Basics of Portfolio Planning and Construction

Portfolio Management

The Investment Policy Statement

Learning Outcome Statement:

describe the reasons for a written investment policy statement (IPS), describe the major components of an IPS

Summary:

The Investment Policy Statement (IPS) is a crucial document in portfolio management, outlining a client's investment objectives and constraints. It serves as a foundational tool for achieving investment success by aligning the client's financial goals with appropriate risk and return parameters. The IPS is developed through a detailed client consultation process and should be regularly reviewed to ensure it remains aligned with the client's changing circumstances. Major components of an IPS include statements of purpose, duties, investment objectives, constraints, guidelines, and procedures for regular evaluation and review.

Key Concepts:

Investment Policy Statement (IPS)

An IPS is a written document that outlines a client's investment objectives and constraints, serving as a guide for portfolio management to achieve specified financial goals.

Client Consultation

The process of developing an IPS begins with a thorough discussion with the client to understand their financial situation, risk tolerance, and investment expectations.

Components of an IPS

An IPS typically includes sections on the introduction of the client, statement of purpose, duties and responsibilities, investment objectives, constraints, guidelines for investment, and procedures for evaluation and review.

Risk and Return Objectives

These objectives define the expected level of risk and return for the client's portfolio, ensuring they are aligned with the client's financial goals and risk tolerance.

Regular Review

The IPS should be regularly reviewed and updated to reflect any significant changes in the client's financial circumstances or objectives.

IPS Risk and Return Objectives

Learning Outcome Statement:

describe the major components of an IPS; describe risk and return objectives and how they may be developed for a client; explain the difference between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance

Summary:

The section on IPS Risk and Return Objectives discusses the importance of aligning a client's risk and return objectives with their investment policy statement (IPS). It emphasizes the need for these objectives to be consistent with the client's financial constraints and overall investment strategy. The content also explores different types of risk objectives (absolute and relative), the significance of understanding a client's willingness and ability to take risks, and how these factors influence the formulation of investment policies, including considerations for responsible investing.

Key Concepts:

Risk Objectives

Risk objectives define the level of risk a client is willing to and capable of taking. These can be absolute (e.g., not losing more than a specific amount) or relative (e.g., performing in relation to a benchmark).

Return Objectives

Return objectives specify the gains a client aims to achieve from their investments. These can also be absolute (a specific return percentage) or relative (e.g., outperforming a benchmark).

Ability and Willingness to Take Risk

A client's risk tolerance is influenced by their ability (financial capacity to bear risk) and willingness (psychological readiness to accept risk) to take risk. These factors must be assessed to align investment strategies appropriately.

Responsible Investing

Incorporates environmental, social, and governance (ESG) considerations into investment strategies, recognizing that these factors can impact the financial risk-return profile and reflect the investor's societal values.

Formulas:

Future Value with Inflation

FV = PV \times (1 + i)^n

Calculates the future value of a present amount considering the annual inflation rate over a specified number of years.

Variables:

$FV$ :: future value
$PV$ :: present value
$i$ :: annual inflation rate
$n$ :: number of years

Units: currency

Required Rate of Return

FV = PV \times (1 + r)^n

Determines the annual rate of return needed to grow a present value to a desired future value over a specified period.

Variables:

$FV$ :: future value
$PV$ :: present value
$r$ :: required annual rate of return
$n$ :: number of years

Units: percentage

IPS Constraints

Learning Outcome Statement:

describe the major components of an IPS; 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

Summary:

Investment Policy Statement (IPS) constraints are critical factors that influence the selection and management of portfolio assets. These constraints include liquidity requirements, time horizon, tax concerns, legal and regulatory factors, and unique circumstances, each affecting asset allocation and investment strategy to align with the client's specific needs and situations.

Key Concepts:

Liquidity Requirements

Liquidity requirements refer to the need for assets that can be quickly converted into cash without significant loss of value. This is crucial for covering anticipated or unforeseen expenses. Portfolio managers must allocate assets that meet these liquidity needs while maintaining low risk at the time of liquidity requirement.

Time Horizon

The time horizon is the duration over which investments are expected to be held before liquidation or restructuring. It influences the suitability of asset types within a portfolio, with longer horizons potentially accommodating higher-risk, higher-return investments.

Tax Concerns

Tax concerns involve understanding the impact of different tax treatments on investment returns. Portfolios should be structured to optimize after-tax returns, considering factors like income tax versus capital gains tax, and the benefits of tax-exempt securities for certain investors.

Legal and Regulatory Factors

These factors include laws and regulations that restrict certain investment practices. Examples include limits on asset allocation for pension funds and restrictions related to insider information, which must be considered to ensure legal compliance.

Unique Circumstances and ESG Considerations

Unique circumstances cover personal, ethical, or religious beliefs that influence investment choices, such as avoiding investments in certain industries. ESG considerations involve environmental, social, and governance factors that are integrated into investment decisions to align with the investor's values and ethical standards.

Gathering Client Information

Learning Outcome Statement:

describe risk and return objectives and how they may be developed for a client; 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

Summary:

The process of gathering client information is crucial for portfolio managers and investment advisers to understand the client's financial situation, objectives, and constraints. This involves conducting thorough fact-finding exercises at the beginning of the client relationship, which includes gathering data about the client's family, employment, financial situation, and discussing their investment objectives and requirements. This information is essential for drafting an Investment Policy Statement (IPS) that aligns with the client's goals and constraints.

Key Concepts:

Conduct-Based Screening Criteria

This refers to the ethical or moral guidelines used to screen investments based on environmental, social, and governance (ESG) criteria. Examples include environmental management, animal welfare, human rights, labor standards, and business ethics.

Client's Total Wealth Consideration

Advisers must consider all aspects of a client's wealth, not just the portion they manage. This includes employment-related investments and other personal or family assets, which might influence the diversification and risk management strategies of the portfolio.

Investment Constraints

These are limitations or restrictions on the investment strategy, which can include liquidity needs, time horizon, tax concerns, legal and regulatory factors, and unique personal or business circumstances. Each constraint affects the choice of portfolio assets and overall investment strategy.

Fact-Finding Exercises

These are thorough investigations carried out at the beginning of the client-adviser relationship to gather essential information about the client's financial and personal circumstances. This can involve structured interviews, questionnaires, and data analysis.

Investment Policy Statement (IPS)

A document drafted by financial advisers that outlines a client's investment goals and constraints. It includes details such as risk tolerance, return objectives, time horizon, tax circumstances, legal considerations, and unique needs.

Portfolio Construction and Capital Market Expectations

Learning Outcome Statement:

explain the specification of asset classes in relation to asset allocation; describe the principles of portfolio construction and the role of asset allocation in relation to the IPS

Summary:

This LOS covers the principles of portfolio construction, focusing on strategic asset allocation (SAA) and its role in achieving investment objectives as outlined in the Investment Policy Statement (IPS). It also discusses capital market expectations, which involve the investor's expectations about the risk and return prospects of various asset classes and how these expectations shape the SAA.

Key Concepts:

Strategic Asset Allocation (SAA)

SAA involves setting percentage allocations to various asset classes based on the client's long-term objectives, risk profile, and investment constraints. It aims to expose the investor to systematic risks of asset classes in proportions that meet their risk and return objectives.

Capital Market Expectations

These are the investor's expectations concerning the risk and return prospects of asset classes. They are quantified in terms of expected returns, standard deviations of returns, and correlations among asset classes, and are crucial in forming the SAA.

Asset Classes

Asset classes are categories of assets with similar characteristics, attributes, and risk-return relationships. Traditional asset classes include cash, equities, and bonds, while alternative investments might include private equity, hedge funds, and commodities.

Investment Policy Statement (IPS)

The IPS outlines the client's investment objectives, risk tolerance, constraints, and other relevant factors. It serves as a foundation for formulating the SAA and guides the overall portfolio construction process.

Formulas:

Expected Return of an Asset Class

E(R) = R_f + \sum (RP_i)

The expected return of an asset class is calculated as the sum of the risk-free rate and the risk premiums associated with that asset class. Risk premiums compensate for the additional risks taken by investing in the asset class over the risk-free rate.

Variables:

$E(R)$ :: Expected return of the asset class
$R_f$ :: Risk-free rate
$RP_i$ :: Risk premium associated with the asset class

Units: percentage or decimal

Strategic Asset Allocation

Learning Outcome Statement:

explain the specification of asset classes in relation to asset allocation; describe the principles of portfolio construction and the role of asset allocation in relation to the IPS

Summary:

Strategic Asset Allocation (SAA) focuses on systematic risk management and aligning investment portfolios with the investor's risk and return objectives through the Investment Policy Statement (IPS) and capital market expectations. It involves defining asset classes, estimating their expected returns, risks, and correlations, and optimizing the portfolio to achieve the desired risk-return trade-off.

Key Concepts:

Systematic vs Nonsystematic Risk

Systematic risk is inherent to the entire market or market segment and cannot be mitigated through diversification. Nonsystematic risk is specific to a single asset or a small group of assets and can be diversified away.

Capital Market Expectations

These are forecasts about how asset classes will perform in terms of risk and return. They are crucial for setting up a strategic asset allocation that aligns with the client's investment objectives.

Asset Class Specification

Defining asset classes involves categorizing assets based on their risk and return characteristics and their correlations with other asset classes. This categorization helps in achieving diversification and controlling portfolio risks.

Efficient Frontier

A graphical representation of optimal portfolios that offer the highest expected return for a given level of risk. It is derived from the correlation and volatility of the asset classes.

Indifference Curves

These curves represent combinations of risk and return that provide the investor with equal levels of satisfaction. The optimal portfolio is found where an indifference curve is tangent to the efficient frontier.

Formulas:

Expected Portfolio Return

E(R_p) = \sum_{i=1}^n w_i E(R_i)

This formula calculates the expected return of the portfolio based on the weighted average of the expected returns of the asset classes included in the portfolio.

Variables:

$E(R_p)$ :: Expected return of the portfolio
$w_i$ :: Weight of asset class i in the portfolio
$E(R_i)$ :: Expected return of asset class i
$n$ :: Number of asset classes

Units: percentage

Portfolio Risk

\sigma_p = \sqrt{\sum_{i=1}^n \sum_{j=1}^n w_{p,i} w_{p,j} \text{Cov}(R_i, R_j)}

This formula calculates the risk (standard deviation) of the portfolio, taking into account the weights of the asset classes and their covariances.

Variables:

$\sigma_p$ :: Standard deviation of the portfolio returns
$w_{p,i}$ :: Weight of asset class i in the portfolio
$w_{p,j}$ :: Weight of asset class j in the portfolio
$Cov(R_i, R_j)$ :: Covariance between the returns of asset classes i and j

Units: percentage

Covariance of Returns

\text{Cov}(R_i, R_j) = \rho_{i,j} \sigma_i \sigma_j

This formula defines the covariance between two asset classes based on their correlation and individual standard deviations.

Variables:

$\text{Cov}(R_i, R_j)$ :: Covariance between the return of asset classes i and j
$\rho_{i,j}$ :: Correlation between the returns of asset classes i and j
$\sigma_i$ :: Standard deviation of returns for asset class i
$\sigma_j$ :: Standard deviation of returns for asset class j

Units: percentage

Portfolio Construction Principles

Learning Outcome Statement:

describe the principles of portfolio construction and the role of asset allocation in relation to the IPS

Summary:

The principles of portfolio construction involve strategic asset allocation, risk budgeting, tactical asset allocation, and security selection. Strategic asset allocation sets the initial investment framework based on systematic risk factors. Risk budgeting allocates the overall risk across different sources of investment returns. Tactical asset allocation involves deviations from policy weights based on short-term forecasts, while security selection focuses on outperforming asset class benchmarks through individual security choices. The process also includes considerations for rebalancing and drift management to maintain alignment with the initial investment policy statement (IPS).

Key Concepts:

Strategic Asset Allocation (SAA)

SAA involves setting the initial framework for an investment portfolio by selecting and sizing exposures to systematic risk factors according to the investor's risk-return profile as outlined in the IPS.

Risk Budgeting

This is the process of deciding the total amount of risk to be assumed in the portfolio and how this risk is allocated across various sources of investment returns such as SAA, tactical asset allocation, and security selection.

Tactical Asset Allocation

This refers to the deliberate deviations from the policy weights of asset classes with the intent to capitalize on short-term market opportunities to add value based on forecasts of near-term returns.

Security Selection

The process of selecting individual securities within an asset class that are expected to perform better than the asset class benchmark, aiming to generate higher returns.

Rebalancing Policy

A set of rules that guide the process of restoring the portfolio's original exposures to systematic risk factors when the actual weights of asset classes deviate from the policy weights due to market movements or other factors.

Formulas:

Portfolio Return Calculation

R_p = \sum (w_i \times r_i)

This formula calculates the overall return of a portfolio based on the returns of individual asset classes and their respective weights in the portfolio.

Variables:

$R_p$ :: Total portfolio return
$w_i$ :: Weight of asset class i in the portfolio
$r_i$ :: Return of asset class i

Units: percentage

ESG Considerations in Portfolio Planning and Construction

Learning Outcome Statement:

describe how environmental, social, and governance (ESG) considerations may be integrated into portfolio planning and construction

Summary:

The integration of ESG considerations into portfolio planning and construction involves incorporating environmental, social, and governance factors into investment decisions. This can be achieved through various strategies such as negative screening, positive screening, thematic investing, engagement/active ownership, and impact investing. These considerations influence asset allocation, risk management, and the selection of investment vehicles, aiming to align investments with broader societal values and sustainability goals.

Key Concepts:

Risk Parity Investing

Risk parity investing is an approach where portfolio weights are adjusted according to risk contribution, typically increasing the weight of less volatile assets like fixed income to balance the higher volatility of equities.

ESG Integration

ESG integration involves the systematic inclusion of ESG factors into traditional financial analysis and investment decision-making processes. This can enhance risk assessment and potentially uncover investment opportunities.

Negative Screening

Negative screening involves excluding certain sectors, companies, or practices from a fund or portfolio based on specific ESG criteria. This can affect the investment universe and potentially the risk and return profile of the portfolio.

Thematic Investing

Thematic investing focuses on specific ESG themes, such as renewable energy or social inclusion. It requires selecting specialist managers who can identify and manage investments that align with these themes.

Impact Investing

Impact investing targets investments aimed at generating specific, positive social or environmental effects in addition to financial returns. This approach directly aligns portfolio investments with targeted ESG outcomes.

Shareholder Engagement

Shareholder engagement involves investors using their rights as shareholders to influence corporate behavior. This includes practices like voting on shareholder resolutions and engaging in dialogues with company management on ESG issues.

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