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The investment management process involves several steps, including security selection,asset mix, market timing decisions and, finally, portfolio management. This chapterexplores that final topic portfolio management.Previous chapters described how investment and consumption decisions are made and howwealth is accumulated, how security selection decisions are made using fundamental analysis,and how asset mix decisions are made using economic, quantitative and technical analysis.

Market timing can have different meanings depending on whether the investor is looking at theshort-term or the long-term. Choosing the precise time to buy or sell a security is also referredto as timing, as is the decision on when to invest in a specific industry. In the short-term, mar-ket timing for a day trader can be a matter of minutes or hours. In the longer-term, measured inyears, market timing refers to tactical asset allocation the timing of when to invest (or sell)specific asset classes such as equities or bonds. Asset allocation is discussed in more detail lateron in the chapter.

The final step in the investment management process is portfolio management, which is themanagement of a collection of securities as a whole, rather than as individual holdings.

A. RISK AND RETURN1. Overview

It is every investors dream to be able to get a very high return without any risk. The reality,however, is that risk and return are interrelated. To earn higher returns investors must usuallychoose investments with higher risk. The Holy Grail of investing is to choose investments thatmaximize returns while minimizing risk.

Given a choice between two investments with the same amount of risk, a rational investor wouldalways take the security with the higher return. Given two investments with the same expected return,the investor would always choose the security with the lower risk.

Investors are risk averse, but not all to the same degree. Each investor has a different risk profile.This means that not all investors choose the same low-risk security. Some investors are willing totake on more risk than others are, if they believe there is a higher potential for returns.

In general, risk can have several different meanings. To some, risk is losing money on an invest-ment. To others, it may be the prospect of losing purchasing power, if the return on the invest-ments does not keep up with inflation. Risk could also refer to not meeting return objectives.For example, a retail investor may need to earn a 10% return in order to maintain a certainlifestyle. Institutional investors may have a target rate of return that they must meet each year.They may be investing to meet anticipated future cash flows. Thus, risk to an institutionalinvestor may result from investing inappropriately, so that these cash flows do not materialize atthe appropriate time.

Most retail investors feel that the prospect of losing money is an unacceptable risk. Institutionalinvestors, on the other hand, are more concerned with the long-term rate of return on the port-folio, and less concerned about the prospect of losing money on one security.

Chapter 9

The Portfolio Approach

CSI Global Education Inc. (2006)

PRE-TEST

Given that all investors do not have the same degree of risk tolerance, different securitiesand different funds have evolved to service each market niche. Guaranteed investmentcertificates (GICs) and fixed-income funds were developed for those seeking safety,while equities and equity funds were developed for those seeking growth or capitalappreciation.

Few individuals would invest all of their funds in a single security. This being the case, aportfolio is designed around an asset allocation based upon the clients propensity forrisk. The creation of a portfolio, or an asset allocation approach, allows the investor todiversify and reduce risk to a suitable level. The advisor, in turn, needs to understandhow risk and return are related so that the clients questions can be answered intelligently.

To maintain and increase their purchasing power investors rent out their money. Inother words, they expect some sort of compensation for the use of their money. Ifinvestors did not expect some kind of return, it would not be classified as an investment it would be a donation without a tax receipt!

Consider the following possible investments and the types of return generated:

Canada Savings Bonds interest income

Common Shares dividend income, capital gain

Gold Bars capital gain

Rental Property rental income, capital gain

An investor who buys Canada Savings Bonds expects to earn interest income (cashflow). An investor in common shares expects to see the stock grow in value (capitalgrowth) and may also be rewarded by dividends (cash flow). An investor in a gold barhopes the price of gold will rise (capital growth), and an investor who purchases a rentalproperty expects to receive rental income (cash flow) and an increase in the value of therental property (capital growth). The caveat on all this is that returns are rarely guaran-teed, and that is why returns are often called expected returns.

While an investment may be purchased in anticipation of a rise in value, the reality is thatvalues can decline. A decline in the value of a security is often referred to as a capital loss.Therefore, returns can be reduced to some sort of combination of: cash flows and capitalgains or losses. The following formula defines the expected return of a single security:

EXPECTED RETURN

Expected Return = Cash Flow + Capital Gain (or Capital Loss)

Where:

Cash Flow = Dividends, interest, or any other type of income

Capital gain/loss = Ending Value Beginning Value

Beginning Value = The initial dollar amount invested by the investor

Ending Value = The dollar amount the investment is sold for

2. Rate of Return

Returns from an investment can be measured in absolute dollars. An investor may statethat she made $100 or lost $20. Unfortunately, using absolute numbers obscures theirsignificance. Was the $100 gain made on an investment of $1,000 or an investment of$100,000? In the first example the gain may be significant, while in the latter it couldsignal a dismal investment.


9-2 CSI Global Education Inc. (2006)

The more common practice is to express returns as a percentage or as a rate of return oryield. Within the investment community it is more common to hear that a fundearned 8% or a stock fell 2%. To convert a dollar amount to a percentage, the usualpractice is to divide the total dollar returns by the amount invested.

The following example illustrates:

RATE OF RETURN ON AN INDIVIDUAL STOCK

a) If you purchased a stock for $10 and sold it one year later for $12, what would be your rate ofreturn?

b) If you purchased a stock for $20 and sold it one year later for $22, and during this period youreceived $1 in dividends, what would be your rate of return?

c) If you purchased a stock for $10, received $2 in dividends, but sold it one year later for only $9,what would be your rate of return?

The above examples illustrate that cash flow and capital gains or losses are used in calcu-lating a rate of return. It should also be noted that all of the above trading periods wereset for one year and hence the percent return can also be called the annual rate ofreturn. If the transaction period were for longer or shorter than a year, the return wouldbe called the holding period return. Adjustments would have to be made to the formulato convert it to an annual rate of return. The above generic formula will form the basisof yield calculations described later in this chapter.

Rates of return can be ex-ante, a projection of expected returns, or ex-post, meaninglooking back at the actual returns previously earned (historical returns). Investors esti-mate future returns, i.e., ex-ante returns, to determine where funds should be invested.Ex-post returns are calculated in order to compare actual results against both anticipatedresults and market benchmarks.

The biggest problem with the rate of return measurement is that it does not take riskinto account.

EX-ANTE AND EX-POST RATES OF RETURN

An investor purchases an equity fund in the expectation that the unit value will rise from $10 per unitto $12 per unit by the end of the year. The investors expected rate of return would be:

At the end of the year the unit's value was actually $10.50. The investor's actual rate of return was:

Rate of Return Zero Cash Flow $0.50 Capital Gain

ex-post =+$100

100 5 = %

Rate of Return Zero Cash Flow $2 Capital Gain

ex-ante =+

$10

1000 20= %

Rate of Return =+

=$ ($ $ )

$%

2 9 1010

100 10

Rate of Return =+

=$ ($ $ )

$%

1 22 2020

100 15

Rate of ReturnZero Cash Flow

=+

=($ $ )

$%

12 1010

100 20

ReturnCash Flow Ending Value Beginning Value

Beginnin%

/ ( )=

+ gg Value

100

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Choosing a realistic expected rate of return can be a very difficult task. One commonmethod is to expect the T-bill rate plus a certain performance percentage related to therisk assumed in the investment. Corporate issues with a higher risk profile would beexpected to earn a higher rate of return than the more secure federal government issues.

a) Historical Returns

An understanding of historical returns is important to the investor. Insights into themarket can be gained by studying historical data. These insights are used to determineappropriate investments and investment strategies.

Consider the following rates of return in Table 9.1:

TABLE 9.1

Comparative Total Rates of Return on Specific Security Classes

ANNUAL TOTAL RETURN(% Change in Value Indices, December to December)

Annual T-Bills Long-Term S&P/TSX CompositeReturns 90-Day Bonds* Stocks

% % %

1990 13.48 4.32 -14.80

1995 7.57 26.34 14.53

2000 5.49 12.97 7.41

2001 4.72 6.06 -12.57

2002 2.52 11.05 -12.44

2003 2.91 9.07 26.72

2004 2.30 10.26 14.48

*Average term to maturity of long bonds is 16 years.

SOURCE: Scotia Capital Fixed Income Research - Annual Investment Returns, January 2005

A study of Table 9.1 reveals that the highest rates of return were achieved by securitiesthat had the greatest variability or risk as measured by standard deviation, a measure ofrisk that will be explained later. The above historical information serves to illustrate thatrisk and return are related. Figure 9.1 demonstrates this relationship graphically.



FIGURE 9.1

Risk and Return Relationship

b) Nominal and Real Rates of Return

So far we have looked only at a simple rate of return (i.e., the nominal rate of return).For example, if a 1-year GIC reports a 6% return, this 6% represents the nominalreturn on the investment. However, investors are more concerned with the real rate ofreturn the return adjusted for the effects of inflation.

Example: A client earned a 10% nominal return on an investment last year. Over thesame period, inflation was measured at 2%. What was the clients approximate real rateof return on this investment?

The approximate real rate of return is calculated as:

Real Return = Nominal Rate Annual Rate of Inflation

The client in the above example earned a real rate of return of 8% on the investment,calculated as:

Real Return = 10% 2% = 8%

This calculation, however, does not take tax into account. If you assume that the returnis 100% taxable, an investor with a return of 10%, having a tax rate of 30%, wouldhave an after-tax return of 7%, calculated as (10% (1 30%). Taking inflation intoaccount (at 2%) the investors approximate real return would be 5% (7% 2%).

c) The Risk-Free Rate

A study of historical returns reveals that treasury bills usually keeps pace with inflationand therefore provide a positive return. Since T-bills are considered essentially risk-free,all other securities must at least pay the T-bill rate plus a risk premium in order toentice clients into investing.

T-bills often represent the risk- free rate as there is essentially zero risk associated withthis type of investment. The yield paid on a T-bill is roughly determined by estimatingthe short-term inflation and adding a real return.

Expected Return

RiskHighLow

High

Derivatives

Common Shares

Preferred Shares

Debentures

Bonds

Treasury Bills

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3. Risk The other side of the coin

As has already been pointed out, there is no universal definition of risk. In a statisticalsense, it is defined as the likelihood that the actual return will be different from expectedreturn. The greater the variability or number of possible outcomes, the greater the risk.This can be illustrated in a simple fashion. If an investor purchases a $500 Canada SavingsBond (CSB) and cashes the bond one year later, the investor will receive exactly $500(plus any accrued interest). However, suppose the same investor purchased $500 worth ofcommon stock at $25 per share in the expectation that the price would rise from $25 pershare to $40 in one years time. The investor may receive much more than $40 per shareor much less than the original $25 per share. Common stocks would be defined as riskierthan Canada Savings Bonds since the future outcomes are much less certain.

a) Types of Risks

The financial press talks about a great variety of risks including inflation rate risk, busi-ness risk, political risk, liquidity risk, interest rate risk, foreign exchange risk and defaultrisk. These types of risks (the list is not all-inclusive) are defined below.

Inflation Rate Risk

As explained previously, inflation reduces future purchasing power and the return oninvestments.

Business Risk

This risk is associated with the variability of a companys earnings due to such things asthe possibility of a labour strike, introduction of new products, the state of the econo-my, and the performance of competing firms, among others. The uncertainty regardinga companys future performance is its basic business risk.

Political Risk

This is the risk associated with unfavourable changes in government policies. For exam-ple, a government may decide to raise taxes on foreign investing, making it less attrac-tive to invest in the country. Political risk also refers to the general instability associatedwith investing in a particular country. Investing in a war-torn country, for example,brings with it the added risk of losing ones investment.

Liquidity Risk

A liquid asset is one that can be bought or sold at a fair price and converted to cash onshort notice. A security that is difficult to sell suffers from liquidity risk, which is therisk that an investor will not be able to buy or sell a security at a fair price quicklyenough due to limited buying or selling opportunities.

Interest Rate Risk

When an investor purchases a fixed-income security, for example, he or she expects toearn a certain return or yield on the investment. As we learned in the chapter on fixed-income securities, there is an inverse relationship between interest rates and bond prices.If interest rates rise, the investment will fall in value; on the other hand, it will rise invalue if rates fall. Interest rate risk is the risk that investors are exposed to because ofchanging interest rates.

Foreign Exchange Risk

Foreign currency risk is the risk of incurring losses resulting from an unfavorable changein exchange rates. Investors who invest abroad or businesses that buy and sell productsin foreign markets run the risk of a loss whenever the exchange rate changes against for-eign currencies.



Default Risk

When a company issues more debt to finance its operations, servicing the debt throughinterest payments creates a further burden on the company. The more debt the companyacquires, the greater the risk that it may have difficulty servicing its debt load through itscurrent operations. Default risk is the risk associated with a company being unable tomake timely interest payments or repay the principal amount of a loan when due.

b) Systematic Risk

Certain risks can be reduced by diversification. The risks known as systematic riskscannot be eliminated, as these risks affect all assets within certain classes. Systematic riskis always present and cannot be eliminated through diversification. This type of riskstems from such things as inflation, the business cycle and high interest rates.

Systematic (or market risk) is the risk associated with investing in each capital market:When stock market averages fall, most individual stocks in the market fall. When inter-est rates rise, nearly all individual bonds and preferred shares fall in value. Systematicrisk cannot be diversified away; in fact, the more a portfolio becomes diversified withina certain asset class, the more it ends up mirroring that market.

c) Non-systematic Risk

Non-systematic, or specific risk, is the risk that the price of a specific security or a spe-cific group of securities will change in price to a different degree or in a different direc-tion from the market as a whole. Stelco may rise in price, for example, when theS&P/TSX Composite Index falls, or Stelco, Dofasco and Co-Steel (all steel companies)as a group may fall more than the Index.

This type of risk can be reduced by diversifying among a number of securities. This typeof risk theoretically could be eliminated completely by buying a portfolio of shares thatconsisted of all S&P/TSX Composite Index stocks, using index funds or buying ETFsbased on the Index. The fund manager could also be asked to create a fund that mirrorsan index.

d) Measuring Risk

Investors may expect a given return on an investment, but the actual results may behigher or lower. To get a better feel for the possible outcomes and their probability ofoccurrence, several measures of risk have been developed. The three common measuresof risk are variance, standard deviation and beta.

Variance measures the extent to which the possible realized returns differ from theexpected return or the mean. The more likely it is that the return will not be the sameas the expected return the more risky the security. When an investor purchases a T-bill,the return is predictable. The return cannot change as long as the investor holds the T-bill until maturity. With other securities (e.g., equities), the outcomes are more varied.The price could increase, stay the same or decrease. The greater the number of possibleoutcomes, the greater the risk that the outcome will not be favourable. The greater thedistance estimated between the expected return and the possible returns, the greater thevariance. The risk of a portfolio is determined by the risk of the various securities withinthat portfolio.

Standard deviation is the measure of risk commonly applied to portfolios and to individ-ual securities within that portfolio. Standard deviation is the square root of the variance.The past performance or historical returns of securities is used to determine a range ofpossible future outcomes. The more volatile the price of a security has been in the past,

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the larger the range of possible future outcomes. The standard deviation, expressed as apercentage, gives the investor an indication of the risk associated with an individual secu-rity or a portfolio. The greater the standard deviation, the greater the risk.

Beta is another statistical measure that links the risk of individual equity securities tothe market as a whole. As we saw earlier, the risk that remains after diversifying is mar-ket risk. Beta is important because it measures the degree to which individual stockstend to move up and down with the market. Once again, the higher the beta, thegreater the risk.

4. Portfolio Risk and Return

Once you have a better understanding of the clients financial objectives and tolerancefor risk, you will need to determine the broad categories from which investments will beselected. Investment assets can be grouped into three main asset classes: cash or near-cash equivalents; fixed-income securities; and equity securities. Near-cash items ensuresome liquidity and include money market instruments and money market funds. Fixed-income securities offer safety and income and include bonds, preferred shares and fixed-income funds. Preferred shares, although technically a type of equity security, are gener-ally considered to be fixed-income securities from a portfolio management standpoint.Growth securities usually include common shares and various types of equity funds. Astheir name implies, growth securities provide potential for growth or capital gain.

Asset allocation involves determining the optimal division of an investors portfolioamong the different asset classes. For example, depending on the clients tolerance forrisk and the investment objectives, the portfolio may be divided as follows: 10% incash, 30% in fixed-income securities, and 60% in equities.

Consider the following examples:

Jenny is a young, healthy, single professional with good investment knowledge and ahigh risk tolerance, a moderate tax rate and a long time investment horizon. She mightbenefit from the following asset mix:

Cash 5%

Fixed-income 25%

Equities 70%

Ahmed is a retired individual in a low tax bracket with no income other than govern-ment pensions, a medium time horizon and a low risk tolerance. He requires incomefrom his portfolio. He might benefit from the following asset mix:

Cash 10%

Fixed-income 60%

Equities 30%

It should be noted that clients needs and objectives will change over their lifetimes.Asset allocation will have to be adjusted to take into account these shifting needs.

Portfolio managers and investors will also alter asset allocation to take advantage ofchanges in the economic environment. For example, when the economy enters a periodof rapid growth, the portfolio manager must decide how best to take advantage of themarket. He or she will likely decide that a heavier weighting in equities would gener-ate better returns than holding more of the portfolio in fixed-income securities or cash.Alternatively, if the portfolio manager believes the market is entering a recession, a heav-ier weighting in cash or fixed-income securities may be pursued to generate higher



returns. This process of altering a portfolios asset allocation to take advantage ofchanges in the economy is one meaning of the term market timing.

THE IMPORTANCE OF ASSET ALLOCATION

Investment returns are derived from:

1) The choice of an asset mix

2) Market timing decisions

3) Securities selection

4) Chance

Asset allocation is the single most important step in structuring a portfolio. It is estimated that itaccounts for approximately 90% of the variation in returns on an investment portfolio.

Table 9.2 lists the top performing securities between the period 1990 and 2004:

TABLE 9.2

Top Performing Security Classes in Canada1990 2004

Year Security Class Total Return (%)

1990 Corporate Paper 13.94

1991 Long Bonds 25.30


1993 Equities 32.55

1994 T-Bills 5.35


1996 Equities 28.35



1999 Equities 31.71


2001 Short Bonds 9.37


2003 Equities 26.72

2004 Equities 14.48

Source: Scotia Capital Fixed Income Research - Annual Investment Returns, January 2005

While historical returns provide insight into the long-term performance of the market, itis obvious from the above that past performance is not necessarily indicative of future per-formance. Since it is extremely difficult to predict the future, an investor should employthe concept of diversification diversification among asset classes to reduce risk.

a) Rate of Return on Portfolios

The expected return on a portfolio is calculated in a slightly different manner from therate of return of a single security. Since the portfolio contains a number of securities, thereturn generated by each security has to be calculated.

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PORTFOLIO RETURNS

The return on a portfolio is calculated as the weighted average return on the securities held in theportfolio. The formula is as follows:

Expected Return: R1(W1) + R2(W2) + Rn(Wn)

Where:

R = The return on a particular security

W = The proportion (weight or %) of the security held in the portfolio based on the dollar investment

The following example illustrates:

RATE OF RETURN ON A PORTFOLIO

A client invests $100 in two securities $60 in ABC Co. and $40 in DEF Co. The expected returnfrom ABC Co is 15% and the expected return from DEF Co. is 12%. To calculate the expected returnof the portfolio an advisor or investor would look at the rate expected to be generated by each pro-portional investment.

Since the total amount invested was $100, ABC Co. represents 60% ($60$100) of the portfolio andDEF represents 40% ($40$100) of the portfolio. If ABC Co. earns a return of 15% and DEF earns12%, the expected return on the portfolio is:

Expected return = (0.15 x 0.60) + (0.12 x 0.40)

= 0.09 + 0.048

= 0.138 (or 13.8 %)

b) Measuring Risk in a Portfolio

While diversification is important, investment managers must also guard against toomuch diversification. When a portfolio contains too many securities, superior per-formance may be difficult to achieve and the accounting, research and valuation func-tions may be needlessly complex. It is estimated that virtually all non-systematic risk inan equity portfolio is eliminated by the time 32 securities are included in the portfolio.

Investment managers have developed a number of strategies for limiting losses on indi-vidual securities or on a portfolio. Most of these strategies involve the use of derivatives.For example, they may use put options on individual equities or on investments such asgold, silver, currencies, and so on. Additionally, the portfolio manager can hedge anentire portfolio by using futures and options on stock index or long-term bond options.

5. Combining Securities to Maximize Return while Reducing Risk

This section addresses portfolio construction for the purpose of maximizing return andreducing risk. In doing so, it brings together the concepts of risk and return. Portfoliomanagement recognizes the fact that while future returns are usually beyond the controlof an individual or fund manager, risk to a certain extent can be managed.

Portfolio management stresses the selection of securities for inclusion in the portfoliobased on the securities contribution to the portfolio as a whole. This suggests some syn-ergy or some interaction among the securities which results in the total portfolio beingsomewhat more than the sum of the parts.

As has been explained previously, if investors place all of their savings in a single securi-ty, their entire portfolio is at risk. If the investment consists of a single equity security,the investment is subject to business risk and market risk. Alternatively, if all of theinvestors funds are invested in a single debt security, the investment is subject to defaultrisk and interest rate risk.



Some of these risks can be eliminated or reduced through diversification. However,diversification must be done carefully and the methodology for combining securitiesmust be understood. Combining any two securities may not diversify the portfolio ifthe risk characteristics of the two securities are extremely similar.

a) Correlation

Correlation looks at how securities relate to each other when they are added to a portfo-lio and how the resulting combination affects the portfolios total risk and return. Toillustrate the concept consider the following:

An investor takes all of his or her savings and invests 100% of those savings in a goldmining stock. Obviously, if the price of gold rises, the company does well and the clientmakes money. If the price of gold declines, the gold mining company does not do welland the investor loses money. In order to reduce this risk, the investor diversifies intoanother stock, which happens to be another gold mining company. Has the investorsportfolio been diversified?

The investors advisor points out that the portfolio has not been adequately diversified.Not understanding, the investor breaks up the portfolio and invests in five different com-panies chosen at random; unfortunately they all turn out to be gold mining companies.

It is clear that the securities in the portfolio are linked their value is tied to the for-tunes of gold. The portfolio thus has a high correlation with the fortunes of gold. Infact if the security price movements mirrored each other exactly, they would have a per-fect positive correlation, which is denoted as a correlation of +1. The investor does notreduce his or her risk by adding securities that are perfectly correlated with each other.

FIGURE 9.2

Combining Two Perfectly Positively Correlated Securities

Figure 9.2 shows that the returns on both Gold Company A and Gold Company Bhave a tendency to move together in tandem they rise and fall at the same time. Thesetwo stocks are said to exhibit perfect positive correlation. If an investor held only thesetwo stocks, the portfolio would not be diversified against any market downturns.Therefore, holding securities with perfect positive correlation does not reduce the overallrisk of the portfolio.

Returns

Time

Gold Company A

Gold Company B

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What if the stocks moved in opposite directions? Consider the following example:

An investor creates a portfolio of two securities an airline company stock and a buscompany stock. In good economic times people fly, but in bad economic times theysave money by taking the bus. In good times the investors airline company sharesincrease in value. In bad times the airline stock declines but the loss is offset by anincrease in the price of bus company shares. Since the stock prices move exactly in theopposite direction, the investor earns a positive return with little risk (there is always thepossibility of market risk). These securities have a perfect negative correlation, denotedas 1.

FIGURE 9.3

Combining Two Perfectly Negatively Correlated Securities

Figure 9.3 shows that the returns on the two companies move in completely oppositedirections. When one rises, the other falls. With perfect negative correlation, there is novariability in the total returns for the two assets thus, no risk for the portfolio.Therefore, the maximum gain from diversification is achieved when securities heldwithin the portfolio exhibit perfect negative correlation. In reality, however, it is verydifficult to find securities with such a high level of negative correlation.

Unfortunately, the above airline/bus example is not entirely correct. In bad times peopletend to stay at home and travel less. So the stocks are not completely negatively correlat-ed. In fact, research has found that most equities are correlated to some degree with theCanadian economy. When the economy does well, most stocks also do well but not tothe same degree.

Further research has revealed that adding poorly correlated securities to a portfolio doesin fact reduce risk. However, each additional security reduces risk at a lower rate. Infact, once there are 32 securities in the portfolio, additional risk reduction is minimal.Since the securities in the portfolio are still positively correlated to some degree, theportfolio is left with one risk that cannot be eliminated systematic or market risk. Thisconcept holds true whether you are dealing with equity securities or debt securities.

Returns

Time

Airline Company

Bus Company



Figure 9.4 shows reduction of risk by adding securities to a portfolio.

FIGURE 9.4

Risk in a Portfolio

The total risk of the portfolio falls quite significantly as the first few stocks are added.As the number of stocks increases, however, the additional reduction in risk declines.Finally, a point is reached where a further reduction in risk through diversification can-not be achieved. Therefore, the main source of uncertainty for an investor with a diver-sified portfolio is the impact of systematic risk on portfolio return.

b) Beta of a Portfolio

As was previously explained, the beta or beta coefficient relates the volatility of a singlesecurity to the volatility of the stock market as a whole. Specifically, beta measures thatpart of the fluctuation in a stock price that is driven by changes in the market.Volatility in this context is a way of describing the changes in a stocks price over along time frame. The wider the range in market prices, the more volatile the stock andthe greater the risk. The same concept can be applied to equity portfolios.

Any security, or portfolio of stocks, that moves up or down to the same degree as thestock market has a beta of 1.0. Any security or portfolio that moves up or down morethan the market has a beta greater than 1.0, and a security that moves less than the mar-ket has a beta of less than 1.0.

If the Toronto Stock Exchange, as measured by the S&P/TSX Composite Index, rose10%, a stock or equity fund with a beta of 1.0 could be expected to advance by 10%. Ifthe Index fell by 5%, the stock or fund would fall by 5%. If a stock had a beta of 1.30,it would rise 13% (1.3 10%) when the Index rose 10%. A stock with a beta of 0.80would only rise 8% when the Index rose 10%.

In real life most portfolios have a beta between 0.75 and 1.40, indicating a positive cor-relation between equities and the stock market. Industries with volatile earnings, typical-ly cyclical industries, tend to have higher betas than the market. Defensive industriestend to have betas that are less than the market, that is, less than 1. This implies thatwhen the market is falling in price, a defensive stock would normally fall relatively lessand a cyclical stock relatively more. Simplistically, it could be stated that in a rising mar-

StandardDeviation(Total Risk

of the Portfolio)

Number of Securities

Systematic Risk

10

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ket it is better to have high beta stocks and in a falling market it is better to have defen-sive, low beta stocks. However, this is an over-generalization and presumes that historyrepeats itself.

Table 9.3 shows examples of betas for selected companies. Note not only how they dif-fer from each other, but also how the beta changes over time.

TABLE 9.3

Betas for Selected Companies

Company 52-Week 3-Year 5-YearBeta Beta Beta

Nortel 3.28 3.65 2.71

BCE 0.58 0.15 0.85

TD Bank 0.74 0.80 1.05

Royal Bank 0.60 0.34 0.56

Rogers Comm. 0.91 1.31 1.37

Sears Canada 0.66 1.01 1.14

Dofasco 0.80 0.29 0.66

Ballard Power Systems 1.75 2.50 2.51

S&P/TSX Index Fund 1.00 1.00 1.00

Source: SEDAR website

c) Alpha

Quite often, individual stocks outperform the market and move more than would beexpected from their beta. The additional movement is due to the fundamental strengthor weakness of the company. This strength, or weakness, could be due to the companysexpertise, or lack of expertise, in marketing, production or management. An advisors orfund managers skill lies in picking those securities that will outperform others. This isknown as the stocks alpha. Mathematically, it measures the portion of an investmentsreturn coming from specific risk.

Those portfolio managers and individuals who can choose the best investments andcreate a portfolio with a positive alpha, will earn higher returns than those who do not.In other words, their portfolios will dominate other weaker portfolios. To be able to cre-ate portfolios that dominate others, the individual investor, or portfolio manager, mustbe capable of analyzing both the company and the market. This is not an easy task.Given that most individual investors have neither the skills nor the time, professionalmanagers usually represent a better choice. Professional management is considered oneof the main advantages of investing in mutual funds.

d) Capital Asset Pricing Model (CAPM)

As we have seen, beta represents the best measure of a stocks risk compared with that ofthe overall market. Since investors generally hold a portfolio of securities, rather thanjust one security in isolation, we can now look at the riskiness of a security in terms ofits contribution to the riskiness of the portfolio.

Investors typically have access to many different types of securities. There are securitiesthat are virtually free from risk, such as Treasury bills, and securities that offer a returnhigher than the Treasury bill rate but are riskier, such as individual stocks or a portfolioof stocks.



The capital asset pricing model (CAPM) was developed in the 1960s to recognize thetrade-off between risk and return. The underlying assumption of this model is thatinvestors who take on more risk expect higher returns.

The CAPM demonstrates graphically how investors are rewarded for assuming this risk.The difference between the risk-free return on Treasury bills and the return on the mar-ket is called the risk premium. This risk premium compensates investors for taking onadditional risk. As we have seen already, the risk premium reflects market or systematicrisk and is measured by beta.

Figure 9.5 illustrates the risk/return trade-off.

FIGURE 9.5

Capital Asset Pricing Model

e) The Market Line Formula

The CAPM produced a formula that can be used to calculate the expected return on astock or portfolio. The security market line shows the relationship between risk and return.

We can write the security market line relationship as:

Expected Return = Return on T-bills + Risk Premium

Mathematically, this is written as

Rp = Rf + (Rm Rf)

Where:

Rp = the expected return on a security or a portfolio of securities

Rf = the risk-free rate of return

Rm = return on the market portfolio

= beta

(Rm Rf) = the market risk premium

To put this relationship in words, the security market line says that the expected return ona security or portfolio, Rp, is equal to the return on a security that has no risk, Rf, plus arisk premium, (Rm Rf), multiplied by beta, , the relative riskiness of the stock or securi-ty in question.

Expected Return on

Investment

Risk or Beta

Treasury bill rate

0.50 1.0 2.0

Rf

Rm

Market portfolio

Security market line

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For example, a client asks an advisor what the expected return is on a particular fund.The fund has a beta of 1.1 and the advisor knows that the return on the S&P/TSXComposite Index has historically been 10% (representing the return on the market) andthat the T-bill rate (the risk-free rate) is currently 4%. Employing the formula:

RP = Rf + (Rm Rf)

= 0.04 + 1.1(0.10 0.04) = 10.6%

In other words, the expected return on this fund is 10.6%.

Note that the above return is only an estimate of the expected return actual resultsmay differ. The formula does, however, address the clients question as to what could beexpected for a specific portfolio or individual equity security.

B. THE PORTFOLIO MANAGEMENT PROCESS1. Introduction to the Portfolio Approach

While securities are sometimes selected on their own merits, portfolio managementstresses the selection of securities for inclusion in the portfolio based on that securityscontribution to the portfolio as a whole. As the previous section on risk and return hasshown, there is some synergy, or some interaction, among the securities, which results inthe total portfolio effect being something more than the sum of its parts. While thereturn of the portfolio will be the weighted average of the returns of each security, therisk of a portfolio is almost always less than the risks of the individual securities thatmake up the portfolio. This results in an improved risk-reward trade-off from using theportfolio approach.

Security selection decisions, then, are made in a context of the effect on the overall port-folio, rather than as discrete decisions that ignore the effect of one security on anotherin the portfolio.

2. The Portfolio Process

For this reason, a portfolio approach is much more desirable than a series of uncoordi-nated decisions. The portfolio management process is a continuous set of six basic steps,with the word process indicating that when the sixth step is completed, work beginsanew on the first step. The six parts to the portfolio management process are:

Determine investment objectives and constraints;

Formulate an asset allocation strategy and select investment styles;

Designing an investment policy statement;

Implement the Asset Allocation;

Monitoring the economy, the markets, the portfolio and the client; and

Evaluate portfolio performance.

Each of these steps is described in detail in this chapter.



POST-TEST

PRE-TEST

C. DETERMINING OBJECTIVES AND CONSTRAINTS1. Major Investment Objectives

Having discovered the clients objectives and constraints, the next step in designing aninvestment policy is to summarize this information in terms of the investment objec-tives. It is these objectives that will help determine the appropriate asset allocation forthat client.

All the information learned from the client through interviews, questionnaires, and fol-low-up discussions should be distilled into a return objective and a risk objective. Theseobjectives must address the following questions:

What rate of return does the client need to attain his or her goals?

What risk is he or she willing and able to take to achieve them?

In general, investors have three primary investment objectives (1) Safety of Principal,(2) Income and (3) Growth of Capital and two secondary objectives (4) Liquidity and(5) Tax Minimization. These investment objectives are described below in the context ofchoosing among different securities.

a) Return

The return objective is a measure of how much the clients portfolio is expected to earneach year on average. The return objective depends primarily on the return required tomeet the clients goals, but it must also be consistent with the clients risk tolerance. Aninvestor must determine whether a strategy of return maximization, in which assets areinvested to make the greatest return possible while staying within the risk tolerancelevel, is preferable to a strategy in which a required minimum return is generated withcertainty. The emphasis in the latter strategy is on risk reduction. In addition, the policyshould be designed to take into account the clients tax position and needs with respectto the proportion of interest income, capital gains and dividend income to be generated.

b) Risk

The risk objective is a specific statement of how much risk the client is willing to sus-tain to meet the return objective. The risk objective is based on the clients risk toler-ance, which in turn is dependent upon the clients willingness and ability to bear risk.

There are many ways to assess the risk tolerance of a particular investor, from the veryrudimentary to the very sophisticated. Each has its value in measuring what degree of riskthe client is prepared to take. Assessment of risk tolerance is a vital element in the ultimatedesign of the portfolio, as it will govern the selection of securities to be included.

Besides the risk the client is willing to assume, there must be a measure of the risk ofeach security to be considered for inclusion in the portfolio. As mentioned in Chapter5, term to maturity and duration are two measures of a bonds risk. Such statistics asbeta and standard deviation are used to measure the risk of equities. Other measures,too, exist, such as independent rating agency assessments and member firm researchreports.

It is important to recognize the difference between the risk of an individual security andthe risk of the portfolio as a whole. Because the risk of a portfolio is less than the aver-age risk of its holdings, the clients risk tolerance should be matched to the risk of theoverall portfolio, and not to the risk of each security.

Although most retail clients will need some degree of inflation protection, the extentwill vary. A retired person with a long time horizon and the goal of using the portfolioto generate income will be very concerned about what the purchasing power of the cash

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flow from the portfolio will be. Another person using short-term trading strategies andinterested in maximization of capital gains may concentrate less on this particular factor.It is important to remember that there are no certainties with any client; just because aclient is a trader and is young does not automatically mean he or she is not concernedabout inflation. Careful listening to and discussion with the client should always replaceassumptions and generalities based on such things as age and wealth.

The role of the investment manager in constructing a portfolio is to ensure that it willgenerate returns while taking into account the investors own particular level of risk tol-erance. Therefore managing risk is a major focus of portfolio management. While anincrease in returns should result from an increase in risk, high-risk portfolios do notalways turn out to be high-return portfolios.

While grouping equities by level of risk is more subjective, the four definitions in Table9.5 provide a basis for risk differentiation. The differences between the four equity riskcategories are largely a function of differences in capitalization, earnings performance,predictability of earnings, liquidity and potential price volatility. Since these variablesapply to all common shares in all industry groups, each industry may have companieswhose securities could be ranked in any of the four groups. Also, because companies arenot static, the risk in an individual security can change over time and may warrant ahigher or lower ranking. Table 9.4 shows some of the alternatives available in construct-ing a portfolio.

TABLE 9.4

Sample Risk Categories within Each Asset Class

CASH OR CASH EQUIVALENTS:

1. Government issues lowest risk, highest quality

2. Corporate issues highest risk, lowest quality

FIXED-INCOME SECURITIES:

1. Short term (up to three years) low risk, low price volatility

2. Medium term (from three to ten years) medium risk, medium price volatility

3. Long term (over ten years) high risk, maximum price volatility

EQUITIES:

1. Conservative Low risk; high capitalization; predictable earnings; high yield; high dividend payouts; lower PE ratios; low price volatility.

2. Growth Medium risk; average capitalization; potential for above average growth in earnings; aggressive management; lower dividend payout; higher PE ratios; potentially higher price volatility.

3. Venture High risk; low capitalization; limited earnings record; no dividends; PE of little significance; short operating history; highly volatile.

4. Speculative Maximum risk; shorter term; maximum price volatility; no earnings; no dividends; PE ratio not significant.

c) Safety of Principal or Preservation of Capital

One major objective is to have some assurance that the initial capital invested will large-ly remain intact. If this is the main concern among the three major objectives, the clientis effectively saying that, regardless of whether a small, large or nil return is generated onthe capital, the advisor should try to avoid erosion of the amount initially invested. Thisobjective is expressed in constant dollars (i.e., not counting inflation).



If the highest degree of safety is required, it may be obtained by accepting a lower rateof income return and giving up much of the opportunity for capital growth. In Canada,a high degree of safety of principal and of certainty of income is offered by most federal,provincial and municipal bonds, if held to maturity. Selected high-grade corporatebonds also fall in this category. Shorter-term bonds also offer a high degree of safetybecause they are close to their maturity dates. Government of Canada treasury bills offerthe highest degree of safety they are virtually risk-free.

There is one simple strategy to make the preservation of an investors principal fairlycertain. Assume an account size of $100,000, and a T-bill rate of approximately 3%.Roughly $97,000 can be invested in T-bills, which are considered risk free, and whichwill mature in one years time at $100,000, restoring the principal amount. The other$3,000 can be invested in some other venture, even a speculative one, and even if thefull $3,000 is lost completely, the investor will receive the principal back (pre-tax).

Examples of individual investors who might be seeking safety as a principal investmentobjective include:

A widow whose primary source of income is her securities portfolio;

A young couple who are investing their savings for the eventual purchase of ahouse; and

A businessman who is temporarily investing the funds he will be using to buy outhis partner in six months time.

The choice of preservation of capital as the major investment objective is a result of theinteraction of several objectives and constraints, including risk, market timing, inflation,return and emotion.

d) Income

This major objective refers to the generation of a regular series of cash flows from aportfolio, whether in the form of dividends, interest or some other form, and is a broad-er definition than the basic minimum income referred to as a constraint. The taxationof dividends and interest income will be a major determinant of the split betweenincome received from debt or equity securities. This split is decided at the time the assetmix is set.

An investor seeking to maximize the rate of income return, usually gives up some safetyif he purchases corporate bonds or preferred shares with lower investment ratings. Theterm usually is used because there are times when the informed investor with access toaccurate and current information may be able to obtain bargains. In general, however,safety goes down as yield goes up. But it should not be assumed that as the yield goesdown the safety of the bond or preferred share improves, because other factors mayaffect price and yield.

Careful selection and periodic review of securities owned are necessary to obtain maxi-mum income consistent with safety.

Examples of investors who might emphasize income as a prime investment objectiveinclude:

A salaried individual who relies on the additional income from investments to meetthe cost of raising and educating a family;

A retired couple whose pension income is insufficient to provide for all livingexpenses;

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A very conservative investor who, temperamentally, is not comfortable with com-mon share investments and fluctuating market values; and

A conservative person who, in a self-directed Registered Retirement Savings Plan(RRSP), is seeking the benefits of long-term, tax deferred compounding of reinvest-ed income.

The choice of income as a major investment objective is influenced by return, risk,inflation and basic minimum income, among others.

e) Growth of Capital or Capital Gains

Growth of capital, or capital gains, refers to the profit generated when securities are soldfor more than they cost to buy. When capital gains are the primary investment objec-tive, the emphasis is on security selection and market timing, and generally a trade-offagainst preservation of capital is required. In recent years, capital gains have been taxedmore favourably than interest income, which provides some incentive for choosing thisobjective over income generation. Many investors are also attracted by the active, mentalchallenge that comes with trading.

The choice of capital gains as a major investment objective involves considering manyfactors, including risk, return, market timing and emotions, as well as others.

Examples of investors primarily seeking growth include:

A well-paid young executive with excess income who wishes to build his own poolof capital for early retirement;

A vice-president of a corporation who is seeking above average returns throughcommon share investments;

Well-to-do members of an investment club who seek capital gains but who can alsosustain potential losses; and

A couple who, as a result of a substantial inheritance, are in a position to investmore aggressively and who are temperamentally prepared to accept a higher degreeof investment risk.

Table 9.5, in very broad terms and disregarding inflation and its effects, shows the threemajor kinds of securities and evaluates them in terms of the three basic investmentobjectives:

TABLE 9.5

Securities and their Investment Objectives

Safety Income Growth

Bonds

Short-Term Best Very Steady Very Limited

Long-Term Next Best Very Steady Variable

Preferred Stocks Good Steady Variable

Common Stocks Often the Least Variable Often the Most

f) Marketability or Liquidity

A fourth goal sought by many investors is marketability, which is not necessarily relatedto safety, income return or capital gain. It simply means that at nearly all times there arebuyers at some price level for the securities (usually at a small discount from fair value).For some investors who may need money on short notice (i.e., liquidity), this feature is



very important. For others, it may not be vital. Most Canadian securities (excludingsome real estate related securities) can be sold in reasonable quantities at some price usu-ally within a day or so.

g) Tax Minimization

When assessing the returns from any investment, the investor must consider the effectof taxation. The tax treatment of any investment varies depending on whether thereturns are categorized as interest, dividends or capital gains. Thus, tax treatment of thereturns influences the choice among investments.

h) Setting the Investment Objectives

Consultation should continue with the client right through this stage in the portfolioprocess. When necessary, the advisor can explain each objective to the client, andtogether, they can come to a joint conclusion as to the appropriate balance among theobjectives. It may be difficult for clients to communicate their wishes in non-tangibleways, but allocation to each major objective, on a percentage basis, is recommended. Itadds clarity to both parties and will translate well into the New Account ApplicationForm (NAAF) categories (refer to the copy of the NAAF shown in Chapter 13). Somefirms have sub-categories to the major ones on the NAAF, which add exactness to theoverall objectives, and for which the percentages will also be useful.

2. Constraints

Constraints provide some discipline in the fulfilment of a clients objectives.Constraints, which may loosely be defined as those items that may hinder or preventthe investment manager from satisfying the clients objectives, are often not given theimportance they deserve in the policy formation process. Perhaps this is because objec-tives are a more comforting concept to dwell on than the discipline of constraints.

a) Time Horizon

A major factor in the design of a good portfolio is how well it reflects the time horizonof its goals. Fundamentally, the time horizon is the period of time from the presentuntil the next major change in the clients circumstances. In other words, just because aclient is 25 years of age and normal retirement is at age 60 does not necessarily meanthe time horizon is 35 years. Clients go through various events in their life, each ofwhich can represent a time horizon and a need for a complete rebalancing of their port-folio. For example, finishing university, planning for a career change, the birth of achild, the purchase of a home, and many other events besides retirement represent theend of one time horizon and the beginning of a new one.

While some major events in a clients life cannot be predicted, such as a serious healthproblem or loss of employment, a clients time horizon should still be the period of timefrom the present to the next major expected change in circumstances.

b) Liquidity

Liquidity can have several meanings, including the net working capital of a business andthe ability to sell a security quickly without a significant sacrifice in price. In portfoliomanagement, liquidity means the amount of cash and near-cash in the portfolio.

While there are no set rules in portfolio management, a rough guide is that wealthy,risk-tolerant clients should have about 5% of their portfolio in cash and very risk-averseclients with more modest accounts should hold approximately 10% in cash.

This is not to say that the cash component in a portfolio never rises above 10%.Typically 10% may be held for liquidity purposes (payment of fees and unexpected

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expenses). The cash component could be higher during certain parts of the marketcycle, such as when securities are judged to be overpriced or too risky for that client, orwhen the yield curve is inverted and the returns on cash are high.

c) Taxation

An investors marginal tax rate will dictate, in part, the proportion of income thatshould be received as dividends, which are eligible for a tax credit, versus other types ofincome. Different marginal tax rates will help to dictate the proportion invested in pre-ferred shares versus other fixed-income securities such as bonds. Taxation levels and rateswill also guide the choice of tax-advantaged securities such as some limited partnerships,as well as the choice of tax deferral plans such as RRSPs and others. High tax rates,which significantly erode the final return on more traditional investments like GICs, areoften a reason for a client to seek out the higher returns available from securities.

d) Market Timing

Two approaches to investing include the buy-and-hold approach and the market timingapproach. As the name indicates, buy-and-hold means long holding periods throughvarious market cycles for long-term growth and income. Market timing involves timingthe short-term entry and exit points in the market in pursuit of quick trading gains overand above the commissions incurred. Clients generally have a preference for one ofthese approaches over the other. Some clients enjoy the excitement of trading for gainsvery much, and will increase their risk tolerance to accommodate this desire.

e) Other Objectives

Clients usually do not communicate their goals to their advisors in terms of return, risk,etc. Instead, primary investment goals might be stated as a desire to retire at a certainage, the acquisition of a business, vacation property or sailboat, or the pursuit of someother tangible goal. With care and explanation to the client, the IA can translate suchevents into the objectives above with the clients full agreement and understanding.

However, some objectives will not fall easily into the above categories. These are mostproperly spelled out in the investment policy statement under this category of Other.

It should be made clear that the objectives above do not often occur in isolation fromother objectives. While return maximization, or risk reduction, may be an objective forsome clients, usually more than one objective is chosen. In particular, liquidity and taxa-tion are not objectives in and of themselves. No person invests in liquid securities sim-ply to experience the enjoyment of selling them; rather they invest in them because theyhave appropriate investment merits and are also liquid. Similarly, no person shouldinvest in a security simply for tax relief. The landscape is littered with miserably failedinvestments with great tax advantages. Instead, the investment merits of the securityshould be considered first, and then the tax relief aspects.

f) Legal Requirements

Certainly any investment activity that contravenes an act, by-law, regulation, rule or theCriminal Code must be considered a constraint. For example, a client must be married(or living common-law) in order to participate in a spousal RRSP, and therefore from itsbenefits of income splitting. Also, a client may be an insider or own a control position.These types of clients must comply with all applicable regulatory guidelines. RRSP rulespreclude certain transactions, and institutions and corporate charters may pose addition-al limits. Persons under the age of majority also pose important potential problems.Possible legal constraints are numerous, and would include proper use of marginaccounts, good delivery, settlement, and many other matters covered in CSIs Conductand Practices Handbook Course.



All firms have compliance personnel and many have legal counsel on staff. It is recom-mended that the investment advisor consult these resources when there is any questionabout legal issues.

g) Moral and Ethical Considerations

Some transactions and investment activities may not be against the law, but shouldinvariably be treated by the portfolio manager as if they are. While clients may havepreferences for certain types of securities, they may also have strong aversions to certainothers. For example, perhaps because of personal convictions, a client may instruct thatno alcohol or tobacco stocks be purchased. Although it is not normally against the lawto purchase these types of securities, and although these securities may fit the clientsother objectives perfectly, if the client has instructed the manager not to purchase them,then that order must be respected.

h) Emotional Factors

As full an assessment as possible should be made of the clients temperament. Throughdiscussion and active listening, the manager can fulfil much more of the Know YourClient requirements than if this area is given only cursory treatment.

One consideration is investment knowledge. Should a certain strategy be followed if theclient clearly does not understand it? For example, writing covered options or using pro-tective puts and other positions may be warranted by the clients circumstances, but theclient may not understand them, and particularly will not if they end up losing money!However, serious discussion with the client, coupled with active listening, can result in aclearer definition of what may be bought and what must be excluded.

It is the responsibility of the investment manager to explain the investment process tothe client, especially when the client is not sophisticated but is interested. Over time,even a novice client can become quite knowledgeable and more inclined to acceptadvanced strategies such as hedges.

Another aspect of the clients personality is risk tolerance. Although risk was mentionedabove in the context of market volatility, here it relates to the clients level of comfortwith volatility in income and volatility in principal. If a client is invested only inGovernment bonds and makes worried calls several times a day for a quote, chances arethat this product is not appropriate for this client. An extra 1% return annually is notworth it if the client cannot sleep in the meantime because of the extra risk involved.On the other hand, a client may be quite comfortable with complicated options strate-gies and speculative positions, because of much higher risk tolerance.

i) Basic Minimum Income

While strategic asset allocation (described later on) will largely determine the totalreturn of a portfolio, as well as the split between current income and capital gains, onefurther related item needs separate attention: the basic minimum level of currentincome required/expected from the portfolio.

Suppose a client has living expenses that are not covered by salary, pension and otherincome. The client requires $10,000 per year in cash flow from the portfolio to meetthese expenses. The portfolio should be structured to generate a good total return, but itmust also be designed to ensure that there is $10,000 in current income available fromthe portfolio or the client will not be able to live on the income.

There are two caveats to this point. The first is that the hypothetical $10,000 is currentincome generated by the portfolio. The required $10,000 is not expected to be met byliquidating securities and thereby eroding the portfolio value. The second caveat is thatthe current income should be spaced so that it matches as closely as possible the clients

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needs for spending throughout the year, rather than have cash flowing in at only one ortwo points in the year. Both the fixed-income and equity components of a portfolio canusually be structured to provide a fairly even monthly income if this is desirable.

j) Realism

An investment advisor will attempt to provide as realistic an approach to investing aspossible. When the desires of a client are unrealistic, it is incumbent on the IA to pointthis out to the client. For example, in the discussion on basic minimum income out-lined above, a hypothetical $10,000 in current income was used as an example of whatthe client desired to support the basic cost of living. If the clients total portfolio wasvalued at only $50,000, it would be very unlikely that current income of $10,000 couldrealistically be generated from the portfolio. The client should be advised to reconsiderobjectives and perhaps spending patterns. Unfortunately, part of good communicationsometimes involves saying no to a client.

In addition to having unrealistic expectations about the amount of current income thatcould be generated from a portfolio, a client could have expectations of extraordinaryreturns from the portfolio. In addition, a client could reveal a lack of investment knowl-edge by professing too low a level of risk tolerance.

k) Other Constraints

Questions related to each of the points above can reveal a great deal about the clientsattitudes and constraints. However, there is also a place for a final overall question, suchas Is there anything else that we havent yet talked about, which might be important?It is surprising what can come from such a question. The client might reveal pertinentfacts such as a family member who is an insider (legal constraint), the presence of a seri-ous illness (income and time horizon implications), the size of the account (very small,or a huge lottery winning), or a pending marital breakup, which somehow did not getuncovered in previous conversation.

3. Managing Investment Objectives

The ultimate in safety of principal, income, capital gain and marketability is neverfound in one security. Some compromise is always necessary. If safety and income arehigh, yield tends to be comparatively low, because those who seek safety and regularincome bid the price up and the yield falls. Similarly, if the growth prospects of aninvestment security are high, eager buyers create a demand, which pushes up the priceand pushes down the yield.

Investment considerations are determined from a thorough discussion with and knowl-edge of the clients needs, preferences and resources. Major considerations are:

a) The Balanced Portfolio

Reconciling the divergent factors of safety, income, growth and marketability may bestbe accomplished by diversification. It is usual to limit the investment in any one securi-ty to no more than 10% of the value of the portfolio. As the portfolio grows, the maxi-mum figure may be reduced towards 5% or below.

A balanced portfolio includes securities from the three major asset classes: cash equiva-lents, fixed-income securities (bonds and preferred shares), and common shares. Theactual weighting of each asset class in a portfolio (the asset allocation) is determined bythe investment objectives of its owner.

As well as diversification by asset class, a portfolio can also be diversified by type ofsecurity, industry, geographical location and, in the case of bonds, by maturity.

A portfolio may have a defensive side emphasizing safety and a steady income return



(usually via bonds and some high quality preferred and common stocks) and an aggres-sive side that emphasizes capital gains (some growth common shares).

An individuals portfolio should be reviewed at least once a year to see if changes ininvestment objectives, risk tolerance, economic conditions or individual securities in theportfolio dictate a readjustment of the composition of the portfolio. Institutionalinvestors review portfolio balance much more frequently, often daily.

b) Risk Preference: Investment versus Speculation

Conservative investors normally seek investment-quality securities to form the mainportion of their largely defensive portfolios. Many middle-aged-to-elderly individualinvestors and most institutional investors fall into this category. In contrast, youngerand moderately wealthy individuals may be prepared to accept greater degrees of risk inselecting securities for their more aggressive portfolios. In so doing, they buy securitiesthat others may consider speculative or even hazardous.

Unfortunately, no clear dividing line exists between investment-grade and speculativesecurities. It is better to look at the range of securities available as a broad spectrumranging from top-quality, high-grade investments, through securities offering greaterand greater degrees of risk to those that are outright gambles.

The distinction is one of quality rather than form, because both bonds and stocks maybe suitable either as investments or as speculations. And quality is never permanent;some degree of risk is always present. Changing circumstances of the securities issuercan turn an investment into a speculation and vice-versa.

The problem for all investors is to determine the degree of safety or risk that best suitstheir investment program. Investors should determine the quality of each security as it isadded to their portfolio and they should review both their objectives and their risk tol-erance against the holdings in the portfolio on an on-going basis to see if they continueto match.

D. DEVELOPING AN ASSET MIXAfter designing the investment policy, it is necessary to determine the broad categoriesfrom which investments will be selected. The main asset classes are cash, fixed-incomesecurities and equity securities. More sophisticated portfolios may also include an inter-national asset class, a derivatives asset class, and alternative investments such as privateequity capital funds, currency funds or hedge funds.

To decide the exact make-up of the portfolio, i.e., to put together the appropriate assetmix, it is critical to understand the relationship between the equity cycle and the eco-nomic cycle and to use this understanding to plan the weighting to give to each assetclass. In addition, it is essential to consider the individual characteristics and risk toler-ance of the client.

1. The Asset Mix

a) Cash

Cash includes currency, money market securities, Canada Savings Bonds, GICs, bondswith a maturity of one year or less, swaps and all other cash equivalents. Cash isrequired to pay for expenses and to capitalize on opportunities, but is primarily used forliquidity purposes in the case of emergencies.

In general terms, cash usually makes up at least 5% of a diversified portfolios asset mix.Investors who are very risk averse may hold as much as 10% in cash. While cash levels

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may temporarily rise greatly above these amounts during certain market periods or port-folio rebalancings, normal long-term strategic asset allocations for cash are often withinthe 510% range.

b) Fixed-Income

Fixed-income products consist of bonds due in more than one year, strips, mortgages,fixed-income private placements and other debt instruments, as well as preferred shares.Convertible securities are not considered to be fixed-income products in the asset alloca-tion process. The purpose of including fixed-income products is primarily to produceincome as well as provide some safety of principal, although they are also sometimespurchased to generate capital gains.

From a portfolio management standpoint, preferred shares are simply another type offixed-income security. They have a stated level of income, trade on a yield basis, offermany of the same sweeteners, are subject to the same protective provisions, and have areasonably definable term. The only difference is that they pay dividends rather thaninterest, and dividends are taxed more favourably than interest income. For this reason,preferred shares can often be substituted for bonds to provide a tax benefit for theinvestor of course, within the bounds of intelligent diversification. Although legallypreferreds are an equity security, they are listed in portfolios as part of the fixed-incomecomponent because of the price action and cash flow characteristics listed above.

Diversification can be achieved in this part of the asset mix in several ways. Both gov-ernment and corporate bonds can be used, a range of credit qualities from AAA to lowergrades can be chosen, and foreign bonds may be added to domestic holdings. A varietyof terms to maturity, or durations, are often used (this is called laddering, with the vari-ous consecutive maturities mimicking rungs on a ladder), and deep discount or strippedbonds can be chosen alongside high-coupon bonds.

The amount of a portfolio allocated to fixed-income securities is governed by severalfactors:

The need for income over capital gains;

The basic minimum income required;

The desire for preservation of capital; and

Other factors such as tax and time horizon.

In very rough terms, fixed-income products generally account for at least 15% of adiversified portfolio, and under special circumstances up to 95% of a portfolio.

c) Equities

Equities not only include common shares but also derivatives such as rights, warrants,options, i60s, LEAPS, instalment receipts, etc., and both convertible bonds and con-vertible preferreds.

Although a dividend stream may flow from the equity section of a portfolio, its mainpurpose is to generate capital gains either through judicious trading or long-termgrowth in value. Objectives and constraints that influence the allocation to equitiesinclude risk, return, time horizon, inflation and emotion. Equities make up from 15%to 95% of a diversified portfolio.



d) Other Asset Classes

While portfolios of most retail clients consist of cash, fixed-income and equities, it ispossible to diversify even further by adding other investments that do not lend them-selves to being included in one of the major asset classes. Many portfolio managersbelieve that income trusts and hedge funds should be considered a separate asset class.

It is also possible to invest directly in real estate, precious metals and collectibles, such asart or coins. Many of these investments, such as gold, are considered to be a good hedgeagainst inflation.

2. Setting the Asset Mix

a) Asset Class Timing

The four phases of the equity cycle (which traces movements in the stock market) areexpansion, peak, contraction and trough. Understanding the equity cycle provides a use-ful approach for a general understanding of stock market movements. Figure 9.6 showsthe S&P/TSX Composite Index over the last two decades and illustrates (with shading)the different phases. It is important to note that within a stock market expansion phase,which may last several years, there are also serious setbacks or corrections to stock priceswhich may last as long as a year.

The general framework that follows outlines the most basic strategies for investors whochoose to time stock, bond and T-bill investments. The benefits from successfully tim-ing asset class selections are impressive. However, this presupposes that the investor hassuccessful asset mix analytic tools available that indicate when to make shifts betweenstocks, bonds and T-bills. In reality, most investors would have trouble determiningwhether a rise in interest rates is designed to slow economic growth or will actually leadto a recession and, therefore, a contraction phase in stock prices.

FIGURE 9.6

Broadly Defined Equity CyclesS&P/TSX Composite Index Price January 1980 to March 2005

Source: TSX Review, March 2005

0

2000

4000

6000

8000

10000

Peak

Contraction

Trough

Expansion

S&P/TSX

'82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04

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Over the last twenty years, T-bills have provided positive steady returns. Stock totalreturns have been the most volatile, but over this period they have outperformed bondsand T-bills. Bond total returns have tended to begin to rise before stock total returns.

The rationale behind asset class timing is that investors who recognize when to switchfrom stocks to T-bills, to bonds and back to stocks can improve returns. In addition, ifat the time in question bonds are the best asset class, then it should make sense tolengthen the term of bond holdings to maximize returns. Similarly, if stocks are the bestasset class, then certain strategies can be implemented to maximize stock market gains.Asset mix decisions affect both industry and stock selection.

Generally, asset mix factors appear to account for 90% or more of the variation in thetotal returns of investment portfolios. Investment analysts have developed sophisticatedcomputer models that assist in the timing of asset class shifts.

b) The Link Between Equity Cycles and Economic Cycles

In order to understand stock market strategies, it is essential to understand that there isa link between equity cycles and economic cycles. In general, the equity and economiccycles are very similar except that the equity cycle tends to lead. Figure 9.7 shows thatthe sustained economic growth beginning in 1983 fits closely the generally sustainedrise in stock prices over that time. It is important to note that the beginning of the equi-ty cycle actually preceded the beginning of the economic cycle by nearly nine monthsduring 19821983, underscoring the Toronto Stock Exchanges role as a leading indica-tor.

For investors who understand the relationship between economic and equity cycles, it ispossible to follow the general investment strategies outlined in Table 9.6.



TABLE 9.6

General Investment Strategies

Equity Cycle Business Cycle Strategy

1. Contraction End of Expansion Recession conditions are apparent.Phase through peak, into Recommendation: Lengthen term of bond holdings,

the Contraction phase e.g., sell short-term bonds and buy mid- to long-term. Try to maintain same yield (income). Avoid or reduce stock exposure.

2. Stock Market End of Contraction The bottom of the business cycle has not beenTrough phase, into the reached but has begun to advance because of falling

Expansion phase interest rates and the expectations of an economic recovery.

Recommendation: Sell long-term bonds since they rallied ahead of stocks in response to falling interest rates. Common stocks usually rally dramatically; often the largest gains occur in the higher-risk cyclical industries.

3. Expansion Expansion phase Sustained economic growth generally allows stocksPhase to do well.

4. Equity Cycle Late expansion Economic growth has been sustained; however, thisPeak into peak phase has also led to higher interest rates and the Bank of

Canada may be tightening its monetary policy.Short-term interest rates tend to be higher than long-term rates, i.e., the yield curve is inverted.

Recommendation: Stop buying commonstocks and invest in short-term interestbearing paper. The equity cycle peak isfollowed by the contraction phase 1.

FIGURE 9.7

S&P/TSX Composite, Canadian GDP (Average Annual % Change)1974 to 2004

S&P/TSX Composite Index (Left-hand scale); Canadian GDP (Right-hand scale)

Source: TSX Review and Canadian Economic Observer

-3

-2

-1

0

1

2

3

4

5

6

7

8

'04'02'00'98'96'94'92'90'88'86'84'82'80'78'76'740

2000

4000

6000

8000

10000

Canadian GDP (% Change)S&P/TSX (Yearly)

% ChangeS&P/TSX

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The problem with these general strategies is that they do not account for the manyimportant variations that occur during an equity cycle. These variations may dramaticallyaffect stock and bond market performance for 12 months or longer. For example, duringthe expansion phase of 1982 to 1989, the stock market experienced sharp declines due tohigh interest rates for six months in 1984 and during the stock market crash of 1987.Finally, the 1994 collapse in bond prices was unprecedented in magnitude when com-pared with the prior 50 years. While the general strategies appear attractive, variationswithin a cycle can affect asset class performance. The following section describes an equi-ty cycle much more precisely by explaining the underlying causal factors.

Changes in the S&P/TSX Composite price level result, generally, from changes in inter-est rates or economic growth. The relationships between interest rate trends and eco-nomic trends (and therefore corporate profit trends) are of the greatest significance toequity price levels. These two factors, in combination, generally account for 8090% ofthe change in stock market prices. As a result, these factors are often used together inasset mix models. As interest rates are used by central banks as a policy tool for manag-ing economic growth, changes in rates tend to lead changes in economic growth.

c) Using the Dividend Discount Model (DDM) to Understand the Equity Cycle

The Dividend Discount Model (DDM) serves as a guide to understanding the way aneconomic cycle influences an equity cycle. It is useful to remember that when the econ-omy is expanding (contracting), corporate profitability is usually growing (falling) aswell.

Table 9.7 illustrates how interest rate changes and corporate profit changes are relatedand how changes in each component of the DDM affect equity prices at different stagesof the equity cycle. We will assume that most of the short-term change in the discountrate (r) results from changes to the general level of interest rates. Changes in expectedlong-term growth (g) are influenced by recent changes in corporate profits.

The DDM can be used to illustrate four different periods of an equity cycle. The modelin Table 9.7 assumes a constant dividend.



TABLE 9.7

The Dividend Discount Model and the Equity Cycle

Point in Changes in Cause of ChangesEquity Cycle Denominator in Denominator

A. Contraction Phase r is still rising, and g is Interest rates are rising because of central bank policy aimed beginning to fall. Therefore, at causing a slowdown and because of currently robust

End of equity cycle. prices are expected to fall. economic growth.Examples: 1981, 1990.

This period often lasts Higher interest rates are designed to reverse the recently Recession related one to two years. higher inflationary trend. The higher interest rate policy is decline in stock prices. beginning to take its toll. The economy is beginning to slow

and corporate profits are beginning to fall.

B. Stock Market Trough g is still falling, however, The rapid decline in r reflects the recent decline in r is falling at a faster rate. interest rates owing to the recession and an attempt

by the central bank to direct a new economic expansion,Interest rate driven rally Therefore, prices are in part, by using lower interest rates.in stock prices. temporarily assumed toExamples: August 1982 be bid up. Stock prices tend to rally rapidly owing to the more rapid fallJuly 1983 and in r than g. Investors also anticipate a recovery in October 1990April 1991 This period has often corporate profit growth that should result from an economic

lasted five to thirteen recovery.The beginning of months.a new equity cycle. As T-bill rates fall, the implied return in stocks begins to

look relatively more attractive and a sudden flow of hot Short-term rally in capital from T-bills to equities tends to produce a rapidstock prices. but unsustainable rise in stock prices.

C. Expansion Phase g is beginning to rise with Interest rate policy tends to serve as a tool for directing a new economic recovery; economic expansions and contractions. Because interest rates

early cycle interest rate however, r briefly rises more tend to overshoot on the downside (as well as on the upside),shock and brief decline rapidly. Therefore, prices there is a period at the beginning of a new economic cyclein stockprices. are expected to fall during where rates are temporarily too low and must be raised or Examples: 1976, a sudden adjustment to normalized in order to moderate the rate of new economic19831984. higher interest rates. growth. This causes a rate shock.

This period often lastssix to nine months.

D. The profit driven cycle in r is stable or rising, but Generally stock prices appreciate steadily, though less rapidlystock prices Expansion rising less quickly than g. than in period B. As long as the economic expansion leads Phase to Peak. g is expected to continue to a rise in g which exceeds the rate of rise in r, prices shouldExamples: 19781980, growing with the sustained rise. However, the economic cycle is getting older and any19881989. and later cycle economic unexpected upward inflation pressure can lead to sudden

recovery. Therefore, prices increases in r, possibly resulting in an interest rate shock asare expected to rise. in C or leading to the end

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