Reading 44 LOS's

Question 1

LOS 44a: Describe the reasons for a written investment policy statement (IPS)

Answer 1

An investment policy statement is an invaluable planning tool that adds discipline to the investment process. The IPS can be thought of as a roadmap that serves the following purposes:

• It helps the investor decide on realistic investment goals after learning about financial markets and associated risks
• It creates a standard according to which the portfolio’s manager’s performance can be judged
• It guides the actions of portfolio managers, who should refer to it from time to time to assess the suitability of particular investments for their clients

A typical IPS specifies investment objectives and constraints, and the types of risks that the investors is willing to take in order to meet those goals. Goals are expressed in terms of both risk and return.

Investment constraints typically include the following:

• Liquidity requirements
• Time horizon
• Tax concerns
• Regulatory requirements
• Unique needs and circumstances

Question 2

LOS 44b: Describe the major components of an IPS

Answer 2

It generally includes the following sections:

• An introduction that describes the client
• A statement of purpose
• A statement of duties and responsibilities of the client, the custodian of the client’s assets, and the investment manager
• Procedures that outline the steps required to keep the IPS updated and steps required to respond to various contingencies
• The client’s investmnet objectives
• The client’s investment constraints
• Investment guidelines regarding how the policy should be executed and specific types of assets that must be excluded
• Evaluation and review guidelines on obtaining feedback on investment results
• Appendices that describe the strategic asset allocation on the rebalancing policy

Question 3

LOS 44c: Describe risk and return objectives and how they may be developed for a client

LOS 44d: Distinguish between the willingness and the ability to take risk in analyzing an investor’s financial risk tolerance

Answer 3

Risk Objectives

Absolute risk objective would be that the client does not want to lose more than 5% of capital over a particular period. This would be put in a probability statement such as the portfolio will not lose 5% over the next 12 months with 95% probability. Measures of absolute risk include the variance, standard deviation, and value at risk

Relative risk objectives relate risk to a certain benchmark that represents an appropriate level of risk. Tracking risk of tracking error is the apporpriate measure of risk relaitve to a benchmark

Risk tolerance is a function of both a client’s ability to take risk and their willingness to take risk. The ability to take risk is a function of several factors including time horizon, expected net income, and total worth. A clients willingness to take risk is all based on them.

When their is a mismatch between a client’s ability and willingness to take risk, the prudent approach is to conclude that the client’s tolerance for risk is the lower of the two factors.

Return Objectives

Absolute return objective state the percentage return desired by the clien. The return may be expressed on a real or nominal basis

Relative return objectives express the required return relative to a stated benchmark. A good benchmark should be investable

The portfolio manager must ensure that the client’s return objective is realistic in light of her tolerance for risk

Question 4

LOS 44e: Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory facots, and unique circumstances and their implications for the choice of portfolio assets

Answer 4

Liquidity

Investors may require ready cash to meet unexpected needs and could be forced to sell their assets at unfavorable terms if the investment plan does not consider their liquidity needs.

Time Horizon

A clost relationship exists between an investor’s time horizon, liquidity needs, and thier ability to take risk. The shorter the time horizon, the harder it would be for an investor to overcome losses. Therefore low-risk investments are more appropriate for investors with short-time horizons

Tax Concerns

Taxes play a very important role in investment planning because, unlike tax-exempt investors, taxable investors are really only concerned with after-tax returns on their portfolios. The tax code is very complex in most counties and must be considered when trying to make returns

Legal and Regulaory Factors

Innvestors also need to be aware of legal and regulatory factors

Unique Circumstances

Because each investore is unique, the implications of this constraint differ for each investor. For example, an investor may not want to invest additional funds in the company she works for if she already has stock options in the company

Question 5

LOS 44f: Explain the specification of asset classes in relation to asset allocation

LOS 44g: Discuss the principles of portfolio construction and the role of asset allocation in relation to the IPS

Answer 5

Portfolio Construction

Once the IPS has been compiled, the investor starts portfolio construction. How the portfolio funds are allocated across different asset classes is referred to as the portfolio’s strategic asset allocation (SAA). This is important because a portfolio’s allocation across various asset classes is the primary determinant of portfolio returns, not allocation across securities within those asset classes

Capital Market Expectations

This refers to a portfolio manager’s expectations regarding the risk and return prospects of varios asset classes. capital market expectations are quantified in terms of expected returns, standard deviation of returns, and correlation among asset classes.

The Strategic Asset Allocation

When defining asset classes, the following must be considered:

• Each asset class should contain assets that carry a similar expected return and risk and correlations among the assets within a class should be relatively high
• Each asset class should provide diversification benefits. The correlation of an asset class with other asset classes should be relatively low
• Asset classes should be mutually exclusive and should cover all investment alternatives

The risk-return characteristics of the SAA depend on the expected returns and risk of the individual asset classes, and on correlations between the asset classes

A theoretical framework for developing the SAA for a client is by developing the client’s utility function and using capital market expectations to determine the risk-return profiles of all investable portfolios available to the client. This framework may not follow exactly in practice due to the following reasons:

• an IPS does not explicitly ecpress the client’s investment objective and constraints in terms of a utility function. It usually only provides threshold levels of risk and return along with description of constraints
• The constraints listed in the IPS make it more apporpriate to use multi-period models

Steps Toward an Actual Portfolio

1. Risk Budgeting: This is the process of subdividing the desired level of portfolio risk across the difference sources of investment returns
2. Tactical asset allocation : This refers to an allocation where the manager deliberately deviates from the strategic asset allocation for the short term.
3. Security selection : A manager may be able to outperform the asset class benchmark by investing in particular securities within the asset class that she expects tto do well
4. Portfolio rebalancing - Changes in security prices will lead to changes in the weights of different asset classes in the portfolio and cause them to deviate or “drift” from policy weights. Therefore, the portfolio should be rebalanced peroidically and brough in line with policy weights. The set of rules that lay out guidelines for rebalancing the portfolio is known as the rebalancing policy and is an important element of risk management

Additional Portfolio Organizing Principles

The top-down investment framework described in this reading has 2 drawbacks:

1. If several managers are hired to manage different subclasses withiin the same asset class, it may result in underutilization of the risk budget
2. Each manager would trade within the portfolio under her management so the portfolio overall may not be efficient from a capital gains tax point of view

In order to avoid this, managers invest most of their funds in passive investments and trade a minority assets actively. This approach is known as the “core-satellite: approach.