The Portfolio Management Process and

the Investment Policy Statement

Chapter 1Managing Investment Portfolios

integrated set of steps undertaken in a consistent manner to create and maintain an appropriate portfolio to meet clients’ stated goals◦ portfolio – group of assets

steps◦ planning◦ execution◦ feedback

investment policy statement (IPS) – written document that clearly sets out a client’s return objectives and risk tolerance over that client’s relevant time horizon, along with applicable constraints such as liquidity needs, tax considerations, regulatory requirements, and unique circumstances

Portfolio Management Process

service of professionally investing money investment management firms

◦ revenues / size of firm◦ investors◦ employees

growth in industry due to importance of defined benefit plans in second half of 20th century◦ shift in 1980s and 1990s to retirement plans

focusing on participant responsibility resulted in growth of individual-oriented investment advisors

Investment Management

focus on aggregate of all investor’s holdings “because economic fundamentals influence the average

returns of many assets, the risk associated with one asset’s return is generally related to the risk associated with other assets’ returns – if we evaluate the prospects of each asset in isolation and ignore the interrelationships, we will likely misunderstand the risk and return prospects of the investor’s total investment position – our most basic concern”

Harry Markowitz (1952) father of modern portfolio theory◦ analysis of rational portfolio choices based on the efficient use of risk

“demand” for the portfolio perspective◦ emergence of importance of institutional investing◦ growth in technology◦ professionalization of investment management field

Portfolio Perspective

continuous and systematic process complete with feedback loops for monitoring and rebalancing

an integrated set of steps undertaken in a consistent manner to create and maintain appropriate combinations of investment assets

steps◦ planning◦ execution◦ feedback

Portfolio Management Process

planning◦ investor-related input factors

specification and quantification of investor objectives, constraints, and preferences objectives are desired investment outcomes that mainly

pertain to return and risk constraints are limitations on investor’s ability to take

full or partial advantage of particular investments portfolio policies and strategies

◦ economic and market input relevant economic, social, political, and sector

considerations capital market expectations

Portfolio Management Process

governing document for all investment decision making

elements of a typical IPS:◦ brief client description◦ purpose of establishing policies and guidelines◦ duties and investment responsibilities or parties

involved◦ statement of investment goals, objectives, and

constraints◦ schedule for review of financial performance◦ performance measures and benchmarks to be used◦ investment strategies and styles◦ guidelines for rebalancing based on feedback

Investment Policy Statement

IPS is basis for strategic asset allocation investment strategy – manager’s approach

to investment analysis and security selection◦ organizes and clarifies basis for investment

decisions◦ guides those decisions toward achieving

investment objectives types of investment strategies

◦ passive◦ active◦ semiactive

Investment Process

Investment style◦ natural grouping of investment disciplines that has some

predictive power in explaining the future dispersion in returns across portfolios

strategic asset allocation◦ combines IPS and capital market expectations to determine

target asset class weights maximum and minimum permissible asset class weights set to

control risk execution step – portfolio selection and composition

decision◦ interacts constantly with feedback step as changes are made◦ use portfolio optimization – quantitative tools for combining

assets efficiently to achieve a set of return and risk objectives

Investment Process

transaction costs◦ explicit – commissions paid to brokers, fees paid to

exchanges, taxes◦ implicit – bid-ask spreads, market price impacts of

large trades, missed trade opportunities, and delay costs

feedback step◦ monitoring and rebalancing

use feedback to manage ongoing exposures to available investment opportunities so that the client’s current objectives and constraints continue to be satisfied

◦ performance evaluation

Investment Process

performance measurement – involves calculation of the portfolio’s rate of return

performance attribution – examines why the portfolio performed as it did and involves determining the sources of a portfolio’s performance

performance appraisal – evaluation of whether the manager is doing a good job based on how the portfolio did relative to a benchmark

sources of return

Performance Evaluation

investment objectives and constraints are identified and specified

investment strategies are developed portfolio composition is decided in detail portfolio decisions are initiated by portfolio

managers and implemented by traders portfolio performance is measured and

evaluated investor and market conditions are

monitored necessary rebalancing is implemented

Portfolio Management

objectives are interdependent◦ risk◦ return

Objectives and Constraints

How do I measure risk?◦ absolute vs. relative risk◦ absolute

variance standard deviation

◦ relative tracking error

What is the investor’s willingness to take on risk?

Risk Objectives

What is investor’s ability to take on risk?◦ In terms of spending needs, how much volatility

would inconvenience an investor who depends on investments? Or how much volatility would inconvenience an investor who cannot afford to incur substantial short-term losses?

◦ In terms of long-run wealth targets or obligations, how much volatility might prevent the investor from reaching these goals?

◦ What are the investor’s liabilities or psudeo-liabilities?◦ What is the investor’s financial strength – that is, the

ability to increase the savings/contribution level if the portfolio cannot support the planned spending?

Risk Objectives

How much risk is the investor both willing and able to bear?◦ risk tolerance – capacity to accept risk

What are the specific risk objective(s)?◦ absolute vs. relative risk objectives◦ example

How should the investor allocate risk?◦ risk budgeting

Risk Objectives

How is return measured?◦ total return – capital appreciation plus investment

income◦ absolute vs. relative◦ nominal vs. real◦ pre-tax vs. post-tax

How much return does the investor say she wants?

Return Objective

How much return does the investor need to achieve, on average?◦ required return◦ examples

amount a pension fund needs to earn to fund liabilities to current and future fund holders

amount an individual investor needs to have to fund retirement at a certain level

amount that a retired investor needs to earn on portfolio to cover his living expenses

What are the specific return objectives?

Return Objective

married couple needs £2 million in 18 years to fund retirement (incorporates inflation)◦ current investable assets are £1.2 million◦ need to earn 2.88% per year after tax to achieve

goal◦ How did we get 2.88%?◦ Suppose couple needs to liquidate £22,000 from

portfolio at end of each year. What return is needed?*

◦ If all investment returns are taxed at 30%, what pre-tax return would you need?

Example of Return Objective

liquidity time horizon

◦ How does the length of the time horizon modify the investor’s ability to take risk?

◦ How does the length of the time horizon modify the investor’s asset allocation?

◦ How does the investor’s willingness and ability to bear fluctuations in portfolio value modify the asset allocation?

◦ How does a multistage time horizon constrain the investor’s asset allocation?

tax concerns legal and regulatory factors unique circumstances

Constraints

taking the inputs from analysts, economists, etc. and moving step by step through the orderly process of converting this raw material into a portfolio that:◦ maximizes expected return relative to the

investor’s ability to bear risk◦ meets investor’s constraints and preferences◦ integrates portfolio policies with expectational

factors and market uncertainties

Portfolio Management