Reading 54: Basics of Portfolio Planning and Construction

Question 1

Identify the drawbacks to a top-down investment framework.

Answer 1

If several managers are hired to manage different subclasses within the same asset class, it may result in underutilization of the risk budget.

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.

Question 2

Explain time horizon.

Answer 2

It refers to the time period between putting funds into an investment and requiring them for use. A close relationship exists between an investor’s time horizon, liquidity needs, and ability to take risk.

Question 3

Define liquidity.

Answer 3

It refers to the ability to readily convert investments into cash at a price close to fair market value. 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.

Question 4

Distinguish between absolute return objectives and relative return objectives.

Answer 4

Absolute return objectives state the percentage return desired by the client. 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.

Question 5

An investment policy statement generally includes what sections?

Answer 5

Introduction that describes the client

Statement of purpose

Statement of duties and responsibilities

Procedures to keep the IPS updated and how to respond to various contingencies

Investment objectives and constraints

Investment guidelines on policy execution and specific types of assets that must be excluded

Evaluation and review guidelines for feedback on investment results

Appendices on the strategic asset allocation and the rebalancing policy

Question 6

Identify the purposes of an investment policy statement.

Answer 6

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 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.

Question 7

What considerations must be made when defining asset classes?

Answer 7

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.

Question 8

Name the investment constraints the investment manager needs to consider when making investments for the client’s portfolio.

Answer 8

Liquidity requirements

Time horizon

Tax concerns

Regulatory requirements

Unique needs and circumstances