Basics of Portfolio Planning and Construction, CFA Level I

Level I – Portfolio Management Basics of Portfolio Planning and Construction 1 Contents and Introduction 1. Introduction 2. Portfolio Planning 3. Portfolio Construction 2 2. Portfolio Planning Planning • Understanding the client’s needs • Preparation of an investment policy statement • Asset allocation • Security analysis Execution • Portfolio construction Feedback • Portfolio monitoring and rebalancing • Performance measurement and reporting ka li B 15 oo 8 kC /9 8 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 men nt policy statement (IPS). It defines a plan for investment success given n the client’s clieent’s situation and requirements. The IPS should be reviewed on a regular basis. gular bas is. 3 Major Components of an IPS • • • • • • • • • Introduction Statement of Purpose Statement of Duties and Responsibilities Procedures Investment Objectives Investment Constraints Investment Guidelines Evaluation and Review Appendices 4 Risk Objectives Risk objectives are specifications for portfolio risk that reflect the risk tolerance of the client. Overall risk tolerance depends on the willingness and ability to take risk • Ability to take risk is based on wealth, time horizon, expected income, etc. • Willingness to take risk is more subjective and is based on the client’s psychology (See Exhibit 1) Risk tolerance can generally expressed qualitatively as high, medium and low / Bo ok C Quantitative risk objectives can be expressed in absolute or relative terms • Absolute: Portfolio should not suffer more than a 5% loss in any 12-month period. eriod. d losee Practically, this could be stated as: With 95% probability, portfolio should not lose more than 5% value in any 12-month period • Relative: Return should be within 4% of the S&P 500 index return 5 Example • Your client has a portfolio worth 10 million. He can not 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? • 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. 99 Example amp e 1 6 Return Objectives • Return objectives can be stated on an absolute or a relative basis ƒ Absolute: Client wants to achieve a particular return. Return of 9% or inflationadjusted (real) return of 2% ƒ Relative: Return 3% greater than 12-month LIBOR or return equal to the S&P 500 index return • Return requirement can be stated before or after fees • Stated risk and return must be compatible 7 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? 99 w Example amp e 3 8 Investment Constraints • Time Horizon: period during which portfolio is accumulating before assets need to be withdrawn ƒ Example 5 • Tax Concerns: tax status varies from investor to investor and must be considered when evaluating a portfolio • Liquidity: requirement related to withdrawing funds from the portfolio • Legal and Regulatory • Unique Circumstances ƒ Example 6 9 Gathering Client Information • Important for portfolio manager and investment advisers to know their clients ƒ Family situation ƒ Employment situation ƒ Financial information • Example 7 • Example 8 10 3. Portfolio Construction Define IPS Construct Portfolio Strategic Asset Allocation Tactical Asset Allocation Security Selection 11 Capital Market Expectations and Strategic Asset Allocation Investment Objectives and Constraints (IPS) Long-term Capital Market Expectations With time the asset allocation will drift from the target allocation;; the amount of allowable drift ift and and rebalancing policy should ld be defined. The SAA and rebalancing balancing policy olicy are generallyy in tthe he IPS appe appendix. ak Strategic Asset Allocation al i 11 B 58 C en te r Optimization and/or Simulation 12 Specifying Asset Classes When defining the SAA it is important to consider the asset class correlation matrix. Asset class: category of assets with similar characteristics ka li 11 Bo 58 ok /9 e Given the matrix on the left, which asset class is most sharply distinguished from m equities? elations What is lower: pair-wise correlations between asset classes OR pair-wise paair wise correlations between assets ssets in th thee sam same asset class? Source: FT Alphaville Example 9 13 Steps Toward an Actual Portfolio Strategic Asset Allocation Risk Budgeting is the process of deciding on the amount of risk to assume in a portfolio isk (overall risk budget), and subdividing that risk over the sources of investment return. e Tactical Asset Allocation The SAA is a means of providing the investor with exposure to the systematic risks of asset classes in proportions that meet the risk and return objectives. It drives a significant percentage of the overall return. Passive versus active investing Core-satellite approach to investing estin ng 2 Security Selection 14 Summary • Risk Objectives • Return Objectives • Constraints ƒ ƒ ƒ ƒ ƒ Liquidity Legal Time Horizon Tax Considerations Unique Circumstances • IPS + Capital Market Expectations Æ SAA • TAA and Security Selection 15 Conclusion • Read summary • Review learning objectives • Examples 1-10 are good; read 11 if you have time • Practice problems: good but not enough • Practice questions from other sources 16