Chapter 1 Overview of the Portfolio Management Process

1. Chapter 1Overview of the Portfolio Management Process • Major learning objectives: To understand the • Importance of the portfolio perspective • Steps of the portfolio management process • Types of investment objectives • Types of investment constraints

2. A. The Importance of the Portfolio Perspective Canada Pension Plan Investment Board (CPPIB) 2011 Q2 AUM: $153.2 billion

3. Change in Asset Allocation 2000-2011 Canada Pension Plan Investment Board (CPPIB)

4. A.The Importance of the Portfolio Perspective • Asset returns are correlated. Analyzing assets in isolation ignores the interrelationships amongst assets • Can lead to misunderstanding of the risk and return prospects for the investor’s total position • Idea dates back to Markowitz • Avoid the behavioral bias of mental accounting • Should care about overall portfolio’s risk and return, tax efficiency, liquidity … etc.

5. B. Steps in the Portfolio Management Process • Planning • Identify and specify the investor’s objectives and constraints • Create the Investment Policy Statement (IPS) • Form “capital market expectations” • Create the strategic asset allocation • Investor works with a financial consultant on this. For institutional clients, the bigger consulting firms are: Mercer, Towers Watson, Russell, Aon Hewitt …etc.

6. B. Steps in the Portfolio Management Process • Execution • Select specific assets managers (with the help of a manager search consultant), implementing decisions from the first stage • Determine need for tactical asset allocation • Feedback • Monitoring and rebalancing • Regular performance evaluation (financial consultant)

7. Discussion of Each Step • Planning • Execution • Feedback

8. Planning: Investment Objectives • Return objective • How much is desired depends on the current and future spending needs • Must be consistent with the risk objective • Specific return objective – can be absolute (i.e. 6%) or relative (e.g., greater than inflation or a benchmark return) • Example of a specific objective: CPP Investment Board • 4.2 percent above inflation per annum • An actuarial estimate based on the liabilities • For pension plans, falling short of this consistently would necessitate an increase in contribution rate or a cut in pension benefits

9. Planning: Investment Objectives • Risk objective • How to measure? Volatility, tracking error, downside risk? • Must take into account • Investor’s “appetite” for risk • Investor’s “ability” to take risk – spending needs, funding targets, obligations, ability to increase contributions to the fund • How should risk be allocated to specific investments? • Even within an asset class, risk differs

12. Planning: Investment Policy Statement (IPS) • Outlines investor objectives and constraints, as well as manager requirements for reporting, rebalancing, fees, investment strategy and style, performance benchmarks • Ensures that all future investment decisions are consistent with outlined objectives and constraints • In Canada, it is called the Statement of Investment Policies and Procedures (SIP&P) • Required by law for pension plans in most jurisdictions

13. Planning: Approaches to Investing • Passive approach does not react to changes in capital market expectations • Indexing • Strict buy and hold a benchmark portfolio • Active approach responds to changing conditions • Holdings differ from benchmark according to management’s assessment of each holding • Goal is to produce excess return relative to the benchmark • Semi-active, risk-controlled active or enhanced index approach seeks positive alpha while tightly controlling risk factors

14. Planning: Capital Market Expectations • Managers should form long-term forecasts of the risk and return characteristics of asset classes • Forms the basis for choosing portfolios that minimize risk relative to return or maximize return relative to risk • Influences asset allocation strategy and frequency of rebalancing

15. Planning: Strategic Asset Allocation • Optimal asset mix for a specific investor/plan • Combine IPS with capital market expectations to determine target weight for each asset class (possibly maximum and minimum weight range) • Single period perspective simplest • Multiple period perspective (dynamic asset allocation), taking into account say, serial correlations in returns

16. Execution: Portfolio Selection, Composition and Implementation • Portfolio Selection/Composition Decision • Managers initiate portfolio decisions based on analysts’ input • May involve a quantitative optimization process • Portfolio Implementation Decision • Trading desk implements decision • Incorporate transaction costs, including explicit (commissions, fees and taxes) and implicit costs (bid-ask spread, market impact, and opportunity costs when orders are unable to be filled or are filled slowly)

17. Monitoring: Elements of Performance Evaluation • Performance evaluation is needed to monitor investor progress toward goals and measure manager skill • Skill assessment has three components • Performance measurement – rate of return • Performance attribution – sources of return include strategic allocation (asset mix), sector and security selection • Performance appraisal – to benchmark returns

18. Example of a Benchmark Portfolio: CPP • “On April 1, 2006 we introduced the CPP Reference Portfolio and implemented it in fiscal 2007. • The Reference Portfolio represents a low-cost strategic alternative to the actual CPP Fund that would earn sufficient returns over the long term to help sustain the current CPP contribution rate at 9.9 per cent. The objective of the CPP Investment Board is to create value-added investment returns above and beyond those that the Reference Portfolio would generate.”

19. CPP Reference Portfolio • Current composition: • 45% foreign developed market equities • 25% Canadian nominal fixed income • 15% Canadian equities • 5% Canadian real return bonds • 5% emerging market equities • 5% foreign sovereign bonds

20. Monitoring: Rebalancing Portfolios • Changes in investor circumstances or in market and economic conditions provide feedback to the portfolio management process • Changing economic and market conditions cause assets to drift away from target weight and necessitate rebalancing portfolio to ensure client objectives and constraints remain satisfied • Issues with rebalancing: Frequency, timing, capital gains/losses

21. Further Discussion: Formulating a Risk Objective • Risk objective will largely determine the return objective (no free lunch plans) • How to measure risk? • Variance, Standard deviation • Tracking error relative to benchmark • Downside risk, Value at risk • Investor’s ability to take risk • How much volatility would inconvenience investor • Wealth targets and achievability • Liabilities • Financial strength outside portfolio (income, ability to save)

22. Further Discussion: Formulating a Risk Objective • Risk tolerance/aversion – how much is investor both willing and able to bear • May translate “low risk tolerance” into “loss in any given year should not exceed x%” or “portfolio standard deviation of x%”. • Risk budgeting – how should the desired level of risk be allocated among various assets?

23. Further Discussion: Types of Investment Constraints • Liquidity requirements • Investment time horizon • Tax • Legal/Regulatory • Socially responsible investing

24. Liquidity Requirements • Liquidity requirements are needs for cash that exceed contributions or savings • Stem from liquidity events • Planned – buying a house in 2 years • Unplanned – house damaged in hurricane • Requires allocation to assets that can be readily converted into cash without impacting value • May also be met using insurance or derivative strategies

25. Investment Time Horizon • Time period associated with investment objective – short term or long-term (> 10 years) • Affects ability to assume risk • Can lead to different asset allocation • Must consider investor tolerance for temporary risks • Longer time horizon typically allows: • higher risk tolerance  higher allocation to risky assets • Target–date funds

26. Other Constraints • Tax • Different tax rates applied to income/dividends/capital gains • Not a consideration for pension funds, eligible non-profit/charitable organizations • Legal and Regulatory • Limits on allocations to certain assets • Limits on investments in tax-advantaged accounts • Pension laws and acts (e.g., ERISA in the U.S.) • Other considerations • Social concerns  Socially Responsible Investing (SRI) • (For individual investors: Health needs, dependents, bequests, estate taxes … etc.)

27. CPP Investment Board Policy • “Consistent with the CPP Investment Board’s belief that constraints decrease returns and/or increase risk over time, we do not screen stocks. • We encourage responsible behaviour in our public equity portfolio through engagement. We believe that engagement is a more effective approach through which shareholders can best effect positive change and enhance long-term financial performance. • Moreover, we believe engagement is consistent with our mandate to maximize investment returns without undue risk of loss.”

28. Digression • Sum up all the assets held by professional portfolio managers • If the sum looks like the market portfolio, what is the implication for the average alpha? • Sharpe (1991): the arithmetic of active management • After fees, active investment is a negative sum game • Sharpe, William F., 1991, The arithmetic of active management, Financial Analysts Journal 47, January/February, 7–9.

29. Practice Question • Characterize each of the investment objectives below as one of the following: absolute risk objective, relative risk objective, absolute return objective, or relative return objective • Achieve a rate of return of 8% a year • Limit the standard deviation of portfolio returns to 20% a year or less • Achieve returns in the top quartile of the portfolio’s peer universe (the set of portfolios with similar investment objectives and characteristics)

30. Cont’d • Maintain a 10% or smaller probability that the portfolio’s return falls below 5% per annum over a one-year time horizon • Achieve a tracking risk of no more than 4% per annum with respect to the portfolio’s benchmark