9.4 basics of portfolio planning and construction

Question 1

Portfolio Planning

Answer 1

done before constructing a portfolio

Question 2

The investment policy statement (IPS)

Answer 2

the written document that governs the portfolio planning process

serves as a reference manual for helping clients achieve their investment objectives.

An IPS should be reviewed regularly to ensure that it remains consistent with the client’s current circumstances.

Question 3

A general framework for an IPS includes the following components:

Answer 3

Introduction

Statement of purpose

Statement of duties

Procedures

Investment objectives

Investment constraints

Investment guidelines

Evaluation and review

Question 4

The most relevant components of the IPS

Answer 4

investment objectives (i.e., risks and returns)

investment constraints (e.g., liquidity, time horizon, taxes

Question 5

Active ownership and shareholder engagement

Answer 5

rely on shareholder voting power to influence the corporation to achieve ESG objectives.

Question 6

Thematic investing

Answer 6

attempts to profit from important trends and structural changes, such as the transition to alternative sources of power generation.

Question 7

Impact investing

Answer 7

managers primarily consider the expected environmental or social benefits when selecting investments.

similar to thematic investing

Question 8

ESG integration

Answer 8

involves adding an ESG perspective to the traditional process of investment analysis, is increasingly popular. However, investors and managers should be aware of potential data quality issues. There are no universal standards for ESG reporting, which is typically voluntary, and companies tend to limit their disclosures to the information that is most favorable to them.

Question 9

the first step after completing the IPS

Answer 9

A strategic asset allocation

The focus should be on systematic risk to make sure it is consistent with the client’s risk and return objectives.

Question 10

Capital market expectations

Answer 10

the risk and return prospects of asset classes

It usually includes expected returns, standard deviations, and correlations.

Question 11

Strategic asset allocation

Answer 11

defines exposure to systematic risk.

Question 12

Tactical asset allocation

Answer 12

seeks to add return by varying the weights between asset classes based on forecasts. Tactical asset allocation involves overweighting or underweighting specific asset classes, securities, or sectors based on short-term capital market expectations.

Such deviations from the systematic risk exposure implied by a portfolio’s policy weights create non-systematic risk exposure that would not be present if the optimal portfolio weights had been maintained.

Question 13

Security selection

Answer 13

can add return by picking securities with higher returns.

Question 14

The core-satellite approach

Answer 14

involves allocating the majority of a portfolio’s assets to passive or low active investments (the “core”) and placing the remaining funds in actively managed “satellite” accounts.

Question 15

here are two newer and less structured developments of portfolio planning and construction framework:

Answer 15

1 Growth in the offering of exchange traded funds (ETFs) with robo-advice

2. Risk-parity investing

Question 16

Risk-parity investing

Answer 16

Advocates of risk-parity investing call for asset classes to be weighted based on their contribution to a portfolio’s overall risk.

They argue that high allocations to equities understate the actual level of risk.

Portfolios based on risk-parity principles have performed well since the global financial crisis of 2007 - 2009, although critics claim that this can be explained by persistently low interest rates that have enhanced fixed-income returns.

Question 17

Which of the following is least important as a reason for a written investment policy statement (IPS)?

a) The IPS may be required by regulation.

b) Having a written IPS is part of best practice for a portfolio manager.

c) Having a written IPS ensures the client’s risk and return objectives can be achieved.

Answer 17

c) Having a written IPS ensures the client’s risk and return objectives can be achieved.

Depending on circumstances, a written IPS or its equivalent may be required by law or regulation and a written IPS is certainly consistent with best practices. The mere fact that a written IPS is prepared for a client, however, does not ensure that risk and return objectives will in fact be achieved.

Question 18

Which of the following best describes the underlying rationale for a written investment policy statement (IPS)?

a) A written IPS communicates a plan for trying to achieve investment success.

b) A written IPS provides investment managers with a ready defense against client lawsuits.

c) A written IPS allows investment managers to instruct clients about the proper use and purpose of investments.

Answer 18

a) A written IPS communicates a plan for trying to achieve investment success.

Question 19

The section of the investment policy statement (IPS) that provides information about how policy may be executed, including restrictions and exclusions, is best described as the:

a) Investment Objectives.

b) Investment Guidelines.

c) Statement of Duties and Responsibilities.

Answer 19

b) Investment Guidelines.

Question 20

Risk assessment questionnaires for investment management clients are most useful in measuring:

a) value at risk.

b) ability to take risk.

c) willingness to take risk.

Answer 20

c) willingness to take risk.

Risk attitude is a subjective factor and measuring risk attitude is difficult. Oftentimes, investment managers use psychometric questionnaires, such as those developed by Grable and Joo (2004), to assess a client’s willingness to take risk.

Question 21

A client who is a 34-year old widow with two healthy young children (aged 5 and 7) has asked you to help her form an investment policy statement. She has been employed as an administrative assistant in a bureau of her national government for the previous 12 years. She has two primary financial goals—her retirement and providing for the college education of her children. This client’s time horizon is best described as being:

a) long term.

b) short term.

c) medium term

Answer 21

a) long term.

The client’s financial objectives are long term. Her stable employment indicates that her immediate liquidity needs are modest. The children will not go to college until 10 or more years later. Her time horizon is best described as being long term.

Question 21

After interviewing a client in order to prepare a written investment policy statement (IPS), you have established the following:

The client has earnings that vary dramatically between £30,000 and £70,000 (pre-tax) depending on weather patterns in Britain.

In three of the previous five years, the after-tax income of the client has been less than £20,000.

The client’s mother is dependent on her son (the client) for approximately £9,000 per year support.

The client’s own subsistence needs are approximately £12,000 per year.

The client has more than 10 years’ experience trading investments including commodity futures, stock options, and selling stock short.

The client’s responses to a standard risk assessment questionnaire suggest he has above average risk tolerance.

The client is best described as having a:

a) low ability to take risk, but a high willingness to take risk.

b) high ability to take risk, but a low willingness to take risk.

c) high ability to take risk and a high willingness to take risk.

Answer 21

a) low ability to take risk, but a high willingness to take risk.

Question 22

eturns on asset classes are best described as being a function of:

a) the failure of arbitrage.

b) exposure to the idiosyncratic risks of those asset classes.

c) exposure to sets of systematic factors relevant to those asset classes.

Answer 22

c) exposure to sets of systematic factors relevant to those asset classes.

Question 23

In defining asset classes as part of the strategic asset allocation decision, pairwise correlations within asset classes should generally be:

a) equal to correlations among asset classes.

b) lower than correlations among asset classes.

c) higher than correlations among asset classes.

Answer 23

c) higher than correlations among asset classes.

As the reading states, “an asset class should contain homogeneous assets… paired correlations of securities would be high within an asset class, but should be lower versus securities in other asset classes.”

Question 24

Tactical asset allocation is best described as:

a) attempts to exploit arbitrage possibilities among asset classes.

b) the decision to deliberately deviate from the policy portfolio.

c) selecting asset classes with the desired exposures to sources of systematic risk in an investment portfolio.

Answer 24

b) the decision to deliberately deviate from the policy portfolio.