The Portfolio Management Process and the Investment Policy Statement

1. The Portfolio Management Process and the Investment Policy Statement Chapter 1 Managing Investment Portfolios

2. Portfolio Management Process • integrated set of steps undertaken in a consistent manner to create and maintain an appropriate portfolio to meet clients’ stated goals • portfolio – group of assets • steps • planning • execution • feedback • investment policy statement (IPS) – written document that clearly sets out a client’s return objectives and risk tolerance over that client’s relevant time horizon, along with applicable constraints such as liquidity needs, tax considerations, regulatory requirements, and unique circumstances

3. Investment Management • service of professionally investing money • investment management firms • revenues / size of firm • investors • employees • growth in industry due to importance of defined benefit plans in second half of 20th century • shift in 1980s and 1990s to retirement plans focusing on participant responsibility resulted in growth of individual-oriented investment advisors

4. Portfolio Perspective • focus on aggregate of all investor’s holdings • “because economic fundamentals influence the average returns of many assets, the risk associated with one asset’s return is generally related to the risk associated with other assets’ returns – if we evaluate the prospects of each asset in isolation and ignore the interrelationships, we will likely misunderstand the risk and return prospects of the investor’s total investment position – our most basic concern” • Harry Markowitz (1952) father of modern portfolio theory • analysis of rational portfolio choices based on the efficient use of risk • “demand” for the portfolio perspective • emergence of importance of institutional investing • growth in technology • professionalization of investment management field

5. Portfolio Management Process • continuous and systematic process complete with feedback loops for monitoring and rebalancing • an integrated set of steps undertaken in a consistent manner to create and maintain appropriate combinations of investment assets • steps • planning • execution • feedback

6. Portfolio Management Process • planning • investor-related input factors • specification and quantification of investor objectives, constraints, and preferences • objectives are desired investment outcomes that mainly pertain to return and risk • constraints are limitations on investor’s ability to take full or partial advantage of particular investments • portfolio policies and strategies • economic and market input • relevant economic, social, political, and sector considerations • capital market expectations

7. Investment Policy Statement • governing document for all investment decision making • elements of a typical IPS: • brief client description • purpose of establishing policies and guidelines • duties and investment responsibilities or parties involved • statement of investment goals, objectives, and constraints • schedule for review of financial performance • performance measures and benchmarks to be used • investment strategies and styles • guidelines for rebalancing based on feedback

8. Investment Process • IPS is basis for strategic asset allocation • investment strategy – manager’s approach to investment analysis and security selection • organizes and clarifies basis for investment decisions • guides those decisions toward achieving investment objectives • types of investment strategies • passive • active • semiactive

9. Investment Process • Investment style • natural grouping of investment disciplines that has some predictive power in explaining the future dispersion in returns across portfolios • strategic asset allocation • combines IPS and capital market expectations to determine target asset class weights • maximum and minimum permissible asset class weights set to control risk • execution step – portfolio selection and composition decision • interacts constantly with feedback step as changes are made • use portfolio optimization – quantitative tools for combining assets efficiently to achieve a set of return and risk objectives

10. Investment Process • transaction costs • explicit – commissions paid to brokers, fees paid to exchanges, taxes • implicit – bid-ask spreads, market price impacts of large trades, missed trade opportunities, and delay costs • feedback step • monitoring and rebalancing • use feedback to manage ongoing exposures to available investment opportunities so that the client’s current objectives and constraints continue to be satisfied • performance evaluation

11. Performance Evaluation • performance measurement – involves calculation of the portfolio’s rate of return • performance attribution – examines why the portfolio performed as it did and involves determining the sources of a portfolio’s performance • performance appraisal – evaluation of whether the manager is doing a good job based on how the portfolio did relative to a benchmark • sources of return

12. Portfolio Management • investment objectives and constraints are identified and specified • investment strategies are developed • portfolio composition is decided in detail • portfolio decisions are initiated by portfolio managers and implemented by traders • portfolio performance is measured and evaluated • investor and market conditions are monitored • necessary rebalancing is implemented

13. Objectives and Constraints • objectives are interdependent • risk • return

14. Risk Objectives • How do I measure risk? • absolute vs. relative risk • absolute • variance • standard deviation • relative • tracking error • What is the investor’s willingness to take on risk?

15. Risk Objectives • What is investor’s ability to take on risk? • In terms of spending needs, how much volatility would inconvenience an investor who depends on investments? Or how much volatility would inconvenience an investor who cannot afford to incur substantial short-term losses? • In terms of long-run wealth targets or obligations, how much volatility might prevent the investor from reaching these goals? • What are the investor’s liabilities or psudeo-liabilities? • What is the investor’s financial strength – that is, the ability to increase the savings/contribution level if the portfolio cannot support the planned spending?

16. Risk Objectives • How much risk is the investor both willing and able to bear? • risk tolerance – capacity to accept risk • What are the specific risk objective(s)? • absolute vs. relative risk objectives • example • How should the investor allocate risk? • risk budgeting

17. Return Objective • How is return measured? • total return – capital appreciation plus investment income • absolute vs. relative • nominal vs. real • pre-tax vs. post-tax • How much return does the investor say she wants?

18. Return Objective • How much return does the investor need to achieve, on average? • required return • examples • amount a pension fund needs to earn to fund liabilities to current and future fund holders • amount an individual investor needs to have to fund retirement at a certain level • amount that a retired investor needs to earn on portfolio to cover his living expenses • What are the specific return objectives?

19. Example of Return Objective • married couple needs £2 million in 18 years to fund retirement (incorporates inflation) • current investable assets are £1.2 million • need to earn 2.88% per year after tax to achieve goal • How did we get 2.88%? • Suppose couple needs to liquidate £22,000 from portfolio at end of each year. What return is needed?* • If all investment returns are taxed at 30%, what pre-tax return would you need?

20. Constraints • liquidity • time horizon • How does the length of the time horizon modify the investor’s ability to take risk? • How does the length of the time horizon modify the investor’s asset allocation? • How does the investor’s willingness and ability to bear fluctuations in portfolio value modify the asset allocation? • How does a multistage time horizon constrain the investor’s asset allocation? • tax concerns • legal and regulatory factors • unique circumstances

21. Portfolio Management • taking the inputs from analysts, economists, etc. and moving step by step through the orderly process of converting this raw material into a portfolio that: • maximizes expected return relative to the investor’s ability to bear risk • meets investor’s constraints and preferences • integrates portfolio policies with expectational factors and market uncertainties