2015, Study Session # 12, Reading # 44

BASICS OF PORTFOLIO PLANNING AND CONSTRUCTION

44.a

Understanding of clients needs, circumstances & constraints are essential to
produce good results.

IPS begin with investors risk / return goals (mutually exclusive & must be
consistent).

44.b

Major components of IPS typically address;

Description of client & statement of purpose of IPS.

Statement of duties & responsibilities of manager, custodian & client.

Procedures of IPS update & investment guidelines.

Investment objectives & constraints.

Evaluation of performance & appendices.

IPS should contain clear statement of circumstances, constraints & benchmark.

44.c

Investment objective

Risk objective

Absolute Risk

Return objective

Relative Risk

For example not to
in

portfolio value by more
than 2% at any point
over any 12-month
period.

Also stated in terms of
probability of specific
portfolio results (either
% losses or $ losses).

Absolute Return

Relative to specific
benchmark.

44.d

Can be stated in real (e.g.

3% > than annual inflation
rate) or nominal (e.g.
overall return of at least
6%) terms.

Relative Return

Relative to benchmark.

Bank relative to cost
of funds.

May be relative to
return on peer groups
portfolios.

Risk

Ability to Bear Risk

Based on financial circumstances other objective factors.

 Investment horizon, greater assets v/s liabilities, higher
expected income, greater ability to bear investment risk.

Willingness to Bear Risk

Based on investors attitude & beliefs.

Willingness is quite subjective & can be assessed
through a short questionnaire.

If ability & willingness is consistent, no problem in selecting appropriate level of risk.

If willingness is above average, ability is below average low ability will prevail in
advisors assessment.

If ability is above average, willingness is below average advisor may attempt to educate
client.

Approach will most likely conform to lower of investors ability or willingness to bear risk.

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2015, Study Session # 12, Reading # 44

44.e

Investment Constraints

Liquidity

Tax Situations

Time horizon

Ability to turn investments into cash

without significant price concessions.

Property & casualty insurance
significant liquidity required
(unpredictable claims). Hedge funds &
private equity funds are not suitable
investments.

Overall tax rate as well as tax

treatment of various accounts is a
consideration.

Expected after tax return in relation to
risk should be focused.

Generally longer the horizon, more risk

& less liquidity the investor can accept.

Legal & Regulatory

Unique Circumstances

Constrain how portfolio funds are

invested.

Specific preferences or restrictions

(ethical, religious & diversification
needs).

44.f

Strategic asset allocation % allocation to IPS-permissable asset classes.

Correlation of return within asset class should be high & between asset
classes should be low (risk reduction)

Recently, alternative investments have gained prominence as an investable
asset class.

Asset classes, being mutually exclusive, should approximate the universe of
permissible investments specified in IPS.

Once asset classes have been specified, then return, standard deviation &
correlation for each asset class with other classes is determined.

44.g

Through efficient frontier, manager identifies portfolio which best meet

risk / return requirement of investor.

Tactical asset allocation variation from strategic asset allocation weights
to take advantage of short term opportunities.

Security selection deviation from index weights on individual securities.

Risk budgeting set an overall risk limit & then allocate risk b/w strategic,
tactical & security selection.

Success of security selection & tactical asset allocation depends on
managers skills & informational efficiency of markets.

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