Portfolio Planning & Construction Flashcards
(26 cards)
Portfolio planning
A program developed in advance of constructing a portfolio that is expected to define the client’s investment objectives. The written document governing this process is IPS.
IPS
Starting point of portfolio mgt process. The IPS can take a variety of forms. A typical format will include the client’s investment objectives and the constraints that apply to the client’s portfolio. The client’s objectives are specified in terms of risk tolerance and return requirements. These elements must be consistent with each other. Should be reviewed on regular basis. No single standard format. From planning perspective, investment objective & constraint section in IPS are most important
Constraint section in IPS
Includes factors that needs to be taken into account when constructing a portfolio for the client that meets the objectives. The typical categories are liquidity requirements, time horizon, regulatory requirements, tax status, and unique needs. The constraints may be either internal (i.e., set by the client) or external (i.e., set by law or regulation)
Strategic Asset Allocation (Investment objective & Constraint + Long term capital mkt expectation = SAA)
Many investors specify a strategic asset allocation (SAA), also known as the policy
portfolio, which is the baseline allocation of portfolio assets to asset classes in view of the investor’s investment objectives and the investor’s policy with respect to rebalancing asset class weights. This SAA may include a statement of policy concerning hedging risks such as currency risk and interest
rate risk. Stated in terms of % allocation to asset classes. It results from combining the constraints and objectives articulated in the IPS and long-term capital market expectations regarding the asset classes.
The strategic asset allocation or policy portfolio will subsequently be implemented
into real portfolios. Clients’ investment objectives and constraints qualitatively differ in nature from capital market expectations, thus requiring different types of analysis, different sources of information, and different review cycles. The combination of investment objectives/ constraints and capital market expectations
theoretically occurs using optimization techniques. This is the first step in implementing an investment strategy. Next step is risk budgeting
Investor’s expected utility from the portfolio
expected return of the portfolio (-) {measure of the investor’s risk aversion x (Portfolio SD)^2}
Efficient Frontier
The line that connects those portfolios with the minimal risk for each level of expected return (above that of the minimum-variance portfolio—the portfolio with the minimum variance for each given level of expected return) is the efficient frontier. Clearly, the efficient frontier will move “upward” as more low-correlation assets with sufficient expected return are added to the mix because it lowers the risk in the portfolios for equal expected returns. Similarly, when return expectations increase for asset classes while volatility and correlation assumptions remain unchanged, the efficient frontier will move upward because each portfolio is able to generate higher returns for the same level of risk. Point where efficient frontier intersect with indifference curve (point of tangency) with highest utility attainable represent optimal asset allocation
Tactical asset allocation
The decision to deliberately deviate from the policy exposures to systematic risk factors (i.e., the policy weights of asset classes) with the intent to add value based on forecasts of the near-term returns of those asset classes. the return contribution from tactical asset allocation equals the difference between the actual return and the return that would have been made if the asset class weights were equal to the policy weights. 192
Security selection
An attempt to generate higher returns than the asset class benchmark by selecting securities with a higher expected return. Unlike SAA where exposure to sources of systematic risk are selected & sized, security selection is not rewarded with long run payoff to risk. It is a zero sum game. The higher the turnover of an index, more trading cost a passive manager will incur making the task of matching return of index more difficult
Drift & Rebalancing policy
As the portfolio is constructed and its value changes with the returns of the asset classes and securities in which it is invested, the weights of the asset classes will gradually deviate from the policy weights in the strategic asset allocation. This process is
referred to as drift. Periodically, or when a certain threshold deviation from the policy
weight (the bandwidth) has been breached, the portfolio should be rebalanced back to
the policy weights. The set of rules that guide the process of restoring the portfolio’s original exposures to systematic risk factors is known as the rebalancing policy
Capital Mkt Expectation
The investor’s expectations concerning the risk and return prospects of asset classes, however broadly or narrowly the investor defines those asset classes. When associated with the client’s investment objectives, the result is the SAA that is expected to allow the client to achieve his investment objectives (at least under normal capital market conditions). Traditionally, capital market expectations are quantified in terms of asset class expected returns, standard deviation of returns, and correlations among pairs of asset classes. Expected returns are in practice developed in a variety of ways, including the use of historical estimates,
economic analysis, and various kinds of valuation models. Standard deviations and
correlation estimates are frequently based on historical data and risk models.
Return objective, Risk objective & constraint
In a portfolio context, return objectives and expectations must be tailored to be consistent with risk objectives. The risk and return objectives must also be consistent with the constraints that apply to the portfolio.
Responsible investing
A growing proportion of investors explicitly include non-financial considerations when
formulating their investment policies which reflects ESG considerations. Responsible investing recognizes that ESG considerations may eventually affect the portfolio’s financial risk–return profile and may express the investor’s societal convictions.
Risk objective
Quantitative risk objectives can be absolute, relative, or a combination of the two. Examples of an absolute risk objective would be a desire not to suffer any loss of
capital or not to lose more than a given percentage of capital in any 12-month period. Measure of absolute risk include variance or SD of returns & VAR. Some clients may choose to express relative risk objectives, which relate risk relative to one or more benchmarks perceived to represent appropriate risk standards. For risk relative to a benchmark, the measure could be tracking risk, or tracking error. In practice, such risk objectives are used in situations where the total wealth management activities on behalf of a client are divided into partial mandates.
Liability driven investment approach
Where the size, timing and/or relative certainty of future investor financial obligations are known, an IPS may be tailored to meet these objectives. Examples of LDI include life insurance companies, defined benefit pension plans or an individual’s budget after retirement.
Ability vs Willingness to bear risk
Objective vs Subjective factor. When A is below avg but W is above avg, risk tolerance should be assessed as below avg overall. In reverse case, manager should talk with investor but should not aim to change client’s willingness
Return objectives
could be absolute or relative. Return requirement can be stated before or after fee & pre or post tax basis
Generic ESG investment approaches
Negative screening, Positive screening, ESG integration, Thematic investing, Engagement/active ownership, Impact investing
Know clients
This is required not only in the case of full-service wealth management or in the context of an IPS but also in “lighter” forms of financial intermediation, such as advisory relationships (in which clients make investment decisions after consultation with their investment adviser or broker) or execution-only relationships (in which the client makes investment decisions independently). An exercise in fact finding about the customer should take place at the beginning of the client relationship.
Important data to gather from a client should cover family and employment situation as well as financial information. If the client is an individual, it may also be necessary to know about the situation and requirements of the client’s spouse or other family members. The health of the client and her dependents is also relevant info. In an institutional relationship, it will be important to know about key stakeholders in the organization and what their perspective and requirements are.
Information gathering may be done in an informal way or may involve structured
interviews, questionnaires, or analysis of data.
Shareholder engagement
Requires good cooperation between investor (client) and investment manager. Engagement efforts are time-consuming, and the interest in such efforts is often that of the clients rather than that of the investment managers. Clients and investment managers must be clear with each other about the exercise of voting rights, filing of shareholder proposals, or entering into conversations with company management.
A written IPS is best seen as
communication instrument allowing clients & portfolio managers to mutually establish investment objective & constraint
Investment Guidelines
The section of the investment policy statement (IPS) that provides information
about how policy may be executed, including restrictions and exclusions
Risk assessment questionnaires for investment management clients are most
useful in measuring
willingness to take risk
Willingness to accept risk
most difficult to quantify
timing of payouts for property and casualty insurers is
unpredictable in comparison with the timing of payouts for life insurance companies. So they have greater liquidity needs than life insurance companies.
