Chapter 10 - Principles Of Investment Planning Flashcards
Pragmatic approach to asset allocation - what is it (return and data) and use what to determine what and influenced by and therefore
Strengths and weaknesses of MPT & pragmatic approach;
- not what and criticism, crisis but can be what and bias and subjectiveness
Assumptions and weaknesses in optimisation models (MPT);
- risk - returns and SD
- historical data - usual weakness
- costs - why high
- forecasts - what may be inaccurate
- implementation - asset use and modelling process
Pragmatic - use long-run average rate of returns and historical data from relevant class. Use forward-looking judgements to determine port weightings. Judgements influenced by historic data but are subjective.
Strengths and weakness of MPT & Pragmatic approach
- MPT not robust and. Heavily criticised
- do not work during crisis
- can be said to work during non crisis and if clients understand this then fine
- pragmatic approach subject to bias due to subjectiveness of fund choice
Assumptions & weaknesses in optimisation models (MPT);
- Risk - assume returns fall into normal standard deviation but not always the case
- Historical data - may be a poor guide to future
- costs - high transaction costs due to rebalancing
- forecasts - for risk, return or correlation may be inaccurate
- Implementation - may use specific assets that differ from ones used in modelling process
Stochastic portfolio modelling - applies what to generate what using what
- takes what and assumes what is affect how and this generates what and
- outcome plotting and path
- assumptions against what model and small change in what leads to what
- Applies mathematical technique to generate probabilistic assessments of volatility and returns. Does this by specifying number of factors.
- Takes an initial set of assets, assumes behaviour is affected in a specific way by a change in a variable and this generates thousands of scenarios using randomised combinations of variables.
- Outcomes are plotted and most common one is taken is most likely path of portfolio.
Even more dependant on assumptions than optimisation models. Often a small change in one variable leads to large outcome.
Strategic asset allocation - why do most focus on this;
- conformity and switches
Tactical asset allocation;
- range of percentage where and deviation from what regarded as? And adjusted when?
- monitor
- proportioning and conventional asset allocation
- applied by who
- appropriate portfolio facts (3)
- why may questionnaires by poor method (2)
Most focus on strategic because;
- should conform to specific portfolio due to ATR results & requirements
- switches between asset classes likely to incur loss than generate profit
Tactical asset allocation;
- give a range of percentage of capital in each asset class e.g. 60-70%, any deviations from 65% regarded as tactical move and adjusted with the market perception.
- must monitor portfolios for this reason
- can also use models with proportion of capital used for conventional asset allocation whilst the rest kept free for tactical movements. Can result in a higher volatility.
- often applied by discretionary fund managers
To create appropriate portfolio must take into account risk tolerance, capacity and target returns. Risk tolerance changes over time and questionnaires may only be snapshot of that particular moment - regular assessment needed.
Assessment of risk capacity - gives indication of what (drawdown)
- if risk profile not used still require what (time, return and loss) for inputs for what.
Creating a portfolio;
- historic - used for
- adjusted historic - take into account what of what over when and means they can adjust what
- stochastic - how generate model portfolio
Investment of risk capacity will give adviser indication of investment drawdown i.e. maximum historical loss incurred on asset mix in a given timeframe.
If risk profiles not used, still require timeframe, annualised target return and max loss as inputs for asset allocation. Can create a portfolio in the following ways;
- Historic- using historic data for return, risk and correlation
- Adjusted historic - taking into account historic ranges of returns and volatility over relevant time periods means they can adjust return and volatility expectations.
- Stochastic - use a model tool to input returns, vol and time period and generate model portfolio.
Whichever chosen, needs to explain why particular model has been chosen.
Portfolio construction - Top down investment - steps;
- determine what, weightings, fund selection, globalisation and correlations, portfolios created what and if compared to index the manager doe what and divergence away means and rules.
Bottom up investment management;
- benchmarks, stock selection and volatility
Fund management styles;
- value - value and price of businesses
- GAARP - advantage and premium and used by?
- Momentum - trends and opinions and used by?
- Contrarianism - trends and who?
Top-down investment management three stages
- determine AA in each of worlds major investment regions
- choose the sector weighting’s
- decide on stock to select within favoured sections
- however globalisation means greater correlation of equities and funds around the world
- portfolios are often created ‘benchmark aware’ and if a portfolio is compared with an index, the manager will take account of stock weightings in the index. Any divergence away from these weightings represents risk.
- usually follow set of house rules
Bottom up investment management
- pay no attention to index benchmarks
- select stocks based on own criteria
- can be more volatile than top down method
Fund management styles;
- Value - using analysis, can identify businesses whose value is greater than the price placed on them by the market. Long term position
- GAARP - based on finding companies with long term sustainable advantage in terms of franchise, management and technology. Premium price for premium quality. Is used by active growth managers
- Momentum - have to be ahead in the latest swings of opinion and sector rotation is one example. Used by middle of the road managers
- Contrarianism - high returns going against trends and found in hedge fund managers.
Portfolio construction - use of derivatives and hedging - derivatives used to separate what from what (beta and alpha), fund can lock in returns how and example (japan)
Structured products;
- capital risk and term, type of risk, hard and soft protection and accommodation
Common to use these and latest trends use derivatives to separate the market related return (beta) from specific return (alpha). Or fund may choose to lock in positive returns by purchasing put options thus lowering potential loss. E.g. buy Japanese shares but sell short market index in future - profit if securities perform better than index.
Structured products;
- limits capital risk for fixed term
- all involve counterparty risk as derivatives are used to secure returns
- some SP give hard protection whereby a given return is guaranteed or soft protection where capital is at risk
- difficult to accommodate in asset allocation framework
Fund selection - fund objective - influenced what
Cost & charges - passive and active fund charges, OCF and doesn’t include, performance, total cots and MIFID2 four main components of fee breakdown.
Strength and rep of management group;
- fashionable funds and manager retention
Type and structure of fund;
- suitability, volatility of open and closes ended, gearing and fund of funds
Fund objective - influences what sector and fund to invest in.
Cost & charges - AMC for passive funds usually .2-.75% and active funds .75%-1.75%
- OCF usually between 1-2% and does not include initial charges, exit costs and dealing costs
- Performance fees
- total cost of ownership - any other fees e,g, platform charge
- MIFID2 requires firms to provide breakdown of all costs and charges into four main components - ongoing, one-off fees, incidental and transaction.
Strength & rep of management groups
- groups offering fashionable funds to attract AUM may suffer rep damage
- some groups may have trouble keeping managers.
Type and structure of fund;
- certain types may be more or less suitable for portfolios;
- open ended less volatile than close ended, which are more appropriate for illiquid asset classes.
- gearing and leverage amount of fund
- multi-manager and fund of funds - assemble portfolio of funds leaving little work in fund selection
Skill and reputation of fund manager also a key factor
Planning tax wrappers - bonds - more attractive for who where…
Offshore bond - how does it grow more but this is offset how and good for who
Discretionary fund management services - need to be careful not to trigger
Recommendations & suitability;
- start recommendations by explaining what and how used, returns and vol, then cover what (funds (2), wrapper, review and costs)
UK life assurance bonds - more attractive to higher rate and additional rate where investments generate income rather than growth.
Offshore bond - not subject to UK tax so should grow more than UK bond although this may be offset at encashment.
- net returns tend to be lower than onshore and good for those who expect to be non-taxpayers in future.
DFM;
- if assets held in clients name could trigger CGT so need clear comms
Recommendations and suitability;
- advisers using asset allocation will start recommendations by explaining risk profile and tolerance and how this has been used to gen asset allocation
- should indicate range of expected returns and volatility.
- should then cover method of selection of funds, summaries on features of funds selected, explanation on choice of tax wrapper and platform, freq of review and ongoing advice basis and costs.
Investment policy statement - fca requires what (objectives) and affect on portfolio
Investment objectives categorised as;
- capital growth priority, income priority and balance
Factors affecting investment strategy;
- legal constraints (trustees), nature of liabilities (DB relevance), cashflow (positive can take what view + accept) and taxation (returns and tax)
FCA requires authorised organisations to agree investment objectives with their clients. These objectives are principals factors or constraints on how the portfolio will be managed.
- investment manager may have house rule for risk level of fund when choosing.
Investment objective can be categorised as;
- Capital growth priority - income requirements are not a prime concern & emphasis should be placed on long term growth
- income priority - income considerations come first and may mean capital erosion.
- balance between two - common sense
Factors affecting investment strategy;
- legal constraints - limitations arise where portfolio being managed for trustees.
- nature of liabilities - relevant for DB funds where liabilities are long term as there could be significant rise in inflation and salary rates rising faster than prices.
- cashflow - with a positive cashflow manager can take a long term view on certain investments and accept short term uncertainty in return for long term profits.
- taxation - try to get best returns for least amount of taxation.
Portfolio reviews - client reporting - frequency, items reported (sales, value and statement including income, interest, divs, cashflow, commentary, returns and recs)
Timing and frequency - MIFID2 min frequency, when must report to clients and MIFID required firms to provide what
Contract notes;
-when given and gives info on (5, straightforward)
Summary of portfolio valuation;
- value when, cash/stock, withdrawals, returns and value
Details of holdings;
- info provided on what (holdings, price, cost, income and yield)
- frequency of reporting must be agreed in writing
- items reported are typically purchase and sales, portfolio valuations and cash statements including income, interest received, dividends collected and cash outflows, general market commentary, investment return and recommended changes in investment strategy.
Timing and frequency of report;
- MIFID2 min frequency is three months
- must report to clients if portfolio falls more than 10% in single period
- MIFID2 requires firms to provide breakdown of all costs and charges impacting their investments.
Contact notes;
- prepared and given after sale or purchase
- gives info on bargain date, name, number of shares bought, amount of charges and settlement date
Summary of portfolio valuation;
- shows value at last report, addition of cash or stock, withdrawals, returns or losses and current value
Details of holdings;
- info provided on holding and description, market price and value, cost and gross income and div yield.
Portfolio review- rebalancing portfolio - churning and underperforming investment
Reasons for switch include - objectives/circumstances, market, instruction, performance, takeover and shareholding
A switch of investments can arise when full or partial encashment;
- churn is a switch done primarily for benefit of a adviser firm and breaks FCA rules
- underperforming investment should be replaced via switch if demonstrated in best interests of client after accounting for tax and transaction costs.
Reasons for switching include;
- change in clients objective or circumstances
- market conditions adversely affect the original investment or weightings
- client gives clear instruction
- underperformance over medium to long term period
- value returned as part of takeover or restructure.
- single shareholding in company constitutes high wealth then switch necessary despite any costs to lower risk
