CHAPTER 7
BASICS OF PORTFOLIO PLANNING AND
CONSTRUCTION
Presenter
Venue
Date
REASONS FOR A WRITTEN INVESTMENT
POLICY STATEMENT (IPS)
Legal or
Regulatory
Requirements
Suitability of
an Investment
Governance
Arrangements
IPS
MAJOR COMPONENTS OF AN IPS
Introduction
Statement of Purpose
Statement of Duties and
Responsibilities
Procedures
Investment Objectives
Investment Guidelines
Evaluation and Review
Appendices
WHAT ARE THE DIFFERENT TYPES OF
RISK OBJECTIVES?
Risk Objectives
Absolute: Stated without context
Relative: A comparison
The 12-month 95% value at
risk (VAR) of the portfolio must
not be more than
¥1 billion.
Achieving a return within 4%
of the TOPIX return
approximately 95% of the
time.
HOW DOES THE WILLINGNESS TO TAKE RISK
DIFFER FROM THE ABILITY TO BEAR RISK?
Willingness to
Take Risk
Personality
type?
Self-esteem?
Inclination for
independent
thinking?
Ability to
Bear Risk
Risk Tolerance
Time horizon?
Expected
income?
Wealth relative
to liabilities?
EXHIBIT 7-1 MEASURING THE
WILLINGNESS TO TAKE RISK
1. Investing is too difficult to understand.
2. I am more comfortable putting my money in a bank account
than in the stock market.
3. When I think of the word “risk,” the term “loss” comes to mind
immediately.
4. Making money in stocks and bonds is based on luck.
5. In terms of investing, safety is more important than returns.
Possible responses for all five questions: (A) Strongly agree, (B)
Tend to agree, (C) Tend to disagree, and (D) Strongly disagree.
Source: Grable and Joo (2004).
EXAMPLE 7-2 THE CASE OF HENRI GASCON:
RISK TOLERANCE
Henri Gascon is an energy trader who works for a major
French oil company based in Paris. He is 30 years old and
married with one son, aged 5. Gascon has decided that it is
time to review his financial situation and consults a financial
adviser. The financial adviser notes the following aspects of
Gascon’s situation:
• Gascon’s annual salary of €250,000 is more than sufficient
to cover the family’s outgoings.
• Gascon owns his apartment outright and has €1,000,000
of savings.
• Gascon perceives that his job is reasonably secure.
EXAMPLE 7-2 THE CASE OF HENRI GASCON:
RISK TOLERANCE (CONTINUED)
• Gascon has a good knowledge of financial matters and is
confident that equity markets will deliver positive returns
over the longer term.
• In the risk tolerance questionnaire, Gascon strongly
disagrees with the statements that “making money in
stocks and bonds is based on luck” and that “in terms of
investing, safety is more important than returns.”
• Gascon expects that most of his savings will be used to
fund his retirement, which he hopes to start at age 50.
HENRI GASCON’S TOLERANCE FOR RISK
Ability to
Bear Risk
Willingness to
Take Risk
• Knowledgeable
about financial
markets
• Answers to
survey suggest
risk tolerance
Risk Tolerance
• Secure job
• High income
relative to
expenses
• Significant assets
• Time horizon of 20
years
WHAT ARE THE IMPORTANT
CONSIDERATIONS WHEN SETTING RETURN
OBJECTIVES?
Nominal,
Real, or
Required?
Absolute
or
Relative?
Realistic?
Return
Objectives
EXAMPLE 7-4 THE CASE OF HENRI GASCON:
RETURN OBJECTIVES
Having assessed his risk tolerance, Henri Gascon
now begins to discuss his retirement income needs
with the financial adviser. He wishes to retire at age
50, which is 20 years from now. His salary meets
current and expected future expenditure
requirements, but he does not expect to be able to
make any additional pension contributions to his
fund. Gascon sets aside €100,000 of his savings as
an emergency fund to be held in cash. The
remaining €900,000 is to be invested for his
retirement.
EXAMPLE 7-4 THE CASE OF HENRI GASCON:
RETURN OBJECTIVES (CONTINUED)
Gascon estimates that a before-tax amount of
€2,000,000 in today’s money will be sufficient to
fund his retirement income needs. The financial
adviser expects inflation to average 2% per year
over the next 20 years. Pension fund contributions
and pension fund returns in France are exempt
from tax, but pension fund distributions are taxable
upon retirement.
WHAT IS HENRI GASCON’S RETURN
OBJECTIVE?
Gascon’s retirement needs:
€2,000,000 × (1 + 0.02)20 = €2,971,895
Gascon’s return objective:
€900,000 × (1 + x)20 = €2,971,895
x ≈ 6.20%
CONSTRAINTS ON PORTFOLIO
SELECTION
Portfolio
Selection
Legal and
Regulatory
Factors
Unique
Circumstances
Tax
Concerns
Time
Horizon
Liquidity
HOW DOES THE NEED FOR LIQUIDITY AFFECT
SAMPO GROUP’S INVESTMENTS?
Allocation of Investment Assets,
Sampo Group
31 December 2008 (€16,502 million)
Fixed-Income Investments by Type of
Instrument, Sampo Group
31 December 2008 (€13,214 million)
Breakdown of fixed-income
investments
HOW THE INVESTOR’S TIME HORIZON
AFFECTS PORTFOLIO ASSET SELECTION
Investor’s
Time
Horizon
Ability
to Take
Risk
Need for
Liquidity
Portfolio
Asset
Selection
TAX CONCERNS AND LEGAL AND
REGULATORY FACTORS
Tax Concerns
Legal and
Regulatory
Factors
Investor’s tax
status
Legal
restrictions on
portfolio
composition
Tax rates:
income and
capital gains
Limits on the
use of material
nonpublic
information
UNIQUE CIRCUMSTANCES
Religious
Beliefs
Ethical
Values
Personal
Preferences
Unique
Circumstances
EXAMPLE 7-7 HENRI GASCON:
DESCRIPTION OF CONSTRAINTS
Gascon expects that he will continue to work for the oil
company and that his relatively high income will continue for
the foreseeable future. Gascon and his wife do not plan to
have any additional children, but expect that their son will go
to a university at age 18. They expect that their son’s
education costs can be met out of their salary income.
EXAMPLE 7-7 HENRI GASCON:
DESCRIPTION OF CONSTRAINTS (CONTINUED)
Gascon’s emergency reserve of €100,000 is considered to
be sufficient as a reserve for unforeseen expenditures and
emergencies. His retirement savings of €900,000 has been
contributed to his defined contribution pension plan account
to fund his retirement. Under French regulation, pension
fund contributions are paid from gross income (i.e., income
prior to deduction of tax) and pension fund returns are
exempt from tax, but pension payments from a fund to
retirees are taxed as income to the retiree.
WHAT ARE THE CONSTRAINTS ON HENRI
GASCON’S RETIREMENT PORTFOLIO?
•
•
•
•
Liquidity: No need for liquidity.
Time Horizon: Approximately 20 years.
Tax Concerns: Portfolio is tax exempt.
Legal and Regulatory Factors: French pension
fund regulations.
• Unique Circumstances: No significant exposure
to oil and other commodity stocks.
HOW ARE PORTFOLIOS CONSTRUCTED?
Investment Policy Statement (IPS)
Capital Market Expectations for
Each Asset Class
Strategic Asset Allocation
Tactical Asset Allocation or
Security Selection
QUANTIFYING CAPITAL MARKET
EXPECTATIONS
Expected
Return
Standard
Deviation
Correlation
with Other
Asset
Classes
STRATEGIC ASSET ALLOCATION (SAA)
Strategic asset allocation (SAA) is a means to providing the
investor with exposure to the systematic risks of asset
classes in proportions consistent with the IPS.
Cash
Equities
Bonds
Real Estate
Alternative
Investments
DEFINING AN ASSET CLASS
Are all of these
specifications
necessary?
Domestic
Government
Foreign
Bonds
Investment
Grade
Corporate
High Yield
EXAMPLE 7-9 SPECIFYING ASSET CLASSES
Asset class correlation matrix:
A. MSCI Europe
B. MSCI Emerging Markets
C. MSCI World
D. MSCI EAFE
E. MSCI U.S.
F. Commodities
G. Real Estate
H. Gold
I. U.S. Treasuries
J. U.S. Investment Grade
K. European Government Bonds
L. European Investment-Grade Corporates
A
1.00
0.77
0.95
0.97
0.88
0.20
0.59
–0.08
–0.35
0.10
–0.29
0.01
B
0.77
1.00
0.82
0.83
0.76
0.35
0.63
0.18
–0.25
0.22
–0.20
0.11
C
0.95
0.82
1.00
0.96
0.97
0.25
0.69
0.00
–0.31
0.18
–0.27
0.06
D
0.97
0.83
0.96
1.00
0.88
0.27
0.65
–0.01
–0.34
0.15
–0.29
0.05
E
0.88
0.76
0.97
0.88
1.00
0.20
0.70
–0.01
–0.27
0.18
–0.24
0.06
F
0.20
0.35
0.25
0.27
0.20
1.00
0.27
0.25
–0.04
0.14
–0.07
0.14
G
0.59
0.63
0.69
0.65
0.70
0.27
1.00
0.18
–0.01
0.40
0.02
0.32
H
–0.08
0.18
0.00
–0.01
–0.01
0.25
0.18
1.00
0.21
0.30
0.12
0.14
I
–0.35
–0.25
–0.31
–0.34
–0.27
–0.04
–0.01
0.21
1.00
0.67
0.78
0.55
J
0.10
0.22
0.18
0.15
0.18
0.14
0.40
0.30
0.67
1.00
0.61
0.79
K
–0.29
–0.20
–0.27
–0.29
–0.24
–0.07
0.02
0.12
0.78
0.61
1.00
0.83
L
0.01
0.11
0.06
0.05
0.06
0.14
0.32
0.14
0.55
0.79
0.83
1.00
Annualized Volatility
16.6%
20.7%
15.0%
15.4%
15.7%
25.4%
18.9%
16.6%
5.0%
6.0%
3.1%
3.2%
Sources: MSCI, NAREIT, Barclays Capital, Standard and Poor’s
• High-paired correlations between equity asset classes
suggest that defining equity asset classes narrowly has
limited value.
• The case for treatment as a separate asset class can
best be made for emerging market stocks.
STEPS TOWARD AN ACTUAL PORTFOLIO
Overall Portfolio Risk
Risk
Budgeting
Strategic
Asset
Allocation
Tactical Asset
Allocation
Security
Selection
TACTICAL ASSET ALLOCATION AND SECURITY
SELECTION
Systematic
risk factors
Market
return:
passive
investing or
indexing
Excess
return or
alpha: active
investing
Nonsystematic
risk factors
Strategic
Asset
Allocation
----
Tactical
Asset
Allocation
Security
Selection
CAN SECURITY SELECTION ADD VALUE?
At the macro level,
security selection is a
zero-sum game.
Value
Added by
Security
Selection
Value
Lost by
Security
Selection
What factors affect the ability to
add value via security selection?
Zero
REBALANCING POLICY
Policy Portfolio
Weights
Portfolio
Rebalanced to
Policy Weights
Returns on
Asset Classes
and Securities
Weights
Deviate from
Policy
EXAMPLE 7-12 STRATEGIC ASSET
ALLOCATION FOR A EUROPEAN CHARITY
Asset Class
European equities
International equities
European government bonds
Corporate bonds
Cash and money market instruments
Total
Policy Corridor
Weight (+/–)
30.0%
2.0%
15.0%
2.0%
20.0%
2.0%
20.0%
2.0%
15.0%
2.0%
100.0%
Upper
Limit
32.0%
17.0%
22.0%
22.0%
17.0%
Lower Period Ending
Limit Return Weight
28.0% 15.0% 32.4%
13.0% 10.0% 15.5%
18.0%
0.5% 18.9%
18.0%
1.5% 19.1%
13.0%
1.0% 14.2%
6.6% 100.0%
Key factors affecting rebalancing:
• Ending weight of European equities.
• Expectations regarding future asset class returns.
SUMMARY
• Components of the IPS
• Risk and return objectives
• Determinants of risk tolerance
• Investment constraints
• Risk budgeting
• Strategic asset allocation
• Tactical asset allocation and security selection
• Rebalancing policy