Reading 72: The Portfolio Management Process And the IPS

This is a small reading and lots of parts build up on what we learned in Level-I. Here’s a small re-cap:

1. Portfolio Perspective: Investments should be judged in the context of the entire portfolio and not on a stand alone basis.

2. There are 3 steps in the Port. Management Process:

• Planning, which includes- Investment Objectives and Constraints, Formulating the IPS (which includes making the investment strategy- active, passive or semi-active), Perceiving the Capital Market Expectations, and Strategic Asset Allocation.

• Execution- Selection of specific assets for the portfolio, interacts constantly with the feedback step. Tactical Asset Allocation- Responding to changes in the short term capital market expectations rather than to investor circumstances. Transaction costs (both explicit and implicit) need to be taken into account).

• The Feedback Step– Includes Monitoring and Rebalancing and Performance Evaluation.

a. During monitoring, two types of factors are monitored: the investor’s circumstances and the economic and market   input factors. We should manage ongoing exposures to available investment opportunities in order to continually satisfy the client’s current objectives and constraints. When asset price changes occur, however, revisions can be required even without changes in expectations.         b. Performance evaluation-Has three steps- Performance measurement (which can be done through 3 sources- market timing, strategic asset allocation and security selection. Port. management is often done against a benchmark. So, both absolute and relative measurement are important), performance attribution (the source of the port’s performance) and performance appraisal (evaluating if the manager did a good job).  The applicability of the benchmark also should be assessed.

Let’s go over the diff. components of the Planning Step in details-

1. Investment Objectives– Includes both risk and return objective. The investment objectives are specific and measurable. Risk tolerance gives more of a range (below average, above average etc.) and risk objective quantifies the risk tolerance. Risk can be measured by absolute methods such as Variance, Std. Deviation, VaR or by relative methods such as Tracking Error. We need to synthesize both the willingness and the ability of the investor to take on risk.

Return Objective: Specify a return measure such as total nominal return, determine the investor’s stated return desire,  the investor’s RRR, and specify an objective in terms of the return measure in the first step. Although an absolute return objective is sometimes set (eg- 10%), the reality of the markets suggest that a relative return objective may be more plausible.

The investment constraints are limitations on the ability to make use of particular investments. They can be liquidity (need for cash in excess of new contributions), time horizon, tax concerns, legal and regulatory factors and unique circumstances (ethical objectives or social responsibility considerations,health needs, support of dependents, avoidance of nondomestic shares etc.)

2. Investment Policy Statement– Is a written document that governs all investment decisions for the client. It is specific to each client and integrates the needs, preferences and circumstances of that client’s objectives and constraints.

It also involved the making of an investment strategy, which is the manager’s approach to investment analysis and security selection. The strategy can either be passive ( a portfolio indexed to a market index or a buy and hold strategy), active (when the port. holdings differ from the port’s benchmark or comparison port, in order to produce a positive alpha), or the semiactive, risk-controlled active or the enhanced index approach (a port. closely following an index strategy, but adding a targeted amt of value by tilting the asset weights in a direction the manager believes to be profitable).

3. Capital Market Expectations– Long run forecasts of risk and return characteristics for various asset classes that form the basis for choosing portfolios.

4. Creating the Strategic Asset Allocation– The manager combines the IPS and the CME to determine the target asset class weights.