The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CONSTRUCTING PORTFOLIOS

In this section we discuss how to construct portfolios based on the forecasts described in the last section. In particular, we compare rule-based approaches to portfolio optimization. The first step in portfolio construction, however, is to specify the investment goals. While having good forecasts (as described in the previous section) is obviously important, the investor’s goals define the portfolio management problem. These goals are usually specified by three major parameters: the benchmark, the risk–return target, and specific restrictions such as the maximum holdings in any single name, industry, or sector.

The benchmark represents the starting point for any active portfolio; it is the client’s neutral position—a low-cost alternative to active management in that asset class. For example, investors interested in holding large-cap U.S. stocks might select the S&P 500 or Russell 1000 as their benchmark, while investors interested in holding small-cap stocks might choose the Russell 2000 or the S&P 600. Investors interested in a portfolio of non-U. S. stocks could pick the FTSE 350 (United Kingdom), TOPIX (Japan), or MSCI EAFE (developed world minus North America) indexes. There are a large number of published benchmarks available, or an investor might develop a customized benchmark to represent the neutral position. In all cases, however, the benchmark should be a reasonably low-cost, investable alternative to active management.

Although some investors ...