4 1 reading 41 basics of portfolio planning and construction pdf

Ability • An investor's ability to bear risk depends on financial circumstances Longer investment horizons, greater assets versus liabilities, more insurance against adverse unexpecte

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• 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

Portfolio Management

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The investment policy statement: What is it?

• Written document governing the process of constructing a portfolio

to meet the client's investment objectives

Suitability of an investment

Governance arrangements

e.g., could outline the procedure for appointing pension managers

Outlines client’s needs preferences

e.g., UK pension schemes must have a statement of investment

principles under the Pensions Act 1995

IPS

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Benefits of an IPS:

statement (IPS)

For the client For the Adviser/Manager

• 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

• Greater knowledge of the client

• Guidance for decision making

• Guidance for resolution of disputes

• Can be used to support the manager’s investment

decisions

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Introduction Statement of purpose Statement of duties &

responsibilities Procedures Investment objectives Investment constraints Investment guidelines Evaluation & review Appendices

Description of the client Purpose of the IPS Client, advisor, custodian, etc Investment procedures

e.g., the target rate of return e.g., minimum shares

e.g., the permissible assets e.g., performance feedback Strategic asset allocation

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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

There’s a need to grow the capital base through both capital

appreciation and reinvestment of that appreciation

developed for a client

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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

(capacity) to take risk in analyzing an investor’s financial

risk tolerance

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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

1 Compared to the average person, I would say I take more risks

2 I would be willing to risk a percentage of my income / capital in

order to get a good return on an investment

3 To achieve high returns, it is necessary to choose high-risk

investments

4 When I'm faced with a financial decision I am generally more

concerned about the possible losses than the probable gains

5 When I think of the word risk, the term “loss” comes to mind

immediately

(capacity) to take risk in analyzing an investor’s financial risk tolerance

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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 4 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

(capacity) to take risk in analyzing an investor’s financial risk tolerance

“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: >>>

(capacity) to take risk in analyzing an investor’s financial risk tolerance

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Willingness vs Ability: David Hertwig

Example cont…

(capacity) to take risk in analyzing an investor’s financial risk tolerance

Willingness to take risk

Ability to bear

risk

Risk tolerance

• High income relative to expenses

• Secure job

• Significant assets

• Time horizon of 30 years

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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

(capacity) to take risk in analyzing an investor’s financial

risk tolerance

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Constraints on portfolio selection

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

Unique circumstances

Legal and regulatory factors

Tax concerns

Time horizon

Liquidity

Portfolio selection

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Constraints on portfolio selection

1 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 do 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 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

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P7 markets pension funds asset allocation 1997-2017

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

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Constraints on portfolio selection

2 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

• 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 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

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Constraints on portfolio selection

4 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

ESG (environment, social, governance) factors

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

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• 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

asset allocation

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

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• 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

Portfolio Management