(54) Basics of Portfolio Planning and Construction Flashcards
LOS 44. a: Describe the reasons for a written investment policy statement.
A written investment policy statement, the first step in the portfolio management process, is a plan for achieving investment success. An IPS forces investment discipline and ensures that goals are realistic by requiring investors to articulate their circumstances, objectives, and constraints.
LOS 44. b: Describe the major components of an IPS. List them.
Many IPSs include the following sections:
Introduction
Statement of Purpose
Statement of Duties and Responsibilities
Procedures
Investment Objectives
Investment Constraints
Investment Guidelines
Evaluation and Review
Appendices
LOS 44. b: Describe the major components of an IPS. Introduction
Describes the client
LOS 44. b: Describe the major components of an IPS. Statement of Purpose
The intentions of the IPS
LOS 44. b: Describe the major components of an IPS. Statement of Duties and Responsibilities
Of the client, the asset custodian, and the investment managers.
LOS 44. b: Describe the major components of an IPS. Procedures
Related to keeping the IPS updated and responding to unforeseen events.
LOS 44. b: Describe the major components of an IPS. Investment Objectives
The client’s investment needs, specified in terms of required return and risk tolerance.
LOS 44. b: Describe the major components of an IPS. Investment Constraints
Factors that may hinder the ability to meet investment objectives; typically categorized as time horizon, taxes, liquidity, legal and regulatory, and unique needs.
LOS 44. b: Describe the major components of an IPS. Investment Guidelines
For example, whether leverage, derivatives, or specific kinds of assets are allowed.
LOS 44. b: Describe the major components of an IPS. Evaluation and Review
Related to feedback on investment results.
LOS 44. b: Describe the major components of an IPS. Appendices
May specify the portfolio’s strategic asset allocation (policy portfolio) or the portfolio’s rebalancing policy.
LOS 44. c: Describe risk and return objectives and how they may be developed for a client.
Risk objectives are specifications for portfolio risk that are developed to embody a client’s risk tolerance. Risk objectives can be either absolute (e.g., no losses greater than 10% in any year) or relative (e.g., annual return will be within 2% of FTSE return).
Return objectives are typically based on investor’s desire to meet a future financial goal, such as a particular level of income in retirement. Return objectives can be absolute (e.g., 9% annual return) or relative (e.g., outperform the S&P 500 by 2% per year).
The achievability of an investor’s return expectations may be hindered by the investor’s risk objectives.
LOS 44. d: Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance.
Willingness to take financial risk is related to an investor’s psychological factors, such as personality type and level of financial knowledge.
Ability or capacity to take risk depends on financial factors, such as wealth relative to liaiblities, income stability, and time horizon.
A client’s overall risk tolerance depends on both his ability to take risk and his willingness to take risk. A willingness greater than ability, or vice versa, is typically resolved by choosing the more conservative of the two and counseling the client.
LOS 44. e: 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. List them.
Investment constraints include:
TTLLU
Time horizon
Tax Considerations
Liquidity
Legal and regulatory
Unique circumstances
LOS 44. e: 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. Liquidity
The need to draw cash from the portfolio for anticipated or unexpected future spending needs. High liquidity needs often translate to a high portfolio allocation to bonds or cash.
LOS 44. e: 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. Time horizon
Often the period over which assets are accumulated and before withdrawals begin. Risky or illiquid investments may be inappropriate for an investor with a short time horizon.
LOS 44. e: 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. Tax considerations
Concerns the tax treatments of the investor’s various accounts, the relative tax treatment of capital gains and income, and the investor’s marginal tax bracket.
LOS 44. e: 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. Legal and regulatory
Constraints such as government restrictions on portfolio contents or laws against insider trading.
LOS 44. e: 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
Restrictions due to investor preferences (religious, ethical, etc.) or other factors not already considered.
LOS 44. f: Explain the specification of asset classes in relation to asset allocations.
An asset class is a group of securities with similar risk and performance characteristics. Examples of major asset classes include equity, fixed income, cash, and real estate. Portfolio managers also use more narrowly defined asset classes, such as large-cap U.S. equities or speculative international bonds, and alternative asset classes, such as commodities or investments in hedge funds.
LOS 44. g: Describe the principles of portfolio construction and the role of asset allocation in relation to the IPS. Strategic asset allocation.
Strategic asset allocation is a set of percentage allocations to various asset classes that is designed to meet the investor’s objectives. The strategic asset allocation is developed by combining the objectives and constraints in the IPS with the performance expectations of the various asset classes. The strategic asset allocation provides the basic structure of a portfolio.
LOS 44. g: Describe the principles of portfolio construction and the role of asset allocation in relation to the IPS. Tactical asset allocation.
Tactical asset allocation refers to the allocation that deviates from the baseline (strategic) allocation in order to profit from a forecast of shorter-term opportunities in specific asset classes.
