Portfolio Management in Practice, Volume 2: Asset Allocation by CFA Institute

Portfolio Management in Practice, Volume 2: Asset Allocation by CFA Institute

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. 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. 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, the IPS (or an equivalent document) is a
legal or regulatory requirement. For example, UK pension schemes must have a statement of investment
principles under the Pensions Act 1995 (Section 35), and this statement is in essence an IPS. The UK
Financial Services Authority also has requirements for investment firms to “know their customers.” The
European Union’s Markets in Financial Instruments Directive (“MiFID”) requires firms to assign clients to
categories, such as eligible counterparties, institutional clients, and retail clients.
In the case of an institution, such as a pension plan or university endowment, the IPS may set out the
governance arrangements that apply to the investment funds. For example, this information could cover the
investment committee’s approach to appointing and reviewing investment managers for the portfolio, and
the discretion that those managers have.
The IPS should be reviewed on a regular basis to ensure that it remains consistent with the client’s
circumstances and requirements. For example, the UK Pensions Regulator suggests that a pension scheme’s
statements of investment principles—a form of IPS—should be reviewed at least every three years. The IPS
should also be reviewed if the manager becomes aware of a material change in the client’s circumstances, or
on the initiative of the client when his or her objectives, time horizon, or liquidity needs change.
2.2. Major Components of an IPS
There is no single standard format for an IPS. Many IPS and investment governance documents with a
similar purpose (as noted previously), however, include the following sections:
Introduction. This section describes the client.
Statement of Purpose. This section states the purpose of the IPS.
Statement of Duties and Responsibilities. This section details the duties and responsibilities of the client,
the custodian of the client’s assets, and the investment managers.
Procedures. This section explains the steps to take to keep the IPS current and the procedures to follow
to respond to various contingencies.
Investment Objectives. This section explains the client’s objectives in investing.
Investment Constraints. This section presents the factors that constrain the client in seeking to achieve
the investment objectives.

Portfolio Management in Practice, Volume 2: Asset Allocation by CFA Institute

Portfolio Management in Practice, Volume 3: Equity Portfolio Management