Portfolio Management Topic 1 PDF

BKFT 4010 – Portfolio Management Topic 1 Investment Policy and Framework Dr. Alexis Stenfors Office: 11.01.08 [email protected] The Investment Management Process BKM Investments 11th Edition Book Chapter 28 Sections 28.1, 2...

BKFT 4010 – Portfolio Management Topic 1 Investment Policy and Framework Dr. Alexis Stenfors Office: 11.01.08 [email protected] The Investment Management Process BKM Investments 11th Edition Book Chapter 28 Sections 28.1, 28.2, 28.3, 28.5, 28.6, and 28.7 The Investment Management Process  The elements of the investment process  Planning: Establishing all the elements necessary for decision making (data about clients/capital markets)  Execution: Details of optimal asset allocation and security selection  Feedback: Adapting to changes in expectations and objectives and changes in portfolio composition Components of the Investment Management Process (1 of 3) I. Planning A. Identifying and specifying the investor’s objectives and constraints B. Creating the Investment Policy Statement Forming capital market expectations C. Creating the strategic asset allocation (target minimum and maximum class weights) Components of the Investment Management Process (2 of 3) 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 Components of the Investment Management Process (3 of 3) III. Feedback A. Monitoring (investor, economic, and market input factors) B. Rebalancing C. Performance evaluation  Components of the Investment Policy Statement 1. Brief client description 2. Purpose of establishing policies and guidelines 3. Duties and investment responsibilities or parties involved 4 Statement of investment goals, objectives, and constraints 5. Schedule for review of investment performance and the investment policy statement 6. Performance measures and benchmarks 7. Any considerations in developing strategic asset allocation 8. Investment strategies and investment styles 9. Guidelines for rebalancing Components of the Investment Policy Statement Determination of Portfolio Policies Objectives Constraints Policies Return requirements Liquidity Asset allocation Risk tolerance Horizon Diversification Regulations Risk positioning Taxes Tax positioning Unique needs Income generation Determination of Portfolio Policies Institutional Investors  Mutual Funds: are pools of investors’ money. They invest in ways specified in their prospectuses and issue shares to investors entitling them to a pro rata portion of the income generated by the funds. Institutional Investors  Pension Funds: its objectives depend on the type of pension plan. There are two basic types: defined contribution plans and defined benefit plans. Defined contribution plans are in effect tax-deferred retirement savings accounts established by the firm in trust for its employees, with the employee bearing all the risk and receiving all the return from the plan’s assets. Institutional Investors  Endowment Funds: are organizations chartered to use their money for specific nonprofit purposes. They are financed by gifts from one or more sponsors and are typically managed by educational, cultural, and charitable organizations or by independent foundations established solely to carry out the fund’s specific purposes. Generally, the investment objectives of an endowment fund are to produce a steady flow of income subject to only a moderate degree of risk. Institutional Investors  Life Insurance companies generally try to invest so as to hedge their liabilities, which are defined by the policies they write. Thus there are as many objectives as there are distinct types of policies. Until a decade or so ago there were only two types of life insurance policies available for individuals: whole-life and term.  A whole-life insurance policy combines a death benefit with a kind of savings plan that provides for a gradual buildup of cash value that the policyholder can withdraw at a later point in life, usually at age 65. Term insurance, on the other hand, provides death benefits only, with no buildup of cash value. Institutional Investors  Non–life insurance companies such as property and casualty insurers have investable funds primarily because they pay claims after they collect policy premiums. Typically, they are conservative in their attitude toward risk. As with life insurers, non–life insurance companies can be either stock companies or mutual companies. Institutional Investors  Banks: The defining characteristic of banks is that most of their investments are loans to businesses and consumers and most of their liabilities are accounts of depositors. As investors, the objective of banks is to try to match the risk of assets to liabilities while earning a profitable spread between the lending and borrowing rates. The Investment Management Process: Objectives  Objectives  Investment managers must assess the level of risk investors can tolerate in pursuit of higher returns  Objectives and risk tolerance differ by type of investor  Individual investors  Personal trusts  Risk Tolerance Questionnaire Example (1 of 2) Question 1 Point 2 Points 3 Points 4 Points No sooner than 1. I plan on using the money I Within 6 Within the Between 3 7 years from am investing: months. next 3 years. and 6 years. now. 2. My investments make up 50% or more 25% or more More than this share of assets but less than but less than Less than 25%. 75%. (excluding home): 75%. 50%. Remain the Grow faster 3. I expect my future income Decrease. same or grow than the rate Grow quickly. to: slowly. of inflation. Yes, but less 4. I have emergency savings: No. No than I’d Yes. like to have.  Risk Tolerance Questionnaire Example (2 of 2) Question 1 Point 2 Points 3 Points 4 Points 5. I would risk this share of my portfolio in exchange for the same Zero. 10%. 25%. 50%. probability of doubling my money: 6. I have invested in Yes, and I was Yes, but I was No, but I look stocks and stock No. comfortable uneasy about it. forward to it. mutual funds: with it. Grow as fast as Grow faster than Preserve my Receive some possible. 7. My most important inflation but still original growth and Income is not investment goal is to: provide some investment. provide income. important income. today.  Matrix of Objectives Type of Investor Return Requirement Risk Tolerance Individual and personal Life cycle (younger are Life cycle (education, children, retirement) trusts more risk tolerant) Mutual funds Variable Variable Depends on proximity of Pension funds Assumed actuarial rate payouts Determined by current income needs and need Endowment funds Generally conservative for asset growth to maintain real value Should exceed new money rate by sufficient Life insurance companies margin to meet expenses and profit objectives; Conservative also actuarial rates important Non-life insurance No minimum Conservative companies Banks Interest-rate spread Variable Constraints 1. Liquidity: Any significant payment(s) that must be funded out of the portfolio should be recorded here. Liquidity needs over multiple time horizons may be addressed, but the primary focus is on near-term (less than one year) and recurring needs. High liquidity needs reduce the ability to bear risk since higher-risk assets should not be viewed as routinely available to meet liquidity demands. 2. Time Horizons: Most clients have multiple investment horizons corresponding to specific future events and/or goals. For individuals, these horizons often reflect lifecycle stages. Longer horizons are deemed to imply a greater ability to bear risk. In general, each period/horizon documented will be associated with a different asset allocation in the next section of the IPS. 3. Taxes: The client’s tax status affects both the selection of instruments (e.g. taxable versus tax-exempt bonds) and the appropriate strategy for handling potentially taxable events (e.g. capital gains/losses). Constraints 4. Legal and Regulatory: Institutional clients are often subject to external constraints imposed by legal and/or regulatory requirements. Trust and estate considerations could impose constraints on individuals that would also fall in this category. 5. Unique Circumstances: This category covers any special situations and concerns specific to the client. For example, a prohibition on so-called sin stocks would be listed here.  Matrix of constraints Regulatio Type of Investor Liquidity Horizon Taxes ns Individuals and Life Variabl Variable None personal trusts cycle e Mutual funds High Variable Few None Young, low; mature, Pension funds Long ERISA None high Endowment funds Low Long Few None Life insurance Low Long Complex Yes companies Non-life insurance High Short Few Yes companies Banks High Short Changing Yes Asset Allocation  Decision of how much of the portfolio to invest in each major asset category 1. Specify Asset Classes: The major classes usually considered are the following: a.Money Market Instruments (usually called cash) b.Fixed-Income Securities (usually called bonds) c.Stocks. d.Real Estate. e.Precious Metals. f.Other. Asset Allocation 2. Specify Capital Market Expectations: This step consists of using both historical data and economic analysis to determine your expectations of future rates of return over the relevant holding period on the assets to be considered for inclusion in the portfolio. 3. Derive the Efficient Portfolio Frontier: This step consists of finding portfolios that achieve the maximum expected return for any given degree of risk. 4. Find the Optimal Asset Mix: This step consists of selecting the efficient portfolio that best meets your risk and return objectives while satisfying the constraints you face. 5. Manage Taxes Managing Portfolios of Individual Investors  Human Capital and Insurance: The first significant investment decision for most individuals concerns education, building up their human capital. The major asset most people have during their early working years is the earning power that draws on their human capital. In these circumstances, the risk of illness or injury is far greater than the risk associated with financial wealth.  The most direct way of hedging human capital risk is to purchase insurance. Viewing the combination of your labor income and a disability insurance policy as a portfolio, the rate of return on this portfolio is less risky than the labor income by itself. Life insurance is a hedge against the complete loss of income as a result of death of any of the family’s income earners. Managing Portfolios of Individual Investors  Investment in Residence: The first major economic asset many people acquire is their own house. Deciding to buy rather than rent a residence qualifies as an investment decision. An important consideration in assessing the risk and return aspects of this investment is the value of a house as a hedge against two kinds of risk.  The first kind is the risk of increases in rental rates. If you own a house, any increase in rental rates will increase the return on your investment.  The second kind of risk is that the particular house or apartment where you live may not always be available to you. By buying, you guarantee its availability. Managing Portfolios of Individual Investors  Saving for Retirement and the Assumption of Risk: People save and invest money to provide for future consumption and leave an estate. The primary aim of lifetime savings is to allow maintenance of the customary standard of living after retirement. Life expectancy, when one makes it to retirement at age 65, approaches 85 years, so the average retiree needs to prepare a 20-year nest egg and sufficient savings to cover unexpected health-care costs.  Investment income may also increase the welfare of one’s heirs, favorite charity, or both. The leisure that investment income can be expected to produce depends on the degree of risk the household is willing to take with its investment portfolio. Empirical observation summarized in the below Table indicates a person’s age and stage in the life cycle affect attitude toward risk.  Questionnaires suggest that attitudes shift away from risk tolerance and toward risk aversion as investors near retirement age. With age, individuals lose the potential to recover from a disastrous investment performance. Managing Portfolios of Individual Investors  Retirement Planning Models: In recent years, investment companies and financial advisory firms have created a variety of “user-friendly” interactive tools and models for retirement planning.  Manage your own portfolio or rely on others? Lots of people have assets such as social security benefits, pension and group insurance plans, and savings components of life insurance policies. Yet they exercise limited control, if any, on the investment decisions of these plans. The funds that secure pension and life insurance plans are managed by institutional investors. Outside of the “forced savings” plans, however, individuals can manage their own investment portfolios. As the population grows richer, more and more people face this decision. Managing your own portfolio appears to be the lowest-cost solution. Tax sheltering  The Tax-Deferral Option: A fundamental feature of the U.S. Internal Revenue Code is that tax on a capital gain on an asset is payable only when the asset is sold; this is its tax-deferral option. The investor therefore can control the timing of the tax payment. From a tax perspective this option makes stocks in general preferable to fixed-income securities.  Tax-Deferred Retirement Plans: Recent years have seen increased use of tax-deferred retirement plans in which investors can choose how to allocate assets. Typically, an individual may have some investment in the form of such qualified retirement accounts and some in the form of ordinary taxable accounts. The basic investment principle that applies is to hold whatever bonds you want to hold in the tax-deferred retirement account while holding equities in the ordinary taxable account. You maximize the tax advantage of the retirement account by holding it in the security that is the least tax advantaged. Tax sheltering Deferred Annuities: are essentially tax-sheltered accounts offered by life insurance companies. They combine the same kind of deferral of taxes available on IRAs with the option of withdrawing one’s funds in the form of a life annuity. There are two types of life annuities, fixed annuities and variable annuities. A fixed annuity pays a fixed nominal sum of money per period (usually each month), whereas a variable annuity pays a periodic amount linked to the investment performance of some underlying portfolio. Variable annuities are structured so that the investment risk of the underlying asset portfolio is passed through to the recipient, much as shareholders bear the risk of a mutual fund. There are two stages in a variable annuity contract: an accumulation phase and a payout phase. During the accumulation phase, the investor contributes money periodically to one or more open- end mutual funds and accumulates shares. The second, or payout, stage usually starts at retirement, when the investor typically has several options, including the following: 1. Taking the market value of the shares in a lump sum payment. 2. Receiving a fixed annuity until death. 3. Receiving a variable amount of money each period that is computed according to a certain procedure.  Variable annuity example Assume that at retirement John Shortlife has $100,000 accumulated in a variable annuity contract. The initial annuity payment is determined by setting an assumed investment return (AIR), 4% per year in this example, and an assumption about mortality probabilities. In Shortlife’s case, we assume he will live for only three years after retirement and will receive three annual payments starting one year from now. The benefit payment in each year, Bt , is given by the recursive formula: where Rt is the actual holding-period return on the underlying portfolio in year t. AIR = Assumed Investment Return Variable annuity example B0 = $100,000 X 0.04 / (1 – (1 + 0.04)^(-3)) B0 = $36,035 Year 1: $36,035 Year 2: $36,035 Year 3: $36,035 Sum: $100,000 Net Present Value check: Year 1: $36,035/(1+0.04)^1 = $36,649 Year 2: $36,035/(1+0.04)^2 = $33,316 Year 3: $36,035/(1+0.04)^3 = $32,035 Sum: = $100,000 Variable annuity example B0 = $100,000 X 0.04 / (1 – (1 + 0.04)^(-3)) B0 = $36,035 Year 1: $36,035 X (1+0.06)/(1+0.04) = $36,728 Year 2: $36,728 X (1+0.02)/(1+0.04) = $36,022 Year 3: $36,022 X (1+0.04)/(1+0.04) = $32,022  Concept check – variable annuity Assume Victor is now 75 years old and is expected to live until age 80. He has $100,000 in a variable annuity account. If the assumed investment return is 4% per year, what is the initial annuity payment? Suppose the annuity’s asset base is the S&P 500 equity portfolio and its holding-period return for the next five years is each of the following: 4% 10% –8% 25% 0 How much would Victor receive each year? Verify that the insurance company would wind up using exactly $100,000 to fund Victor’s benefits. Concept Check - variable annuity B0 = $100,000 X 0.04 / (1 – (1 + 0.04)^(-5)) B0 = $22,463 Year 1: $22,463 X (1+0.04)/(1+0.04) = $22,463 Year 2: $22,463 X (1+0.10)/(1+0.04) = $23,759 Year 3: $23,759 X (1-0.08)/(1+0.04) = $21,017 Year 4: $21,017 X (1+0.25)/(1+0.04) = $25,261 Year 5: $25,261 X (1+0.00)/(1+0.04) = $24,290 Pension funds  The pension fund of the plan is the cumulation of assets created from contributions and the investment earnings on those contributions, less any payments of benefits from the fund. In the United States, contributions to the fund by either employer or employee are tax-deductible, and investment income of the fund is not taxed. Distributions from the fund, whether to the employer or the employee, are taxed as ordinary income.  There are two “pure” types of pension plans: 1.Defined Contribution Plan 2.Defined Benefit Plan Pension funds  Defined Benefit Plans In a defined benefit plan, a formula specifies benefits, but not the manner, including contributions, in which these benefits are funded. The benefit formula typically takes into account years of service for the employer and level of wages or salary (e.g., the employer pays the employee for life, beginning at age 65, a yearly amount equal to 1% of his final annual wage for each year of service). The employer (called the “plan sponsor”) or an insurance company hired by the sponsor guarantees the benefits and thus absorbs the investment risk. The obligation of the plan sponsor to pay the promised benefits is like a long-term debt liability of the employer. Pension funds  Defined Contribution Plans In a defined contribution plan, a formula specifies contributions but not benefit payments. Contribution rules usually are specified as a predetermined fraction of salary although that fraction need not be constant over the course of an employee’s career. The pension fund consists of a set of individual investment accounts, one for each employee. Pension benefits are not specified, other than that at retirement the employee applies that total accumulated value of contributions and earnings on those contributions to purchase an annuity. The employee often has some choice over both the level of contributions and the way the account is invested. In principle, contributions could be invested in any security, although in practice most plans limit investment choices to bond, stock, and money market funds. The employee bears all the investment risk; the retirement account is, by definition, fully funded by the contributions, and the employer has no legal obligation beyond making its periodic contributions. Pension Funds  Pension Investment Strategies  The tax status of pension funds makes them favor assets with the largest spread between pre-tax and after-tax rates of return  Pension funds make use of immunization  Investing in equities occurs for both correct and wrong reasons