class 3: Investment process and the IPS Flashcards
asset allocation
the process used to determine what proportion of money we should put in each asset class
asset class
group of securities that exhibit similar characteristics
behave similarly in market place
subject to same laws
investable
steps to do asset allocation
- determine strategic asset allocation
- choose benchmark
- rebalance portfolio
- tactical asset allocation (optional)
the difference between strategic asset allocation and tactical asset allocation
strategic asset allocation is long term
tactical asset allocation is temporary
–> when we spot exceptional opportunities in the market
determining the asset allocation (steps)
- client’s investment objectives and constraints
2. capital expectations (like assignment #1)
IPS (investment policy statement) (components)
- objectives
2. constraints
IPS objectives
Risk
–> willingness to assume risk
–> ability to assume risk
Return
–> difficult to articulate (never give a certain amount)
VaR (value at risk)
an estimate of the minimum loss with a given probability over a specified period
–> expressed as a $ amount or a % of portfolio value
VaR components
- amount of loss
- probability
- period of time
IPS constraints
- time horizon
- taxes
- liquidity
- legal and regulation
- unique circumstances
investment horizon (time horizon) constraint
the planned liquidation date
affects portfolio risk and security maturity dates
taxes constraint
income tax
tax on interest
tax on dividends
capital gains tax
estate tax (not in canada)
gift tax (not in canada)
wealth tax (not in canada)
liquidity constraint
speed and easy with which an asset can be converted into cash
need for cash in short notice increases liquidity requirement
liquidity
how easy we can convert asset into cash without needing to drastically reduce price
legal and regulations constraints
specific regulations that may apply to institutional investors
prudent investor rule
prudent investor rule
the fiduciary responsibility of a professional investor
a legal principle that is used to restrict the choices of the financial manager of an account to the types of investments that a person seeking reasonable income and preservation of capital might buy for his or her own portfolio
unique needs constant
special considerations related to the underlying investors
capital market expectations sub categories
expected return
risk
correlation
how do we forecast the fixed income market?
we look at interest rates
theory of the term structure
- liquidity preference theory
- the expectations theory
- market segmentation theory
liquidity preference theory
yield curve should be upper sloping
a model that suggests that an investor should demand a higher interest rate or premium on securities with long-term maturities that carry greater risk because, all other factors being equal, investors prefer cash or other highly liquid holdings
Liquidity Preference Theory refers to money demand as measured through liquidity
the expectations theory
attempts to predict what short-term interest rates will be in the future based on current long-term interest rates
The theory suggests that an investor earns the same interest by investing in two consecutive one-year bond investments versus investing in one two-year bond today
market segmentation theory
long and short-term interest rates are not related to each other
the prevailing interest rates for short, intermediate, and long-term bonds should be viewed separately like items in different markets for debt securities
what drives the stock market?
the GDP
all capital markets driven by miacroeconomic factors
what drives the GDP?
intérêts rates / inflation
fiscal and monetary policy
unemployment
retail sailes
consumer confidence
durable sales
$US
Inventory
transportation and warehousing
budget deficit
etc.
fundamental analysis (top down approach)
–> why is this recommended?
- macroeconomic analysis
- industry analysis
- company analysis
choosing our benchmark (second step of asset allocation)
we need it to compare to see if we did well or nah
we need it to achieve client’s long term objectives
we need it to see if its consistent with risk tolerance
what is a good benchmark
specified in advance
appropriate
measurable
unambiguous
reflective of current situations
accountable
investable
SAMURAI
rebalancing our portfolio (third step of asset allocation)
should be rebalanced to periodically maintain Asset Allocation
Drift
drift in rebalancing the portfolio
appreciation or decline in values (will influence our AA allocation)
interest income (we gotta put it somewhere and it will change the AA)
dividend income (we gotta put it somewhere and it will change the AA)
Macroeconomic factors
client
the different types of clients
- individuals
- life insurance
- casualty insurance
- banks
- pension funds
- endowments/foundations
life insurance
term insurance
whole life
think long term
casualty insurance (non life)
short term
profit seeking and are willing to get more risk
how long do we keep bank deposits for?
not longer than a few weeks
they think medium term
heavily regulate
work on spreads
two types of pension funds
defined benefit plan
defined contribution plan
defined benefit plan vs defined contribution plan
defined benefit plan is the best choice for us
–> pension is guaranteed even if the investments are terrible
defined contribution plan
–> if they fuck up, we won’t get our pension
do pension funds pay taxes?
when could they pay taxes?
nooo they are tax free
only pay taxes if they have 40% of their assets outside Canada
ar pension funds heavily regulated?
yeee
AA approaches
- asset only
- liability driven investments (LDI)
- goal-based
asset only AA approach
fixed income
equity
alternatives
maximize assets to be able to meet PBO
liability driven investments (LDI)
PBO
have enough $ to meet future liabilities
endowments/foundations
non taxable unless they fail they pay out around 5% of their money to different projects
