Canadian Securities - Chapter 16 - Portfolio Management

CANADIAN SECURITIES Chapter 16 The Portfolio Management Process Agenda Determine Investment Objectives Describe the various investment objectives and constraints, and their use in creating an investment policy statement for a client. Design an Investment Policy...

CANADIAN SECURITIES Chapter 16 The Portfolio Management Process Agenda Determine Investment Objectives Describe the various investment objectives and constraints, and their use in creating an investment policy statement for a client. Design an Investment Policy List the components of an investment policy statement. Develop the Asset Mix Explain how asset classes are used to construct an appropriate asset mix Select the Securities Differentiate between the approaches to asset allocation. Monitor the Client, the Market, and the Economy Describe the process for monitoring the portfolio Evaluate Portfolio Performance Calculate and interpret the total return and risk adjusted rate of return of a portfolio Rebalance the Portfolio Define the purpose of rebalancing the portfolio. Learning Outcomes 3.6 Categorize the steps in the portfolio management process. 3.7 Evaluate the investment considerations, objectives and constraints involved in designing an investment policy for a client. 3.8 Outline the structure and purpose of an Investment Policy Statement. 4.1 Explain the process and importance of developing the correct asset mix. 4.2 Investigate the link between equity markets and economic cycles. 4.3 Compare different equity and fixed income management styles. 4.4 Differentiate between strategic, dynamic, tactical and integrated asset allocation. 4.5 Explain the importance of monitoring the economy, the markets and the client on an ongoing basis. 4.6 Calculate risk-adjusted rate of return for a portfolio using the Sharpe ratio. Introduction Portfolio management is a continual process because financial markets and individual circumstances are ever changing There is no “one size fits all” solution to investing, and finding the right fit is critical to achieving financial objectives Portfolio management involves analyzing a great deal of personal and financial information about your clients to determine an asset mix that best suits them Introduction Consequently… …it is crucial that you understand what is involved in the decision-making process. When working with clients as an advisor, you must be able to explain the asset choices you make. You must also be prepared to react to changing markets, investor objectives, and economic factors. CHAPTER 16 The Portfolio Management Process  The Portfolio Management Process The portfolio management process consists of the following seven basic steps: 1. Determine investment objectives and constraints. 2. Design an investment policy statement. 3. Develop the asset mix. 4. Select the securities. 5. Monitor the client, the market, and the economy. 6. Evaluate portfolio performance. 7. Rebalance the portfolio The Portfolio Management Process  CHAPTER 16 Step 1: Determine Investment Objectives and Constraints Step 1: Investment Objectives Constraints Constraints: Conditions that exist which might restrict/limit investment opportunities/strategies A family member who is an insider, which presents a legal constraint A serious illness, which has income and time horizon implications A pending marital breakup, which can have a material impact on future plans See NAAF & IPS Step 1: Risk & Return Objectives The return objective is a measure of how much a client’s portfolio is expected to earn each year, on average. This objective depends primarily on the return required to meet the client’s goals, but it must also be consistent with the client’s risk tolerance. The risk objective is a specific statement of how much risk the client is willing to sustain to meet the return objective. The risk objective is based on the client’s risk tolerance—the client’s willingness and ability to bear risk Assessment of risk tolerance is a vital element in the ultimate design of the portfolio because it governs the selection of securities. Step 1: Risk & Return Objectives Because the risk of a portfolio is less than the average risk of its holdings, a client’s risk tolerance should be matched to the risk of the overall portfolio, rather than the risk of each security. The purpose of portfolio management is to ensure that the portfolio generates returns in consideration of the investor’s particular level of risk tolerance. Risk management is therefore a major focus of the process. An increase in returns should result from an increase in risk; however, high-risk portfolios do not always turn out to be high-return portfolios. Step 1: Sample Risk Categories Historic Returns  Step 1: Investment Objectives In general, an investor’s objectives comprise the following three primary investment components: Safety of principal (also called preservation of capital) Income Growth of capital Secondary investment objectives include liquidity (or marketability) tax minimization.  Step 1: Investment Objectives As an advisor, you should explain each objective to your client and jointly determine the appropriate balance among all objectives. Allocation to each primary objective on a percentage basis is recommended. This approach adds clarity for both parties, especially when clients have trouble communicating their wishes. Clarity of objectives also translates well into the categories of the New Account Application Form (NAAF).  Step 1: Primary Objectives Safety of principal Many clients want some assurance that their initial capital invested will largely remain intact. If this is your client’s main concern among the three primary objectives, you should help to prevent erosion of the amount initially invested, regardless of the return generated on the capital. However, if safety of principal is the main concern, the client must accept a lower rate of income return and give up much of the opportunity for capital growth. Examples: Cash Money Market investments Federal, provincial, and municipal bonds, if they are held to maturity. Shorter-term bonds A Government of Canada Treasury bill (T-bill) offers the highest degree of safety; it is virtually risk-free.  Step 1: Primary Objectives Income Income from a portfolio is a regular series of cash flows received from debt and equity securities, whether as dividends, interest, or other form. In determining the income objective and the split between debt and equity securities, major considerations are taxation of dividends and interest income. This decision is made at the time the asset mix is set. To maximize the rate of income return, investors usually give up some safety. Examples: Corporate Bonds Preferred Shares High Yielding Common Shares with consistent dividends Income-focused mutual funds REITs, MBS, Some Structured Products  Step 1: Primary Objectives Growth Growth of capital, or capital gains, refers to the profit generated when securities are sold for more than they originally cost to buy. When capital gains are the primary investment objective, the emphasis is on security selection and market timing. Note that capital gains are taxed more favourably than interest income; however, taxation details are more fully discussed in a later chapter. Examples: Common stocks Many mutual fund Labor Sponsored Funds Other investments that do not provide safety of principal or a focus on income generation Step 1: Primary Objectives  Step 1: Secondary Objectives Liquidity Liquidity is not necessarily related to safety, income return, or capital gain. It simply means that, at nearly all times, there are buyers at some price level for the securities, usually at a small discount from fair value. Liquidity is important for investors who may need money on short notice. For others, it may not be vital. Most Canadian securities can be sold quickly in reasonable quantities at some price. Typically, they sell within one business day with settlement to follow within two business days. Some real estate– related securities are an exception.  Step 1: Secondary Objectives Tax Avoidance When assessing the returns from any investment, you must consider the effect of taxation. The tax treatment of an investment varies depending on whether the returns are categorized as interest, dividends, or capital gains. Therefore, tax treatment of the returns influences the choice of investments. Considerations Clients with high income Small business owners Clients with assets that exceed tax deferral/shelter accounts (RRSP, DFSA, DB & DC pensions etc).  Step 1: Constraints Investment constraints impose necessary discipline on clients in the fulfilment of their objectives. Constraints may loosely be defined as those items that may hinder or prevent you from satisfying your client’s objectives. Constraints are often not given the importance they deserve in the policy formation process. *** it is prudent to place a strong priority on risk and constraints*** “it is better to prepare and prevent than repair and repent” – E. Benson Understanding and applying constraints (when other advisors may not), creates a strong connection and level of advocacy between the advisor and client. Investments should be matched with the time horizon of the Objective (in terms of return expectation, risk assumptions, liquidity, and taxation). Fundamentally, the time horizon is the period spanning the present until the next major change in the client’s circumstances. Clients go through various events in their lives, each of which can represent a time horizon and a need to completely rebalance their portfolio. For example, a 25-year-old client who plans to retire at age 60 will not likely have a single time horizon of 35 years. Various events in that client’s life will end one time horizon and begin a new one. Events might include finishing university, making a career change, planning for the birth of a child, or purchasing a home. ***Portfolios should be reviewed and rebalanced regularly to account for life events however, an objectives may maintain its time horizon throughout despite client life cycle adversity. *** for example: the primary objective of retiring at 60 may continue in spite of a career change or birth  Step 1: Constraints – Liquidity In portfolio management, liquidity refers to the amount of cash and near-cash in the portfolio. The cash component could be higher during certain parts of the market cycle. For example, it could go up when securities are judged to be overpriced, or when the yield curve is inverted and the returns on cash are high. The liquidity constraint may be different from a Portfolio Manger standpoint than from an Investor Standpoint. Portfolio Manager: Mandated cash position, declared distributions, pension funding etc. Investor: availability to access and liquidate their holding to fund some objective  Step 1: Constraints – Tax Your client’s marginal tax rate dictates, in part, the proportion of income that the client should receive as interest income in relation to dividends. Remember that dividends from Canadian corporations are eligible for a tax credit. The marginal tax rate also guides the proportion that should be invested in preferred shares versus other fixed-income securities, such as bonds. High tax rates can significantly erode the final return on more traditional investments, such as guaranteed investment certificates (GIC). Therefore, clients in a higher tax bracket often seek out the higher returns available from securities. *Consider those with foreign income  Step 1: Constraints – Legal & Regulatory Any investment activity that contravenes an act, law, by-law, regulation, or rule must be considered a constraint. For example, a client who is an insider or owner of a control position at a publicly-traded company must comply with all applicable regulatory guidelines. (See NAAF) All firms have compliance personnel and many have legal counsel on staff. You should consult these resources when you have any question about legal issues  Step 1: Constraints – SRI Investors with specific ESG/SRI investing objectives ESG: Environmental, Social, Governance SRI: Socially Responsible Investing Negative screening (not participating in):weapons, alcohol, tobacco, pornography, oil & gas, coal, etc. Positive screening (participating in): clean energy, electric vehicles, impact investing, best in industry Step 1: Constraints – Unique Circumstances Any other criteria that may affect the investment portfolio composition and investment selection process: Personal Preferences Beliefs Personal circumstances Trust agreements Estate settlements Investment club rules Professional portfolio management mandates Etc. CHAPTER 16 Step 2: Design an Investment Policy Statement (IPS)  Step 2: Design the IPS An investment policy statement is an agreement between a portfolio manager and a client that provides the investment guidelines for the manager. The purpose of an investment policy statement is to document the investment management process by: 1. identifying the key roles and responsibilities relating to the ongoing management of the fund’s assets; and 2. setting forth an investment structure for the fund’s assets, which includes all of the fund’s asset classes and acceptable ranges that, in aggregate, are expected to produce a sufficient investment return over the long term while prudently managing risk. Generally speaking, the IPS outlines “how the assets within the portfolio are to be managed”*. This strategy should provide guidance in all market environments, and should be based on a clear understanding of worst-case outcomes.  Step 2: Design the IPS Though there is no standardized list of components to include in an investment policy statement, some important considerations are listed below: Operating rules Guidelines Investment objectives and constraints A list of acceptable and prohibited investments The method used for performance appraisal agreed to by the advisor and the client The statement can be a lengthy written and signed document, or it can be derived from the NAAF in accordance with the Know Your Client rule. Regardless of its level of formality, the investment policy is the result of many complex inputs. CHAPTER 16 Step 3: Develop the Asset Mix  Step 3: Develop the Asset Mix After designing the investment policy based on the client’s investment objectives and constraints, the portfolio manager must select appropriate investments for the portfolio. If it is your role to select the asset mix, you must: - Understand the investment opportunities available to your client - The relationship between equity cycle and economic cycle - Client risk tolerances, objectives, and personal characteristics The main asset classes are - cash, fixed - income securities - equity securities - More sophisticated portfolios may also include alternative investments such as private equity capital funds, currency funds, or hedge funds  Step 3: Develop the Asset Mix Cash Cash and cash equivalents includes - Currency - money market securities - redeemable GICs - bonds with a maturity of one year or less - and all other cash equivalents Cash is needed to pay for expenses and to capitalize on opportunities, but is primarily used as a source of liquid funds in case of emergencies. In general terms, cash usually makes up at least 5% of a diversified portfolio’s asset mix. Investors who are very risk averse may hold as much as 10% in cash. Cash levels may temporarily rise greatly above these amounts during certain market periods or during portfolio rebalancing.  Step 3: Develop the Asset Mix Fixed Income Fixed-income products consist of - bonds due in more than one year - strip bonds - mortgage-backed securities - fixed-income exchange-traded funds - bond mutual funds - and other debt instruments & preferred shares - *Convertible securities are not considered to be fixed-income products The purpose of including fixed-income products is primarily to produce income, but also to provide some safety of principal. They are also sometimes purchased to generate capital gains.  Step 3: Develop the Asset Mix Fixed Income The amount of a portfolio allocated to fixed-income securities is governed by the following factors: The need for income over capital gains The basic minimum income required The desire for preservation of capital Investor risk profile, objectives, and constraints Portfolio mandate and/or portfolio strategy Other factors such as tax and time horizon  Step 3: Develop the Asset Mix Equity Securities Equities include - common shares - equity exchange-traded funds - equity mutual funds - both convertible bonds and convertible preferred shares. Although a dividend stream may flow from the equity section of a portfolio, its main purpose is to generate capital gains, either through trading or long-term growth in value. *Recognize that not all equity holdings are the same in terms of risk and return, therefore, not all equity portfolios are the same. For example, one equity portfolio, might investing in highly speculative small cap foreign oil & gas companies, while another may invest defensive large cap domestic stocks  Step 3: Develop the Asset Mix Other Asset Classes Although portfolios of most retail clients consist of cash, fixed-income, and equities, investors can diversify further by adding the following types of investments, which fall outside of the major asset classes: - Hedge funds - Real estate - Precious metals - Collectibles, such as art or coins - Commodities, such as gold (which is considered a good hedge against inflation)  Step 3: Develop the Asset Mix Other Asset Classes Although portfolios of most retail clients consist of cash, fixed-income, and equities, investors can diversify further by adding the following types of investments, which fall outside of the major asset classes: - Hedge funds - Real estate - Precious metals - Collectibles, such as art or coins - Commodities, such as gold (which is considered a good hedge against inflation) Step 3: Setting the Asset Mix  Step 3: Asset Class Timing The rationale behind asset class timing is that investors can improve returns by strategically switching from stocks to T-bills, to bonds, and back to stocks (Consider Sector Rotation sytle) - however, investors do not always have the analytic tools available that tell them when to shift between asset classes. - In reality, most investors are unable to determine whether a rise in interest rates is designed to slow economic growth or whether it is pointing to a coming contraction or recession. Other considerations - Term to maturity - Liquidity It is generally accepted that asset allocation has an important impact on the variation in the total returns of investment portfolios Step 3: Asset Class Timing  Step 3: Asset Class Timing Changes in the S&P/TSX Composite Index price level generally result from changes in: - interest rates (monetary policy) - or economic growth (GDP, inflation) The relationships between interest rate trends and economic trends (and therefore corporate profit trends) are of the greatest significance to equity price levels. These two factors, in combination, generally account for a high percentage of the change in stock market prices (recall: Systematic risk) As a result, these factors are often used together in asset mix models. Interest rates are used by central banks as a policy tool for managing economic growth; therefore, changes in rates tend to lead to changes in economic growth. CHAPTER 16 Step 4: Select the Securities  Step 4: Asset Allocation Asset allocation involves determining the optimal division of an investor’s portfolio among the different asset classes. For example, based on the client’s tolerance for risk and investment objectives, the portfolio may be divided as follows: 10% in cash, 30% in fixed-income securities, and 60% in equities. Portfolio managers and investors may also alter asset allocation to take advantage of changes in the economic environment. However, when working with clients, asset allocations should be set based on the IPS, reviewed regularly for circumstantial changes, but otherwise maintained in order to achieve the risk/return profile established in the IPS.  Step 4: Asset Allocation Portfolio managers generate investment returns through the following four means: Choice of an asset mix Market timing decisions Securities selection Chance Asset allocation is the single most important step in structuring a portfolio. All of the previous steps in the portfolio management process do nothing to benefit the client unless the manager purchases suitable securities. Because the portfolio approach is being emphasized, an important consideration is how the securities interact with each other. Even more important is how the asset classes perform against each other, with each class generating returns while offsetting some of the others’ risk.  Step 4: Asset Allocation Asset allocation is the single most important step in structuring a portfolio. All of the previous steps in the portfolio management process do nothing to benefit the client unless the manager purchases suitable securities. The conclusion is clear: when seeking to maximize the total return of a balanced portfolio, it is more important to focus on getting the asset group right than to outperform an index or market average within an asset group. See example: CSI p16.16 (p112)  Step 4: Strategic Asset Allocation The balance between asset classes is called the strategic asset allocation, which is the long-term mix that the manager will adhere to through monitoring and, when necessary, rebalancing. See CSI example: p16.17 (p114) The expected return of each asset mix combination is calculated by the manager. After viewing the possibilities outlined above, and considering the relative riskiness of stocks versus bonds, the manager will choose the optimal combination in consultation with the client. Recall: The Efficient Frontier (see next slide) Step 4: Strategic Asset Allocation 100% Asset Class B 100% Asset Class A  Step 4: Strategic Asset Allocation The base policy mix does not necessarily imply a buy-and-hold strategy because shifting values of the asset classes will cause the allocation to drift from the strategic mix. After the asset mix is implemented, the asset classes will change in value along with fluctuations in the market, and dividends and interest income will flow into the cash component. As a result, the asset mix will also change (drift/shift) EXAMPLE A portfolio starting out with an asset mix of 10% cash, 40% fixed-income, and 50% equities could see its cash increase to 15% through cash flows from interest, dividends, and maturing bonds, and the equity component could rise to 55% through rising stock values. The fixed-income class might be higher in value than before; proportionately, however, it would nevertheless be underweighted at only 30% of the total portfolio value. This drift calls for a rebalancing back to the original policy mix of 10% to 40% to 50%. With this strategy, you should rebalance in a disciplined manner: you should act before the mix gets too far out of balance, while remaining conscious of transaction costs. You would typically specify this activity and limits within the IPS.  Step 4: Dynamic Asset Allocation (ongoing) Dynamic asset allocation is a portfolio management technique that involves adjusting the asset mix to systematically rebalance the portfolio back to its long-term target or strategic asset mix. The portfolio manager follows a policy that places a limit on the degree to which each asset category can drift above or below the long-term target mix. Rebalancing becomes necessary once an asset category moves above or below this range. For example, the policy may call for rebalancing if equities rise by more than 5% above their target weighting. The dynamic strategy is suitable for a more risk-averse investor, such as a retired individual with low risk tolerance. The tax situation of the investor should be reviewed carefully, because active management will result in more realized capital gains and losses.  Step 4: Tactical Asset Allocation (ongoing) The investment policy statement may indicate a particular long-run balance of equities to fixed- income, but this strategic asset allocation need not be rigid. The statement may also allow for some short-term, tactical, deviations from the strategic mix. This strategy, called tactical asset allocation, allows you to capitalize on investment opportunities in one asset class before reverting back to the long-term strategic asset allocation. CHAPTER 16 Step 5: Monitor the Client, the Market, the Economy  Step 5: Monitoring Constructing a portfolio is only the beginning of an ongoing management process. But life is ever changing… It is essential, therefore, that you develop a system to monitor the appropriateness of the securities that comprise the portfolio and the strategies that govern it. The monitoring process involves three key areas of focus: Changes in the investor’s goals, financial position, and preferences Expectations for individual securities and capital markets Industry trends and the overall economic climate  Step 5: Monitoring Monitoring the Client (regular meetings, check in): - Stay informed, update client profile - Monitor current situation compared with NAAF/ original information. - Changes in risk tolerances, personal & financial circumstances. - ***If any significant changes occur at any time, you should update the NAAF, review fin. plan, and IPS Monitoring the Markets: - Stay informed > capital markets, rate announcements, inflation economics cycle - Your challenge is to anticipate change and adjust accordingly. - Use same methodology used to construct a portfolio to adjust a portfolio - Monitoring the Markets: - Virtually all information that may affect each asset class must be incorporated into the decision-making process. - Stay informed - forecasts are sometimes expressed in ranges, with a minimum and maximum level CHAPTER 16 Step 6: Evaluate Portfolio Performance  Step 6: Evaluate Managers are often measured against a predetermined benchmark that was specified in the investment policy statement. One common benchmark is the T-bill rate plus some sort of performance benchmark; for example, the T-bill rate plus 4%. On portfolios that have low turnover to avoid capital gains taxes, performance against the market benchmark may not be appropriate. A benchmark may be: - Inflation - T-bill rates - Short/long term bond yields - The S&P/TSX, S&P500 - Average fund (in class) return - An expected return included in the IPS  Step 6: Evaluate Recall that => Total Return = [cash flow + (End value – Beginning value)] / Beginning value Risk Adjusted return: a measure of how much risk is involved to produce a return. Risk-adjusted measures can be applied to individual securities as well as to portfolios. The Sharpe ratio: a risk-adjusted measure used by mutual fund companies and portfolio managers to compare the excess return of the portfolio (i.e., the return on the portfolio minus the risk-free return) to the portfolio’s standard deviation, thereby taking the portfolio’s risk into account.  Step 6: Evaluate Risk Free Rate = 2% Fund A return: 10% Fund B return: 7% Fund A standard deviation: 8% Fund B standard deviation: 2% Which Fund performed better on an absolute basis? Answer: Fund A earned 10%, which is 3% more than Fund B. Which Fund performed better on a risk adjusted basis (used the Sharpe Ratio to find out)? Fund A = (10-2)/8 = 1 Fund B = (7-2)/2 = 2.5 Fund B was able to earn a greater return for each unit of risk compared to the Fund A. Even though the Fund A produced a higher total return, the Fund A employed 4 times as much risk to do so. CHAPTER 16 Step 7: Rebalance the Portfolio  Step 7: Rebalance Rebalancing is the final step in the investment management process. The rebalancing process is more or less a repeat of the security selection process we discussed in Step 4, and closely related to monitoring and performance evaluation. As financial markets and values evolve, their relative weights within client portfolios change. Severe market swings can result in the actual weight of an asset class in the portfolio becoming significantly different from the strategic weight established to meet the client’s long-term goals. Rebalancing involves reallocating assets back to their originally intended portfolio weights by selling securities that have performed well and buying others that have done poorly. QUESTIONS? Thank you