Portfolio Management in Practice, Volume 2

Asset Allocation

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• Publisher: Wiley
• Year: 2020
• Print ISBN:
  9781119787969
• Edition: 1
• eBook ISBN:
  9781119787976
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Discover the latest essential resource on asset allocation for students and investment professionals.

Part of the CFA Institute's three-volume Portfolio Management in Practice series, Asset Allocation offers a deep, comprehensive ­treatment of the asset allocation process and the underlying theories and markets that support it. As the second volume in the series, Asset Allocation meets the needs of both graduate-level students focused on finance and industry professionals looking to become more dynamic investors.

Filled with the insights and industry knowledge of the CFA Institute's subject matter experts, Asset Allocation effectively blends theory and practice while helping the reader expand their skillsets in key areas of interest.

This volume provides complete coverage on the following topics:

• Setting capital market expectations to support the asset allocation process
• Principles and processes in the asset allocation process, including handling ESG-integration and client-specific constraints
• Allocation beyond the traditional asset classes to include allocation to alternative investments
• The role of exchange-traded funds can play in implementing investment strategies
• An integrative case study in portfolio management involving a university endowment

To further enhance your understanding of tools and techniques explored in Asset Allocation, don't forget to pick up the Portfolio Management in Practice, Volume 2: Asset Allocation Workbook. The workbook is the perfect companion resource containing learning outcomes, summary overview sections, and challenging practice questions that align chapter-by-chapter with the main text.

CHAPTER 1
BASICS OF PORTFOLIO PLANNING AND CONSTRUCTION

Alistair Byrne, PhD, CFA

Frank E. Smudde, MSc, CFA

LEARNING OUTCOMES

The candidate should be able to:

• describe the reasons for a written investment policy statement (IPS);
• describe the major components of an IPS;
• describe risk and return objectives and how they may be developed for a client;
• distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance;
• describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets;
• explain the specification of asset classes in relation to asset allocation;
• describe the principles of portfolio construction and the role of asset allocation in relation to the IPS;
• describe how environmental, social, and governance (ESG) considerations may be integrated into portfolio planning and construction.

1. INTRODUCTION

To build a suitable portfolio for a client, investment advisers should first seek to understand the client’s investment goals, resources, circumstances, and constraints. Investors can be categorized into broad groups based on shared characteristics with respect to these factors (e.g., various types of individual investors and institutional investors). Even investors within a given type, however, will invariably have a number of distinctive requirements. In this chapter, we consider in detail the planning for investment success based on an individualized understanding of the client.

This chapter is organized as follows: Section 2 discusses the investment policy statement, a written document that captures the client’s investment objectives and the constraints. Section 3 discusses the portfolio construction process, including the first step of specifying a strategic asset allocation for the client. Section 4 concludes and summarizes the chapter.

2. PORTFOLIO PLANNING

Portfolio planning can be defined as a program developed in advance of constructing a portfolio that is expected to define the client’s investment objectives. The written document governing this process is the investment policy statement (IPS). The IPS is sometimes complemented by a document outlining policy on sustainable investing—distinguishing between companies (or sectors) that either can or cannot efficiently manage their financial, environmental, and human capital resources to generate attractive long-term profitability.¹ Policies on sustainable investing may also be integrated within the IPS itself. In the remainder of this chapter, the integration of sustainable investing within the IPS will be our working assumption.

2.1. The Investment Policy Statement

The IPS is the starting point of the portfolio management process. Without a full understanding of the client’s situation and requirements, it is unlikely that successful results will be achieved. “Success” can be defined as a client achieving his or her important investment goals using means that he or she is comfortable with (in terms of risks taken and other concerns). The IPS essentially communicates a plan for achieving investment success.

The IPS is typically developed following a fact-finding discussion with the client. This fact-finding discussion can include the use of a questionnaire designed to articulate the client’s risk tolerance as well as specific circumstances. In the case of institutional clients, the fact finding may involve asset–liability management studies, identification of liquidity needs, and a wide range of tax and legal considerations.

The IPS can take a variety of forms.² A typical format will include the client’s investment objectives and the constraints that apply to the client’s portfolio.

The client’s objectives are specified in terms of risk tolerance and return requirements. These must be consistent with each other: a client is unlikely to be able to find a portfolio that offers a relatively high expected return without taking on a relatively high level of expected risk. As part of their financial planning, clients may specify specific spending goals, each of which could have different risk tolerance and return objectives.

The constraints section covers factors that need to be taken into account when constructing a portfolio for the client that meets the objectives. The typical categories are liquidity requirements, time horizon, regulatory requirements, tax status, and unique needs. The constraints may be internal (i.e., set by the client), or external (i.e., set by law or regulation). These are discussed in detail below.

Having a well-constructed IPS for all clients should be standard procedure for an investment manager. The investment manager should build the portfolio with reference to the IPS and be able to refer to it to assess the suitability of a particular investment for the client. In some cases, the need for the IPS goes beyond simply being a matter of standard procedure. In some countries,...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• PREFACE
• ACKNOWLEDGMENTS
• ABOUT THE CFA INSTITUTE INVESTMENT SERIES
• CHAPTER 1: BASICS OF PORTFOLIO PLANNING AND CONSTRUCTION
• CHAPTER 2: SECURITY MARKET INDEXES
• CHAPTER 3: CAPITAL MARKET EXPECTATIONS, PART 1: FRAMEWORK AND MACRO CONSIDERATIONS
• CHAPTER 4: CAPITAL MARKET EXPECTATIONS, PART 2: FORECASTING ASSET CLASS RETURNS
• CHAPTER 5: OVERVIEW OF ASSET ALLOCATION
• CHAPTER 6: PRINCIPLES OF ASSET ALLOCATION
• CHAPTER 7: ASSET ALLOCATION WITH REAL-WORLD CONSTRAINTS
• CHAPTER 8: ASSET ALLOCATION TO ALTERNATIVE INVESTMENTS
• CHAPTER 9: EXCHANGE-TRADED FUNDS: MECHANICS AND APPLICATIONS
• CHAPTER 10: CASE STUDY IN PORTFOLIO MANAGEMENT: INSTITUTIONAL
• GLOSSARY
• ABOUT THE AUTHORS
• ABOUT THE CFA PROGRAM
• INDEX
• END USER LICENSE AGREEMENT