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2018 Curriculum CFA Program Level II Portfolio Management and Wealth Planning

The Portfolio Management Process and the Investment Policy Statement (2018)

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Introduction

In setting out to master the concepts and tools of portfolio management, we first need a coherent description of the portfolio management process. The portfolio management process is an integrated set of steps undertaken in a consistent manner to create and maintain an appropriate portfolio (combination of assets) to meet clients’ stated goals. The process we present in this reading is a distillation of the shared elements of current practice.

Because it serves as the foundation for the process, we also introduce the investment policy statement through a discussion of its main components. An investment policy statement (IPS) is a written document that clearly sets out a client’s return objectives and risk tolerance over that client’s relevant time horizon, along with applicable constraints such as liquidity needs, tax considerations, regulatory requirements, and unique circumstances.

The portfolio management process moves from planning, through execution, and then to feedback. In the planning step, investment objectives and policies are formulated, capital market expectations are formed, and strategic asset allocations are established. In the execution step, the portfolio manager constructs the portfolio. In the feedback step, the manager monitors and evaluates the portfolio compared with the plan. Any changes suggested by the feedback must be examined carefully to ensure that they represent long-run considerations.

The investment policy statement provides the foundation of the portfolio management process. In creating an IPS, the manager writes down the client’s special characteristics and needs. The IPS must clearly communicate the client’s objectives and constraints. The IPS thereby becomes a plan that can be executed by any advisor or portfolio manager the client might subsequently hire. A properly developed IPS disciplines the portfolio management process and helps ensure against ad hoc revisions in strategy.

When combined with capital market expectations, the IPS forms the basis for a strategic asset allocation. Capital market expectations concern the risk and return characteristics of capital market instruments such as stocks and bonds. The strategic asset allocation establishes acceptable exposures to IPS-permissible asset classes to achieve the client’s long-run objectives and constraints.

The portfolio perspective underlies the portfolio management process and IPS. The next sections illustrate this perspective.

Learning Outcomes

The candidate should be able to:

  1. explain the importance of the portfolio perspective;
  2. describe the steps of the portfolio management process and the components of those steps;
  3. explain the role of the investment policy statement in the portfolio management process and describe the elements of an investment policy statement;
  4. explain how capital market expectations and the investment policy statement help influence the strategic asset allocation decision and how an investor’s investment time horizon may influence the investor’s strategic asset allocation;
  5. define investment objectives and constraints and explain and distinguish among the types of investment objectives and constraints;
  6. contrast the types of investment time horizons, determine the time horizon for a particular investor, and evaluate the effects of this time horizon on portfolio choice;
  7. justify ethical conduct as a requirement for managing investment portfolios.

Summary

In this reading, we have presented the portfolio management process and the elements of the investment policy statement.

  • According to the portfolio perspective, individual investments should be judged in the context of how much risk they add to a portfolio rather than on how risky they are on a stand-alone basis.
  • The three steps in the portfolio management process are the planning step (objectives and constraint determination, investment policy statement creation, capital market expectation formation, and strategic asset allocation creation); the execution step (portfolio selection/composition and portfolio implementation); and the feedback step (performance evaluation and portfolio monitoring and rebalancing).
  • Investment objectives are specific and measurable desired performance outcomes, and constraints are limitations on the ability to make use of particular investments. The two types of objectives are risk and return. The two types of constraints are internal (posed by the characteristics of the investor) and external (imposed by outside agencies).
  • An investment policy statement is a written planning document that governs all investment decisions for the client. This document integrates a client’s needs, preferences, and circumstances into a statement of that client’s objectives and constraints.
  • A policy or strategic asset allocation establishes exposures to IPS-permissible asset classes in a manner designed to satisfy the client’s long-run objectives and constraints. The plan reflects the interaction of objectives and constraints with long-run capital market expectations.
  • In a passive investment strategy approach, portfolio composition does not react to changes in expectations; an example is indexing, which involves a fixed portfolio designed to replicate the returns on an index. An active approach involves holding a portfolio different from a benchmark or comparison portfolio for the purpose of producing positive excess risk-adjusted returns. A semiactive approach refers to an indexing approach with controlled use of weights different from the benchmark.
  • The portfolio selection/composition decision concerns portfolio construction and often uses portfolio optimization to combine assets efficiently to achieve return and risk objectives. The portfolio implementation decision concerns the trading desk function of implementing portfolio decisions and involves explicit and implicit transaction costs.
  • The elements of performance evaluation are performance measurement, attribution, and appraisal. Performance measurement is the calculation of portfolio rates of return. Performance attribution is the analysis of those rates of return to determine the factors that explain how the return was achieved. Performance appraisal assesses how well the portfolio manager performed on a risk-adjusted basis, whether absolute or relative to a benchmark.
  • Portfolio monitoring and rebalancing use feedback to manage ongoing exposures to available investment opportunities in order to continually satisfy the client’s current objectives and constraints.
  • Portfolio management is an ongoing process in which the investment objectives and constraints are identified and specified, investment policies and strategies are developed, the portfolio composition is decided in detail, portfolio decisions are initiated by portfolio managers and implemented by traders, portfolio performance is evaluated, investor and market conditions are monitored, and any necessary rebalancing is implemented.
  • To determine a risk objective, there are several steps: specify a risk measure (or measures) such as standard deviation, determine the investor’s willingness to take risk, determine the investor’s ability to take risk, synthesize the investor’s willingness and ability into the investor’s risk tolerance, and specify an objective using the measure(s) in the first step above.
  • To determine a return objective, there are several steps: specify a return measure such as total nominal return, determine the investor’s stated return desire, determine the investor’s required rate of return, and specify an objective in terms of the return measure in the first step above.
  • A liquidity requirement is a need for cash in excess of the contribution rate or the savings rate at a specified point in time. This need may be either anticipated or unanticipated.
  • A time horizon is the time period associated with an investment objective. Investment objectives and associated time horizons may be short term, long term, or a combination of these two. A multistage horizon is a combination of shorter term and longer term horizons. A time horizon can be considered a constraint because shorter time horizons generally indicate lower risk tolerance and hence constrain portfolio choice, making it more conservative.
  • A tax concern is any issue arising from a tax structure that reduces the amount of the total return that can be used for current needs or reinvested for future growth. Tax concerns constrain portfolio choice. If differences exist between the tax rates applying to investment income and capital gains, tax considerations will influence the choice of investment.
  • Legal and regulatory factors are external considerations that may constrain investment decision making. For example, a government agency may limit the use of certain asset classes in retirement portfolios.
  • Unique circumstances are internal factors (other than a liquidity requirement, time horizon, or tax concerns) that may constrain portfolio choices. For example, an investor seeking to avoid investments in tobacco companies will place an internal constraint on portfolio choice.

1 CE

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