LOS 47: The Portfolio Management Process and the Investment Policy Statement

Portfolio perspective

tells us that our fundamental concern is to understand the risk and return in a portfolio context

Importance of the portfolio perspective

- Investors, analysts, and portfolio managers should analyze the risk-return tradeoff of the portfolio as a whole, not the risk-return tradeoff of the individual investments in the portfolio, because unsystematic risk can be diversified away by combining

Steps of the portfolio management process

(1) Planning
(2) Execution
(3) Feedback

Planning

consists of analyzing objectives and constraints, developing an IPS, determining the appropriate investment strategy, and selecting an appropriate asset allocation

Execution

relates to portfolio construction and revision

Feedback

consists of monitoring, rebalancing, and performance evaluation

Investment policy statement

is a written document providing guidelines for portfolio investment decision making

Investment policy statement [Purpose]

- Provides guidance for current and subsequent investment adviser decisions
- Promotes long-term discipline in investment decision making
- Protects against short-term shifts in strategy when either market conditions or portfolio
performance cause panic o

Investment policy statement [Components]

(1) a description of the client's situation
(2) the purpose, as well as identification, of responsibilities
(3) Formal statements of objectives and constraints
(4) a schedule for portfolio performance and IPS review
(5) Asset allocation ranges
(6) Guidanc

Strategic asset allocation

- The final step in the planning stage of the IPS
- This step combines the IPS and capital market expectations to formulate long-term target weightings for the asset classes to be included in the portfolio

Capital market expectations & the IPS influence on the strategic asset allocation decision

While the investment policy statement will outline the appropriate risk-return characteristics for an investment portfolio, the strategic asset allocation to provide these characteristics will depend on capital markets expectations (risk, returns, and cor

Investment time horizon influence on strategic asset allocation

Typically, a longer investment time horizon will lead investors to tolerate more portfolio risk and employ strategic asset allocations more heavily weighted toward asset classes with greater risk and greater expected returns, such as equities

Strategic asset allocation [Common approaches]

(1) Passive investment strategies
(2) Active investment strategies
(3) Semi-active, risk-controlled active, or enhanced index strategies

Investment objectives

- relate to what the investor wants to accomplish with the portfolio
- Objectives are mainly concerned with risk and return considerations

Return objectives

- can be classified as either a desired or a required return
- A desired return is that level of return stated by the client, indicating how much the investor wishes to receive from the portfolio
- A required return represents some level of return that mu

Risk objectives

- are those factors associated with an investor's willingness and ability to take risk
- Combining willingness and ability to accept risk is termed risk tolerance
- Risk aversion indicates an investor's inability and unwillingness to take risk

Willingness vs Ability to Take Risk

Factors that affect risk objectives

(1) Required spending needs
(2) Long-term wealth target
(3) Financial strength
(4) Liabilities

Required spending needs

How much variation in portfolio value can the investor tolerate before being inconvenienced in the short term

Long-term wealth target

How much variation in portfolio value can the investor tolerate before it jeopardizes meeting long-term wealth goals

Financial strength

Can the investor increase savings (or decrease expenditures) if the portfolio is insufficient to meet spending needs

Liabilities

Is the investor legally obligated to make future payments to beneficiaries, or does the investor have certain set spending requirements in retirement (i.e., pseudo liabilities)

Types of investment constraints

(1) Liquidity constraints
(2) Time horizon constraints
(3) Tax constraints
(4) Legal and regulatory factors
(5) Unique circumstances

Investor time horizons

- Investors may have short or long investment horizons, or some combination of the two when multiple investment goals are identified
- Investors with longer horizons (>10 years) have the ability, but not necessarily the willingness, to employ strategic as

Ethical conduct

- The investment professional who manages client portfolios well meets standards of competence and standards of conduct
- It is important to recognize that the portfolio manager, who is an expert in the field with presumably more knowledge of investment p