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Reading 54: Basics of Portfolio Planning and Construction (Investment'…
Reading 54: Basics of Portfolio Planning and Construction
Investment Policy Statement (IPS)
Definition
to ensure that goals are realistic by requiring investors to articulate their circumstances, objectives and constraints
Is a plan for achieving investment success
Major components
Introduction
Describe the client
Statement of Purpose
IPS's intention
Statement of Duties and Responsibilities
of the client, the asset custodian and the investment manager
Procedure
Related to keeping the IPS updated and responding to unforeseen event
Investment Objectives
Client's investment needs, specified in term of required return and risk tolerance
Investment Constraints
Factor that may hinder the ability to meet investment objectives, typically categorized as the time horizon, taxes, liquidity, legal and regulatory, and unique needs.
Investment Guidelines
For example, whether leverage, derivatives or specific kinds of assets are allowed.
Evaluation and Review
Related to feedback on investment results.
Appendices
May specify the portfolio's strategic assets allocation (policy portfolio) or the portfolio's rebalancing policy.
Risk and Return Objectives
Risk objectives
are specifications for portfolios risk, that are developed to embody a client's risk tolerance.
Can be either absolute or relative.
Factors affecting risk tolerance
Psychological factors
Personal factors: age, family situation, existing wealth, insurance coverage, cash reserve, income
Return objectives
are typically based on investor's desire to meet a future financial goal, such as a particular level of income in retirement
Can be absolute or relative
maybe hindered by the risk objectives
Risk tolerance
Willingness to take risk
depends on attitudes and beliefs about investment risk
Capacity to take risk
depends on investment horizon, insurance, income, wealth, financial resoponsibility
Willingness > ability: Go with ability
Ability > willingness: educate investor about investment risk, do not attempt to change personality/ psychological characteristics
Investment's constraint
Liquidity constraint
Potential need for cash
High liquidity needs often means high portfolio allocation to bond and cash.
Time horizon
Often the period over which assets are accumulated and before withdrawals begin.
Risky or illiquid investments may be inappropriate for investor with short time-horizon
Tax consideration
Concern the tax treatment of investor's various accounts, the relative tax treatment of capital gains and income and the investor's marginal tax bracket.
Legal and regulatory constraints
such as government's restriction on portfolio contents and law against insider trading.
Unique Circumstances
Restrictions due to investor preferences (religious, ethical, etc.) or other factor not already considered.
Portfolio Construction Principles
Strategic asset allocation
Asset Specification
Examples: Equity, fixed income, cash, real estate,etc.
Asset class
is a group of securities with similar risk and performance characteristics
is a set of % allocation to various asset classes that is designed to meet the investor's objectives.
is developed by combining the objectives and constraints in the IPS with the performance expectation of various asset class
provides the basic structure of portfolios
Based on risk, returns, and correlations of asset classes
Correlations of returns of assets
within an asset class
should be relatively high
Correlations of returns between asset classes should be
low
Tactical asset allocation
refers to an allocation that deviates from the Strategic allocation
in order to profit from a forecast or shorter-term opportunities in specific asset classes.
Steps
Use risk, return, and correlations of asset classes to construct an efficient frontier
Use objectives and constraints from IPS to select an optimal portfolio (strategic asset allocation)
Tactical asset allocation (deviations from strategic) and security selection as permitted and appropriate
Risk budgeting allocates permitted risk to strategic allocation, tactical allocation, and security selection
ESG(environment\social\government) in Portfolio planning
If negative screening is used, portfolio performance should be measured against a benchmark that excludes companies with negative ESG factors
however, the benchmark must be screened in the same manner
positive screening, best-in-class or thematic investing typically require portfolio construction to be customized for the investor's choices of ESG factors
For active ownership, clarify whether investors intend to vote their own shares or delegate to managers