We believe that a portfolio of assets should be viewed as more than the sum of the parts. Perhaps surprisingly, many practitioners who offer traditional “portfolio valuation” services simply add up the value of the individual assets. This is correct if one takes the view that there are no relevant interactions between the assets, and that the only objective of such activities is to derive a single valuation figure for the portfolio. Also, from a practical perspective, it allows the analysis to be split into individual components, and can therefore be split within a team of staff working with essentially separate models.
However, there are many cases where the “sum of the parts” approach is insufficient:
- Portfolio construction and optimisation. The selection of new assets to include (or of assets to divest) may depend on criteria that are not purely valuation-related (such as liquidity, risk-correlations, financing constraints or cash flow projections, and so on). Such approaches also allow the calculation of many types of performance indicators (such as earnings-at-risk, cash flow-at-risk, portfolio volatility and skewness, and so on).
- Optimal planning for businesses with multiple assets, products, or geographies (analytic approaches to achieving KPI objectives by deploying resources/capital in the most effective way, highlighting trade-offs, constraints, and required management decisions).
- Full risk assessments (such as for value-at-risk, stress-testing etc). To calculate the relevant ranges and probabilities for the possible variation in the value of a portfolio, one needs to understand the underlying risks drivers, and their impact on the portfolio elements, including the commonalities and correlations. Indeed, we believe that risk assessment in such cases is not only just a compliance or regulatory issue, but also a commercial imperative; it can support the raising and management of capital, and the relationships with investors.
- Reduced-form risk assessment and valuation tools. Where it is desired to establish the value of a total portfolio and how this value may change on a regular basis, it may be more effective (and sufficiently) accurate to work with “reduced-form” models. These are models where changes in the value (of each asset) are assumed to be related to observable value drivers (e.g. interest rates, equity market volatility, currency changes etc.), and to update the portfolio value by tracking changes in the value drivers. Overall, this can save significant work to the building and updating of full models for each asset (e.g. cash flow projections), even as such full models may be required if an individual asset is to be bought or sold.
Thus, the traditional approach does not business (or fund) performance, nor the management (or raising) of capital. Instead, the consideration and modelling of risk drivers, correlations and commonalities, cash flow profiles and so on is paramount.
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