfolios to accommodate them.
There are a myriad of factors that would suggest some type of rebalancing in a portfolio. From the side of the investor, an important change in your financial condition or objectives would demand that rebalancing be considered. Examples include; a change in wealth, changing time horizons, changing liquidity requirements, laws/regulations and tax circumstances.
From our perspective, changes in the markets' risk attributes or in return prospects for individual investments may also lead us, as your portfolio manager, to act. Under this type of scenario, there are three primary types of revision we would look to make in the portfolio:
- We may adjust the asset mix by selling overpriced or over weighted individual issues or classes and reinvesting in others.
- We may alter investment emphasis within sub portfolios. Two examples are changing the duration (or variability/aggressiveness) in a fixed-income sector or adjusting the style (growth vs. value) of the equity portfolio.
- Finally, our incentive may simply be to upgrade an individual issue for one that seems to offer better value.
Attainment of Investor Objectives and Performance Measurement
The purposes of performance management are pretty easy to see. As an investor, you want to identify skill at your portfolio management firm, to provide evidence that favorable performance coincides with the investment skills that were touted by your advisor and to monitor the investment strategy that has been developed based on your particular objectives. From our standpoint, performance management will provide needed feedback concerning whether results coincide with expectations.
The basic purpose of all rate of return calculations is to account for changes in asset value plus dividend or interest income plus realized capital gains or losses. These changes are then expressed as a percentage of initial capital value, adjusted for net contributions or withdrawals. Delta Capital Management, time-weighted rates of return are used in performance measurement because they minimize the impact of external cash flows – over which the portfolio manager has no control – on the rate of return calculation.
We are always able to run performance measures for our clients and feel that this is crucial in the investment process. As well, we will furnish this information on request. For accuracy of the computation, we feel performance measurement should be computed as often as practical, but results should not be taken as significant by the investor or the investment manager until a reasonable period of time – such as a market cycle for equities or an interest rate cycle for fixed-income securities – has elapsed.