What is Portfolio Engineering?
Team Latte
Apr 26, 2006

We are frequently asked by clients, as well as visitors to our site, as to what exactly do we mean by Portfolio Engineering . The term, it seems, is not in active use anywhere in the world, either in the academia or the industry. It has taken almost a decade and a half for practitioners and the academics to come to terms with the term Financial Engineering and that too with a great deal of skepticism. So, it is no surprise that many main stream fund managers (yes, especially fund managers) and a handful of sell side bankers have displayed distaste towards this term- Portfolio Engineering.

What is Portfolio Engineering?

(Those of you who are art history major or something similar and are currently managing more than a billion dollars in assets and have never ever heard terms such as "linear", "non-linear", "derivatives" or "Engineering", please excuse!)

Portfolio Engineering is the science of using asset allocation models and techniques (as well as derivatives strategies and models) to create synthetic portfolios for enhancing yield . To be fair, it is not a science in itself. It is pure engineering. The discipline takes in the mathematical tools of computational finance and portfolio theory and then designs processes and methodologies to construct synthetic portfolios with the sole objective of improving on the market's rate of return.

Major portfolio construction techniques, which in turn are based on the science of mathematical programming are:

• Strategic asset allocation models (markowitz's model, efficient frontier construction and optimization along the efficient frontier);
• Dynamic hedging strategies (with and without derivatives);
• Tactical asset allocation models (using Gaussian distribution);

Further, Dynamic Hedging Strategies consists of two major techniques:

1. Portfolio Insurance;
2. Constant Proportion Portfolio Insurance  (CPPI) (extremely popular these days);

Portfolio Engineering originated as a science of developing math models of portfolios of stocks and bonds for the purpose of creating superior or more appropriately, optimum returns. Optimum, in the sense that under a certain set of circumstances of the investor and market conditions such return was the best possible return for a certain level of risk. Though, the underlying math was fairly complex, the objective was simple. Even to this day the objective- of portfolio engineering-remains simple: to create optimum portfolios under constraints of market conditions and risk.

Of course, today partly due to the proliferation of financial derivatives and their ubiquitous applications, the field of portfolio engineering has widened substantially. Today a vast array of linear and quasi-linear (stocks, bonds, swaps, FRAs, money market, etc.) and non-linear asset classes (options, exotic derivatives, etc.) is used to synthesize portfolios. Such synthesis is primarily done using:

1. linear and non-linear optimization process;
2. using option-like payoffs by combining strings of linear assets;
3. using derivatives directly with or without combination of linear assets;

Portfolio Engineering is a discipline will grow rapidly in the coming years mostly due to the accumulation of humongous wealth in the hands of money managers and the extreme variation (and uncertainty) in the volatility (both high and low volatility) of the asset markets.

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