Chapter 16 - CSC.pdf

The Portfolio Management Process 16 CHAPTER OVERVIEW In the previous chapter, you learned about the basic skills of investment management using a portfolio approach. In this chap...

The Portfolio Management Process 16 CHAPTER OVERVIEW In the previous chapter, you learned about the basic skills of investment management using a portfolio approach. In this chapter, you will learn to apply those skills within a seven-step portfolio management process. LEARNING OBJECTIVES CONTENT AREAS 1 | Describe the various investment objectives Step 1: Determine Investment Objectives and constraints. and Constraints 2 | Describe the purpose and use of an Step 2: Design an Investment Policy investment policy statement. Statement 3 | Explain how asset classes are used to Step 3: Develop the Asset Mix construct an appropriate asset mix. 4 | Differentiate between security selection and Step 4: Select the Securities asset allocation. 5 | Describe the process for monitoring the Step 5: Monitor the Client, the Market, portfolio. and the Economy 6 | Calculate and interpret the total return and Step 6: Evaluate Portfolio Performance risk adjusted rate of return of a portfolio. 7 | Define the purpose of rebalancing the Step 7: Rebalance the Portfolio portfolio. © CANADIAN SECURITIES INSTITUTE 16 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. asset allocation risk-adjusted rate of return benchmark Sharpe ratio dynamic asset allocation strategic asset allocation investment policy statement tactical asset allocation © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 3 INTRODUCTION Portfolio management is a continual process because financial markets and individual circumstances are ever changing. Advisors must therefore be flexible to adapt to change. As we have seen before, there is no “one size fits all” solution to investing, and finding the right fit is critical to achieving financial objectives. Portfolio management requires analyzing a great deal of personal and financial information about your clients to determine an asset mix that best suits them. A portfolio is never made up of one security; rather, it is a mix of a variety of securities that add up to something that is, or should be, more than the sum of its individual parts. The asset mix can be allocated between cash, fixed-income securities, and equities in any number of ways. It is often quoted that the asset allocation decision has a significant impact on the overall return of a portfolio. Asset allocation means the proportion of a portfolio invested in each asset class. 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. In this chapter, we discuss some of the key industry theories, practices, and measurements that are a standard procedure in the process of managing investment portfolios. THE PORTFOLIO MANAGEMENT PROCESS Although securities are sometimes selected on their own merits, portfolio management stresses the selection of securities based on their interaction with each other and their contribution to the portfolio as a whole. This process is known as the portfolio approach. The return of the portfolio is the weighted average of the returns of each security, but the risk of a portfolio is almost always less than the risks of the individual securities within it. Interaction among the securities results in the total portfolio effect being more than the sum of its parts. This improved risk-reward trade-off is a benefit of the portfolio approach, compared to making uncoordinated decisions. 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 is a continuous cycle, as shown in Figure 16.1. Your clients’ investment objectives and constraints will change throughout their lives. Therefore, you must re-evaluate them periodically. © CANADIAN SECURITIES INSTITUTE 16 4 CANADIAN SECURITIES COURSE      VOLUME 2 Figure 16.1 | The Portfolio Management Process 1. Determine investment objectives and constraints 7. Rebalance the 2. Design an IPS portfolio 6. Evaluate 3. Develop the asset performance mix 5. Monitor the client, 4. Select securities the market, and the economy STEP 1: DETERMINE INVESTMENT OBJECTIVES AND CONSTRAINTS 1 | Describe the various investment objectives and constraints. To determine the appropriate asset allocation for a particular portfolio, you must first determine the client’s investment objectives and constraints. Clients usually do not communicate their primary investment goals in terms of risk and return. Goals might be stated, for example, as a desire to retire at a certain age; a plan to acquire a business, vacation property, or sailboat; or the pursuit of some other tangible goal. With the right approach, and with the client’s full agreement and understanding, you can help translate such desires into realistic investment objectives that recognize the client’s particular constraints. Pointed interview questions about related objectives and constraints can reveal a great deal of information. You can also learn a lot from a concluding general question. For example, you might ask, “Is there anything we haven’t talked about that might be relevant?” Such questions can reveal important things you may have missed, such as the following pertinent facts: 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 © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 5 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) and tax minimization. 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 account application. Below are descriptions of the three types of primary objectives, which were noted above. 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. In Canada, a high degree of safety of principal and certainty of income is offered by most federal, provincial, and municipal bonds, if they are held to maturity. Shorter-term bonds also offer a high degree of safety because they are close to their maturity dates. A Government of Canada Treasury bill (T-bill) offers the highest degree of safety; it is virtually risk-free. 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 if they purchase corporate bonds or preferred shares with lower investment ratings. In general, safety goes down as yield goes up. 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 the Canadian Taxation chapter. © CANADIAN SECURITIES INSTITUTE 16 6 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE Applying the three primary objectives to different types of investors might include: Safety of principal: A young couple invest their savings for the eventual purchase of a house. A business executive temporarily invests funds that will be used to buy out a business partner six months later. Income: A single parent earning a salary relies on additional income from investments to meet the cost of raising and educating a child. A retired couple’s pension income is insufficient to provide for all living expenses. Growth: A well-paid young executive with excess income wishes to build a pool of capital for early retirement. A vice-president of a corporation seeks above average returns through common share investments. Table 16.1 shows, in broad terms, the four major kinds of securities and evaluates them in terms of the three primary investment objectives. Note: For our purposes, the evaluation in the table disregards the effects of inflation. Table 16.1 | Securities and Their Investment Objectives Type of Security Primary Objectives Safety Income Growth Short-term bonds Best Very steady Very limited Long-term bonds Next best Very steady Variable Preferred shares Good Steady Variable Common shares Often the least Variable Often the most Generally, clients have secondary objectives in addition to the three primary objectives discussed above. Typical secondary objectives include liquidity and tax avoidance, which are detailed below. 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 one business day after the transaction. Some real estate–related securities are an exception. 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. © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 7 RETURN AND RISK OBJECTIVES All information learned from the clients through interviews, questionnaires, and follow-up discussions should be distilled into a return objective and a risk objective. These objectives must address two questions: What rate of return does the client need to attain the stated goals? What risk is the client willing and able to take on to achieve those goals? 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 profile. The client interview should help reveal the preferred result, whether it is maximum return or minimum loss. In the first case, your strategy should be to focus on earning the highest return possible while adhering to the client’s risk profile. In the second case, you should focus on risk reduction. In addition, the investment policy should be designed to take into account the client’s tax position and needs with respect to the proportion of interest income, capital gains, and dividend income to be generated. 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 willingness and ability to bear risk. Assessment of the client’s risk profile is a vital element in the ultimate design of the portfolio because it governs the selection of securities. Inflation is one consideration in determining a client’s risk profile. Most retail clients need some degree of inflation protection, but the extent of the need varies. For example, consider a retired person with a long time horizon and income as the primary objective. The future purchasing power of the cash flow from this client’s portfolio is an important concern; therefore, protection from inflation is essential. DID YOU KNOW? Because the risk of a portfolio is usually less than the average risk of its holdings, a client’s risk profile should be matched to the risk of the overall portfolio, rather than the risk of each security. Table 16.2 shows some alternatives available when constructing a portfolio. Table 16.2 | Sample Risk Categories Within Each Asset Class Cash and Cash Equivalents Government issues (less than a year) Lowest risk, highest quality Corporate issues (less than a year) Highest risk, lowest quality Fixed-Income Securities Short term (one to five years) Low risk, low price volatility Medium term (five to 10 years) Medium risk, medium price volatility Long term (over 10 years) High risk, maximum price volatility © CANADIAN SECURITIES INSTITUTE 16 8 CANADIAN SECURITIES COURSE      VOLUME 2 Table 16.2 | Sample Risk Categories Within Each Asset Class Equities 1. Conservative Low risk; high capitalization; predictable earnings; high yield; high dividend payouts; lower price-to-earnings ratio; low price volatility 2. Growth Medium risk; average capitalization; potential for above average growth in earnings; aggressive management; lower dividend payout; higher price-to-earnings ratio; potentially higher price volatility 3. Venture High risk; low capitalization; limited earnings record; no dividends; price-to-earnings ratio of little significance; short operating history; highly volatile 4. Speculative Maximum risk; shorter term; maximum price volatility; no earnings; no dividends; price- to-earnings ratio not significant As Table 16.2 shows, equities are grouped by level of risk. Risk assessment is a subjective process, but the four categories provide a basis for risk differentiation. The differences between the categories are largely a function of differences in capitalization, earnings performance, predictability of earnings, liquidity, and potential price volatility. Because these variables apply to all common shares in all industry groups, each industry may have companies whose securities could be ranked in any of the four groups. Also, because companies are not static, the risk in an individual security can change over time and may warrant a shift to a higher or lower ranking. INVESTMENT 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. Typical constraints include a variety of issues, including the factors described below. Time horizon A major factor in the design of a good portfolio is how well it reflects the time horizon of its goals. 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 re- evaluate their portfolio. Some major events, such as a serious health problem or loss of employment, cannot be predicted. Nevertheless, a client’s time horizon should extend from the present until the next major expected change in circumstances. 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. Liquidity requirements 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. © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 9 Tax requirements 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. Dividends from Canadian corporations are eligible for a tax credit. The subject of the dividend tax credit is discussed in chapter 24. 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). Legal and regulatory Any investment activity that contravenes an act, law, by-law, regulation, or rule must requirements 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. 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. Unique circumstances When creating the investment policy, you must consider the unique circumstances specific to your client. Unique circumstances may include such preferences as the desire for ethically and socially responsible investing. For example, some clients may instruct you to ensure that no alcohol or tobacco stocks are purchased to respect their personal convictions. STEP 2: DESIGN AN INVESTMENT POLICY STATEMENT 2 | Describe the purpose and use of an investment policy statement. An investment policy statement is an agreement between a portfolio manager and a client that provides the investment guidelines for the manager. The investment policy statement outlines how the assets within the portfolio are to be managed. Though there is no standardized list of components to include in an investment policy statement, some important considerations are listed below: Operating rules and guidelines Asset allocation 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 Schedule for portfolio reviews The statement can be a lengthy written and signed document, or it can be derived from the account application in accordance with the Know Your Client rule. Regardless of its level of formality, the investment policy is the result of many complex inputs. PORTFOLIO MANAGEMENT PROCESS Can you advise a client as she starts her investment journey? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 16 10 CANADIAN SECURITIES COURSE      VOLUME 2 STEP 3: DEVELOP THE ASSET MIX 3 | Explain how asset classes are used to construct an appropriate 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, it is critical that you understand the relationship between the equity cycle and the economic cycle. You must use this understanding to plan the weighting of each asset class. You must also consider the individual characteristics and risk profile of the client. THE ASSET MIX The main asset classes are cash, fixed-income securities, and equity securities. More sophisticated portfolios may also include alternative investments such as private equity capital funds, currency funds, or hedge funds. 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. However, normal long-term strategic asset allocations for cash are within 5% and 10%. FIXED-INCOME SECURITIES Fixed-income securities 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, as well as preferred shares. 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. From a portfolio management standpoint, preferred shares are simply another type of fixed-income security. They have a stated level of income, trade on a yield basis, are subject to the same protective provisions, and have a reasonably definable term. Legally, preferred shares are an equity security. However, they are listed in portfolios as part of the fixed-income component because of their price action and cash flow characteristics. You can diversify this part of the asset mix in several ways, including the following methods: Both government and corporate bonds can be used in a range of credit qualities, from Aaa to lower grades. Foreign bonds may be added to domestic holdings. A variety of terms-to-maturity are often used (e.g., in a concept called laddering, the various consecutive durations mimic rungs on a ladder). Deep discount or strip bonds can be chosen alongside high-coupon bonds. 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 Other factors such as tax and time horizon © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 11 EQUITY SECURITIES Equities include common shares, equity exchange-traded funds, equity mutual funds, and 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. DID YOU KNOW? If the conversion privilege expires on a convertible security, and the security is therefore no longer convertible, it should be re-categorized as fixed income. 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: Collectibles, such as art or coins Commodities, such as gold (which is considered a good hedge against inflation) Derivatives Hedge funds Precious metals Real estate SETTING THE ASSET MIX The phases of the equity cycle trace movements in the stock market, which include expansion, peak, contraction, trough, and recovery. A study of the equity cycle is a useful approach for a general understanding of stock market movements. Figure 16.2 shows the S&P/TSX Composite Index over the last few decades and illustrates (with shading) the different phases. It is important to note that within a stock market expansion phase, which may last several years, there are also serious setbacks or corrections to stock prices, which may last as long as a year. © CANADIAN SECURITIES INSTITUTE 16 12 CANADIAN SECURITIES COURSE      VOLUME 2 Figure 16.2 | Broadly Defined Equity Cycles: S&P/TSX Composite Index Price, 2005—2023 22,000 Legend: 21,000 Peak Recovery Contraction Expansion Trough S&P/TSX 20,000 19,000 18,000 17,000 16,000 15,000 14,000 13,000 12,000 10,000 8,000 6,000 4,000 2,000 0 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21 '22 '23 Source: adapted from the TSX. © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 13 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. The benefits of successful timing are undeniable; 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. Another consideration in asset class timing is term-to-maturity. If, at the time in question, bonds are the best asset class, then it should make sense to lengthen the term of bond holdings to maximize returns. Similarly, if stocks are the best asset class, then certain strategies can be implemented to maximize stock market gains. It is generally accepted that asset allocation has an important impact on the variation in the total returns of investment portfolios. THE LINK BETWEEN EQUITY AND ECONOMIC CYCLES To understand stock market strategies, you must also understand the link between equity cycles and economic cycles. In general, the cycles are very similar, except that the equity cycle tends to lead. Figure 16.3 shows that the sustained economic growth in nominal gross domestic product, beginning in 1982 and 1996, fits closely with the generally sustained rise in stock prices over that time. You should note that the beginning of the equity cycle preceded the beginning of the economic cycle by several months during 1982 and 1983, and also during 1996 and 1997. The equity cycle also preceded the beginning of the economic cycle in 2009, which further underscores the Toronto Stock Exchange’s role as a leading indicator. It is also important to note that the annual chart reflects the impact of the world-wide pandemic that affected Canadian and other economies around the world starting in the first quarter of 2020. © CANADIAN SECURITIES INSTITUTE 16 14 CANADIAN SECURITIES COURSE      VOLUME 2 Figure 16.3 | S&P/TSX Composite Canadian Gross Domestic Product (Average Annual Percentage Change) 1979–2023 22,000 Legend: 21,000 S&P/TSX (Yearly) Canadian GDP (% Change) 20,000 19,000 18,000 17,000 16,000 S&P/TSX Composite Index (Yearly) Canadian GDP (% Change) 15,000 14,000 12 11 13,000 10 9 12,000 8 7 10,000 6 5 8,000 4 3 6,000 2 1 4,000 0 2,000 -1 -2 0 -3 -4 -5 -6 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Source: adapted from Statistics Canada. For investors who understand the relationship between economic and equity cycles, it is possible to follow the general investment strategies outlined in Table 16.3. © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 15 Table 16.3 | General Investment Strategies Equity Cycle Business Cycle Market Conditions Strategies Contraction phase End of expansion Recession conditions are Lengthen term of bond through peak, into the apparent. Interest rates are holdings by selling short-term contraction phase high. bonds and buying mid-term to long-term bonds. Try to maintain same yield (income). Avoid or reduce stock exposure. Stock market Late contraction phase The bottom of the business Sell long-term bonds because trough to end of contraction cycle has not been reached, they rallied ahead of stocks phase but the stock market has in response to falling interest begun to advance because of rates. falling interest rates and the Common stocks usually expectations of an economic rally dramatically; often, the recovery. largest gains occur in the higher-risk cyclical industries. Recovery and End of trough, The bottom of the business Increase common stock expansion into recovery and cycle has been reached. exposure, given that expansion phase Economy starts growing again, sustained economic growth unemployment is falling and generally allows stocks to do businesses are making profits. well. Equity cycle peak Late expansion Economic growth has been Reduce common stocks into peak phase sustained; however, this has exposure and invest in short- also led to higher interest term interest-bearing paper. rates and the Bank of The equity cycle peak is Canada may be tightening generally followed by the its monetary policy. Short- contraction phase. term interest rates tend to be higher than long-term rates (i.e., the yield curve is inverted). The problem with these general strategies is that they do not account for the many important variations that occur during an equity cycle. These variations may dramatically affect stock and bond market performance for 12 months or longer. EXAMPLE During the expansion phase of 1982 to 1989, the stock market experienced sharp declines due to high interest rates for six months in 1984 and during the stock market crash of 1987. Although the general strategies appear attractive, variations within a cycle can affect asset class performance. © CANADIAN SECURITIES INSTITUTE 16 16 CANADIAN SECURITIES COURSE      VOLUME 2 Changes in the S&P/TSX Composite Index price level generally result from changes in interest rates or economic growth. 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. 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. ASSET ALLOCATION Asset allocation requires a determination of 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. For example, when the economy enters a period of rapid growth, you must decide how best to take advantage of the market to manage a portfolio. You may find that a heavier weighting in equities will generate better returns than holding more of the portfolio in fixed-income securities or cash. Alternatively, if you determine that the economy is likely to enter a recession, a heavier weighting in cash or fixed-income securities may generate higher returns. This process of altering a portfolio’s asset allocation to take advantage of changes in the economy is one meaning of the term market timing. THE IMPORTANCE OF 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. An asset allocation strategy is usually specified in the investment policy statement. Although investment advisors may have the freedom to recommend an array of individual securities – subject to any investment restrictions – the overall proportion of a client’s portfolio invested in cash, debt securities and equity securities may be fixed. Decisions regarding asset allocation depend on the client’s investment objectives and constraints, as well as the returns available from capital markets. Table 16.4 demonstrates the importance of the asset mix in determining overall portfolio returns. Table 16.4 | Asset Mix and Total Return Asset Group Index or Average Portfolio Manager X Portfolio Manager Y A. Annual Return by Asset Class Cash 10% 11% 9% Fixed-Income Securities 6% 8% 4% Equities 25% 30% 20% © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 17 Table 16.4 | Asset Mix and Total Return B. Actual Asset Mix Cash 5% 5% Fixed-Income Securities 70% 25% Equities 25% 70% C. Total Return on a $1,000 Portfolio Cash $5.50 $4.50 Fixed-Income Securities 56.00 10.00 Equities 75.00 140.00 Total Return $136.50 $154.50 Total Percentage Return 13.65% 15.45% In the first part of Table 16.4 (A. Annual Return by Asset Class), Portfolio Manager X outperforms Portfolio Manager Y by 22% in cash, 100% in fixed-income securities, and 50% in equities. However, the second part (B. Actual Asset Mix) highlights the actual allocation of assets in each portfolio. Clearly, Portfolio Manager X invested more heavily in fixed-income securities, whereas Portfolio Manager Y emphasized equities. The third part (C. Total Return on a $1,000 Portfolio) shows the total return realized by each portfolio manager in a $1,000 portfolio. Note that total return is calculated by multiplying the amount invested in each asset group by the rate of return for that group and adding the results. Even though Manager X significantly outperformed Manager Y in each asset class, Manager Y’s asset mix decisions resulted in the portfolio achieving a higher total return. 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. This principle is particularly true when capital markets are volatile. BALANCING THE ASSET CLASSES The next step in the asset allocation process is to determine the appropriate balance among the selected asset classes by investigating the client’s full circumstances to determine an appropriate asset mix. The asset allocations shown in Table 16.5 use cash, fixed-income, and equity asset classes to make up suitable portfolios for three different clients. These particular allocations should serve as examples only—they should not be mistaken for templates. Each client’s situation is unique. Table 16.5 | Allocation of Asset Classes Client Investments A young, healthy, single professional with Cash 5% good investment knowledge, high willingness Fixed Income 25% to accept risk, moderate tax rate, and a long- time horizon. Equities 70% Allocation 100% © CANADIAN SECURITIES INSTITUTE 16 18 CANADIAN SECURITIES COURSE      VOLUME 2 Table 16.5 | Allocation of Asset Classes Client Investments A senior citizen in a low tax bracket with no Cash 8% income other than government pensions, Fixed Income 67% a medium-time horizon, and low ability to endure a potential financial loss. Equities 25% Allocation 100% A middle-aged line factory worker, married, Cash 10% with three teenaged children, homeowner, Fixed Income 40% with limited investment knowledge, whose main concerns are employment security and Equities 50% college education funding. Allocation 100% STRATEGIC ASSET ALLOCATION Investment management firms, both large and small, often have proprietary, highly sophisticated models to forecast security prices. For the purposes of this course, we show how asset allocation is determined through historical results, as shown in Table 16.6. Considering only equities and fixed income, and with 10% increments in the asset mix, the following are the expected returns for the various asset mixes. Table 16.6 | Expected Returns for the Various Asset Mixes (as a Percentage) Asset Mix Historical Returns Equities Fixed Income Equities Fixed Income Expected Return on Portfolio 0 100 10 4.4 4.40 10 90 10 4.4 4.96 20 80 10 4.4 5.52 30 70 10 4.4 6.08 40 60 10 4.4 6.64 50 50 10 4.4 7.20 60 40 10 4.4 7.76 70 30 10 4.4 8.32 80 20 10 4.4 8.88 90 10 10 4.4 9.44 100 0 10 4.4 10.00 Table 16.6 above illustrates an analysis that considers equities-to-fixed-income in various combinations: 0% equities-to-100% fixed income; 10% equities-to-90% fixed income; 20% equities-to-80% fixed income; and so on, to 100% equities-to-0% fixed income. 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. This asset mix is usually expressed in terms of percentage holdings, such as a 60-to-40 equities-to-fixed-income mix (in which case the portfolio will have an expected return of 7.76%). © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 19 This base policy mix is called the strategic asset allocation, which is the long-term mix that the manager will adhere to through monitoring and, when necessary, rebalancing. As shown in Table 16.6 above, a limited number of asset mixes are analyzed to determine the expected return of each combination. In consultation with the client, the manager then reviews the range of outcomes and chooses the most desirable allocation. This strategic allocation determines the long-term policy asset mix. Suppose a $100,000 portfolio is invested $60,000 in equities and $40,000 in fixed income, for a 60-to-40 asset mix. If the stock market rose 10%, while the bond market sagged 10%, the investor’s portfolio mix would be higher than 60% equities, and lower than 40% fixed income, after the change in market values. This is shown in Table 16.7. Table 16.7 | Portfolio Changes in Asset Mix Type of Security Before Change Change After Change Equities $60,000 +$6,000 $66,000 Fixed Income $40,000 −$4,000 $36,000 Asset Mix 60 to 40 64.7 to 35.3 ONGOING ASSET ALLOCATION 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. 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 that an asset class must move more than a certain percentage—perhaps 5%—before rebalancing. DYNAMIC ASSET ALLOCATION Portfolio rebalancing, also known as dynamic asset allocation, is a portfolio management technique that adjusts the asset mix to systematically rebalance the portfolio back to its long-term target or strategic asset mix. Rebalancing may be necessary in the following situations: There is a build-up of idle cash reserves, possibly from dividends or interest income cash flows that have not been reinvested. There are movements in the capital markets causing abnormal returns, such as happened during the 1987 market crash, the 1998 Asian financial crisis, or the 2008–2009 global financial crisis. 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. © CANADIAN SECURITIES INSTITUTE 16 20 CANADIAN SECURITIES COURSE      VOLUME 2 A dynamic rebalancing approach is demonstrated in Table 16.8. The strong performance in the stock market has altered the target asset mix to 64.7% equities and 35.3% fixed income. One method of rebalancing the portfolio back to its target mix is the direct buying and selling of the securities in the portfolio. The table demonstrates the approach needed to restore the target mix, as follows: Sell $4,800 worth of equities Buy $4,800 worth of fixed income Table 16.8 | Dynamic Rebalancing Asset Mix After Rise New Dynamic Re-balanced New Asset Class in Stock Market Asset Mix Rebalancing Portfolio Asset Mix Equities $66,000 64.7% −$4,800 $61,200 60% Fixed Income $36,000 35.3% +$4,800 $40,800 40% Asset Mix $102,000 100.0% $102,000 100% Using the dynamic approach, rebalancing dampens returns in a strong market because the portfolio manager is reducing the strongest-performing component. On the other hand, it enhances returns in a weak market period because the manager purchases under-performing asset classes at reduced prices. The dynamic strategy is suitable for a more risk-averse investor, such as a retired individual with low risk profile. The tax situation of the investor should be reviewed carefully, because active management will result in more realized capital gains and losses. TACTICAL ASSET ALLOCATION 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 to the long-term strategic asset allocation. DID YOU KNOW? The strategic allocation is considered the long-term strategy, whereas tactical deviations are short-term strategies. EXAMPLE If the bond market is depressed and poised for an upswing, you might overweight the portfolio in fixed-income products well over the strategic asset allocation for fixed income. After a few weeks or months, having profited from this move, you would then move back to the long-term strategic asset allocation. In this way, you can exercise your market timing skills while investing for the expected return indicated by the strategic mix. Though not a passive strategy, this approach is only moderately active, and is appropriate for the long-term investor who is interested in market timing. ASSET ALLOCATION STRATEGY Can you help a client rebalance her portfolio? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 21 STEP 4: SELECT THE SECURITIES 4 | Differentiate between security selection and asset allocation. Many investors and advisors mistake security selection for investment management. Selecting securities without following the other steps in the investment management process is meaningless. Still, the investment management process is pointless without the execution of a plan, thus security selection is the pivotal step in the process. Very simply, security selection is the step in which specific securities—stocks, bonds, managed products or any other investment vehicle—are chosen for inclusion in a client’s portfolio. Selection stems from the equity and fixed- income analysis which are covered in other chapters of this course. STEP 5: MONITOR THE CLIENT, THE MARKET, AND THE ECONOMY 5 | Describe the process for monitoring the portfolio. Constructing a portfolio is only the beginning of an ongoing management process. Having set the investment policy, and having designed and implemented an asset mix, the next step is to monitor the portfolio. 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 MONITORING THE CLIENT It is critical that you stay informed about your client’s objectives and that you update the client profile regularly. The account application sets out the original profile of income, assets, investment knowledge, and goals. You must monitor the client for changes in these areas. As well, you must monitor the client for changes in tolerance for risk, need for liquidity, need for savings, and tax brackets. If any significant changes occur, you should complete an amended account application. MONITORING THE MARKETS Capital markets evolve constantly to reflect changes in government and central bank policies, economic growth or recession, and sectoral shifts in prosperity within the economy. You must be constantly aware of the direction of monetary policy, forecasts for gross domestic product and the inflation rate, shifts in consumer demand and capital spending, and the potential impact of all these factors on the strategic asset mix or on individual holdings. Your challenge is to anticipate change and systematically adjust the portfolio to reflect both return expectations and the objectives of the client. In adjusting a portfolio, you should follow the same methodology you used when constructing it. MONITORING THE ECONOMY The asset mix decision is complex because it involves an analysis of all capital markets. The decision-making process should incorporate virtually all information that may affect each asset class. The scope of this material includes © CANADIAN SECURITIES INSTITUTE 16 22 CANADIAN SECURITIES COURSE      VOLUME 2 expected activities in the private and public sectors (both nationally and internationally), government policies, corporate earnings, economic analysis, existing market conditions, and the forecaster’s interpretation of the data. Because of the complexity of the data and the subjectivity in interpretation, it is very difficult to make an accurate prediction about the magnitude of change in a particular asset class. Therefore, forecasts are sometimes expressed in ranges, with a minimum and maximum level. This method reflects the unpredictability of capital markets and indicates the degree of risk anticipated. The expected total returns for each asset group are calculated by adding the expected annual income to the expected capital gain or loss for each group. EXAMPLE If stock prices are expected to increase 10% and dividend yields are forecast to be 4%, then the expected total pre-tax return for equities would be 14%. PORTFOLIO MONITORING Can you determine the impact of the economy, the market, and the client’s situation on a client’s portfolio? Complete the online learning activity to assess your knowledge. STEP 6: EVALUATE PORTFOLIO PERFORMANCE 6 | Calculate and interpret the total return and risk adjusted rate of return of a portfolio. The success of a portfolio is determined by comparing the total rate of return of the portfolio under evaluation with the average total return of comparable portfolios. In this way, you and your client can compare the client’s returns to industry norms and estimate your approximate ranking in relation to the returns of other portfolio managers. You can estimate the ranking of most individual investors most easily by comparing their performance with the averages shown in one of the surveys of funds appearing regularly in financial publications. Because many different funds are measured in the surveys, you can compare both the total return and the component returns of the client’s portfolio. For example, the equity component of a diversified portfolio can be compared with the equity funds shown. Advisors 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. What investors are interested in is the protection and growth of their purchasing power. MEASURING PORTFOLIO RETURNS A simple method of computing total return is to divide the portfolio’s total earnings by the amount invested in the portfolio. Total earnings consist of income plus capital gains or losses. In other words, total earnings consist of the increase (or decrease) in the market value of the portfolio, and are calculated using the following formula: Increase in Market Value Total Return = ´ 100 Beginning Value © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 23 EXAMPLE In the course of a particular year, a portfolio’s market value was $106,000 on January 1 and $110,000 on December 31. On this basis, the return for the portfolio for the year was 3.77%, calculated using the total return formula (pre-tax), as follows: $110,000 - $106,000 = ´ 100 $106,000 $4,000 = ´ 100 $106,000 = 0.0377 ´ 100 = 3.77% The Total Return formula shown above assumes no contributions to or withdrawals from the portfolio by the client. When cash flows in or out of the portfolio, a portion of the change in the value of the portfolio is the result of the cash flows themselves. EXAMPLE In the course of a particular year, a portfolio’s market value was $100,000 on January 1 and $150,000 on December 31. The client added $15,000 in cash to the portfolio during the year. Therefore, $15,000 of the $50,000 increase in the value of the portfolio is due to the client contribution, not return on the investment. The return on a portfolio is affected by both the amount and timing of portfolio cash flows. There are several ways to deal with cash flows, and different portfolio reporting systems use different methods. Although a thorough discussion of these methods is not within the scope of this course, they are explained fully in two other Canadian Securities Institute courses: Investment Management Techniques and Wealth Management Essentials. CALCULATING THE RISK-ADJUSTED RATE OF RETURN Simply comparing the returns of two portfolios to measure performance does not provide an adequate assessment. You must also factor in the risk assumed to earn those returns. A risk-adjusted rate of return is 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 shown in Figure 16.4 below, is 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. Figure 16.4 | The Sharpe Ratio Rp - Rf Sp = sp Where: Sp = Sharpe ratio Rp = Return of the portfolio Rf = Risk-free rate (i.e., typically the average of the three-month T-bill rate over the period being measured) σP = Standard deviation of the portfolio © CANADIAN SECURITIES INSTITUTE 16 24 CANADIAN SECURITIES COURSE      VOLUME 2 If a portfolio is being measured against a benchmark, its Sharpe ratio can be compared to the Sharpe ratio of the applicable benchmark. The larger the Sharpe ratio, the better the portfolio’s performance. A group of portfolios can therefore be ranked by their risk-adjusted performance. If a portfolio has a Sharpe ratio greater than the Sharpe ratio of the benchmark, that portfolio’s manager has outperformed the benchmark. A portfolio’s Sharpe ratio that is smaller than the benchmark’s signals underperformance. A negative Sharpe ratio means that the portfolio’s manager earned a return less than the risk-free return. EXAMPLE A Canadian Equity Fund called DEF had an average fund return of 6% and a standard deviation of 5%. The Canadian Equity Benchmark had an average fund return of 8% and a standard deviation of 10%. The average risk- free return was 1%. For this example, the Sharpe ratio of the fund and its benchmark are calculated as shown below. Sharpe ratio: 6-1 SDEF = = 1 5 Benchmark: 8-1 SB = = 0.70 10 Both the fund and the benchmark had a positive Sharpe ratio, which means that both had an average return greater than the average risk-free return. However, the DEF risk-adjusted return was higher than the benchmark’s risk-adjusted return. That means that DEF was able to earn a greater return for each unit of risk compared to the benchmark. Even though the benchmark produced a higher total return, the benchmark employed twice as much risk to do so. OTHER FACTORS IN PERFORMANCE MEASUREMENT Dissimilarities in portfolios also make it difficult to get an accurate performance comparison. Each portfolio may have different risk characteristics or special investor constraints or objectives. When you find that dissimilarities are affecting portfolio returns, you should adjust the conclusions you draw from comparing their performance to accurately reflect the impact of the variables. The large number of variables in the management and measurement of portfolios make it difficult to assess investment performance. Regardless, in comparing performance, you should be concerned primarily with longer- term results. Those results best measure your management ability in all phases of the business cycle. It is also important to have consistent results and performance trends over several previous measurement periods. STEP 7: REBALANCE THE PORTFOLIO 7 | Define the purpose of rebalancing the portfolio. Rebalancing is the final step in the investment management process. This step is 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 is the process of reallocating assets back to their originally intended portfolio weights by selling securities that have performed well and buying others that have done poorly. © CANADIAN SECURITIES INSTITUTE  CHAPTER 16      THE PORTFOLIO MANAGEMENT PROCESS 16 25 The rebalancing process is more or less a repeat of the dynamic asset allocation process noted in Step 3. During rebalancing, keep in mind the method of developing a strategic asset mix and the dynamic and tactical approaches to asset allocation. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 16 26 CANADIAN SECURITIES COURSE      VOLUME 2 SUMMARY In this chapter, we discussed the following key aspects of the portfolio management process: Managing a portfolio of investments is a cyclical, seven-step process. As part of the first step, you must determine what rate of return your clients need to attain their goals, and what risk they are willing and able to take to achieve those goals. In general, investors have three primary investment objectives: safety of principal, income, and growth of capital. Investment constraints are limitations that could prevent a client from taking full advantage of particular investments. The second step is to create an investment policy statement containing the rules, guidelines, investment objectives, and asset mix agreed on by you and your client. The third step is to formulate an asset mix. The basic asset classes are cash, fixed-income securities, and equities. Asset class timing is the practice of switching among industries and asset classes with a goal of maximizing returns and minimizing losses. In making these decisions, you must observe the stages of the economic cycle, which are directly linked to equity cycles. Tactical asset allocation refers to short-term deviations from the strategic mix to capitalize on investment opportunities. Dynamic asset allocation refers to adjusting the asset mix to systematically rebalance the portfolio back to its long-term strategic asset mix. The fourth step is to select specific securities for inclusion in a client’s portfolio. The fifth step is to monitor the client, the markets, and the economy. The manager makes decisions in light of changes in the investor’s goals, financial position and preferences, relative to changing expectations for capital markets and individual securities and shifts in the economy as a whole. The sixth step is to evaluate performance. Success is measured by the total rate of return of the portfolio in comparison to the average total return of comparable portfolios. A portfolio manager’s results are often measured against a predetermined benchmark specified in the investment policy statement. A simple method of computing total return is to divide the portfolio’s total earnings by the amount invested in the portfolio. The Sharpe ratio measures the portfolio’s risk-adjusted rate of return, using standard deviation as the measure of risk. Finally, you must rebalance the portfolio by reallocating assets back to their originally intended portfolio weights. In other words, sell the securities that have performed well and buy others that have done poorly. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 16 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 16 FAQs. © CANADIAN SECURITIES INSTITUTE