LM04 Basics of Portfolio Planning and Construction

Part 1

1.  Introduction

This reading addresses the following topics:

• What is an investment policy statement (IPS) and what does it contain?
• The portfolio construction process.
• How is asset allocation done for a client?

2. Portfolio Planning, the IPS and Its Major Components

2.1.     The Investment Policy Statement

Portfolio planning can be defined as a program developed in advance of constructing a portfolio that is expected to satisfy the client’s investment objectives. The written document governing this process is the investment policy statement (IPS). It defines a plan for investment success given the client’s situation and requirements. The IPS should be reviewed on a regular basis.

2.2.     Major Components of an IPS

The major components of an IPS are:

• Introduction: Describes the investment objectives, circumstances, and state of client.
• Statement of Purpose: Covers the scope of the IPS.
• Statement of Duties and Responsibilities: Applies to investment manager, client, and other parties involved.
• Procedures: Methodologies to tackle various circumstances and updating the IPS.
• Investment Objectives: Desired rate of return and the amount of risk the client is willing to take.
• Investment Constraints: Liquidity, legal, taxes, time horizon, and other unique constraints.
• Investment Guidelines: Specifies permitted classes, selection of asset classes, use of leverage, asset allocation, and rebalancing, etc.
• Evaluation of performance: Specifies the benchmark portfolio to compare investment results with, the frequency of evaluation, and other related information.
• Appendices: Contains information on specific guidelines like permitted deviations, strategic asset allocation, rebalancing strategies, statement of policy concerning hedging risks such as currency risk and interest rate risk, etc.

3. IPS Risk and Return Objectives

Risk Objectives

A client’s risk tolerance is generally expressed qualitatively as high, moderate, or low. Two factors determine the overall risk tolerance: ability and willingness to take risk:

• Ability to take risk is based on wealth, time horizon, and expected income. etc. It is relatively easy to determine. Risk tolerance is usually expressed in both terms: ability and willingness. For example, a salaried person close to retirement with modest savings has low ability to take risk.
• Willingness to take risk is more subjective and is based on the client’s psychology. For example, a client who has recently lost his job may not be willing to take a risk, even though he has the ability to do so, as job loss has a huge psychological impact.

Risk Tolerance

Source: CFAI

For some clients, the risk objective might be defined quantitatively. Quantitative risk objectives can be expressed in absolute or relative terms.

• Absolute risk objective example: Portfolio should not suffer more than a 5% loss in any 12-month period. Practically, this could be stated as: with 95% probability, portfolio should not lose more than 5% value in any 12-month period. Absolute risk measures are not related to market performance. They are expressed in terms of standard deviation, variance, or value at risk.
• Relative risk objective example: For example, return should be within 4% of the S&P 500 index return. The risk objective is expressed relative to a benchmark.

Example

Your client has a portfolio worth 10 million. He cannot handle losing more than 1 million over the next 12 months. Is this an absolute or relative risk objective? How can this be stated in practical terms?

Solution:

This is an absolute risk objective. In practical terms, it can be stated as: with 95% probability, portfolio should not lose more than 10% in the next 12 months.

Example

Another client specifies a risk objective of achieving returns within 4% of the BSE 100. Is this an absolute or relative risk objective? Identify a measure for quantifying the risk objective.

Solution:

This is a relative risk objective as it is relative to BSE 100 (market) performance. A measure for tracking a relative risk objective is tracking the risk.

3.1 Return Objectives

Return objectives can be stated on an absolute or a relative basis.

• Absolute: Absolute return is the return a portfolio must achieve over a certain period of time. For example, a client wants to achieve a return of 9% or inflation-adjusted (real) return of 2%. The objective is to deliver a positive return over time, irrespective of how good or bad the market performance is. No index or benchmark is used to measure the performance. Many strategies may be employed to generate absolute return, the success of which depends on the skills of the manager.
• Relative: A relative return objective will be stated relative to a benchmark. Examples: return 3% greater than 12-month LIBOR or return equal to the S&P500 index return.

The return objective can be stated before or after fees, and pre- or post-tax. The fee structure must be clear and understood by both the parties, i.e., the investment manager and the client. If there is a required return that must be met for the client to meet a specific goal, such as down payment of $100,000 for a house next year or $20,000 for college education for a child next year, then it must be mentioned.

Stated risk and return must be compatible. For example, it would be unrealistic to expect a very high return with low risk tolerance.

Example

Your client is 35 and wishes to retire in 30 years. His salary meets current and expected future expenses. He has 100,000 in savings of which he wants to put aside 10,000 as an emergency fund to be held in cash. You estimate that 300,000 in today’s money will be sufficient to fund your client’s retirement income needs. Expected inflation is 2% over the next 30 years. How much money must your client have in nominal terms to fund his retirement? What is the required return objective?

Solution:

First, let us calculate how much money the client must have in nominal terms after 30 years, at his retirement. You can solve it two ways:

Using the formula: 300,000 to grow at 2% for 30 years =  = 543,408

Using a financial calculator: N = 30, I/Y = 2, PV = -300,000, PMT = 0, CPT FV. FV = 543,408

To calculate the return objective, we have the following data.

The client is investing 90,000 now after keeping aside 10,000 for emergency in cash. This 90,000 must grow to 543,408.47 in 30 years. To compute the interest rate, we enter the following values in the calculator:

FV = -543,408.47, PV = 90,000, N = 30, PMT = 0, CPT I/Y. Interest rate = 6.18%

Note: If the client is saving a particular amount every year, then key in that number for PMT.

4. IPS Constraints

The five major investment constraints are:

• Liquidity requirements:
  • The ability to convert invested assets into cash without suffering significant price erosion.
  • Cash requirement varies from client to client and may require a certain portion of assets to be invested in highly liquid investments.
• Legal and Regulatory:
  • Restrictions on investments and percentage allocation in certain assets for investors, like insurance firms, trusts, etc.
• Time Horizon:
  • The longer the time horizon, the greater is the ability to take risk and the lower are the liquidity needs in the portfolio.
• Tax Concerns:
  • Investors tax status, jurisdiction of investments, and the tax treatment of various types of investment accounts should be considered.
• Unique Circumstances:
  • Factors influenced by religion, ethical preferences, government policies, or investor circumstances (including beliefs and values).

Instructor’s Note:

You can use the acronym ‘LLTTU’ to remember these five constraints.

IPS may also include policy regarding responsible investing which takes into account environmental, social, and governance (ESG) factors.  The six main ESG investment approaches are:

• Negative screening: Excluding certain sectors or companies or practices from a fund or portfolio on the basis of specific ESG criteria.

• Positive screening: Including certain sectors, companies, or practices in a fund or portfolio on the basis of specific ESG
• ESG integration: Refers to the practice of including material ESG factors in the investment process.

• Thematic investing: This strategy picks investments based on a theme or single factor, such as energy efficiency or climate change.
• Engagement/active ownership: This strategy involves achieving targeted social or environmental objectives along with measurable financial returns by using shareholder power to influence corporate behavior.

• Impact investing: Investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.

These ESG investment approaches can impact the portfolio manager’s investment universe and may also require the manager to put in place a process to systematically incorporate ESG factors into the portfolio.

5. Gathering Client Information

It is important for portfolio managers and investment advisers to know their clients. They must find out all the facts about the client at the start of the relationship. This includes collecting information about the client’s current circumstances, spending requirements, return objectives, goals, etc. Some of the important data gathered include:

• Family situation: Married or not, if the spouse works, any additional dependents, number of children and their education plans, etc.
• Employment situation: Client’s salary, sources of income, industry the client is working in, stability of job, etc.
• Financial information: Level of savings, other investments such as real estate, etc. Adequate information on financial position will help in evaluating the client’s risk tolerance.

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