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Chapter 16 The portfolio management process - Coggle Diagram

- - - - “What rate of return does the client need to attain the stated goals?
      - • What risk is the client willing and able to take on to achieve those goals?”
    - - expected to earn year, on average
      - “your strategy should be to focus on earning the highest return possible while staying within the client’s risk tolerance level.”
      - in the second case, you should focus on risk reduction
      - “the investment policy should be designed to take into account the client’s tax position and needs with respect to the proportion of interest income, capital gains, and dividend income to be generated.”
    - - “a specific statement of how much risk the client is willing to sustain to meet the return objective.”
      - “ Assessment of risk tolerance is a vital element in the ultimate design of the portfolio because it governs the selection of securities.”
    - - “one consideration in determining a client’s risk tolerance”
      - “Most retail clients need some degree of inflation protection, but the extent of the need varies. ”
  - - - “Safety of principal (also called preservation of capital)
        
        “the client must accept a lower rate of income return and give up much of the opportunity for capital growth”
        
        “a high degree of safety of principal and certainty of income is offered by most federal, provincial, and municipal bonds”
        T-bill offers the highest degree of safety (virtually risk-free)
        
        e.g. “A business executive temporarily invests funds that will be used to buy out a business partner six months later.”
        e.g. A young couple invest their savings for the eventual purchase of a house
      - • Income
        
        “Income from a portfolio is a regular series of cash flows received from debt and equity securities, whether as dividends, interest, or other form”
        
        “major considerations are taxation of dividends and interest income. ”
        
        “investors usually give up some safety if they purchase corporate bonds or preferred shares with lower investment ratings.”
        
        e.g. “A retired couple’s pension income is insufficient to provide for all living expenses.”
      - • Growth of capital”
        
        “Growth of capital, or capital gains, refers to the profit generated when securities are sold for more than they originally cost to buy. ”
        
        “the emphasis is on security selection and market timing. ”
        
        capital gains are taxed more favourably than interest income
        
        e.g. “A vice-president of a corporation seeks above average returns through common share investments.”
        “A well-paid young executive with excess income wishes to build a pool of capital for early retirement.”
    - - liquidity (marketability)
        
        “at nearly all times, there are buyers at some price level for the securities, usually at a small discount from fair value. ”
        
        “Liquidity is important for investors who may need money on short notice”
        
        “Most Canadian securities can be sold quickly in reasonable quantities at some price”
        some real estate-related securities are an exception
      - tax minimization
        
        “The tax treatment of an investment varies depending on whether the returns are categorized as interest, dividends, or capital gains.”
    - - must be completed and approved before any trades are put through on an account
    - - short-term bonds
        
        best safety; very steady income; very limited growth
      - long-term bonds
        
        next best safety ; very steady income; variable growth
      - preferred shares
        
        good safety; steady income; variable growth
      - common shares
        
        often the least safety; variable income; often the most growth
  - - - “A major factor in the design of a good portfolio is how well it reflects the time horizon of its goals”
      - “Clients go through various events in their lives, each of which can represent a time horizon and a need to completely re-evaluate their portfolio.”
        e.g. health problems, loss of employment; planning for the birth of a child, or purchasing a house
    - - “the amount of cash and near-cash in the portfolio”
      - The cash component could be higher during certain parts of the market cycle. For example, it could go up when securities are judged to be overpriced, or when the yield curve is inverted and the returns on cash are high ”
    - - “the proportion of income that the client should receive as interest income in relation to dividends.”
      - Dividends from Canadian corporations are eligible for a tax credit
      - “The marginal tax rate also guides the proportion that should be invested in preferred shares versus other fixed-income securities, such as bonds.”
      - “High tax rates can significantly erode the final return on more traditional investments, such as guaranteed investment certificates (GIC).”
    - - “Any investment activity that contravenes an act, law, by-law, regulation, or rule must be considered a constraint. ”
      - “All firms have compliance personnel and many have legal counsel on staff. You should consult these resources when you have any question about legal issues.”
    - - “you must consider the unique circumstances specific to your client”
      - some ethical or social responsibility: “For example, some clients may instruct you to ensure that no alcohol or tobacco stocks are purchased to respect their personal convictions.”
- - - - “Cash and cash equivalents includes currency, money market securities, redeemable GICs, bonds with a maturity of one year or less, and all other cash equivalents. ”
      - “In general terms, cash usually makes up at least 5% of a diversified portfolio’s asset mix.”
        “Investors who are very risk averse may hold as much as 10% in cash.”
      - “normal long-term strategic asset allocations for cash are within 5% and 10%.”
    - - “Fixed-income securities consist of bonds due in more than one year, strip bonds, mortgage-backed securities, fixed-income exchange-traded funds, bond mutual funds, and other debt instruments, as well as preferred shares. ”
      - convertible securities may or may not be considered fixed-income products in the asset allocation process
      - “The purpose of including fixed-income products is primarily to produce income, but also to provide some safety of principal and generate capital gains”
      - “preferred shares are an equity security. However, they are listed in portfolios as part of the fixed-income component because of their price action and cash flow characteristics.”
      - diversify this part of the asset mix using the following methods
        
        “Both government and corporate bonds can be used in a range of credit qualities, from Aaa to lower grades.
        
        • Foreign bonds may be added to domestic holdings.
        
        • A variety of terms-to-maturity are often used (e.g., in a concept called laddering, the various consecutive durations mimic rungs on a ladder).
        
        • Deep discount or strip bonds can be chosen alongside high-coupon bonds.”
      - allocated to fixed-income securities for the following factors
        
        “The need for income over capital gains
        
        • The basic minimum income required
        
        • The desire for preservation of capital
        
        • Other factors such as tax and time horizon”
    - - “Equities include common shares, equity exchange-traded funds, equity mutual funds, and both convertible bonds and convertible preferred shares. ”
      - “ its main purpose is to generate capital gains, either through trading or long-term growth in value.”
      - “If the conversion privilege expires on a convertible security, and the security is therefore no longer convertible, it should be re-categorized as fixed income.”
    - - “Hedge funds
      - • Real estate
      - • Precious metals
      - • Collectibles, such as art or coins
      - • Commodities, such as gold (which is considered a good hedge against inflation)”
  - - - book 16.14 table 16.3
    - - “The rationale behind asset class timing is that investors can improve returns by strategically switching from stocks to T-bills, to bonds, and back to stocks.”
      - “however, investors do not always have the analytic tools available that tell them when to shift between asset classes. ”
      - “Another consideration in asset class timing is term-to-maturity. If, at the time in question, bonds are the best asset class, then it should make sense to lengthen the term of bond holdings to maximize returns.
        Similarly, if stocks are the best asset class, then certain strategies can be implemented to maximize stock market gains.”
  - - - “• Choice of an asset mix
      - • Market timing decisions
      - • Securities selection
      - • Chance”
  - - - “a portfolio management technique that involves adjusting the asset mix to systematically rebalance the portfolio back to its long-term target or strategic asset mix.”
      - rebalancing is necessary in the following situations
        
        “There is a build-up of idle cash reserves, possibly from dividends or interest income cash flows that have not been reinvested.
        
        • There are movements in the capital markets causing abnormal returns, such as happened during the 1987 market crash, the 1998 Asian financial crisis, or the 2008–2009 global financial crisis.”
        
        if equities rise by more than 5% above their target weighting
      - “Using the dynamic approach, rebalancing dampens returns in a strong market because the portfolio manager is reducing the strongest-performing component. On the other hand, it enhances returns in a weak market period because the manager purchases under-performing asset classes at reduced prices.”
      - “The dynamic strategy is suitable for a more risk-averse investor, such as a retired individual with low risk tolerance.
        
        The tax situation of the investor should be reviewed carefully, because active management will result in more realized capital gains and losses
    - - “The statement may also allow for some short-term, tactical, deviations from the strategic mix. This strategy, called tactical asset allocation, allows you to capitalize on investment opportunities in one asset class before reverting back to the long-term strategic asset allocation.”
      - “The strategic allocation is considered the long-term strategy, whereas tactical deviations are short-term strategies.”
      - “If the bond market is depressed and poised for an upswing, you might overweight the portfolio in fixed-income products well over the strategic asset allocation for fixed income.”
      - “After a few weeks or months, having profited from this move, you would then move back to the long-term strategic asset allocation. In this way, you can exercise your market timing skills while investing for the expected return indicated by the strategic mix.”
      - “this approach is only moderately active, and is appropriate for the long-term investor who is interested in market timing.”