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Portfolio Management: An Overview

Q: What does Modern Portfolio Theory conclude?

Modern Portfolio Theory states that investors are not rewarded for holding only one stock instead of a diversified portfolio . By holding only one stock, an investor fails to diversify and therefore keeps unsystematic (company-specific) risk . This type of risk can be eliminated through diversification , so the market does not offer a higher expected return for bearing it. Key intuition: Holding one stock increases risk, but diversification could remove that risk for free — so the market doesn’t pay you extra.

Q: The three steps in the portfolio management process are:

1️⃣ Planning (What does the investor need?) Assess: risk tolerance, return objectives, time horizon, taxes, liquidity, income, constraints Result: Investment Policy Statement (IPS) IPS defines objectives, constraints, and a benchmark Update when circumstances change 2️⃣ Execution (How do we invest?) Decide asset allocation (top-down: economy, GDP, inflation, rates) Diversify across asset classes Select individual securities (bottom-up analysis) 3️⃣ Feedback (Is it still on track?) Monitor changes in investor needs and markets Rebalance portfolio when weights drift Measure performance vs benchmark

Q: What is a defined contribution pension plan?

In a defined contribution plan, the employer only promises how much they contribute , not how much the employee will get at retirement. Employer pays a fixed contribution Employee chooses investments Employee bears investment risk Final retirement value is uncertain Intuition: The company pays in — the employee takes the risk.

Q: What is a defined benefit pension plan?

Back (Answer): In a defined benefit plan, the employer promises a fixed retirement income , usually based on salary and years of service. Retirement payment is predefined Employer manages investments Employer bears investment risk Poor returns → employer must contribute more Intuition: The employee gets a promise — the company takes the risk.

Q: What is the difference between buy-side firms and sell-side firms?

Buy-side firms manage and invest client money (they decide what to buy and hold). Sell-side firms sell financial products and services , help with trading, and advise on issuing securities. Intuition: Buy-side invests money; sell-side sells advice, trades, and securities. Exam hook: Portfolio decisions → buy-side Trading, underwriting, research → sell-side

Q: What is the difference between active management and passive management?

Active management: tries to beat a benchmark using manager skill (e.g. analysis, timing, security selection). Passive management: tries to match a benchmark , not beat it (e.g. index funds). Intuition: Active = “Can I do better?” Passive = “I’ll follow the market.” Exam hook: Outperformance goal → active Index replication → passive

Q: What is the difference between open-end and closed-end mutual funds?

An open-end fund lets investors buy and sell shares directly with the fund at net asset value ( NAV = total value of the fund’s assets ÷ number of shares ). The fund issues new shares when money comes in and redeems shares when investors leave. A closed-end fund has a fixed number of shares. Investors trade shares with each other on an exchange, so the market price can be above or below NAV (the fund’s per-share value based on its underlying assets).

8 important questions on Portfolio Management: An Overview

What does Modern Portfolio Theory conclude?

Modern Portfolio Theory states that investors are not rewarded for holding only one stock instead of a diversified portfolio.
By holding only one stock, an investor fails to diversify and therefore keeps unsystematic (company-specific) risk.
This type of risk can be eliminated through diversification, so the market does not offer a higher expected return for bearing it.

Key intuition:

Holding one stock increases risk, but diversification could remove that risk for free — so the market doesn’t pay you extra.

The three steps in the portfolio management process are:

1️⃣ Planning (What does the investor need?)

Assess: risk tolerance, return objectives, time horizon, taxes, liquidity, income, constraints
Result: Investment Policy Statement (IPS)
IPS defines objectives, constraints, and a benchmark
Update when circumstances change

2️⃣ Execution (How do we invest?)

Decide asset allocation (top-down: economy, GDP, inflation, rates)
Diversify across asset classes
Select individual securities (bottom-up analysis)

3️⃣ Feedback (Is it still on track?)

Monitor changes in investor needs and markets
Rebalance portfolio when weights drift
Measure performance vs benchmark

Explain Sovereign wealth funds

refer to pools of assets owned by a government. For example, the Abu Dhabi Investment Authority, a sovereign wealth fund in the United Arab Emirates funded by Abu Dhabi government surpluses, has approximately USD 700
billion in assets.1

What is a defined contribution pension plan?

In a defined contribution plan, the employer only promises how much they contribute, not how much the employee will get at retirement.

Employer pays a fixed contribution
Employee chooses investments
Employee bears investment risk
Final retirement value is uncertain

Intuition:
The company pays in — the employee takes the risk.

What is a defined benefit pension plan?

Back (Answer):
In a defined benefit plan, the employer promises a fixed retirement income, usually based on salary and years of service.

Retirement payment is predefined
Employer manages investments
Employer bears investment risk
Poor returns → employer must contribute more

Intuition:
The employee gets a promise — the company takes the risk.

What is the difference between buy-side firms and sell-side firms?

Buy-side firms manage and invest client money (they decide what to buy and hold).
Sell-side firms sell financial products and services, help with trading, and advise on issuing securities.

Intuition:
Buy-side invests money; sell-side sells advice, trades, and securities.
Exam hook:

Portfolio decisions → buy-side
Trading, underwriting, research → sell-side

What is the difference between active management and passive management?

Active management: tries to beat a benchmark using manager skill (e.g. analysis, timing, security selection).
Passive management: tries to match a benchmark, not beat it (e.g. index funds).

Intuition:
Active = “Can I do better?”
Passive = “I’ll follow the market.”
Exam hook:

Outperformance goal → active
Index replication → passive

What is the difference between open-end and closed-end mutual funds?

An open-end fund lets investors buy and sell shares directly with the fund at net asset value (NAV = total value of the fund’s assets ÷ number of shares). The fund issues new shares when money comes in and redeems shares when investors leave.

A closed-end fund has a fixed number of shares. Investors trade shares with each other on an exchange, so the market price can be above or below NAV (the fund’s per-share value based on its underlying assets).

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Portfolio management

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Portfolio Management: An Overview

8 important questions on Portfolio Management: An Overview

What does Modern Portfolio Theory conclude?

The three steps in the portfolio management process are:

Explain Sovereign wealth funds

What is a defined contribution pension plan?

What is a defined benefit pension plan?

What is the difference between buy-side firms and sell-side firms?

What is the difference between active management and passive management?

What is the difference between open-end and closed-end mutual funds?

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