Chapter 16: The portfolio management process Flashcards
1
Q
Why portfolio management is a continual process?
A
Because financial markets and individual circumstances are ever-changing.
2
Q
What is portfolio approach?
A
the process of securities selection based on their interaction with each other and their contribution to the portfolio as a whole
3
Q
What is the difference between portfolio returns and risk?
A
Return is weighted average but risk is amost always less than avarage risk of individual securities within it.
4
Q
What are the 7 steps of portfolio management process?
A
- Determine investment objectives and constraints.
- Design an investment policy statement.
- Develop the asset mix.
- Select the securities.
- Monitor the client, the market, and the economy.
- Evaluate portfolio performance.
- Rebalance the portfolio.
5
Q
What do they do in step 1 to determine investment objectives and constraints?
A
- First, determine clients’ investment objectives and constraints (ràng buộc).
- Pointed interview questions is a good way
- > Clients’ return and risk objective (whether maximum return or minimum loss)
- Identify risk tolerance is very important.
6
Q
What is the purpose of portfolio management?
A
to ensure that the portfolio generates returns in consideration of the investor’s particular level of risk tolerance -> risk management is important.
7
Q
What is risk of Government issues (less than a year)?
A
Lowest risk, highest quality
8
Q
What is risk of Corporate issues (less than a year)?
A
Highest risk, lowest quality
9
Q
What is the risk of fixed-income securities short-term?
A
low risk, low price volatility
10
Q
What is the risk of fixed-income securities medium term?
A
medium risk, medium price volatility
11
Q
What is the risk of fixed-income securities long-term?
A
high risk, maximum price volatility
12
Q
How is risk of conservative equity?
A
Low risk; high capitalization; predictable earnings; high yield; high dividend payouts; lower price-to-earnings ratio; low price volatility
13
Q
How is risk of growth equity?
A
Medium risk; average capitalization; potential for above average growth in earnings; aggressive management; lower dividend payout; higher price-to-earnings ratio; potentially higher price volatility
14
Q
How is risk of venture equity?
A
High risk; low capitalization; limited earnings record; no dividends; price-to-earnings ratio of little significance; short operating history; highly volatile
15
Q
How is risk of speculative equity?
A
Maximum risk; shorter term; maximum price volatility; no earnings; no dividends; priceto-earnings ratio not significant
16
Q
What are the primary investment components in an investor’s objective?
A
- safety of principal
- Income
- Growth of capital
17
Q
What are the secondary investment components in an investor’s objective?
A
- Liquidity
- tax minimization
18
Q
What should you do as an advisor regarding the primary investment components of your client’s objective?
A
should explain about them and jointly determine the appropriate balance among all objectives. (% basis) -> then translate into categories of the New account application form (NAAF).
19
Q
How is the type of security match with the primary objective (namely 1. safety of principal, 2. Income, 3. Growth of capital)?
A
- Short-term bonds (Safety: best, Income: very steady, Growth: very limited)
- Long-term bonds (Safety: Next best, Income: very steady, Growth: variable)
- Preferred stocks (Safety: Good, Income: steady, Growth: variable)
- Common stocks (Safety: Often the least, Income: variable, Growth: often the most)
20
Q
What is Secondary objective 1—Liquidity?
A
- important for investors who may need money on short notice.
- Most Canadian securities can be sold quickly in reasonable quantities at some price.
21
Q
What is Secondary objective 2—Tax avoidance?
A
- Advisor must consider the effect of taxation.
- Varies depending on whether the returns are categorized as interest, dividends, or capital gains.
- > influences the choice of investments.
22
Q
What is investment constraints? (rang buoc)
A
Constraints may loosely be defined as those items that may hinder or prevent you from satisfying your client’s objectives.
23
Q
What are the factors of investment constraints?
A
- Time horizon
- liquidity requirements
- Tax requirements
- Legal and regulatory requirements
- Unique circumstances
24
Q
What is time horizon in investment constraints?
A
- A major factor
- It is the period spanning the present until the next major change in the client’s circumstances. -> need to completely rebalance their portfolio.
- A client’s time horizon should extend from the present until the next major expected change in circumstances.
25
What is liquidity requirements in investment constraints?
Liquidity refers to the amount of cash and near-cash in the portfolio. The cash component could be higher during certain parts of the market cycle.
26
What is Tax requirements in investment constraints?
- Your client’s marginal tax rate dictates (ra lệnh), in part, the proportion of income that the client should receive as interest income in relation to dividends. Remember that dividends from Canadian corporations are eligible for a tax credit.
The marginal tax rate also guides the proportion that should be invested in preferred shares versus other fixed-income securities, such as bonds. High tax rates can significantly erode the final return on more traditional investments, such as guaranteed investment certificates (GIC). Therefore, clients in a higher tax bracket often seek out the higher returns available from securities.
27
What is Legal and regulatory requirements in investment constraints?
Any investment activity that contravenes an act, law, by-law, regulation, or rule must be considered a constraint. For example, a client who is an insider or owner of a control position at a publicly-traded company must comply with all applicable regulatory guidelines. All firms have compliance personnel and many have legal counsel on staff. You should consult these resources when you have any question about legal issues
28
What is Unique circumstances in investment constraints?
When creating the investment policy, you must consider the unique circumstances specific to your client. Unique circumstances may include such preferences as the desire for ethically and socially responsible investing. For example, some clients may instruct you to ensure that no alcohol or tobacco stocks are purchased to respect their personal convictions
29
What is the second second step of the portfolio management process?
design investment policy statement
30
What is investment policy statement's components?
- Operating rules
- Guidelines
- Investment objectives and constraints
- A list of acceptable and prohibited investments
- The method used for performance appraisal agreed to by the advisor and the client
31
What is the form of Investment policy statement
The statement can be a lengthy written and signed document, or it can be derived from the NAAF in accordance with the Know Your Client rule. Regardless of its level of formality, the investment policy is the result of many complex inputs.
32
What is the third step of the portfolio management process?
Develop the asset mix (select appropriate investments for the portfolio)
33
What do you need to notice when selecting the asset mix?
it is critical that you understand the relationship between the equity cycle and the economic cycle. You must use this understanding to plan the weighting of each asset class. You must also consider the individual characteristics and risk tolerance of the client
34
What are the assets in Asset mix?
- The main asset classes are cash, fixed-income securities, and equity securities.
- More sophisticated assets: private equity capital funds, currency funds, or hedge funds.
35
What is Cash and equivalent in Asset mix?
- includes currency, money market securities, redeemable GICs, bonds with a maturity of one year or less, and all other cash equivalents.
- Purpose: for expenses and to capitalize on opportunities, but is primarily used as a source of liquid funds in case of emergencies.
36
How much cash usually make up in a diversified portfolio's asset mix?
- Usually makes up at least 5%. Investors who are very risk averse may hold as much as 10% in cash. Cash levels may temporarily rise greatly above these amounts during certain market periods or during portfolio rebalancing. However, normal long-term strategic asset allocations for cash are within 5% and 10%.
37
What is Fix income securities in Asset mix?
- Bonds (>one year), strip bonds, mortgage-backed securities, fixed-income exchange-traded funds, bond mutual funds, and other debt instruments, as well as preferred shares (From a portfolio management standpoint).
- Convertible securities are not considered to be fixed-income products in the asset allocation process.
- Purpose: primarily to produce income, but also to provide some safety of principal. They are also sometimes purchased to generate capital gains.
38
What are the methods to diversify Fix income of the Asset mix?
* Both government and corporate bonds can be used in a range of credit qualities, from Aaa to lower grades.
* Foreign bonds may be added to domestic holdings.
* Deep discount or strip bonds can be chosen alongside high-coupon bonds.
39
What are the factors affect the amount of a portfolio allocated to fixed-income securities?
* The need for income over capital gains
* The basic minimum income required
* The desire for preservation of capital
* Other factors such as tax and time horizon
40
What is Equity securities in Asset mix?
- Equities include common shares and derivatives such as rights, warrants, stock and stock index options, equity exchange-traded funds, equity mutual funds, and both convertible bonds and convertible preferred shares.
- Purpose: Mainly for capital gains (through trading or long-term) (Dividend stream may occur but not main purpose)
41
What are other asset classes in Asset mix?
* Hedge funds
* Real estate
* Precious metals
* Collectibles, such as art or coins
* Commodities, such as gold (which is considered a good hedge against inflation)
42
When setting the asset mix, what do you need to study?
The phases of the equity cycle trace movements in the stock market, which include expansion, peak, contraction, trough, and recovery. A study of the equity cycle is a useful approach for a general understanding of stock market movements.
43
What is asset class timing in Asset mix?
- The rationale behind asset class timing is that investors can improve returns by strategically switching from stocks to T-bills, to bonds, and back to stocks.
- In reality, difficult to do so (most investors are unable to determine whether a rise in interest rates is designed to slow economic growth or whether it is pointing to a coming contraction or recession.)
- Also term-to-maturity (ex: if bonds are the best
asset class, then it should make sense to lengthen the term of bond holdings to maximize returns or if stocks are the best asset class, then certain strategies can be implemented to maximize stock market gains if stocks are the best asset class, then certain strategies can be implemented to maximize stock market gains)
44
What is the characteristic of contractions phase In Equity cycle?
- Business cycle: End of expansion through peak, into the contraction phase
- Market condition: Recession conditions are apparent. Interest rates are high
- Strategies: Lengthen term of bond holdings by selling short-term bonds and buying mid-term to long-term bonds. Try to maintain same yield (income). Avoid or reduce stock exposure.
45
What is the characteristic of Trough phase In Equity cycle?
- Business cycle: Late contraction phase to end of contraction phase
- Market condition: The bottom of the business cycle has not been reached, but the stock market has begun to advance because of falling interest rates and the expectations of an economic recovery.
- Strategies: Sell long-term bonds because they rallied ahead of stocks in response to falling interest rates.
Common stocks usually rally dramatically; often, the largest gains occur in the higher-risk cyclical industries.
46
What is the characteristic of expansion phase In Equity cycle?
- Business cycle: End of trough, into recovery and expansion phase
- Market condition: The bottom of the business cycle has been reached. Economy starts growing again, unemployment is falling and businesses are making profits
- Strategies: Increase common stock exposure, given that sustained economic growth generally allows stocks to do well.
47
What is the characteristic of peak phase In Equity cycle?
- Business cycle: Late expansion into peak phase
- Market condition: Economic growth has been sustained; however, this has also led to higher interest rates and the Bank of Canada may be tightening its monetary policy. Short- term interest rates tend to be higher than long-term rates (i.e., the yield curve is inverted).
- Strategies: Reduce common stocks exposure and invest in short- term interest-bearing paper.
The equity cycle peak is generally followed by the contraction phase.
48
What is the problem with the general strategies
They do not account many important variations that occur during an equity cycle. These variations may dramatically affect stock and bond market performance for 12 months or longer.
49
What are the reasons of Changes in the S&P/TSX Composite Index price level?
- Changes in interest rates or economic growth. (These two factors, in combination, generally account for a high percentage of the change in stock market prices)
- The relationships between interest rate trends and economic trends (and therefore corporate profit trends) are of the greatest significance to equity price levels. .
- > these factors are often used together in asset mix models. Interest rates are used by central banks as a policy tool for managing economic growth; therefore, changes in rates tend to lead to changes in economic growth.
50
What is asset allocation?
- determining the optimal division of an investor’s portfolio among the different asset classes (based on the client’s tolerance for risk and investment objectives)
51
What is market timing?
- Portfolio managers and investors may also alter asset allocation to take advantage of changes in the economic environment.
Ex: In the period of rapid growth, portfolio can have heavier weighting in equities and when the market is likely to enter a recession, a heavier weighting in cash or fixed- income securities may generate higher returns.
52
What are the means that portfolio managers use to generate investment returns?
* Choice of an asset mix
* Market timing decisions
* Securities selection
* Chance
53
What is the single most important step in structuring a portfolio?
- Asset allocation.
- An asset allocation strategy is usually specified in the investment policy statement.
- Investment advisors may have the freedom to recommend an array of individual securities but the overall proportion of a client’s portfolio invested in cash, debt securities and equity securities may be fixed.
- Decisions regarding asset allocation depend on the client’s investment objectives and constraints, as well as the returns available from capital markets.
54
What need to be notice when allocating asset?
when seeking to maximize the total return of a balanced portfolio, it is more important to focus on getting the asset group right than to outperform an index or market average within an asset group. This principle is particularly true when capital markets are volatile.
55
How can they determine the appropriate balance among the selected asset classes when doing the asset allocation process?
by investigating the client’s full circumstances to determine an appropriate asset mix.
56
Investment management firms, both large and small, How do they forecast security price?
They often have proprietary, highly sophisticated models to forecast security price.
57
What is the base policy mix (strategic asset location)
- Is the long-term mix that the manager will adhere to through monitoring and, when necessary, rebalancing.
- A limited number of asset mixes are analyzed to determine the expected return of each combination. In consultation with the client, the manager then reviews the range of outcomes and chooses the most desirable allocation.
- This strategic allocation determines the long-term policy asset mix.
- The base policy mix does not necessarily imply a buy-and-hold strategy because shifting values of the asset classes will cause the allocation to drift from the strategic mix.
58
Why do they need the step ONGOING ASSET ALLOCATION After the asset mix is implemented?
- the asset classes will change in value along with fluctuations in the market, and dividends and interest income will flow into the cash component. As a result, the asset mix will also change.
- > Should act before the mix gets too far out of balance, while remaining conscious of transaction costs. You would typically specify that an asset class must move more than a certain percentage—perhaps 5%—before rebalancing
59
What is dynamic asset allocation?
- adjusting the asset mix to systematically rebalance the portfolio back to its long-term target or strategic asset mix. Rebalancing may be necessary in the following situations:
• There is a build-up of idle cash reserves (dự trữ tiền mặt nhàn rỗi), possibly from dividends or interest income cash flows that have not been reinvested.
• There are movements in the capital markets causing abnormal returns. (ex: crisis).
- The portfolio manager follows a policy that places a limit on the degree to which each asset category can drift (trôi dạt) above or below the long-term target mix. Rebalancing becomes necessary once an asset category moves above or below this range.
60
When should we use the dynamic approach?
- it enhances returns in a weak market period because the manager purchases under-performing asset classes at reduced prices. (and dampens returns in a strong market because the portfolio manager is reducing the strongest-performing component)
- Suitable for a more risk-averse investor (retired individual). The tax situation of the investor should be reviewed carefully, because active management will result in more realized capital gains and losses.
61
What is tactical asset allocation?
The investment policy statement may indicate a particular long-run balance of equities to fixed-income, but this strategic asset allocation need not be rigid (cứng rắn). The statement may also allow for some short-term, tactical, deviations (sai lệch) from the strategic mix. This strategy, called tactical asset allocation, allows you to capitalize on investment opportunities in one asset class before reverting back to the long-term strategic asset allocation
62
What is the difference between dynamic approach and tactical asset allocation?
The strategic allocation is considered the long-term strategy, whereas tactical deviations are short-term strategies.
63
What is example for tactical asset allocation?
If the bond market is depressed and poised for an upswing, you might overweight the portfolio in fixed-income products well over the strategic asset allocation for fixed-income. After a few weeks or months, having profited from this move, you would then move back to the long-term strategic asset allocation. In this way, you can exercise your market timing skills while investing for the expected return indicated by the strategic mix.
Though not a passive strategy, this approach is only moderately active, and is appropriate for the long-term investor who is interested in market timing.
64
What is INTEGRATED ASSET ALLOCATION?
Strategic, dynamic, and tactical asset allocation strategies all include consideration of capital market expectations, but they do not all account for changes in capital markets or client risk tolerance. Integrated asset allocation is an all-encompassing strategy that includes all of these factors. The other asset allocation techniques are partial versions of the integrated approach
65
What is step 4 of portfolio management process?
- SELECT THE SECURITIES
| - Base on previous chapter and volume 1
66
What is step 5 of portfolio management process?
MONITOR THE CLIENT, THE MARKET, AND THE ECONOMY
67
What are the key factor of The monitoring process?
* Changes in the investor’s goals, financial position, and preferences
* Expectations for individual securities and capital markets
* Industry trends and the overall economic climate
68
What is monitor the client?
It is critical that you stay informed about your client’s objectives and that you update the client profile regularly. The NAAF sets out the original profile of income, assets, investment knowledge, and goals. You must monitor the client for changes in these areas. As well, you must monitor the client for changes in tolerance for risk, need for liquidity, need for savings, and tax brackets.
If any significant changes occur, you should complete an amended NAAF.
69
What is monitor the market?
Capital markets evolve constantly to reflect changes in government and central bank policies, economic growth or recession, and sectoral shifts in prosperity within the economy. You must be constantly aware of the direction of monetary policy, forecasts for gross domestic product and the inflation rate, shifts in consumer demand and capital spending, and the potential impact of all these factors on the strategic asset mix or on individual holdings.
Your challenge is to anticipate change and systematically adjust the portfolio to reflect both return expectations and the objectives of the client. In adjusting a portfolio, you should follow the same methodology you used when constructing it.
70
What is monitor the economy?
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The asset mix decision is complex because it involves an analysis of all capital markets. Virtually all information that may affect each asset class must be incorporated into the decision-making process. The scope of this material includes expected activities in the private and public sectors (both nationally and internationally), government policies, corporate earnings, economic analysis, existing market conditions, and the forecaster’s interpretation of the data.
Because of the complexity of the data and the subjectivity in interpretation, it is very difficult to make an accurate prediction about the magnitude of change in a particular asset class. Therefore, forecasts are sometimes expressed in ranges, with a minimum and maximum level. This method reflects the unpredictability of capital markets and indicates the degree of risk anticipated.
The expected total returns for each asset group are calculated by adding the expected annual income to the expected capital gain or loss for each group.
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71
What is step 6 of portfolio management process?
EVALUATE PORTFOLIO PERFORMANCE
72
How EVALUATE PORTFOLIO PERFORMANCE?
- You can estimate the ranking of most individual investors most easily by comparing their performance with the averages shown in one of the surveys of funds appearing regularly in financial publications. Because many different funds are measured in the surveys, you can compare both the total return and the component returns of the client’s portfolio. For example, the equity component of a diversified portfolio can be compared with the equity funds shown
- Managers are often measured against a predetermined benchmark that was specified in the investment policy statement. One common benchmark is the T-bill rate plus some sort of performance benchmark; for example, the T-bill rate plus 4%. On portfolios that have low turnover to avoid capital gains taxes, performance against the market benchmark may not be appropriate. What investors are interested in is the protection and growth of their purchasing power.
73
What are the step of evaluate fortfolio performance?
- MEASURING PORTFOLIO RETURNS
- CALCULATING THE RISK-ADJUSTED RATE OF RETURN
- OTHER FACTORS IN PERFORMANCE MEASUREMENT
74
How to measuring portfolio returns?
Total return = (increase in the market value) / beginning value *100%
75
What affect the return of portfolio?
The return on a portfolio is affected by both the amount and timing of portfolio cash flows
76
What is CALCULATING THE RISK-ADJUSTED RATE OF RETURN?
- Is a measure of how much risk is involved to produce a return (can use for individual securities as well as to portfolios)
- The Sharpe ratio is used by mutual fund companies and portfolio managers to compare the return of the portfolio to the riskless rate of return, thereby taking the portfolio’s risk into account.
77
Why do you need to CALCULATING THE RISK-ADJUSTED RATE OF RETURN?
Simply comparing the returns of two portfolios to measure performance does not provide an adequate assessment. You must also factor in the risk assumed to earn those returns.
78
How to CALCULATING THE RISK-ADJUSTED RATE OF RETURN?
```
Sp = (Rp - Rf)/ Omega p
Sp: Sharpe ratio
Rp: Return of the portfolio
Rf: Risk-free rate
Omega p: Standard deviation of the portfolio
```
79
How does risk-adjusted rate of return work?
- Compare return per unit of risk.
- If sharpe ratio positive -> risk-adjusted rate of return that is greater than the risk-free rate (A skilled portfolio manager should able to achieve that)
- If Sharpe ratio negative -> risk-adjusted rate is lower than the risk-free rate. -> the portfolio’s manager earned a return less than the risk-free return
- When comparing risk with a benchmark, Sharpe ratio can be compared to the Sharpe ratio of the applicable benchmark. The larger the Sharpe ratio, the better the portfolio’s performance -> outperformed the benchmark.
- A portfolio’s Sharpe ratio that is smaller than the benchmark’s signals underperformance.
80
what are OTHER FACTORS IN PERFORMANCE MEASUREMENT?
Dissimilarities in portfolios also make it difficult to get an accurate performance comparison. Each portfolio may have different risk characteristics or special investor constraints or objectives -> adjust the conclusion with these dissimilarities to accurately reflect the impact of the variables.
The large number of variables in the management and measurement of portfolios make it difficult to assess investment performance. Regardless, in comparing performance, you should be concerned primarily with longer- term results. Those results best measure your management ability in all phases of the business cycle. It is also important to have consistent results and performance trends over several previous measurement periods.
81
What is step 7 of portfolio management process?
REBALANCE THE PORTFOLIO
82
what is REBALANCE THE PORTFOLIO?
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This step is closely related to monitoring and performance evaluation. As financial markets and values evolve, their relative weights within client portfolios change -> the actual weight of an asset class in the portfolio becoming significantly different from the strategic weight established to meet the client’s long-term goals. Rebalancing involves reallocating assets back to their originally intended portfolio weights by selling securities that have performed well and buying others that have done poorly.
During rebalancing, keep in mind the method of developing a strategic asset mix and the dynamic and tactical approaches to asset allocation.
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