Reading 70: The Portfolio Management Process and the Investm 2011, Investment, investment, center, style

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Session 18: Portfolio Management: Capital Market Theory and the Portfolio Management Process
Reading 70: The Portfolio Management Process and the Investment Policy Statement

LOS c: Define investment objectives and constraints, and explain and distinguish among the types of investment objectives and constraints.

 

 

Which of the following does not relate to return objectives? Specifying:

A) security-specific returns.

B) return requirements.

C) portfolio real after-tax returns.

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Required and desired returns, specified in real after-tax levels, relate directly to the formulation of the investor’s return objective. Security-specific returns are important in analyzing potential additions to the portfolio, but do not come into play when specifying the overall portfolio return objective.

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The objective of achieving a 10% annual rate of return is an example of a(n):

A) absolute risk objective.

B) required return objective.

C) relative return objective.

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The objective of earning a 10% return is a required return objective because it represents some level of return that must be acheived by the portfolio.

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Investor objectives relate to which of the following? Evaluating:

A) capital market and security factors.

B) risk and return factors.

C) asset allocation and security factors.

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Investor objectives relate directly to the risk and return factors acceptable to the investor. Risk factors are associated with how much risk the investor can tolerate. Return factors relate to required and desired returns.

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Which of the following is not typically included in an investment policy statement?

A) Names of specific managers or mutual funds that should be used.

B) Identification of duties.

C) A client description.

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General statements about how funds should be invested are included in the investment policy statements. It would not be wise to include specific manager/mutual funds, as the people involved in managing money change over time. Instead, asset allocation objectives should be used.

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Which of the following best represents the general steps of the planning phase of the portfolio management process? Determining:

A) the investor's time horizon.

B) the investor's tax situation and unique circumstances.

C) investor objectives and constraints.

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The two major steps in the planning phase are determining investor objectives and constraints. The other choices are subsets of this choice. Objectives are concerned with what an investor wishes or requires to happen with the investment portfolio as well as being mainly concerned with risk and return considerations. Constraints pertain to limitations placed on how portfolio objectives are achieved. Five primary constraints associated with liquidity include (1) time horizon, (2) legal and regulatory issues, (3) taxes, and (4) unique circumstance considerations.

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Yoo Jin, CFA, is the Chief Investment Officer of Park, Kim & Lee Investment Management (PKL), which specializes in private wealth management for affluent families. Yoo has recently met with a potential new client, the Ahn family. PKL was highly recommended by a business associate of eldest member of the family, Ahn Kwan, and three generations of the family are considering investing with the firm to establish a new investment portfolio. The portfolio is intended solely to provide capital for the fourth and youngest generation of the family and their descendents, so the family can maintain its position in future generations. Portfolio income is not currently needed to support the three eldest generations of the Ahn family because the business ventures provide an income sufficient to maintain a luxurious lifestyle.

Since the elderly Ahn Kwan is not in sufficiently good health to attend the meeting in person, the family represented at this initial conference by Ahn Kwan’s eldest son, Ahn Yong. He explains to Yoo that the family wants to take a cautious approach to its investments. The family takes substantial risk in its business ventures and does not want to risk its capital.

As the discussion proceeds, he informs Yoo that the family is also interested in exploring new investment opportunities for their existing portfolios as well. The three adult generations of the Ahn family have so far kept their money in various bank accounts because of concern about possible losses in the securities market. The accounts generally pay an interest rate between 4% and 5%. Ahn Kwan, however, has been persuaded by his business associate that the family is losing an important opportunity to increase its returns by not investing in the stock market. The Korean equity market soared more than 40% in the previous year, and Ahn Kwan realizes that keeping money in interest-bearing accounts is costing the family substantially in missed opportunities. He has agreed to consider moving a substantial portion of the family’s assets over to PKL since he has been assured that PKL is a responsible, cautious firm.

In discussing the move into equities, Ahn Yong explains his father’s position. “My father has devoted his entire life to establishing the success of his family. The financial position of his children, his grandchildren, and their descendants is of primary importance to him. He does not want to risk losing money that he has worked decades for.”

Ahn Yong elaborates on his father’s concerns by saying, “My father has seen what happened in Japan. The peak in the Nikkei index came in 1989, and the market has never recovered. Anyone who invested back then lost nearly two-thirds of his money. My father does not want that to happen to our family.”

Yoo Jin asks, “We would of course only invest your family’s money in markets that you want to participate in. Would your father want the family’s money invested in the Japanese market?” Ahn Yong asserts emphatically, “My father is only interested in participating in the Korean markets. He does not want our money invested overseas.”

The portfolio manager who would be responsible for the Ahn family portfolios is Shin Sun, CFA. In reviewing the meeting with Shin, Yoo explains that in her view, the family’s goals are inconsistent and education is required to resolve the inconsistency. Yoo notes that the family is only interested in investing in the Korean equity market, but the Korean equity market is highly volatile. It would not be possible to create a portfolio consisting solely of Korean equities that would be consistent with Ahn Kwan’s investment risk tolerance.

Shin makes the case that the family has a very high risk tolerance. Shin argues, “The time horizon of the Ahn family is virtually infinite, since the money is intended for future generations. In addition, the portfolio has no current income requirements. In this case, they can have a very high risk tolerance. Certainly the Ahn family is in an excellent position to invest in the Korean equity market.”

Shin suggests, “Educating a new client can be a very delicate issue. That is especially true when the client is the elderly head of a very successful family. I would not want to tell Ahn Kwan that we cannot do what he wants. We should follow his instructions and invest the family’s money in a portfolio of Korean equities. If that is what he says, then it is our duty to follow his wishes.” Shin concludes that PKL should construct a portfolio consistent with the Ahn family’s substantial ability to assume risk.

The best description of the importance of portfolio perspective is that investors, analysts and portfolio managers should analyze the:

A) unsystematic risk of the individual investments in the portfolio.

B) risk-return tradeoff of the individual investments in the portfolio.

C) risk-return tradeoff of the portfolio as a whole.

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Investors, analysts and portfolio managers should analyze the risk-return tradeoff of the portfolio as a whole, not the individual investments in the portfolio. (Study Session 18, LOS 68.a)

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Which of the following is least likely to determine an individual investor’s ability to accept risk?

A) Long-term wealth target.

B) Market expectations.

C) Liabilities.

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Liabilities and long-term wealth target are each direct determinants of an individual investor’s ability to accept risk. Market expectations will affect return achieved but is not a direct determinant of an investor’s ability to accept risk. (Study Session 18, LOS 68.c)

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The two principal risk objective measurements are best described as:

A) tracking risk and absolute risk.

B) absolute risk and relative risk.

C) absolute risk and qualitative risk.

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The two risk objective measurements are absolute and relative risk. Tracking risk is an example of a relative risk objective. Qualitative risk is a form in which an absolute risk objective may be stated. (Study Session 18, LOS 68.c)

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Regarding Shin’s and Yoo’s assertions about the family’s risk tolerance and the implications for the management of their portfolios:

A) Yoo’s statement is correct; Shin’s statement is incorrect.

B) Yoo’s statement is correct; Shin’s statement is correct.

C) Yoo’s statement is incorrect; Shin’s statement is correct.

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Shin’s statement that the family has a very substantial ability to assume risk is correct, but he is incorrect to claim that the portfolio should be constructed in accordance with their ability to assume risk without resolving the conflict with their low willingness to assume risk). When the investor’s ability and willingness to assume risk are in conflict, the curriculum always recommends designing portfolios consistent with the willingness, not ability, to assume risk. Yoo is correct that there is an inconsistency in the stated risk tolerance – not increasing the risk of the portfolio above that of interest-bearing bank accounts – and the goal of investing in the stock market, and that educating the client is required. Since the willingness to assume risk is inherently in conflict with the stated objective of investing in equities (which cannot duplicate the low risk of interest-bearing bank accounts), there is no way around having to educate the family to resolve the conflict. (Study Session 18, LOS 68.c)

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A return objective should best be considered from the perspective of:

A) total return.

B) return from income relative to return from capital gains.

C) required return.

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The return objective should be considered from a total return perspective, even if there is a specific income or capital gains target. Desired or required return may be unrealistic given available market conditions or risk tolerance. (Study Session 18, LOS 68.c)

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Which is least likely to be considered one of the three integrative steps in the portfolio management process?

A) Feedback.

B) Developing an investment policy statement.

C) Planning.

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The three integrative steps in the portfolio management process are planning, execution and feedback. Developing an IPS is part of the planning phase. (Study Session 18, LOS 68.b)

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Ophelia McGillicutty, a retired airline executive, has been buying and selling stocks for more than 50 years. At 74, she controls a modest investment portfolio of $280,000. Over the last three decades, McGillicutty has given away millions of dollars to charities. She lives comfortably on her pension and her deceased husband’s Social Security benefits. McGillicutty keeps the bulk of her investments in stocks, although her children and grandchildren say she is taking on too much risk at her age.

McGillicutty should be most concerned about:

A) tax considerations.

B) diversification.

C) liquidity.

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Given McGillicutty’s ability and willingness to live on her existing monthly income, liquidity is not a concern. We have no reason to believe that income will not support her for the rest of her life, and we know of no pressing needs for her investment funds. As such, while a high stock weighting may look odd on paper considering her age, it is not necessarily inappropriate, particularly if she is investing for growth to fund charitable donations or her children’s inheritance. Taxes, however, concern most investors. Given McGillicutty’s relative insensitivity to the other two options, tax considerations seem to be the biggest potential problem area.

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Herbert von Soltanini, CFA, manages a variety of balanced portfolios for Great Performance Asset Management (GPAM). GPAM has a broad base of clients covering the entire spectrum of institutional investors. The firm manages money globally, but the bulk of its clients are located in Europe and the Americas.

Soltanini is scheduled to travel to the US in a few weeks for annual meetings with key clients in New York, Boston, and Chicago. Great Performance requires portfolio managers to review the investment policy statements (IPS) of each client before the annual meeting to ensure that the IPS still meets the current requirements of the client, and that the IPS is up to date before any revisions are made to it as a result of the annual meeting.

In preparation for the trip, Soltanini asked his assistant, Domenico Bachandel, to review the relevant United States-based clients and the status of their investment policy statements. Bachandel immediately finds a potential discrepancy in the IPS among the firm’s pension fund clients, and asks Soltanini for a meeting to discuss the problem.

Soltanini manages portfolios for many large plans. Although the majority of the plans are defined benefit, there are also several defined contribution plans for which Soltanini manages investment funds. The status of the defined benefit plans varies considerably. Most try to maintain contributions in line with actuarial requirements, but Soltanini’s defined benefit pension clients cover the full spectrum, from severely underfunded to significantly overfunded.

In addition, the range of beneficiaries varies widely as well. Some of Soltanini’s oldest client relationships are with the defined benefit plans sponsored by long-established firms. These firms’ employee bases often consist mostly of skilled manufacturing workers with high salaries and generous pension benefits. They generally have a very large proportion of retirees and extremely high requirements for current income to pay the benefits of the plan’s retirees. Often, their plans are severely underfunded. A clear example is Riverbank Manufacturing, which covers all employees with a defined benefit plan. The plan is extremely generous and drastically underfunded because more plan participants are retired than are currently employed.

In contrast, Soltanini has more recently developed relationships with many firms in the service sector, especially financial services, communications, and technology. Most of these firms have defined contribution plans, but Soltanini also manages several defined benefit plans sponsored by service sector firms as well.

The defined benefit plans for the newer clients tend to be fully-funded. In fact, many of them are significantly overfunded because the firms make large pension contributions in good years to give themselves the flexibility to reduce required contributions in bad years. These plans tend to have a very small percentage of retirees – in many cases, less than 5% – and very high turnover among workers, so that only a small percentage become vested in the plan.

In addition, these plans tend to offer less generous pension benefits than the plans established earlier by the manufacturing firms. Consequently, many of Soltanini’s service sector clients find that funding their defined benefit plans is relatively inexpensive for the plan sponsor. Sunrise Telecom is a perfect example of this. Only 3% of the plan participants at Sunrise are retired, and it experiences a very high turnover among workers. Previous contributions to the pension plan have provided sufficient portfolio assets to make the plan substantially overfunded.

Bachandel is concerned because his review showed a great divergence of investment objectives in the IPS for the various pension clients and several of the IPS for the plans appear to conflict. The IPS for the plan at Riverbank Manufacturing indicates a very low tolerance for risk, while that for Sunside Telecom indicates a very high risk tolerance. Given that these are both defined benefit plans, Bachandel wonders why the IPSs are so different.

At the meeting with Soltanini, Bachandel suggests one possible explanation for the discrepancies by saying, “The return requirements for defined benefit pension plans don’t have to be similar since they are determined by the life cycle stage of the beneficiaries.” Soltanini points out, “The risk tolerance of the plan will depend on the risk tolerance of the beneficiaries.”

Bachandel also raises concern about the IPS statements in general, since the problems extend beyond the pension fund clients. He sees a striking difference in the IPS of the various insurance companies for which Great Performance manages portfolios, as well.

Bachandel clarifies for Soltanini, “The return requirements for life insurance companies depend primarily on policy pricing and financial strength.” He hypothesizes to Soltanini that this fact could explain the discrepancies in their stated return requirements. Soltanini adds that all their insurance company clients will most likely have similar risk tolerances. “The risk tolerance at both life and casualty insurance companies is likely to be below average because of regulatory constraints.”

Bachandel and Soltanini decide that there is no obvious problem with the client investment policy statements. They agree to wait and review the IPS with the clients at the upcoming annual meetings.

The most likely event to be successfully diversified away in a portfolio would be:

A) business cycle risk.

B) unanticipated corporate loss.

C) unanticipated inflation.

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Portfolios can diversify unsystematic risk but cannot diversify systematic risk. Corporate events are sources of unsystematic risk in a portfolio and thus can be diversified away. Inflation, consumer confidence and the business cycle are all sources of systematic risk. (Study Session 18, LOS 68.a)

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Regarding Bachandel’s and Soltanini’s assertions about the risk tolerance of defined benefit pension plans:

A) Soltanini’s statement is incorrect; Bachandel’s statement is correct.

B) Soltanini’s statement is correct; Bachandel’s statement is correct.

C) Soltanini’s statement is incorrect; Bachandel’s statement is incorrect.

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Both statements are incorrect. Bachandel’s statement is incorrect because return requirements depend on the life cycle stage of beneficiaries at defined contribution, not defined benefit, plans. Soltanini’s statement is also incorrect because the risk tolerance of a defined contribution, not defined benefit, plan is determined by the risk tolerance of the beneficiaries. (Study Session 18, LOS 68.f)

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Which of the following is least likely to be considered part of the planning phase of the portfolio management process?

A) Determining the appropriate investment strategy.

B) Selecting appropriate individual investments.

C) Developing an investment policy statement.

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The planning phase of the portfolio management process consists of analyzing objectives and constraints, developing an IPS, determining the appropriate investment strategy, and selecting an appropriate asset allocation. Selecting appropriate individual investments is part of the execution phase, not the planning phase. (Study Session 18, LOS 68.b)

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Regarding Bachandel’s and Soltanini’s assertions about the return requirements and risk tolerances for insurance companies:

A) Soltanini’s statement is incorrect; Bachandel’s statement is correct.

B) Soltanini’s statement is correct; Bachandel’s statement is correct.

C) Soltanini’s statement is correct; Bachandel’s statement is incorrect.

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Soltanini’s statement is correct since both life and non-life insurance companies tend to have below average risk tolerance because of significant regulatory constraints. Bachandel’s statement is incorrect because the return requirements of non-life insurance companies depend primarily on policy pricing and financial strength. The return requirements of life insurance companies depend primarily on policy holder reserve rates. (Study Session 18, LOS 68.f)

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The most accurate characterization of the proper use of strategic asset allocation would be:

A) market expectations determine the objectives and constraints of the investor, which translate into strategic asset allocation.

B) active investment strategies should be used instead of strategic asset allocation when the portfolio manager believes he can exceed market returns.

C) forecasts of risk-return characteristics of asset classes included in the portfolio connect market expectations to the objectives and constraints of the investor.

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Active and passive investment strategies are investment approaches, not replacements for strategic asset allocation. Passive approaches are less, not more, responsive to changes in expectations. Market expectations do not determine the objectives or constraints of the investor. (Study Session 18, LOS 68.c)

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Which of the following is least likely to be considered one of the five main classes of investment constraints?

A) Willingness to assume risk.

B) Tax considerations.

C) Time horizon.

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The five main classes of investment constraints are liquidity, time horizon, legal and regulatory concerns, tax considerations, and unique circumstances. Willingness to assume risk is an aspect of risk tolerance, which is considered an investment objective, not an investment constraint. (Study Session 18, LOS 68.c)

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Investment constraints are best defined as factors:

A) determining investment choices.

B) restricting investment choices.

C) encouraging investment choices.

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Investment constraints are those factors limiting or restricting investment choices.

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Individual investors and institutional investors can be impacted differently by different constraints. Which constraints have a large impact on individual investors and a large impact on pension funds, respectively?

A) Legal and regulatory issues for individual investors and tax considerations for pensions.

B) Liquidity concerns for individual investors and tax considerations for pensions.

C) Tax considerations for individual investors and legal and regulatory issues for pensions.

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Individual investors are taxable entities, whereas pensions are tax exempt. Institutional investors must operate under ERISA regulations, whereas individuals can invest as they see fit. Liquidity concerns and unique considerations do affect both individual investors and pensions.