BKFT 4010 Portfolio Management - Topic 1

Portfolio Management - Topic 1

• Course: BKFT 4010
• Topic: Investment Policy and Framework
• Lecturer: Dr. Alexis Stenfors
• Office: 11.01.08
• Email: [email protected]

Investment Management Process

• Consists of three key elements:
  • Planning: Establishing the necessary elements for decision-making, including data on clients and capital markets.
  • Execution: Details of optimal asset allocation and security selection.
  • Feedback: Adapting to changes in expectations, objectives, and portfolio composition.

Components of the Investment Management Process

• I. Planning:

  • A. Identifying and specifying the investor's objectives and constraints.
  • B. Creating the Investment Policy Statement (IPS) and forming capital market expectations.
  • C. Creating the strategic asset allocation (target minimum and maximum class weights).

• II. Execution: Portfolio construction and revision

  • A. Asset allocation (including tactical) and portfolio optimization (combining assets to meet risk and return objectives).
  • B. Security selection.
  • C. Implementation and execution.

• III. Feedback:

  • A. Monitoring (investor, economic, and market input factors).
  • B. Rebalancing.
  • C. Performance evaluation.

Components of the Investment Policy Statement (IPS)

• Brief client description
• Purpose of establishing policies and guidelines
• Duties and investment responsibilities of parties involved
• Statement of investment goals, objectives, and constraints
• Schedule for the review of investment performance and the investment policy statement
• Performance measures and benchmarks
• Any considerations in developing strategic asset allocation
• Investment strategies and investment styles
• Guidelines for rebalancing

Determination of Portfolio Policies

• Objectives (e.g., return requirements, risk tolerance)
• Constraints (e.g., liquidity, horizon, regulations, taxes, unique needs)
• Policies (e.g., asset allocation, diversification, risk positioning, tax positioning, income generation)

Institutional Investors

• Mutual Funds: Pools of investor money, investing as specified in prospectuses and issuing shares to investors, entitling them to a pro rata portion of the funds' income.
• Pension Funds: Objectives depend on the specific plan (defined contribution or defined benefit). Defined contribution plans are tax-deferred retirement accounts where employees bear all risk and receive plan returns.
• Endowment Funds: Organizations chartered to use funds for specific nonprofit purposes, financed by gifts and managed by educational, cultural, or charitable organizations.
• Life Insurance Companies: Invest to hedge liabilities, with objectives varying based on the types of policies written (e.g., whole-life and term).
• Non-life Insurance Companies: (e.g., property and casualty) Invest funds conservatively, primarily due to claims payments following premium collection.
• Banks: Invest primarily in loans to businesses and consumers; aiming to match asset risk with liabilities (deposits) and achieve a profitable spread between lending and borrowing rates.

The Investment Management Process: Objectives

• Investment managers assess investor risk tolerance to maximize return.
• Risk tolerance differs based on investor type.
  • Individual investors.
  • Personal trusts.

Risk Tolerance Questionnaire Example

• (Multiple questions used to rate risk tolerance)

Matrix of Objectives

• Lists return requirements and risk tolerance for different investor types (individual trusts, mutual funds, pensions, endowments, life insurance, non-life insurance, banks).

Constraints

• Liquidity: Short-term/recurring needs impacting risk-bearing capacity.
• Time Horizons: Multiple horizons with varying risk tolerances.
• Taxes: Tax status impacting instrument choice & tax strategy.
• Legal and Regulatory: External constraints from legal/regulatory requirements – e.g., trust and estate considerations.
• Unique Circumstances: Special situations specific to the client.

Matrix of Constraints

• Provides relevant constraints for different investor types (liquidity needs, time horizons, regulations, taxes).

Asset Allocation

• 1. Specify Asset Classes: Defining major categories for investment (money market instruments, fixed-income securities, stocks, real estate, precious metals.).
• 2. Specify Capital Market Expectations: Analyzing historical and economic data about future return rates in the relevant holding period.
• 3. Derive the Efficient Portfolio Frontier: Identifying optimal portfolios achieving maximum expected return given different risk levels.
• 4. Find the Optimal Asset Mix: Selecting the efficient portfolio fitting risk and return objectives while meeting constraints.
• 5. Manage Taxes: Optimizing tax implications for portfolio holdings.

Managing Portfolios of Individual Investors

• Human Capital and Insurance: Importance of human capital investment, like education, and risk hedging via insurance (e.g, disability and life insurance).
• Investment in Residence: Purchasing a residence as an investment, recognizing risks associated with rental rate increases and ensuring availability.
• Saving for Retirement and the Assumption of Risk: Factors affecting retirement savings, risk tolerance at different life stages, and the importance of lifetime financial planning.

Tax Sheltering

• Tax-Deferred Retirement Plans: Tax advantages of capital gains deferred until asset sale.
• Deferred Annuities: Tax-sheltered accounts combining tax deferral features from IRAs and offering withdrawal options (e.g., lump sum, fixed/variable annuity).

Pension Funds

• Pension Investment Strategies: Preference for higher-yield assets considering tax status. Usage of immunization, and reasons for equity investment.
• Defined Contribution Plans: Specified contributions (not benefits) with employee bearing investment risk.
• Defined Benefit Plans: Benefit formulas ensuring benefits and sponsoring liability.