CSC Volume 2 Section 2 PDF - Portfolio Analysis

SECTION 6 PORTFOLIO ANALYSIS 15 Introduction to the Portfolio Approach 16 The Portfolio Management Process © CANADIAN SECURITIES INSTITUTE  Introduction to the Portfolio Approach...

SECTION 6 PORTFOLIO ANALYSIS 15 Introduction to the Portfolio Approach 16 The Portfolio Management Process © CANADIAN SECURITIES INSTITUTE  Introduction to the Portfolio Approach 15 CHAPTER OVERVIEW In this chapter, we introduce you to the different techniques used to analyze and measure risk and return in a portfolio. You will also learn the formulas used to calculate and interpret expected return and identify strategies for maximizing return while reducing risk. Finally, we will discuss the different management styles used in equity and fixed-income portfolios. LEARNING OBJECTIVES CONTENT AREAS 1 | Calculate rates of return of a single security. Risk and Return 2 | Differentiate among the types and measures of risk, and the role of risk in asset selection. 3 | Calculate and interpret the expected return of Relationship Between Risk and Return a portfolio of securities. in a Portfolio 4 | Summarize the benefits and challenges of combining securities in a portfolio. 5 | Compare and contrast the portfolio The Portfolio Manager Styles management styles of equity and fixed- income managers. © CANADIAN SECURITIES INSTITUTE 15 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. active investment strategy inflation rate risk alpha interest rate risk beta liquidity risk bottom-up analysis non-systematic risk business risk passive investment strategy buy and hold political risk capital gain rate of return capital loss real rate of return cash flow risk-free rate of return correlation sector rotation default risk specific risk diversification standard deviation ex-ante systematic risk ex-post top-down analysis foreign exchange rate risk volatility holding period return yield indexing © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 3 INTRODUCTION No perfect security exists that meets all the needs of every investor. If it did exist, there would be no need for investment and portfolio management, and no need to measure the return and risk of investments. In fact, advisors and portfolio managers spend a great deal of time selecting securities, allocating funds among security classes, and managing risks and returns. The portfolio approach to making investment decisions consists of creating a diversified portfolio that allows investors to reduce overall risk without necessarily decreasing the expected return. In taking a portfolio approach to investing, you can theoretically eliminate some types of risks altogether through diversification. Diversification is a strategy that combines a variety of distinct investments in a portfolio with the aim of reducing the investor’s risk of any individual security. Recognizing that there are no perfect securities, investors and advisors use measures and methods to estimate risk and predict return. Based on these results, they construct portfolios designed to fit the particular needs and circumstances of individual investors. Building portfolios that correlate to specific investor needs is key to being successful in the investment industry. Generating the highest returns is not enough; higher returns that require exposure to risky investments may not be appropriate for a particular investor. In this chapter, we integrate information about individual securities, the markets, and the different analysis techniques. We focus on the relationship between risk and return and the various measures used to assess these factors. We also discuss the reasons why an advisor or portfolio manager might choose an active or passive approach to managing an equity or fixed-income portfolio. All this information provides a foundation of knowledge on which to build your skills in using a portfolio approach to investing. RISK AND RETURN 1 | Calculate rates of return of a single security. 2 | Differentiate among the types and measures of risk, and the role of risk in asset selection. Given a choice between two investments with the same amount of risk, a rational investor would always take the security with the higher expected return. Likewise, given two investments with the same expected return, the investor would always choose the security with the lower risk. In reality, the choice is rarely so simple. Risk and return are interrelated in such a way that, to earn higher returns, investors must accept higher risk; and to avoid risk, they must accept lower returns. The choice investors make depends on their risk profile. Some investors will always choose lower-risk securities; others are willing to take on more risk if they believe there is a potential for higher returns. Investors also have different views of what constitutes risk. To some, it means the risk of losing money on an investment. To others, it means the risk of losing purchasing power if the return on the investments does not keep up with inflation. Given that all investors do not have the same risk profile, different securities and different funds were developed to serve various market niches. For example, guaranteed investment certificates (GIC) suit investors seeking safety, fixed-income securities suit those seeking income, and equities suit those seeking growth or capital appreciation. No matter what their risk profile, few people invest all of their funds in a single security. With a portfolio of securities, they are able to diversify their investments and reduce risk to a suitable level. For example, the same portfolio might contain the following investments: Government of Canada bonds, from which the investor expects to earn interest income Common shares, which the investor expects to grow in value while providing dividend payments © CANADIAN SECURITIES INSTITUTE 15 4 CANADIAN SECURITIES COURSE      VOLUME 2 DID YOU KNOW? The return on an investment is rarely guaranteed, which is why it is often called the expected return. Investments are typically purchased in anticipation that they will grow in value; in reality, however, values can also decline. Selling a security for more than its purchase price is called a capital gain, whereas selling a security for less than its purchase price is a capital loss. For an investor, any income derived from an investment, in the form of interest payments or dividend, is called cash flow. Returns on an investment are some combination of cash flows and capital gains or losses. Figure 15.1 shows the formula used to calculate the expected return of a single security. Figure 15.1 | Expected Return of a Single Security Expected Cash Flow + Expected Capital Gain (or - Capital Loss) Expected Return = Beginning Value Where: Expected Cash Flow = Expected dividends, interest, or any other type of income Expected Capital Gain/Loss = Expected Ending Value − Beginning Value Beginning Value = The initial dollar amount invested by the investor Expected Ending Value = The expected dollar amount the investment is sold for RATE OF RETURN Returns from an investment can be stated in absolute dollars; however, absolute numbers obscure the significance of a gain or loss. For example, an investor may state that she earned $100 on a particular investment, but without knowing the amount of the original investment, the number is meaningless. A $100 gain made on an investment of $1,000 is significant, whereas the same gain on an investment of $100,000 might signal a poor investment choice. The more common practice is to express returns as a percentage, called the rate of return or yield. To convert a dollar amount to a percentage, the usual practice is to divide the total dollar returns by the amount invested, as follows: Cash Flow + (Ending Value - Beginning Value) Return % = ´ 100 Beginning Value © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 5 EXAMPLE Consider the following three scenarios: 1. You purchase a stock for $10 and sell it one year later for $12. The rate of return is 20%, calculated as follows: 0 + (12 - 10) ´ 100 = 20% 10 2. You purchase a stock for $20 and sell it one year later for $22, and during this period you receive $1 in dividends. The rate of return is 15%, calculated as follows: 1 + (22 - 20) ´ 100 = 15% 20 3. You purchase a stock for $10 and receive $2 in dividends, but one year later you sell it for only $9. Your rate of return is 10%, calculated as follows: 2 + (9 - 10) ´ 100 = 10% 10 The examples show that cash flow and capital gains or losses are used in calculating a rate of return. You should also note that all trading periods in the examples are set for one year; hence, the percentage of return is also called the annual rate of return. If the transaction period were longer or shorter than a year, the return would be called the holding period return. The generic formula used to calculate return forms the basis of yield calculations throughout this chapter. DID YOU KNOW? Rates of return can be ex-ante (expected returns) or ex-post (actual historical returns). Investors estimate ex-ante returns to determine where funds should be invested. They calculate ex-post returns to compare actual results against both anticipated results and market benchmarks. Choosing a realistic expected rate of return can be difficult. One common method is to expect the Treasury bill (T-bill) rate plus a certain performance percentage related to the risk assumed in the investment. Thus, corporate bond issues with a higher risk profile are expected to earn a higher rate of return than the more secure Government of Canada bond issues. HISTORICAL RETURNS You can gain important insights into the market and determine appropriate investments and investment strategies by studying historical data. However, past performance is not necessarily indicative of future performance, although historical returns do provide insight into the long-term performance of the market. In other words, we can create an estimate of the future return based on past performance, but we cannot predict it accurately. © CANADIAN SECURITIES INSTITUTE 15 6 CANADIAN SECURITIES COURSE      VOLUME 2 Figure 15.2 illustrates the connected relationship between risk and return. Figure 15.2 | Risk and Return Relationship High Common Shares Expected Return Preferred Shares Debentures Bonds Treasury Bills Low High Risk NOMINAL AND REAL RATES OF RETURN So far, we have looked only at a simple rate of return, otherwise known as the nominal rate of return. For example, if a one-year GIC reports a 6% return, this 6% represents the nominal return on the investment. However, investors are more concerned with the real rate of return, which is the return adjusted for the effects of inflation. The formula used to calculate the real rate of return is as follows: Real Return = Nominal Rate − Annual Inflation Rate EXAMPLE A client earned a 10% nominal return on an investment last year. Over the same period, inflation was measured at 2%. The client therefore earned an approximate real rate of return of 8% on the investment, calculated as follows: 10% − 2% = 8% THE RISK-FREE RATE OF RETURN T-bills often represent the risk-free rate of return, given that there is essentially zero risk associated with this type of investment. The yield paid on a T-bill is roughly determined by estimating the short-term inflation rate and adding a real return. Because T-bills are considered essentially risk-free, other securities must pay at least the T-bill rate plus a risk premium to compensate investors for the added risk. In a statistical sense, risk is defined as the likelihood that the actual return will be different from the expected return. As the uncertainty of the outcome increases, so does the degree of risk. © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 7 EXAMPLE An investor purchases a $500, 2% GIC and cashes it one year later. He receives exactly $500 plus 2% accrued interest. The same investor purchases $500 worth of common stock at $25 per share in the expectation that the price will rise from $25 per share to $30 in one year. He may receive much more than $30 per share or much less than the original $25 per share. Common stocks are riskier than GICs because the outcomes are much less certain. TYPES OF RISKS Investing in the markets entails the following types of risks, each of which can add to the uncertainty of expected returns for a particular security: Inflation rate risk Inflation rate risk is the risk that inflation will reduce future purchasing power and the real return on investments. Business risk Business risk is the risk that a company’s earnings will be reduced as a result of a labour strike, the introduction of a new product into the market, or the outperformance of a competing firm, among other factors. The uncertainty regarding a company’s future performance is its basic business risk. Political risk Political risk is the risk of unfavourable changes in government policies. For example, the government may decide to raise taxes on foreign direct investment, making it less attractive for foreign investors to invest in the country. Political risk also refers to the general instability associated with investing in a particular country. Investing in a war- torn country, for example, brings additional risk of investment loss. Liquidity risk A liquid asset is one that can be bought or sold at a fair price and converted to cash on short notice. Liquidity risk is the risk that an investor will not be able to buy or sell a security at a fair price quickly enough because buying or selling opportunities are limited. Interest rate risk Interest rate risk is the risk that changing interest rates will adversely affect an investment. For example, investors purchase fixed-income securities expecting to earn a certain return on the investment. However, because of the inverse relationship between interest rates and bond prices, if interest rates rise, the investment will fall in value. Foreign investment risk There are several risks associated with foreign investments. Foreign exchange rate risk is the risk of loss resulting from an unfavourable change in exchange rates. Investors who invest abroad or in businesses that buy and sell products in foreign markets are subject to this risk. Other foreign investment risks include: A dramatic drop off of liquidity for international small-cap issuers Larger bid-ask spreads for small cap international issuers Varying legal rights of shareholders and bond investors Poor shareholder communication in terms of reliability, quality, level of detail, and frequency of reporting © CANADIAN SECURITIES INSTITUTE 15 8 CANADIAN SECURITIES COURSE      VOLUME 2 Default risk When a company issues debt to finance its operations, servicing the debt through interest payments creates a further burden on the company. The more debt the company issues, the greater is the risk that it may have difficulty servicing its debt load through its current operations. Default risk is the risk that such a company will be unable to make timely interest payments or repay the principal amount of a loan when it comes due. SYSTEMATIC AND NON-SYSTEMATIC RISK The risk of a portfolio is determined by the risk of the various securities within it. Certain risks can be reduced by diversifying among a number of securities. However, other risks are always present that cannot be reduced or eliminated through diversification. These risks stem from such things as inflation, the business cycle, and high interest rates. Altogether, this type of risk is called systematic risk, or market risk. Systematic risk is the risk associated with investing in each capital market. When stock market averages fall, most individual stocks in the market also fall. When interest rates rise, nearly all individual bonds and preferred shares fall in value. Systematic risk cannot be diversified away. DID YOU KNOW? The more a portfolio becomes diversified within a certain asset class, the more it ends up mirroring the market for that asset. Non-systematic risk, or specific risk, is the risk that the price of a specific security or a specific group of securities will change in price to a different degree or in a different direction from the market as a whole. For example, the stock of a particular bank may rise in price when the S&P/TSX Composite Index falls, or financial companies as a group may fall more than the S&P/TSX Composite Index. Specific risk can be reduced through diversification. This type of risk theoretically could be eliminated completely by buying a portfolio of shares that consisted of all S&P/TSX Composite Index stocks, by using index funds, or by buying exchange-traded funds based on the S&P/TSX Composite Index. MEASURING RISK Investors may expect a given return on an investment, but the actual results may be higher or lower. To get a better feel for the possible outcomes and their probability of occurrence, several measures of risk have been developed. The two most common of these are standard deviation and beta (also called beta coefficient). Standard deviation is the measure of risk commonly applied to portfolios and to individual securities within that portfolio. The past performance (i.e., the historical returns of securities) is used to determine a range of possible future outcomes. The more volatile the price of a security has been in the past, the larger the range of possible future outcomes. The standard deviation, expressed as a percentage, gives the investor an indication of the risk associated with an individual security or a portfolio. The greater the standard deviation, the greater the risk. When an investor purchases a T-bill, the return is predictable; it cannot change as long as the investor holds the T-bill until maturity. With securities such as equities, the possible outcomes are varied: the price could increase, stay the same, or decrease. The greater the number of possible outcomes, the greater the risk that the outcome will not be favourable. And the greater the distance estimated between the expected return and the possible returns, the greater the standard deviation. Beta is another statistical measure that links the risk of individual securities or a portfolio of securities to the market as a whole. As we saw earlier, the risk that remains after diversifying is market risk. Beta is important because it © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 9 measures the degree to which individual securities, or a portfolio of securities, tend to move up and down with the market. Once again, the higher the beta, the greater the risk. RELATIONSHIP BETWEEN RISK AND RETURN IN A PORTFOLIO 3 | Calculate and interpret the expected return of a portfolio of securities. 4 | Summarize the benefits and challenges of combining securities in a portfolio. As indicated earlier, few people invest all of their funds in a single security. The focus now shifts to the expected return of a portfolio and the effects of combining securities. CALCULATING THE RATE OF RETURN IN A PORTFOLIO The expected rate of return on a portfolio is calculated using a slightly different method than the one used for the rate of return of a single security. Because the portfolio contains a number of securities, you must first calculate the return generated by each security. The return on the whole portfolio is then calculated as the weighted average return on all the securities held in the portfolio. Figure 15.3 shows the formula for the second calculation. Figure 15.3 | Portfolio Expected Returns Expected Return = R1 (W1 ) + R2 (W2 ) +  + Rn (Wn ) Where: R = The expected return on a particular security W = The proportion (weight or %) of the security held in the portfolio based on the dollar value of the security n = The number of securities in the portfolio EXAMPLE A client invests $100 in two securities: $60 in ABC Co. and $40 in DEF Co. The expected return from ABC Co. is 15%, and the expected return from DEF Co. is 12%. To calculate the expected return of the portfolio, you should look at the rate expected to be generated by each investment proportionally. Because the total amount invested is $100, ABC Co. represents 60% of the portfolio ($60 ÷ $100) and DEF Co. represents 40% ($40 ÷ $100). If ABC Co. earns a return of 15% and DEF Co. earns 12%, the expected return on the portfolio is calculated as follows: Expected Return = (0.15 ´ 0.60) + (0.12 ´ 0.40) = 0.09 + 0.048 = 0.138 = 13.8% MEASURING RISK IN A PORTFOLIO Diversification is an important risk management tool; however, as an advisor, you must guard against too much diversification. When a portfolio contains too many securities, it may be difficult to achieve superior performance. The accounting, research, and valuation functions may also be needlessly complex. Advisors have developed a number of strategies for limiting losses on individual securities or on a portfolio. Most of these strategies involve the use of derivatives. For example, they may use put options on individual equities or on © CANADIAN SECURITIES INSTITUTE 15 10 CANADIAN SECURITIES COURSE      VOLUME 2 investments such as gold, silver, and currencies. Additionally, they can hedge an entire portfolio by using derivatives on stock indexes, bonds, or interest rates. COMBINING SECURITIES IN A PORTFOLIO This section brings together the concepts of diversification, risk and return. Portfolio management stresses the selection of securities for inclusion in the portfolio based on the securities’ contribution to the portfolio as a whole. This approach suggests that some interaction among securities can result in the total portfolio achieving more than the sum of its parts. If investors place all of their savings in a single security, their entire portfolio is at risk. If the investment consists of a single equity security, the investment is subject to business risk and market risk. Alternatively, if all of the investor’s funds are invested in a single debt security, the investment is subject to default risk and interest rate risk. You can eliminate or reduce some of these risks through diversification. However, you must do so carefully, with a good understanding of the methodology for combining securities. A portfolio holding multiple securities whose risk characteristics are very similar is not properly diversified. Furthermore, although total risk does fall significantly when the first few stocks are added, the rate of reduction declines as the number of stocks increases. A point is finally reached where risk can no longer be reduced through diversification. CORRELATION Correlation is the statistical measure of how the returns on two securities move together over time and, therefore, how a change to the value of one security can predict the change in value of another. From a portfolio perspective, we are interested in the way securities relate to each other when they are added to a portfolio, and to how the resulting combination affects the portfolio’s total risk and return. For example, a portfolio consisting only of the stock of several companies in the same industry has a high correlation with the fortunes of that industry. If the stock prices of those companies always move in the same direction and in the same proportion, they would have a perfect positive correlation. Perfect positive correlation is denoted as a correlation of +1. Adding securities with perfect positive correlation to a portfolio does not reduce the overall risk of the portfolio. EXAMPLE Your client has invested 100% of her savings in a gold mining stock. She knows she will make money if the price of gold rises, and if the price declines, she will lose money. To reduce this risk, she wants to diversify into another stock, which happens to be another gold mining company. You explain to your client that her portfolio would not be properly diversified because the value of both securities is tied to the fortunes of gold. If one security declines in value, the other almost certainly will as well. But what if the stock prices of two companies always move in opposite directions and in the same proportion? Such securities have a perfect negative correlation, denoted as −1. When the stock of one company rises as the other falls, the investor holding both stocks can earn a positive return with little risk (other than market risk). EXAMPLE Your client has a portfolio of two securities: an airline company stock and a bus company stock. In good economic times people fly, and in hard times they save money by taking the bus. Therefore, when the economy is strong, the investor’s airline company shares increase in value. When the economy declines, the airline stock declines accordingly, but the loss is offset by an increase in the price of bus company shares. © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 11 With perfect negative correlation between two assets, there is no variability in the total returns of the assets, and thus no risk for the portfolio. The maximum gain from diversification is therefore achieved when securities held within the portfolio exhibit perfect negative correlation. In reality, however, it is very difficult to find securities with perfect negative correlation. Because the securities in an equity portfolio are always positively correlated to some degree, the portfolio is left with systematic risk, which cannot be eliminated. The impact of systematic risk on return is the main source of uncertainty for an investor with a well-diversified portfolio. Figure 15.4 shows how risk is reduced by adding securities to an equity portfolio. Figure 15.4 | Risk in an Equity Portfolio (Total Risk of the Portfolio) Standard Deviation Systematic Risk 0 1 Number of Securities PORTFOLIO BETA As discussed earlier, the beta relates the volatility of a single equity or equity portfolio to the volatility of the stock market as a whole. Specifically, beta measures that part of the fluctuation in returns driven by changes in the stock market. Volatility in this context is a way of describing the changes in return over a long time frame. The wider the range in market returns, the greater the volatility and the greater the risk. Any equity or equity portfolio that moves up or down to the same degree as the stock market has a beta of 1.0. Any security or portfolio that moves up or down more than the market has a beta greater than 1.0, and a security that moves less than the market has a beta of less than 1.0. EXAMPLE If the S&P/TSX Composite Index rose 10%, an equity fund with a beta of 1.0 would be expected to rise by 10%. If the S&P/TSX Composite Index fell by 5%, the equity fund would be expected to fall by 5%. An equity portfolio with a beta of 1.30, would be expected to rise 13% (calculated as 1.3 × 10%) when the S&P/TSX Composite Index rose 10%. An equity portfolio with a beta of 0.80 would be expected to rise only 8% when the S&P/TSX Composite Index rose 10%. Most portfolio betas indicate a positive correlation between equities and the stock market. © CANADIAN SECURITIES INSTITUTE 15 12 CANADIAN SECURITIES COURSE      VOLUME 2 Industries with volatile earnings (typically cyclical industries) tend to have higher betas than the market, whereas defensive industries tend to have lower betas. This difference implies that, when the market is falling in price, defensive stocks normally fall relatively less and cyclical stocks relatively more. Simplistically, we could say that it is better to have high beta stocks in a rising market and low beta stocks in a falling market. However, this statement is an over-generalization and presumes that history repeats itself. PORTFOLIO ALPHA Equity portfolios often outperform the market and move more than would be expected from their beta. The additional movement is credited to the skill of the advisor or fund manager in picking securities that outperform. This excess return earned on the portfolio is called the alpha. RISK AND RETURN How does the mix of securities in a portfolio affect both the risk and return of the portfolio? Complete the online learning activity to assess your knowledge. THE PORTFOLIO MANAGER STYLES 5 | Compare and contrast the portfolio management styles of equity and fixed-income managers. Portfolio managers, advisors, and investors to some extent, tend to use a combination of two investment strategies: active or passive. ACTIVE INVESTMENT MANAGEMENT The goal of an active investment strategy is to outperform a benchmark portfolio on a risk-adjusted basis. You can judge the success of active strategies by comparing the performance of a portfolio or an asset class within the portfolio to that of an appropriate benchmark or index. EXAMPLE The performance of an equity strategy that focuses on small-capitalization stocks should be gauged against a small-cap equity index. Active equity investment strategies use one of two approaches, bottom-up analysis or top-down analysis, depending on how stocks are selected for purchase or sale. Bottom-up analysis begins with a focus on individual stocks. The portfolio manager looks at the characteristics of various stocks and builds portfolios of the best stocks in terms of forecasted risk-return characteristics. Top-down analysis begins with a study of broad macroeconomic factors before narrowing the analysis to individual stocks. The classic approach is to analyze macroeconomic and capital market factors, and then look at industry-specific factors to evaluate a particular company’s operating environment. Finally, the manager uses company-specific factors to assess the value of the company’s common stock. The two approaches are not mutually exclusive. A compelling recommendation about a particular stock or managed product should always include both external (macroeconomic and industry) and internal factors that are likely to affect the price of the security. © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 13 PASSIVE MANAGEMENT Managers using a passive investment strategy tend to replicate the performance of a specific market index without trying to beat it. Passive investment strategies also use two approaches: indexing and buy and hold. A buy-and-hold strategy is consistent with the view that securities markets are efficient, meaning that the price of a security at all times reflects all relevant information on expected return and risk. The passive portfolio manager does not believe it is possible to identify stocks as underpriced or overpriced, at least to an extent that would achieve enough extra return to cover the added transactions costs. Indexing involves buying and holding a portfolio of securities that matches the composition of a benchmark index. This method does not require much trading or managerial expertise unless the underlying stocks in the index change. At that point, the manager must trade, to keep the index fund matching the index. EQUITY MANAGER STYLES Equity portfolio managers use one of three approaches to investment management: growth, value, or sector rotation. GROWTH MANAGERS Growth managers focus on current and future earnings of individual companies, specifically earnings per share (EPS). Growth managers look for earnings momentum and will pay more for a company if they feel its growth potential warrants the higher price. Stocks in this type of portfolio usually have a lower dividend yield, or provide no dividend at all, and managers may turn over the securities in the portfolio more often. Growth portfolios have the following risks: If EPS falters, it can cause large percentage price declines. Reported EPS, above or below analysts’ expectations, produces high portfolio volatility. These types of securities are highly vulnerable to market cycles. In terms of valuation ratios, growth portfolios have the following characteristics: High price-to-earnings High price-to-book value High price-to-cash flow Long-term total return is gathered mostly through capital appreciation. Growth managers are usually not concerned with quarterly portfolio fluctuations. Clients must focus on long-term investment horizons and be prepared to tolerate risk in down markets. Growth investing is a matter of expectations. The growth manager’s challenge is to avoid paying too much for over- priced stocks. However, stocks that may seem high today will represent a good investment a year or two from now, if the company continues to grow as expected. This growth style works best in rising markets. Stocks with above-average prices are more vulnerable in bear markets. Growth portfolios are appropriate for investors who are aggressive or who favour momentum investing, and who enjoy making spectacular gains in rising markets. The growth style holds greater potential for capital appreciation because of faster earnings growth. Growth stocks tend to reinvest more of their earnings. However, this style has greater volatility, and hence risk, because more of the total return of the portfolio is derived from capital appreciation than from more stable dividend income. Also, growth stocks may fall more rapidly than other stocks in a declining market. Because portfolio turnover tends to be higher, investors in taxable accounts may be liable for increased amounts of capital gains tax every year. © CANADIAN SECURITIES INSTITUTE 15 14 CANADIAN SECURITIES COURSE      VOLUME 2 VALUE MANAGERS For value investing managers, the focus is on stocks that are perceived to be trading for less than their true or intrinsic value. These managers are bottom-up stock pickers with a research-intensive approach. Security turnover is typically low because these managers usually wait for a stock’s intrinsic value to be realized. By screening stocks for cheap fundamentals, and by investigating a company’s management, products and services, and competitive position, managers can buy discounted stocks that should eventually rise in price. Value managers seek stocks that are overlooked, disliked, or out of favour with individual investors, institutional investors, and equity analysts. However, these reasons also imply that it may take some time for the discounted stock to realize its intrinsic value, if ever. A value portfolio has the following risk characteristics: Lower annualized standard deviation Lower historical beta Stock price is already low and could remain low for a long time In terms of valuation, it has the following characteristics: Low price-to-earnings ratio Low price-to-book value ratio Low price-to-cash flow ratio High dividend yield Over the long term, value investing has produced total returns virtually identical to those of growth investing but with higher current dividend yield and less portfolio volatility. This style tends to perform best in down markets, with some participation in up markets. Because of the lower volatility associated with this style of management, value managers can be used as core managers for clients with low-to-medium tolerance for market risk and long-term investment horizons. This style of investing requires patience as the value of the underpriced bargains are slowly realized by the market. Because turnover in portfolios with a value bias tends to be low, investors incur fewer capital gains. Value investing largely ignores short-term market fluctuations. A value manager’s picks may not be immediately recognized as undervalued by the market. Value investing is more successful in inefficient markets, when stock prices may be out of line with corporate fundamentals. It also tends to work in a stagnant or declining market, when there is greater emphasis on preserving capital or minimizing short- term losses. One drawback to the value style of investing is that, in efficient stock markets, the price of individual securities tends to reflect all that is known about the stocks. An individual stock may therefore be trading at a low price for good reason, which may not show up in its financial statements. Because of the focus on good value, value managers may be drawn to companies that are in need of a turnaround to overcome financial or competitive difficulties. SECTOR ROTATION Sector rotation applies a top-down approach, focusing on analyzing the prospects for the overall economy. Based on that assessment, the managers invest in the industry sectors expected to outperform. These managers typically buy large-cap stocks to maximize their liquidity. They are not as concerned with individual stock characteristics. Their primary focus is to identify the current phase of the economic cycle, the direction the economy is headed in, and the various sectors affected. © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 15 In other words, managers applying this strategy try to identify emerging trends in the belief that industry selection is more important than stock selection. Risk features include high volatility caused by industry concentration and rotation between industries. The consequences are worse if the manager’s economic scenario is wrong and the favoured industries do not perform as expected. Over short periods, managers and investors who use sector rotation may significantly underperform the market benchmark. The turnover for a portfolio using sector rotation also tends to be high, which pushes up trading costs and the expenses charged to the fund. The higher turnover may create problems for taxable accounts; capital gains tax may be payable because of frequent trades. Also, because this style emphasizes the industry sector, the merits of individual companies get less scrutiny and good individual stocks may be overlooked. The emphasis on large, liquid companies that lead their particular sector also means that the actual stocks picked may not necessarily represent the performance of the entire sector. Stock-specific circumstances may cause an individual holding to behave very differently from its industry peers. Sector rotation is concerned with trying to outperform the market averages such as the S&P/TSX Composite Index. EXAMPLE During the last stages of recession, bank stocks may rally first, to be followed by consumer growth stocks, consumer cyclical stocks, and thereafter those stocks that tend to benefit even later in an economic cycle, such as those for capital goods and commodity-based industries. Theoretically, successful shifts between these groups can produce greater returns than just buying and holding a diversified portfolio of stocks. The most basic industry rotation strategy involves shifting back and forth between cyclical industries and defensive industries. During periods in which stock prices are falling, cyclical stocks tend to fall relatively faster. Defensive stocks, such as banks or utilities, fall at a relatively slower pace, helping the investor to preserve capital. Conversely, during periods of economic expansion, the profit growth of cyclical industries, such as paper and forestry or integrated mines, is more robust; therefore, their stock tends to rise relatively faster. Industry rotation strategies become more complex once additional industry types are considered and variations in economic cycles are taken into account. EXAMPLE Some industry groups are interest rate sensitive. They follow a pattern that conforms almost entirely to the interest rate cycle. However, growth industries may do consistently well in most economic environments because of sustained growth in corporate profits. A minority of industries are counter-cyclical, or they may lag below the market averages. For example, gold stocks are occasionally inversely related to the S&P/TSX Composite Index. Gold stock prices sometimes rise during recessions, while stock market average price levels are falling. Variations in the economic cycle can also have a dramatic bearing on the timing of sector rotation. Generally, two- thirds of an economic recovery is driven by an increase in consumer spending. As a consequence, businesses need to add to plant and capacity, which results in an increased demand for capital goods and provides a boost for the stocks of capital goods makers. © CANADIAN SECURITIES INSTITUTE 15 16 CANADIAN SECURITIES COURSE      VOLUME 2 FIXED-INCOME MANAGER STYLES Fixed-income managers invest in fixed-income products such as bonds, mortgage-backed securities, fixed-income mutual funds, exchange-traded funds, and preferred shares. The managers’ choices may vary depending on the product’s term-to-maturity period or credit quality, or on their expectations regarding interest rates. TERM TO MATURITY Short-term managers hold T-bills and short-term bonds with maturities less than five years. Portfolios holding these products are less volatile when interest rates rise because they have investments maturing that can be reinvested at the higher rates. Medium-term managers focus on terms to maturity that range from five to 10 years. Mortgage funds are a good example. These funds generally invest in high-quality residential mortgages (usually NHA insured) with terms of five years. Long-term managers hold bonds with maturities of greater than 10 years. CREDIT QUALITY The quality of investment-grade bonds ranges from a high Aaa to a low of Baa3 (refer to Moody’s Long-Term Rating Scale in Chapter 6). High-quality issuers are typically federal and provincial governments and some very well- capitalized corporations. Generally, the lower the quality of the bond, the higher the yield it must have. Managers must balance the return potential with the risk of default. Many bond portfolios have predetermined credit quality limits, under which they will not invest. High-yield bonds are non-investment grade products, often called junk bonds. Bonds in this category should have a higher yield, but they face greater credit risk. To mitigate this risk, managers often invest in high-yield bonds that mature in less than three years. Because of the higher credit risk, corporate issues have higher yields than comparable Government of Canada issues. Therefore, by selecting higher-quality corporate issues, a manager can improve a portfolio’s yield without taking on much additional risk. Another factor to consider with corporate issuers is liquidity. Lower-rated bonds have less liquidity than government issues. In a declining market, it may be difficult to find a buyer for this kind of debt. INTEREST RATE ANTICIPATORS Some managers feel they can add value by anticipating the direction of interest rates and structuring their portfolios accordingly. When they anticipate a decrease in the general level of interest rates, they extend the average term on their bond investments. Conversely, when they anticipate an increase in interest rates, they shorten the term. Interest rate anticipation is sometimes also referred to as a form of duration switching. It works best when the yield curve is normal—that is, when there is a wide gap between short-term and long-term rates. If the yield curve is flat, it is not advantageous to extend the term to maturity of the portfolio. DID YOU KNOW? As discussed earlier, duration is an approximate measure of a bond’s price sensitivity to changes in interest rates. Therefore, if you anticipate that interest rates are going to fall, you could sell lower duration bonds and replace them with higher duration bonds. You thus extend the average duration of the portfolio and increase the portfolio’s price sensitivity. As interest rates fall, the increased price sensitivity should lead to greater capital gains. © CANADIAN SECURITIES INSTITUTE  CHAPTER 15      INTRODUCTION TO THE PORTFOLIO APPROACH 15 17 PORTFOLIO MANAGER STYLES Different fund managers will vary in the management styles they employ. It is important to know the style that a manager uses to better understand how the portfolio will behave in different market environments. Complete the online learning activity to assess your knowledge of the different portfolio manager styles. CASE SCENARIO Can you help Sal with his questions about risk? Complete the online learning activity to assess your knowledge. 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 15 18 CANADIAN SECURITIES COURSE      VOLUME 2 SUMMARY In this chapter, we discussed the following key aspects of the portfolio approach to investment: In a portfolio, diversification is a strategy that combines a variety of distinct investments with the aim of reducing the investor’s risk of any individual security. Generally, to achieve higher returns, investors must be willing to accept a higher degree of risk. In statistics, risk is defined as the likelihood that the actual return will be different from the expected return. Systematic risk is non-diversifiable risk; it is always present and affects all assets within a certain class. Non- systematic risk is the risk that the price of a specific security or group of securities will change to a different degree or in a different direction from the market as a whole. Non-systematic risk can be reduced through diversification. Two common measures of risk are standard deviation and beta. Asset allocation involves determining the optimal division of an investor’s portfolio among the different asset classes of cash, fixed income, and equities to maximize portfolio return and reduce overall risk. The return is calculated as the weighted average return on the securities held in the portfolio. Correlation refers to the way securities relate to each other when they are added to a portfolio and how the resulting combination affects the portfolio’s total risk and return. Beta is a measure of a portfolio’s volatility in comparison to that of the market. Higher beta means greater risk. Alpha measures the degree to which an equity portfolio performs better than would be expected from beta. Active managers attempt to outperform the market by actively seeking stocks that will do better than the market. Passive managers tend to replicate the performance of a specific market index without trying to beat it. Fixed-income managers make choices based on term to maturity, credit quality, and their expectations of changes in interest rates. Equity growth managers use the bottom-up style of growth investing by focusing on current and future earnings of individual companies. Equity value managers focus on buying undervalued stock. Equity sector rotators apply a top-down investing approach. They analyze the overall economy and invest in promising industry sectors. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 15 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 15 FAQs. © CANADIAN SECURITIES INSTITUTE  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 rat