Part 7. Basics of Portfolio Planning & Construction Flashcards
Portfolio planning
A program developed in advance of constructing a portfolio that is expected to define clients investment objectives.
IPS
A document governing construction of client’s investment portfolio.
Complemented by document outlining policy on responsible investing.
To describe principles typically addressing one or more environmental, social and governance themes that investor requires when evaluating whether to invest in a particular company.
Process of IPS:
- Developed following a fact finding discussion with client; such as a questionnaire designed to articulate clients risk tolerance, and address expectations to specific circumstances.
- For institutional clients, this may involve asset liability management reviews, identification of liquidity needs, and range of tax, legal and other considerations.
- this is the basic mechanism for evaluating and trying to improve investors overall expected return-risk stance.
Major components of IPS
- Introduction - describes the client.
- Statement of purpose - states purpose of IPS.
- Statement of duties and responsibilities - of client, custodian of clients assets and investment managers.
- Procedures - the steps to keep IPS current and procedures to follow to respond to various contingencies.
- Investment objectives - explains client objectives in investing.
- Investment constraints - presents the factors that constrain the client in seeking to achieve investment objectives.
- Investment guidelines - info about how policy should be executed (e.g. on permissible use of leverage and derivatives), and on specific types of assets excluded from investment.
- Evaluation and review - provides guidance on obtaining feedback on investments results.
- Appendices - a) strategic asset allocation, b) rebalancing policy
Absolute risk objective
The desire to not suffer any loss of capital or not to lose more than a given percentage of capital in any 12-month period.
Relative risk objectives
This relates to risk relative to one or more benchmarks perceived to represent appropriate risk standards.
e.g. investments in large-cap UK equities could be benchmarked to equity market index, such as FTSE 100 index.
Ability to take risk
This is mainly measured in terms of objective factors such as time horizon, expected income and level of wealth relative to liabilities.
Willingness to take risk
This measure is more subjective factor based on clients psychology and also current circumstances.
It is believed some psychological factors such as personality type, self-esteem, and inclination to independent thinking are correlated to risk attitude.
Solution:
- complete psychometric questionnaire; 13 item 5 item risk attitude questionnaire.
Return objectives
These can be stated in a number of ways:
- Absolute or relative basis
- Set relative to a peer group or universe of managers.
- This can be stated before or after fees.
- A required return
Liquidity requirements
The likely requirements to withdraw funds from portfolio.
for individual investor = outlays for covering healthcare payments or tuition fees.
for institutions = spending rules and requirements for endowment funds, existence of claims coming due in case of property and casualty insurance, or benefit payments for pension funds and life insurance companies.
- the manager should allocate part of the portfolio to cover the liability.
e. g. invest in assets that are liquid - easily converted to cash, low risk, maturing bonds at when private education expenses will be incurred, fixed maturities
Time horizon
This will affect nature of investments used in portfolio, where illiquid or risky investments may be unsuitable for investor with short time horizon.
Reason:
- investor may not have enough time to recover from investment losses
Self investment limits
When pension funds face restrictions on the percentage of assets that can be invested in securities issued by the plan sponsor.
Socially responsible investing
Investing in accordance to considerations where client may have personal objections to certain products (i.e. tobacco, gambling), or practices (i.e. environmental impact of business activities).
6 generic ESG investment approaches:
- Negative screening = excluding companies or sectors based on business activities or environment/social concerns.
- Positive screening = including sectors or companies based on specific ESG criteria, typically ESG performance relative to industry peers.
- ESG integration = systematic consideration of material ESG factors in asset allocation, security selection, portfolio construction decision’s.
- Thematic investing = investing in themes or assets related to ESG factors.
- Engagement/active ownership = using shareholder power to influence corporate behaviour to achieve targeted ESG objectives along with financial returns.
- Impact investing = investments made with intention to generate positive, measurable social and environmental impact alongside financial return.
Portfolio implications:
- When portion of wealth is not under the control of the manager may have implications for the portfolio.
i. e. employees having concentrated share positions in equity of company where they work. - employee share options and stock holdings may decide their portfolio should not invest in additional amounts in that stock, or shares in competing businesses.
- if employer encounters difficulties, not only may employees lose their jobs but investment portfolios could also suffer significant loss.