TOPIC 12 - THE INVESTMENT MANAGEMENT PROCESS Flashcards
the 3 key elements of the investment process
1) planning (est inputs necessary for decision making - data about client + capital market)
2) execution (details of optimal asset allocation and security selection)
3) feedback (process of adapting to changes in expectations and objectives as well as to changes in portfolio composition that result from changes in market prices)
when principles of of portfolio management are discussed, it’s useful to distinguish among 8 classes of investors:
a. Individual investors
b. Personal trusts
c. Mutual funds
d. Pension funds
e. Endowment funds
f. Life insurance companies
g. Non-life insurance companies
h. Banks
To some extent, most institutional investors seek to match
the risk-and-return characteristics of their investment portfolios to the characteristics of their liabilities
4 parts to the asset allocation process
- Specifying the asset classes to be included
- Defining capital market expectations
- Specifying the investor’s objectives and constraints
- Determining the asset allocation that gives the best risk-return trade-off consistent with the investor’s particular circumstances
People living on money-fixed incomes are vulnerable
to inflation risk and may want to hedge against it.
The effectiveness of an asset as an inflation hedge is related to its
correlation with unanticipated inflation
For investors who must pay taxes on their investment income, the process of asset allocation is complicated by the fact that
they pay income taxes only on certain kinds of investment income.
The life-cycle approach to the management of an individual’s investment portfolio views the individual as
passing through a series of stages, becoming more risk averse in later years.
The rationale underlying the life-cycle approach is that
as we age, we use up our human capital and have less time remaining to recoup possible portfolio losses through increased labour supply
People buy life and disability insurance during their prime earning years to hedge against
the risk associated with loss of their human capital (their future earning power)
3 ways to shelter investment income from federal income taxes besides investing in tax-exempt bonds:
A) Investing in assets whose returns take the form of appreciation in value, ie common stocks or real estate
B) b. Investing in tax-deferred retirement plans such as IRAs
C) Invest in the tax-advantaged products offered by the life insurance industry
ax-advantaged products offered by the life insurance industry
tax deferred annuities and variable and universal life insurance. They combine the flexibility of mutual fund investing with the tax advantages of tax deferral
Defined contribution plans are in effect
retirement funds held in trust for the employee by the employer. The employees in such plans bear all the risk of the plan’s assets and often have some choice the allocation of those assets.
Defined benefit plans give the employees a claim to a
money-fixed annuity at retirement. The annuity level is determined by a formula that takes into account years of service and the employee’s wage or salary history.
If sponsors viewed their pension liabilities as indexed for inflation, then the appropriate way for them to minimise the cost of providing benefit guarantees would be to
hedge using securities whose returns are highly correlated with inflation. Common stocks wouldn’t be an effective hedge because they have a low correlation with inflation.
