Chapter 8 (8 marks) – The Principles Of Investment Planning Flashcards
Key info to remember
What is an ‘optimised portfolio’ and how do you create one?
An optimised portfolio = A portfolio that is expected to deliver the highest return for the level of risk. It is the most efficient it can be for risk level
Its based off of the Modern Portfolio Theory (in chapter 3) - ie cust will not take risks that they don’t need to when trying to achieve their investment objectives so their portfolio should lie on the ‘efficient frontier curve’
A portfolio is deemed to be optimised if it sits on the ‘efficient frontier’ curve. SEE IMAGE. A rational investor will only ever hold a portfolio that lies on the frontier as this is ‘optimised’ and most efficient for their risk level
The theoretical approach to asset allocation aim is to create optimised portfolios and is based off of these theories
There are two main approaches to asset allocation
What are they and what do they mean?
Theoretical approach (seen in chapter 3 Modern Portfolio Theories)- It aims to create ‘optimum portfolios’ shown by whether it lies on the efficient frontier curve. - uses mathematical analysis
Pragmatic approach - spreads money over different asset classes but, rather than using analysis to arrive at the best portfolio for a risk profile like with the TA. It simily just compares each asset class’s long-term performance. Less technical. Uses historical data
Look at image
This is a ‘correlation matrix. What is this and how is it used. And what does this table tell us about those assets?
It shows how an asset contributes to the risk-return profile of a portfolio by looking at its correlation with other assets in the portfolio
This is one of the mathematical tools used when using the Theoretical Approach to asset allocation when trying to create the optimised portfolio for the client
WHAT THE TABLE TELLS US:
Looking at Asset A, the first asset you come to is Asset A. This is the same asset, so it is 100% correlated so can be ignored for comparison purposes. Effectively the 100% correlation is decimalised to show 1.0.
You then come to Asset B which is effectively 50% correlated (shown as 0.50).
Asset C is 75% correlated (shown as 0.75).
Asset D is 25% correlated (shown as 0.25).
OK, but again… what does this tell us?
Assets A and C have the highest correlation at 0.75. This means these assets are likely to be similarly affected by market conditions be they good or bad.
Assets A and D have the lowest correlation at 0.25 which means they are less likely to see their returns move in parallel with each other.
An adviser may be considering including two of the four asset classes shown in the portfolio, and can use the table to help him choose which two this should be.
Lower volatility = More diversification = more negatively correlated assets
What are the risks associated with trying to achieve an optimised portfolio
Uses assumptions
See image for weaknesses
See image
What does this table show you. What assets will you want to include in your portfolio for highest diversification?
Assets A and C have the highest correlation at 0.75. This means these assets are likely to be similarly affected by market conditions whether good or bad.
Assets A and D have the lowest correlation at 0.25 which means they are less likely to see their returns move in parallel with each other.
You want assets A and D to achieve higher diversification as negatively correlated assets = higher diversification
What is Stochastic modelling?
It is an alternative to plot the different risk levels of portfolios to the ‘optimisation models’
However, it uses many more assumptions than optimisation models
HOW IT WORKS:
What a stochastic model does is:
Set up a set of standard assumptions, including ‘rules’ such as:
if inflation goes to ‘x’ equities will increase by ‘a’%
if inflation goes to ‘x’ bonds will move by ‘b’%
etc
This creates many possible combinations . These assumptions are then applied to a particular asset allocation. You then end up with 100s or 1000s of ‘possible’ returns for
the portfolio. The results are then plotted graphically as seen in image.
There will be some extreme outcomes that are statistically unlikely and a group of very close outcomes which are statistically much more likely to happen as can be seen in the image.
In a single portfolio, can you have both Strategic and tactical asset allocation being used?
Yes
See image
See image. This is a portfolio. What approach to asset allocation is being used here?
tactical asset allocation as ranges are being used
Strategic Asset Allocation is when the portfolio is fixed in its allocation. For example, 60% cash, 30% fixed interest and 10% equities, not ranges
Remember, a combo of both can be used in a single portfolio. SEE RIGHT IMAGE
The Modern Portfolio Theory implies that a developed market like the London stock exchange is efficient. True or false
True
As a reminder, this means that:
there are no restrictions on dealing.
information moves efficiently between investors.
This should mean that, at any time, the price of an asset represents its true price, and it should be impossible to ‘time the market’ in a way that can provide a profit.
The advisor has decided on the asset allocation model that they will use, ie tactical asset allocation with a theoretical approach (this is something I have made up, check this is correct)
What is the next step
They will then actually choose the individual investments. This is where the portfolio is constructed
What is the Top down approach to portfolio construction?
Many geographical-based portfolios adopt a ‘benchmark-aware’ approach nowadays
What is this?
Where the portfolio manager (who creates the portfolio) will tend to ‘mirror’ the weightings of a benchmark or index to avoid risk and bad performance from their portfolio and therefore looking bad.
This is because of Globalisation, where assets have become more positively correlated and therefore influenced by the same factors and to avoid this managers tend to benchmark
By benchmarking, their is less risk that his portfolio’s performance will preform badly when compared to the benchmark or index
See both images:
By not benchmarking, Chester will be more scrutinised when his portfolio is compared.
He has added risks for himself and for Valentino and Valentino must appreciate the extent of this in agreeing to Chester’s recommendation
BENCHMARKING APPLIES TO THE TOP DOWN APPROACH TO PORTFOLIO CREATION
What is the Bottom up approach
to portfolio construction
What does it stop fund managers from doing?
SEE LEFT IMAGE FOR TOP DOWN APPROACH
SEE RIGHT IMAGE
Opposite of top down
Where stocks are chosen first and this then decides the geographical location etc depending on where the stocks are
It stops the portfolio manager from benchmarking
SEE LEFT IMAGE FOR TOP DOWN APPROACH AND RIGHT IMAGE FOR BOTTOM DOWN APPROACH TO PORTFOLIO CREATION
They are opposite
Top down is more traditional
Bottom down stops benchmarking
The way a fund manager makes his selections will be a personal or a ‘management group’ decision, but it will always affect the way the portfolio is structured.
This is one of the reasons why a change in manager is often so well-reported in the financial press.
What will the new manager do? What are the implications to asset allocation and performance?
Different management styles will affect the selection of stocks.
The 4 main styles that managers have are typically:
Value
Growth at a reasonable price
Momentum
Contrarianism
Tell me about each
Value -
Finds undervalued shares and keeps them over long term (goes against MPT)
Growth at a reasonable price -
Charges more but get more for your money. Based in long term
Momentum -
based off investor sentiment and trends. Often used by average managers
Contrarianism -
goes against trends. Used by hedgefund managers
for context: Most successful managers develop their own style that will broadly align to those listed above. Multi-style approaches are increasingly common.
An alternative to the use of investment funds is structured products
structured products can have either hard protection or soft protection
Tell me the difference
(look back at chapter 6 if u cannot remember what structured products are)
Hard protection - Capital is not at risk. Investor will not lose anything if investment value falls.
Soft Protection - Capital is at risk if value decreases past a certain point say 20%. Ie, in this example, capital is returned if investments don’t fall more than 20% but if it does fall more, say 25%, it isnt returned
Structured products are considered ‘low risk’ and can be used to balance other higher risk investments in arriving at an overall strategy for the customer. They are difficult to accommodate within a conventional asset allocation framework.
Counter party risk is there because structured deposits use call options as part of its structure and obv if the option writer fails then the contract and guarantee is basically lost like with lehaman brothers
Portfolio managers have literally thousands of actively managed funds to choose from, making selection a tricky process.
They therefore have several methods of filtering the available funds
Their filtering is based on many factors such as: see image
Tell me about using the funds objectives as a filter
All the 1000s of actively managed funds can be filtered down by separating them into their respective objectives
For example: Some may favour investment in equities that pay good dividends, whilst others may favour companies that offer good growth potential.
The portfolio manager will look at the clients objectives and decide from there
NOTE:
SIMIPLY looking at the Investment Association (IA) sectors (in chapter 6) is not enough to distinguish between fund objectives. See example above. These are funds that are in same sector but with different objectives.
Portfolio managers have literally thousands of actively managed funds to choose from, making selection a tricky process.
They therefore have several methods of filtering the available funds
Their filtering is based on many factors such as: see image
Tell me about using the costs and charges as a way to filter down funds
All the 1000s of actively managed funds can be filtered down by looking at their costs and charges
These can be very difficult to understand and evaluate but the main charges that apply are: SEE IMAGE
A portfolio manager may separate funds into what they deem has low performance fees for example or ones with a certain range in annual management charges
NOTE: There are generally no initial fees nowadays
Questions on charges are inevitable in R02 and it is not uncommon to get a question about initial fees, ongoing charges fees and performance fees.
Questions on the various charges on investments are inevitable in R02 and it is not uncommon to get a question about initial fees, ongoing charges fees and performance fees.
LOOK AT FLASHCARD 14 FOR ALL CHARGES POSSIBLE
MAIN CHARGES APPLICABLE TO INVESTMENTS. Learn this as questions that include charges are guaranteed to show
Portfolio managers have literally thousands of actively managed funds to choose from, making selection a tricky process.
They therefore have several methods of filtering the available funds
Their filtering is based on many factors such as
One of the factors is the fund managers that are in charge of the fund. Look at the image and complete the exercise
Past performance
Fund volatility
Consistency/stability (do staff and managers of the fund change often as this can affect performance)
The 3 above are the main factors taken into account when assessing a fund manager. Obvs there are more as can be seen in the image
The fund size - Generally bigger the fund the better. Smaller funds could suffer if there aren’t sufficient funds to take advantages of new issues of shares etc.
There are many ways in which a portfolio manager can measure the performance of funds that he may be considering for inclusion in his portfolio, but care needs to be taken.
On the face of it, a table showing cumulative past performance over different time periods could be a good indicator of performance, but looking deeper often reveals very different results. These tables often do not show how volatile a fund has been or any periods of erratic performance. They also do not allow the manager to look at specific, discrete time periods.
However, recently more sophisticated tools were introduced to allow deeper analysis of funds so now portfolio managers can look at something called ‘performance ratios’
What are ‘performance ratios’
Performance ratios show things like where a return came from. E.g Was it from taking higher risks? Or did the fund manager make the difference? etc
There are 3 main types:
-The information ratio
-Sharpe ration
-Alpha
The 3 main types of performance ratio are:
-The information ratio
-Sharpe ration
-Alpha
Tell me about each
Firstly, performance ratios allow portfolio managers to have a deeper analysis of a fund that they are considering in their portfolio. Performance ratios show things like where a return came from. E.g Was it from taking higher risks? Or did the fund manager make the difference? etc details you dont get otherwise when you look at past performance of a fund
SEE IMAGE OF EACH TYPE OF RATIO
A portfolio manager is choosing from some potential funds to add into his client’s bespoke portfolio that he creating. He has used some performance ratios and found that a fund has a positive alpha. What does this tell the portfolio manager
That the fund has a good stock selection
The manager will also look at many other factors about the fund such as cost, the manager, and so on (all named above) but using performance ratios tells you that he is specifically looking at a funds performance
Should tax be the main thing that is assessed when choosing an investment?
LEFT IMAGE SHOWS THE TAX WRAPPERS AVAILABLE WHEN INVESTING
No it should not be the main consideration
make sure the investment is suitable then make it more tax efficient if possible
Whilst we have said that tax should not be the main driver for any investment, a client’s tax position, both now and in the future, is a critical factor in decisions about the suitability of different tax wrappers.
Many wrappers can be discounted due to characteristics such as their lack of tax-efficiency, cost ratio or access restrictions. see left image for different wrappers
Here are two examples of clients who are considering which tax wrapper would suit them best:
FOR CONTEXT. SHOULD U FOCUS MORE IN CGT OR INCOME TAX
OBVS depends on individual both income tax is generally more important to mitigate if possible as it affects more people
The two images summarise all of the considerations for financial planners about tax wrappers in more detail
Any recommendation must be adequately disclosed and cover the following points: SEE IMAGE
One of the most important part of ongoing reviews with customers is reports that firms send out typically every quarter or six-monthly
What are these ‘reports’
The main items reported are: see image
It allows the individual to review their plan
The Ongoing Charges Figures (OCF)…SELECT WHAT APPLIES
includes the initial charge
is often higher for larger funds
is typically higher than the annual management charge
is typically a flat fee per year
is typically higher than the annual management charge
EXPLANATION
The OCF includes the annual management charge and other expenses, such as audit and custody fees, so it should always be higher than the AMC.
It does not include any initial charge, as that would be taken separately.
It is a percentage of funds under management not a flat fee, and is often smaller for larger funds, due to economies of scale.
THIS QUESTION IS ALL ABOVE THE POTENTIAL FEES INVOLVED IN INVESTING
