CHAPTER 7 BASICS OF PORTFOLIO PLANNING AND CONSTRUCTION

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REASONS FOR A WRITTEN INVESTMENT POLICY STATEMENT (IPS)

IPS

Suitability of an Investment

Legal or Regulatory

Requirements

Governance Arrangements

MAJOR COMPONENTS OF AN IPS

Introduction

Statement of PurposeStatement of Duties and

ResponsibilitiesProcedures

Investment Objectives

Investment Guidelines

Evaluation and Review

Appendices

WHAT ARE THE DIFFERENT TYPES OF RISK OBJECTIVES?

Risk Objectives

Absolute: Stated without context

The 12-month 95% value at risk (VAR) of the portfolio must

not be more than ¥1 billion.

Relative: A comparison

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?

Risk Tolerance

Willingness to Take Risk

Ability to Bear Risk

Time horizon?Expected income?Wealth relative to liabilities?

Personality type?Self-esteem?Inclination for independent thinking?

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

Risk Tolerance

Willingness to Take Risk

Ability to Bear Risk

• Secure job• High income

relative to expenses

• Significant assets• Time horizon of 20

years

• Knowledgeable about financial markets

• Answers to survey suggest risk tolerance

WHAT ARE THE IMPORTANT CONSIDERATIONS WHEN SETTING RETURN OBJECTIVES?

Return

Objective

s

Absolute or

Relative?

Nominal,

Real, or

Required?

Realistic?

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 = €2,971,895x ≈ 6.20%

CONSTRAINTS ON PORTFOLIO SELECTION

Unique Circumstances

Legal and Regulatory Factors

Tax Concerns

Time Horizon

Liquidity

Portfolio Selection

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

PortfolioAsset

Selection

TAX CONCERNS AND LEGAL AND REGULATORY FACTORS

Tax Concerns

Investor’s tax status

Tax rates: income and capital gains

UNIQUE CIRCUMSTANCES

Unique Circumstances

Ethical Values

Religious Beliefs

Personal Preference

s

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?

QUANTIFYING CAPITAL MARKET EXPECTATIONS

Correlation with Other

Asset Classes

Standard

Deviation

Expected

Return

STRATEGIC ASSET ALLOCATION (SAA)

Cash

Equities

Bonds

Real EstateAlternative Investments

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.

DEFINING AN ASSET CLASS

Bonds

Government

Domestic

Foreign

Corporate

Investment Grade

High Yield

Are all of these specifications necessary?

EXAMPLE 7-9 SPECIFYING ASSET CLASSESAsset class correlation matrix:

• 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.

A B C D E F G H I J K L A. MSCI Europe 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. MSCI Emerging Markets 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. MSCI World 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. MSCI EAFE 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. MSCI U.S. 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. Commodities 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. Real Estate 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. Gold –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. U.S. Treasuries –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. U.S. Investment Grade 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. European Government Bonds –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. European Investment-Grade Corporates 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

STEPS TOWARD AN ACTUAL PORTFOLIOOverall Portfolio Risk

Risk Budgeting

Strategic Asset Allocation

Tactical Asset Allocation

Security Selection

TACTICAL ASSET ALLOCATION AND SECURITY SELECTION

Strategic Asset

Allocation - - - -

Tactical Asset

Allocation

Security Selection

Nonsystematic risk factors

Systematic risk factors

Market return: passive investing or indexing

Excess return or alpha: active investing

CAN SECURITY SELECTION ADD VALUE?

Value Added by Security

Selection

Value Lost by

Security

Selection

Zero

At the macro level, security selection is a zero-sum game.

What factors affect the ability to add value via security selection?

REBALANCING POLICY

Policy Portfolio Weights

Returns on Asset Classes and Securities

Weights Deviate from

Policy

Portfolio Rebalanced to Policy Weights

EXAMPLE 7-12 STRATEGIC ASSET ALLOCATION FOR A EUROPEAN CHARITY

Asset Class

Policy Weight

Corridor (+/–)

Upper Limit

Lower Limit

Period Return

Ending Weight

European equities 30.0% 2.0% 32.0% 28.0% 15.0% 32.4% International equities 15.0% 2.0% 17.0% 13.0% 10.0% 15.5% European government bonds 20.0% 2.0% 22.0% 18.0% 0.5% 18.9% Corporate bonds 20.0% 2.0% 22.0% 18.0% 1.5% 19.1% Cash and money market instruments 15.0% 2.0% 17.0% 13.0% 1.0% 14.2% Total 100.0% 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