Chapter 13 - Portfolio construction (15 questions (included with chapter 12)) Flashcards
Now that we have all the client information, their objectives and risk profile, how do we go about constructing portfolios for them?
In this chapter, we’ll start with the measurements of risk and return and see how these are used to build a portfolio for a customer. We’ll also explore the principles of diversification and correlation, and the role they play in reducing risk.
We’ll look at Modern Portfolio Theory (MPT) and all its constituent parts, and the implications of the Efficient Market Hypothesis (EMH) and behavioural finance.
Now that we have all the client information, their objectives and risk profile, how do we go about constructing portfolios for them?
In this chapter, we’ll start with the measurements of risk and return and see how these are used to build a portfolio for a customer. We’ll also explore the principles of diversification and correlation, and the role they play in reducing risk.
We’ll look at Modern Portfolio Theory (MPT) and all its constituent parts, and the implications of the Efficient Market Hypothesis (EMH) and behavioural finance.
13.1.1: Modern portfolio theory (MPT)
Modern Portfolio Theory is all about the way portfolios of investments can be structured to maximise returns and minimise risks.
investors are risk-averse and would choose a less-risky investment if they were given the choice of two that offered the same return.
What are mean, median & mode used for?
Different ways to calculate averages
Mode = most
Median = middle
Mean = Add all up and divide by how many there are
The mean is the one that is used within investment analysis to understand the average return that has been achieved.
So, what is ‘normal distribution’?
It means that most of the examples in a set of data are close to the ‘average’, whilst relatively few examples tend to be at one extreme or the other.
This can apply to all kinds of data, such as people’s heights, blood pressure results, the marks scored on J12 or, for our purposes, the returns on an investment.
The mathematical measure of how tightly the data is gathered around the ‘mean’ is known as standard deviation.
When the results are pretty tightly bunched together, and the bell-shaped curve is steep, the standard deviation is small.
Most results are pretty near the average.
When the results are spread apart, and the bell curve is relatively flat, that tells you that you have a relatively large standard deviation.
So, the returns have tended to vary quite a lot.
Standard deviation in relation investing
SD measures how widely the actual return from an investment varies arounds its average or median
The greater, the more it varies, which means higher volatility
In ‘normally distributed’ data…
o 68% of outcomes will be within 1 standard deviation of the mean
o 95% of outcomes will be within 2 standard deviations of the mean o 99.7%+ of outcomes will be within 3 standard deviation of the mean
AND
Standard deviation measures how widely the actual return from an investment varies arounds its average or median
The greater, the more it varies, which means higher volatility
The BTS fund has a mean of 9% and a standard deviation of 2%.
1 standard deviation it could fluctuate between 7-11% = 68% of the time we would expect this return
2 standard deviation it could fluctuate between 5-13% = 95% of the time we would expect this return
3 standard deviation it could fluctuate between 3-15% = 99.7% of the time we would expect this return
IMPORTANT = Standard deviation is an acceptable measure of risk ONLY if the returns are ‘distributed normally’.
The issue here is that returns may not always follow a normal distribution. The peak may be skewed to the left (positive skew) or the right (negative skew), which can means that risk can be over or under estimated. The technical term for this skew is kurtosis
13.1.1b: Systematic (market risk) and non-systematic risk
What is Beta?
It tells us how much a security or portfolio will move in line with the market.
The market has a beta of 1 as it is the benchmark against which a security’s beta is measured.
An asset’s beta will show the extent to which that asset moves (up or down) in line with changes in the market in which that security fits.
Systematic (market risk) = unavoidable
Non-systematic risk = Can be reduced through diversification
The efficient frontier
It explains the relationship between the return that can be expected from a portfolio and the portfolio’s risk.
Shows the best return that can be expected for any given level of risk. An investor will want their investment to be as close to the efficient frontier as possible as it means that their portfolio has performed the best it can for the level of risk taken
This is used alongside the modern portfolio theory
The efficient frontier is not without its critics and limitations:
It assumes that investment returns follow a ‘normal distribution’ pattern, and that standard deviation is the correct measure of risk.
For some investors, ‘attitude to risk’ may not be their only or key consideration. For example, they may have ethical preferences that mean some portfolios are unacceptable to them.
It works on historic data and, as we know, past performance is no guide to future performance.
The model takes no account of charges within the investments.
It is difficult to get sufficient data to plot the graph.
Some securities are more sensitive to systematic risk.
What is the 13.1.2: Capital Asset Pricing Model (CAPM)
This is an extension of MPT
CAPM states that ‘in order to consider a risky asset, an investor would want a return that equals the risk-free return plus, as a form of compensation, an additional return that takes account of the risks taken’.
To understand CAPM, we need to consider that all investments have a notional element of risk-free return (typically cash) and a notional element of risk-based returns (other asset classes).
CAPM measures the riskiness of a security by comparing it to the market. It uses beta (β) as part of its measure.
REMEMBER: Markets have a Beta of 1. The investment that you compare the market to has a Beta that varies (the market is the benchmark)
LESS volatile than the market = Beta of less than 1
MORE volatile than the market = Beta of more than 1
If a security has a beta of 1, it has, historically, matched the market’s volatility exactly.
The higher the beta of a security; the higher the risk and the higher the return investors should expect, so that they are rewarded for taking the added risk. This is according to CAPM
Beta of 0.2 = 80% less volatile than the market = If market falls by
10%, the shares are likely to fall by 2% and vice versa
This is based on part data and is not a guarantee
13.1.2b: CAPM formula
ASSET ALLOCATION is responsible for almost 90% of the variability between performance of differing portfolios
Difference between strategic and tactical asset allocation
A fund may choose their asset allocation percentages and stick to those percentages; rebalancing the portfolio regularly to ensure that the percentages are maintained. This is known as strategic asset allocation.
Other funds may allocate the asset classes within a range, to give the fund manager a bit of scope to take advantage of market opportunities by being overweight in one asset class and underweight in others at any one time. This is known as tactical asset allocation.
Look at 13.7. It is a rebalancing question
What are strategic ranges?
Tactical asset allocation is a more hands-on approach than strategic asset allocation.
It involves the short-term variation of the asset allocation of the fund (within pre-defined ranges) in order to take advantage of market changes or fluctuations.
Investment managers seek to counterbalance the defensive tendencies of asset allocation methodology by applying tactical asset allocation.
More often than not, tactical asset allocation models are present in discretionary managed portfolios rather than advisory ones.
A fund manager is ‘applying their skills’ far more in a tactical model than in a strategic one.
With tactical asset allocation, you start with a base allocation, such as the 60% shares, 30% bonds, 10% cash allocation we used in the strategic example, but have a range of (for example) plus or minus ten or twenty percent within each asset allocation.
These are known as strategic ranges.
The fund manager must ensure that she stays within the bands, so if we assume 20% bands, in our example shares could go anywhere between 40% and 80%, bonds anywhere between 10% and 50%, and cash zero to 30%.
So, rather than following a static allocation and rebalancing on a periodic basis, the manager can choose to overweight or underweight asset classes, (basically being at the top or bottom of the bands at any one point) based on an assessment of the value of the asset.
If the fund manager was feeling bullish on equities and bearish on bonds, then they could easily switch the asset allocation from 60,30,10 to 70,20,10.
Tactical asset allocations put far more onus on the adviser or fund manager to monitor the market and vary the portfolio to suit market conditions.
What are closet trackers?
Actively managed funds that basically just tracked an index due to the fund managers selection. Regulators forced them to pay compensation to the investors who had paid higher charges for the active management
13.5.1b: Active bond strategies
There are 3 types of active bond strategy:
Riding the yield curve
Anomaly switches
Policy switches
13.5.2b: Passive bond strategies
Fund managers don’t just include bonds in their client’s portfolio to benefit from a rise in their price (although of course that is an added bonus!). Sometimes they are using them to help meet their client’s investment objectives to match a future liability.
There are three bond strategies that you should be aware of.
Cash flow matching o As the name suggests, this is where bonds are purchased where either the redemption proceeds or the coupons match future liabilities.
o This could simply be achieved by buying a bond whose maturity matches that of a future liability.
o A bullet strategy (single bond) or a ladder approach could be taken. With the ladder strategy, a series of bonds with different maturities are purchased and the proceeds used for the future liabilities. Say for example you had school fee payments to make for the next 5 years; you could buy a 1-year, 2-year, 3-year, 4-year and 5-year bond using the proceeds when each bond redeems to pay that year’s fees.
Duration matching or immunisation
o This is another term for hedging interest rate risk.
o It ensures that the duration of the portfolio’s assets matches the duration of the future liabilities to ensure that the value of a portfolio is protected against changes in interest rates.
Barbell strategy
o This is another passive strategy, whereby the duration of a liability is matched using bonds with a maturity either side of the maturity of the liability.
o For example, a 7-year liability can be matched by holding 5-year and 10-year bonds.
o This strategy will require a greater amount of rebalancing than a bullet strategy.
Horizon or combination matching
o This isn’t a separate strategy. It is more a combination of cash flow matching and immunisation.
o The portfolio cash flow matches short-term liabilities and then immunises the remaining liabilities.
What are core-satellite strategies?
As there are different views on which is best, active or passive, there are funds that incorporate both strategies!
With core-satellite strategies, you could have a core, for example 80% of the fund, indexed to minimise the risk of underperformance.
Then the remainder could be invested in a number of specialist actively managed funds, or individual securities, known as satellites.
Many different management styles can be combined in this way, such as value, or momentum investing, along indexation or buy and hold cores.