PORTFOLIO MANAGEMENT

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PORTFOLIO MANAGEMENT

• Chapter 21

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The Investment Management Process
Evaluate Investor
Investment Strategy Asset Allocation
Market, Investor Portfolio Monitored
Portfolio Changed to reflect changes
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Evaluate Investor

• Must evaluate objectives and constraints of an
  investor to be able to provide suitable
  investment advice
• know your client legislation
• Objectives are in terms of risk and return
• Constraints are things that limit ability to take
  on risk, or limit types of investment that can be
  made
• Note that markets and investor are monitored
  continuously - Portfolio management process is a
  continuum, it never stops.

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Evaluate Investor

• Objectives of Investor - Risk
• Ability to accept risk affected by
• spending needs
• long term targets obligations
• financial strength
• individual characteristics (willingness to take
  on risk)

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Evaluate Investor

• Objectives of Investor - Return
• Return objectives must be consistent with risk
  objectives!
• May be specific (i.e. an actual )
• May be more general (e.g. capital preservation,
  income, or growth of capital)
• Should account for effect of inflation

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Evaluate Investor

• Investment Constraints
• limit investment choices
• Liquidity
• expected/unexpected cashflows
• Time Horizon

Will affect ability to accept risk
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Evaluate Investor

• (c) Tax
• capital gains versus income
• (d) Legal and Regulatory Factors
• mostly institutional investors
• Prudent Man Rule
• (e) Unique Circumstances

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Evaluate Investor

• To evaluate an investor and their investment
  needs, sometimes useful to look at what point in
  the life cycle they are in
• Life Cycle investment needs (objectives,
  constraints) change as people go through
  different stages of life

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Evaluate Investor

• General Stages of Life Cycle
• 1. Accumulation Phase
• Early to middle working years, starting to
  accumulate wealth
• Net worth usually small (often have debt)
• Typically long investment horizon, therefore able
  to take on more risk
• Emphasis on capital appreciation
• May have some shorter term goals (buy house, buy
  car etc.)

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Evaluate Investor

• 2. Consolidation phase
• 20 or 30 years to retirement
• Salary has increased so earnings exceed expenses,
  therefore do not need much liquidity from
  investments
• Time horizon still long so able to take moderate
  amounts of risk, but less risk tolerance than in
  accumulation phase
• Emphasis on capital appreciation, do not need
  income

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Evaluate Investor

• 3. Spending Phase
• Retirement
• Since do not earn money now, protection of
  capital is important. Take less risk.
• Emphasis on current income provided by
  investments (rather than appreciation)
• many years of life left, so some growth still
  needed (to protect against inflation)
• May be need for liquidity in investments to meet
  unexpected expenses

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Evaluate Investor and Market

• 4. Gifting Phase
• Basic risk/return trade off is same as in
  spending phase, but the purpose of investing has
  changed
• general goal now is to maximize amount that can
  be given to relatives or charity.

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Investment Strategy Asset Allocation

• After evaluating investor, evaluate markets
• Form expectations about returns
• May be based, in part, on historical averages
• E.g. average return on TSX is 10.32 per year,
  from 1938-2003
• BUTpast performance is no guarantee of future
  performance

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Investment Strategy Asset Allocation

• Based on investor and market evaluation, form
  optimal asset allocation
• Asset allocation proportion of funds invested
  in general asset classes
• Asset classes may be very general
• stocks/bonds/cash equivalents
• Safety/income /growth
• or more specific
• by equity sector, long bonds, short bonds
• Canadian equities/foreign equities/Canadian
  bonds/foreign bonds

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Investment Strategy Asset Allocation

• asset allocation often done through optimization
  in mean-variance framework
• many people consider asset allocation the most
  important decision (more important than actual
  bonds/stocks chosen)
• Brinson, Hood and Beebower (1986)
• Asset allocation explains 93.6 of return
  variation over time
• allocation may be Strategic Asset Allocation
  (only change allocation when investor changes) or
  Tactical Asset Allocation (market timing,
  changing allocation as markets change)

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Investment Strategy Asset Allocation

• after asset allocation decision, must chose
  specific securities (e.g. stocks, bonds, etc.) to
  make up portfolio
• active versus passive investing may be used here
• mean-variance optimal portfolio might be used to
  find best portfolio of stocks, of bonds, etc.

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Market, Investor Portfolio Monitored

• monitor market conditions, possibly make changes
  as warranted (this would be Tactical Asset
  Allocation)
• trade-off trading too frequently (high
  transaction costs) versus not trading frequently
  enough (holding on to bad positions)
• Strategic Asset Allocation would only change if
  long term expectations about markets change
• monitor changes in client (objectives,
  constraints), make changes to asset allocation as
  warranted
• this is important step

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Institutional vs Individual Investors

• There are some key differences between
  individuals and institutions in terms of forming
  investment objectives and constraints
• Institutions typically more quantitative in
  evaluating risk (e.g. use standard deviation)
• Individuals defined by their personalities, while
  institutional portfolios should be evaluated in
  terms of needs/constraints of beneficiaries of
  portfolio
• General goals are important for individuals,
  while institutions tend to be more precise.
• Institutions often subject to legal and
  regulatory constraints on what they can invest
  in.
• Taxes important for individuals, but often
  institutions are not taxed.