CHAPTER 7 BASICS OF PORTFOLIO PLANNING AND CONSTRUCTION
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REASONS FOR A WRITTEN INVESTMENT POLICY STATEMENT (IPS)
IPS
Suitability of an Investment
Legal or Regulatory
Requirements
Governance Arrangements
MAJOR COMPONENTS OF AN IPS
Introduction
Statement of PurposeStatement of Duties and
ResponsibilitiesProcedures
Investment Objectives
Investment Guidelines
Evaluation and Review
Appendices
WHAT ARE THE DIFFERENT TYPES OF RISK OBJECTIVES?
Risk Objectives
Absolute: Stated without context
The 12-month 95% value at risk (VAR) of the portfolio must
not be more than ¥1 billion.
Relative: A comparison
Achieving a return within 4% of the TOPIX return
approximately 95% of the time.
HOW DOES THE WILLINGNESS TO TAKE RISK DIFFER FROM THE ABILITY TO BEAR RISK?
Risk Tolerance
Willingness to Take Risk
Ability to Bear Risk
Time horizon?Expected income?Wealth relative to liabilities?
Personality type?Self-esteem?Inclination for independent thinking?
EXHIBIT 7-1 MEASURING THE WILLINGNESS TO TAKE RISK
1. Investing is too difficult to understand.2. I am more comfortable putting my money in a bank account
than in the stock market.3. When I think of the word “risk,” the term “loss” comes to
mind immediately.4. Making money in stocks and bonds is based on luck.5. In terms of investing, safety is more important than returns.
Possible responses for all five questions: (A) Strongly agree, (B) Tend to agree, (C) Tend to disagree, and (D) Strongly disagree.Source: Grable and Joo (2004).
EXAMPLE 7-2 THE CASE OF HENRI GASCON: RISK TOLERANCE
Henri Gascon is an energy trader who works for a major French oil company based in Paris. He is 30 years old and married with one son, aged 5. Gascon has decided that it is time to review his financial situation and consults a financial adviser. The financial adviser notes the following aspects of Gascon’s situation:• Gascon’s annual salary of €250,000 is more than sufficient
to cover the family’s outgoings.• Gascon owns his apartment outright and has €1,000,000
of savings. • Gascon perceives that his job is reasonably secure.
EXAMPLE 7-2 THE CASE OF HENRI GASCON: RISK TOLERANCE (CONTINUED)
• Gascon has a good knowledge of financial matters and is confident that equity markets will deliver positive returns over the longer term.
• In the risk tolerance questionnaire, Gascon strongly disagrees with the statements that “making money in stocks and bonds is based on luck” and that “in terms of investing, safety is more important than returns.”
• Gascon expects that most of his savings will be used to fund his retirement, which he hopes to start at age 50.
HENRI GASCON’S TOLERANCE FOR RISK
Risk Tolerance
Willingness to Take Risk
Ability to Bear Risk
• Secure job• High income
relative to expenses
• Significant assets• Time horizon of 20
years
• Knowledgeable about financial markets
• Answers to survey suggest risk tolerance
WHAT ARE THE IMPORTANT CONSIDERATIONS WHEN SETTING RETURN OBJECTIVES?
Return
Objective
s
Absolute or
Relative?
Nominal,
Real, or
Required?
Realistic?
EXAMPLE 7-4 THE CASE OF HENRI GASCON: RETURN OBJECTIVES
Having assessed his risk tolerance, Henri Gascon now begins to discuss his retirement income needs with the financial adviser. He wishes to retire at age 50, which is 20 years from now. His salary meets current and expected future expenditure requirements, but he does not expect to be able to make any additional pension contributions to his fund. Gascon sets aside €100,000 of his savings as an emergency fund to be held in cash. The remaining €900,000 is to be invested for his retirement.
EXAMPLE 7-4 THE CASE OF HENRI GASCON: RETURN OBJECTIVES (CONTINUED)
Gascon estimates that a before-tax amount of €2,000,000 in today’s money will be sufficient to fund his retirement income needs. The financial adviser expects inflation to average 2% per year over the next 20 years. Pension fund contributions and pension fund returns in France are exempt from tax, but pension fund distributions are taxable upon retirement.
WHAT IS HENRI GASCON’S RETURN OBJECTIVE?
Gascon’s retirement needs:€2,000,000 × (1 + 0.02)20 = €2,971,895
Gascon’s return objective:€900,000 × (1 + x)20 = €2,971,895x ≈ 6.20%
CONSTRAINTS ON PORTFOLIO SELECTION
Unique Circumstances
Legal and Regulatory Factors
Tax Concerns
Time Horizon
Liquidity
Portfolio Selection
HOW DOES THE NEED FOR LIQUIDITY AFFECT SAMPO GROUP’S INVESTMENTS?
Allocation of Investment Assets, Sampo Group
31 December 2008 (€16,502 million)
Fixed-Income Investments by Type of Instrument, Sampo Group
31 December 2008 (€13,214 million)
Breakdown of fixed-income investments
HOW THE INVESTOR’S TIME HORIZON AFFECTS PORTFOLIO ASSET SELECTION
Investor’s Time Horizon
Ability to Take Risk
PortfolioAsset
Selection
TAX CONCERNS AND LEGAL AND REGULATORY FACTORS
Tax Concerns
Investor’s tax status
Tax rates: income and capital gains
UNIQUE CIRCUMSTANCES
Unique Circumstances
Ethical Values
Religious Beliefs
Personal Preference
s
EXAMPLE 7-7 HENRI GASCON: DESCRIPTION OF CONSTRAINTS
Gascon expects that he will continue to work for the oil company and that his relatively high income will continue for the foreseeable future. Gascon and his wife do not plan to have any additional children, but expect that their son will go to a university at age 18. They expect that their son’s education costs can be met out of their salary income.
EXAMPLE 7-7 HENRI GASCON: DESCRIPTION OF CONSTRAINTS (CONTINUED)
Gascon’s emergency reserve of €100,000 is considered to be sufficient as a reserve for unforeseen expenditures and emergencies. His retirement savings of €900,000 has been contributed to his defined contribution pension plan account to fund his retirement. Under French regulation, pension fund contributions are paid from gross income (i.e., income prior to deduction of tax) and pension fund returns are exempt from tax, but pension payments from a fund to retirees are taxed as income to the retiree.
WHAT ARE THE CONSTRAINTS ON HENRI GASCON’S RETIREMENT PORTFOLIO?
• Liquidity: No need for liquidity.• Time Horizon: Approximately 20 years.• Tax Concerns: Portfolio is tax exempt.• Legal and Regulatory Factors: French pension
fund regulations.• Unique Circumstances: No significant exposure
to oil and other commodity stocks.
HOW ARE PORTFOLIOS CONSTRUCTED?
QUANTIFYING CAPITAL MARKET EXPECTATIONS
Correlation with Other
Asset Classes
Standard
Deviation
Expected
Return
STRATEGIC ASSET ALLOCATION (SAA)
Cash
Equities
Bonds
Real EstateAlternative Investments
Strategic asset allocation (SAA) is a means to providing the investor with exposure to the systematic risks of asset classes in proportions consistent with the IPS.
DEFINING AN ASSET CLASS
Bonds
Government
Domestic
Foreign
Corporate
Investment Grade
High Yield
Are all of these specifications necessary?
EXAMPLE 7-9 SPECIFYING ASSET CLASSESAsset class correlation matrix:
• High-paired correlations between equity asset classes suggest that defining equity asset classes narrowly has limited value.
• The case for treatment as a separate asset class can best be made for emerging market stocks.
A B C D E F G H I J K L A. MSCI Europe 1.00 0.77 0.95 0.97 0.88 0.20 0.59 –0.08 –0.35 0.10 –0.29 0.01 B. MSCI Emerging Markets 0.77 1.00 0.82 0.83 0.76 0.35 0.63 0.18 –0.25 0.22 –0.20 0.11 C. MSCI World 0.95 0.82 1.00 0.96 0.97 0.25 0.69 0.00 –0.31 0.18 –0.27 0.06 D. MSCI EAFE 0.97 0.83 0.96 1.00 0.88 0.27 0.65 –0.01 –0.34 0.15 –0.29 0.05 E. MSCI U.S. 0.88 0.76 0.97 0.88 1.00 0.20 0.70 –0.01 –0.27 0.18 –0.24 0.06 F. Commodities 0.20 0.35 0.25 0.27 0.20 1.00 0.27 0.25 –0.04 0.14 –0.07 0.14 G. Real Estate 0.59 0.63 0.69 0.65 0.70 0.27 1.00 0.18 –0.01 0.40 0.02 0.32 H. Gold –0.08 0.18 0.00 –0.01 –0.01 0.25 0.18 1.00 0.21 0.30 0.12 0.14 I. U.S. Treasuries –0.35 –0.25 –0.31 –0.34 –0.27 –0.04 –0.01 0.21 1.00 0.67 0.78 0.55 J. U.S. Investment Grade 0.10 0.22 0.18 0.15 0.18 0.14 0.40 0.30 0.67 1.00 0.61 0.79 K. European Government Bonds –0.29 –0.20 –0.27 –0.29 –0.24 –0.07 0.02 0.12 0.78 0.61 1.00 0.83 L. European Investment-Grade Corporates 0.01 0.11 0.06 0.05 0.06 0.14 0.32 0.14 0.55 0.79 0.83 1.00 Annualized Volatility 16.6% 20.7% 15.0% 15.4% 15.7% 25.4% 18.9% 16.6% 5.0% 6.0% 3.1% 3.2% Sources: MSCI, NAREIT, Barclays Capital, Standard and Poor’s
STEPS TOWARD AN ACTUAL PORTFOLIOOverall Portfolio Risk
Risk Budgeting
Strategic Asset Allocation
Tactical Asset Allocation
Security Selection
TACTICAL ASSET ALLOCATION AND SECURITY SELECTION
Strategic Asset
Allocation - - - -
Tactical Asset
Allocation
Security Selection
Nonsystematic risk factors
Systematic risk factors
Market return: passive investing or indexing
Excess return or alpha: active investing
CAN SECURITY SELECTION ADD VALUE?
Value Added by Security
Selection
Value Lost by
Security
Selection
Zero
At the macro level, security selection is a zero-sum game.
What factors affect the ability to add value via security selection?
REBALANCING POLICY
Policy Portfolio Weights
Returns on Asset Classes and Securities
Weights Deviate from
Policy
Portfolio Rebalanced to Policy Weights
EXAMPLE 7-12 STRATEGIC ASSET ALLOCATION FOR A EUROPEAN CHARITY
Asset Class
Policy Weight
Corridor (+/–)
Upper Limit
Lower Limit
Period Return
Ending Weight
European equities 30.0% 2.0% 32.0% 28.0% 15.0% 32.4% International equities 15.0% 2.0% 17.0% 13.0% 10.0% 15.5% European government bonds 20.0% 2.0% 22.0% 18.0% 0.5% 18.9% Corporate bonds 20.0% 2.0% 22.0% 18.0% 1.5% 19.1% Cash and money market instruments 15.0% 2.0% 17.0% 13.0% 1.0% 14.2% Total 100.0% 6.6% 100.0%
Key factors affecting rebalancing:• Ending weight of European equities.• Expectations regarding future asset class returns.
SUMMARY
• Components of the IPS• Risk and return objectives• Determinants of risk tolerance• Investment constraints• Risk budgeting• Strategic asset allocation• Tactical asset allocation and security selection• Rebalancing policy