Part 7. Basics of Portfolio Planning & Construction

Question 1

Portfolio planning

Answer 1

A program developed in advance of constructing a portfolio that is expected to define clients investment objectives.

Question 2

IPS

Answer 2

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.

Question 3

Process of IPS:

Answer 3

• 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.

Question 4

Major components of IPS

Answer 4

1. Introduction - describes the client.
2. Statement of purpose - states purpose of IPS.
3. Statement of duties and responsibilities - of client, custodian of clients assets and investment managers.
4. Procedures - the steps to keep IPS current and procedures to follow to respond to various contingencies.
5. Investment objectives - explains client objectives in investing.
6. Investment constraints - presents the factors that constrain the client in seeking to achieve investment objectives.
7. 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.
8. Evaluation and review - provides guidance on obtaining feedback on investments results.
9. Appendices - a) strategic asset allocation, b) rebalancing policy

Question 5

Absolute risk objective

Answer 5

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.

Question 6

Relative risk objectives

Answer 6

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.

Question 7

Ability to take risk

Answer 7

This is mainly measured in terms of objective factors such as time horizon, expected income and level of wealth relative to liabilities.

Question 8

Willingness to take risk

Answer 8

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.

Question 9

Return objectives

Answer 9

These can be stated in a number of ways:

1. Absolute or relative basis
2. Set relative to a peer group or universe of managers.
3. This can be stated before or after fees.
4. A required return

Question 10

Liquidity requirements

Answer 10

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

Question 11

Time horizon

Answer 11

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

Question 12

Self investment limits

Answer 12

When pension funds face restrictions on the percentage of assets that can be invested in securities issued by the plan sponsor.

Question 13

Socially responsible investing

Answer 13

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).

Question 14

6 generic ESG investment approaches:

Answer 14

1. Negative screening = excluding companies or sectors based on business activities or environment/social concerns.
2. Positive screening = including sectors or companies based on specific ESG criteria, typically ESG performance relative to industry peers.
3. ESG integration = systematic consideration of material ESG factors in asset allocation, security selection, portfolio construction decision’s.
4. Thematic investing = investing in themes or assets related to ESG factors.
5. Engagement/active ownership = using shareholder power to influence corporate behaviour to achieve targeted ESG objectives along with financial returns.
6. Impact investing = investments made with intention to generate positive, measurable social and environmental impact alongside financial return.

Question 15

Portfolio implications:

Answer 15

• 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.

Question 16

Outline of IPS:

Answer 16

1. Risk Objectives - time horizon, knowledge on investments, assets and income, diversification level.
2. Return objectives - LT return requirement/goal.
3. Constraints:

Liquidity - need for ST income.
Time horizon - retirement?
Tax status - law in country living
Legal & regulatory factors - compliance to French pension fund regulations?
Unique needs - minimise certain exposures to related stocks

Question 17

Asset class

Answer 17

A category of assets that have similar characteristics, attributes and risk-return relationships.

Specifying asset classes, in order to separate into different market capitalisation brackets, asset class correlation matrix are useful.

Question 18

Strategic asset allocation (SAA)

Answer 18

The set of exposures to IPS permissible asset classes that is expected to achieve the clients LT objectives given clients risk profile and investment constraints.

Includes:

• a policy of hedging portfolio risks not explicitly covered by asset class weights.
  e. g. hedge ratios for foreign currency exposure, management of IR risk from asset-liability mismatch, hedging for inflation risk

A means of providing investor with exposure to systematic risks of asset classes in proportions that meet risk and return objectives.

Question 19

Capital market expectations

Answer 19

The investors expectations concerning the risk and return prospects of asset classes.

When associated with clients investment objectives, the result of SAA is expected to allow client to achieve their investment objectives.

Expected returns are developed in a variety of ways including use of historical estimates, economic analysis, and various kinds of valuation models.

Question 20

Use of asset class correlation matrix:

Answer 20

• The decomposition into smaller asset classes corresponds to the way asset allocation is structured in portfolios for an organisational perspective.
• Adding classes with low correlation improves the risk return trade off.

Question 21

Best in class policy

Answer 21

This limits the number of securities to choose from, potentially impacting the risk and expected return estimates for these asset classes.

e.g. exclusions include controversial weaponry, tobacco companies, investments in certain countries.

In these circumstances risk and return estimates based on asset class benchmarks may not be applicable.

Question 22

SAA for a Dutch government pension fund:

Answer 22

1. Equity (36%) - in developed and emerging markets
2. Alternatives (27%) - real estate, private equity, hedge funds, commodities, infrastructure
3. Fixed income securities (37%) - government bonds, corporate bonds, inflation linked bonds, emerging market bonds

Question 23

Minimum variance portfolio

Answer 23

The portfolio with the minimum variance for each given level of expected return is the efficient frontier.

The efficient frontier will move upward as more low correlation assets with sufficient expected return are added to mix, as it lowers risk in portfolios for equal expected returns.

Question 24

Risk budgeting

Answer 24

The process of deciding on the amount of risk to assume in a portfolio, and subdividing risk over sources of investment return (e.g. SAA, tactical asset allocation, security selection).

The returns on investment strategy depend on 2 other sources: tactical asset allocation and security allocation.

Question 25

Tactical asset allocation

Answer 25

- The decision to deliberately deviate from the policy exposures to systematic risk factors (i.e. policy weights of asset classes) with intent to add value based on forecasts of near term returns of those asset classes. e. g. investor temporarily decides to invest more of portfolio in equities than SAA prescribes if investor anticipates equities will deliver higher return over ST than other asset classes.

Question 26

Security selection

Answer 26

An attempt to generate higher returns than the asset classes benchmark by selecting securities with higher expected return. e.g. investment manager may decide to add more IBM stock to portfolio than weight of equity benchmark if expects stock to do better than benchmark. zero sum game = security selection not rewarded with LR payoff to risk.

Question 27

Adding value to security selection:

Answer 27

- This depends on skills of manager, informational efficiency of market. - An efficient market - a market in which prices on average very quickly reflect newly available information. - requirements = sizeable participation of investors trading risk against expected return, acting on rational expectations, using same/similar pricing models, equal opportunity to access relevant information.

Question 28

Drift

Answer 28

- if values change with return of asset classes and securities as portfolio is constructed, the weights of asset classes will gradually deviated from policy weights in SAA.

Question 29

Rebalancing policy

Answer 29

- the set of rules that guide the process of restoring the portfolios original exposures to systematic risk factors. - used when certain threshold deviation from policy weight (the bandwidth) has been breached, the portfolio should be rebalanced back to policy weights.

Question 30

Process of executing an investment strategy:

Answer 30

1. selecting the appropriate manager for each asset class and allocating funds to them. 2. Investment managers performance will be monitored, as well as results of TAA and SAA. 3. If asset class weights move outside their corridors, money is transferred from asset classes too large compared with SAA to those that fall short. 4. Managers as well as SAA will be reviewed on basis of outcome of monitoring process. 5. Capital market expectations may change, as well as circumstances and objectives of client resulting in adjusting SAA.

Question 31

New developments in portfolio management:

Answer 31

1. The growth in offering of EFTs in combination with algorithm-based financial advice (or robo-advice). 2. The criticism of asset class return forecasts over relevant time horizons, as well as perceived instability of asset class correlations and volatilities. risk parity investing = investment approach where asset classes are weighted according to risk contribution.

Question 32

Examples of frameworks setting out standards on responsible investing:

Answer 32

1. Principles of Responsible Investment 2. The OECD Guidelines for Multinational Enterprises 3. The UN Global Compact - form the basis of responsible investing policies for asset owners.

Question 33

Shareholder engagment

Answer 33

This requires good cooperation between investor and investment manager. - Clarity over voting rights, filing of shareholder proposals, entering into conversations with company management.

Question 34

Collaborative engagement initiatives:

Answer 34

They have gained popularity as it is easier to gain the attention of and encourage positive action from corporations on material ESG issues through collective action. e.g. Climate Action +100 initiative aims to ensure world's largest corporate GHG emitters take necessary action on climate change.

Question 35

ESG integration

Answer 35

A process enhancer. The approach integrates material qualitative and quantitative ESG factors into traditional security and industry analysis, as well as portfolio construction. It is now widely adopted across mainstream funds, not just limited to client-specific separate accounts.