4 1 reading 41 basics of portfolio planning and construction pdf

LOS Portfolio Management • • • • Portfolio Management – An Overview Portfolio Risk and Return – Part I Portfolio Risk and Return – Part II Basics of Portfolio Planning and Construction • Risk Management – An Introduction • Fintech in Investment Management LOS LOS Describe the reasons for a written investment policy statement (IPS) The investment policy statement: What is it? • Written document governing the process of constructing a portfolio to meet the client's investment objectives Why is it necessary? Legal/Regulatory Requirements Suitability of an investment e.g., UK pension schemes must have a statement of investment principles under the Pensions Act 1995 Outlines client’s needs preferences IPS Governance arrangements e.g., could outline the procedure for appointing pension managers LOS LOS Describe the reasons for a written investment policy statement (IPS) Benefits of an IPS: For the client • • • • • The IPS identifies and documents investment objectives and constraints Can easily identify areas that need changes in response to changing circumstances Developing the IPS should be an educational experience Learns more about themselves and investment decision making Management can change hands without disruption of the investment process For the Adviser/Manager • • • • Greater knowledge of the client Guidance for decision making Guidance for resolution of disputes Can be used to support the manager’s investment decisions LOS LOS Describe the major components of an IPS Introduction Description of the client Statement of purpose Purpose of the IPS Statement of duties & responsibilities Client, advisor, custodian, etc Procedures Investment procedures Investment objectives e.g., the target rate of return Investment constraints e.g., minimum shares Investment guidelines e.g., the permissible assets Evaluation & review e.g., performance feedback Appendices Strategic asset allocation LOS LOS Describe risk and return objectives and how they may be developed for a client Risk objectives Absolute: Stated without context Relative: Stated comparatively e.g., the 1-year 95% VaR (value at risk) of the portfolio must not exceed $10 million e.g., achieving a return within 5% of the S&P 500 index approximately 95% of the time LOS LOS Describe risk and return objectives and how they may be developed for a client Return objectives can be divided into the following needs: Capital preservation  Capital should be maintained, for instance by earning a return equal to the inflation rate Capital appreciation  Capital needs to grow, not just merely preserved, for instance by earning a return that exceeds the inflation rate Current Income  Need to create income from the investor's capital base Total Return  There’s a need to grow the capital base through both capital appreciation and reinvestment of that appreciation LOS LOS Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance Willingness vs Ability • An investor's ability to bear risk depends on financial circumstances  Longer investment horizons, greater assets versus liabilities, more insurance against adverse unexpected events, and a secure job all suggest a greater ability to bear investment risk • An investor's willingness to bear risk is based primarily on the investor's attitudes and beliefs about various types of investments  Assessing an investor’s willingness to bear risk is fairly objective and may involve the administration of questionnaire in an attempt to categorize the investor’s risk aversion LOS LOS Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance Willingness vs Ability Sample questions in a questionnaire meant to measure an investor’s willingness to take risks Possible responses: (A) Strongly agree, (B) Tend to agree, (C) Tend to disagree, (D) Strongly disagree Compared to the average person, I would say I take more risks I would be willing to risk a percentage of my income / capital in order to get a good return on an investment To achieve high returns, it is necessary to choose high-risk investments When I'm faced with a financial decision I am generally more concerned about the possible losses than the probable gains When I think of the word risk, the term “loss” comes to mind immediately LOS LOS Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance Example David Hertwig is a 35 year-old engineer who works for a major motor company based in California, USA He is married with a year-old daughter David has decided that it’s time to review his financial situation His financial advisor notes the following: • David’s $100,000 annual salary is more than sufficient to cover the family’s cash outflows • The family lives in Los Angeles and David owns the condominium the family lives in • David has savings amounting to $200,000 in his bank account • David considers his job reasonably secure LOS LOS Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance Example cont… • David is well versed in financial matters and is confident the equity market will generate positive returns over the coming years • In the risk tolerance questionnaire, David strongly agrees with the statement, “I would be willing to risk a percentage of my income / capital in order to get a good return on an investment” and that “returns are more important than safety.” • David hopes that most of his savings will be used to fund his retirement He plans to retire at age 65 Based on this information, we can come up with the following risk tolerance analysis for David: >>> LOS LOS Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance Willingness vs Ability: David Hertwig Example cont… Ability to bear risk Willingness to take risk • • Deep knowledge about financial markets Answers in questionnaire suggest risk tolerance • Risk tolerance • • • High income relative to expenses Secure job Significant assets Time horizon of 30 years LOS LOS Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance Conflict between willingness and ability to take risks • The willingness to take on risk has to be consistent with the ability to take on risk • There may be instances within an institutional environment where there is a conflict between the willingness and ability to take on risk Example In a well-funded pension plan, the trustees and beneficiaries may wish to adopt a low-risk investment approach while the plan sponsor wants to invest more aggressively In such a situation, the trustees must always act in the best interests of the beneficiaries LOS LOS Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets Constraints on portfolio selection Portfolio selection Time horizon Tax concerns Legal and regulatory factors Unique circumstances Liquidity LOS LOS Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets Constraints on portfolio selection Liquidity • It refers to the ability to turn investment assets into spendable cash in a short period of time without having to make significant price concessions to so • When a client has a known liquidity requirement, the portfolio manager should allocate a portion of the portfolio to cover this liability by ensuring the allocated assets can be quickly converted to cash at the point in time at which the obligation needs to be met • Illiquid investments in hedge funds and private equity funds - which typically have trading and redemption restrictions - are not suitable for an investor who may unexpectedly need access to the funds LOS LOS Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets P7 markets pension funds asset allocation 1997-2017 LOS LOS Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets Constraints on portfolio selection Time Horizon • The IPS should state the time horizon over which the client is investing The longer an investor's time horizon, the more risk and less liquidity the investor can accept in the portfolio Tax Concerns • Different investors will have a different tax status which should be stated in the IPS • Besides an individual's overall tax rate, the tax treatment of various types of investment accounts should also be considered • Investors subject to higher tax rates may prefer tax-free bonds (U.S.) to taxable bonds or prefer equities expected to record capital gains since capital gains tax rate is lower than the income tax rate LOS LOS Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets Constraints on portfolio selection Legal and Regulatory Factors • The IPS should contain any legal or regulatory restrictions that are applicable • Trust and corporate investment accounts may all be restricted by law from investing in particular types of securities Unique Circumstances • The IPS should also cover any unique circumstances that are applicable:  Investment restrictions in countries accused of human rights abuses  Religious preferences  ESG (environment, social, governance) factors LOS LOS Explain the specification of asset classes in relation to asset allocation • Once the IPS has been specified, the advisor can begin to construct the portfolio The asset classes need to be defined and then a strategic asset allocation (SAA) formulated • A SAA specifies the percentage allocations to the included asset classes • Correlations of returns within an asset class should be relatively high, an indication that the assets within the class are similar in their investment performance • There should be low correlation of returns between asset classes as this indicates the asset classes have different investment performance LOS LOS Describe the principles of portfolio construction and the role of asset allocation in relation to the IPS • Once the portfolio manager has identified the investable asset classes for the portfolio and the risk, return, and correlation characteristics of each asset class, an efficient frontier can be constructed with the help of a computer program • By comparing the risk-return guidelines in the IPS with the actual risk-return properties of portfolios along the efficient frontier, the optimal portfolio can be identified • In addition to strategic asset allocation, we can also have tactical asset allocation, TAA:  The manager varies from strategic asset allocation weights in order to take advantage of perceived short-term opportunities LOS LOS Describe the principles of portfolio construction and the role of asset allocation in relation to the IPS Example – Tactical asset allocation in practice • A portfolio manager might overweight financial stocks and underweight energy stocks because he believes crude oil will remain at relatively low prices, relative to the index weights for U.S large-cap equities as an asset class  This is called active portfolio management  While such an active strategy may produce higher returns, it also increases the risk of the portfolio compared to a passive portfolio of asset class indexes  The risk can be managed via risk budgeting and rebalancing LOS Portfolio Management • Portfolio Management – An Overview • Portfolio Risk and Return – Part I • Portfolio Risk and Return – Part II • Basics of Portfolio Planning and Construction  Risk Management – An Introduction • Fintech in Investment Management ... budgeting and rebalancing LOS Portfolio Management • Portfolio Management – An Overview • Portfolio Risk and Return – Part I • Portfolio Risk and Return – Part II • Basics of Portfolio Planning and Construction. .. principles of portfolio construction and the role of asset allocation in relation to the IPS • Once the portfolio manager has identified the investable asset classes for the portfolio and the risk,... constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets Constraints on portfolio selection