There is a generally accepted 5-step
investment process used in professional portfolio management:
1. Investment Policy
Statement (IPS)
The investment policy statement
is both the beginning and the end of the investment process. It documents
the issues to be addressed as well as the conclusions drawn from the
process. It should contain the following elements:
Purpose of an IPS
- Records the presumptions: Both the
investor and the investment advisor come to the investment process with
certain presumptions. Issues usually arise because these presumptions
are different between the parties. The IPS is intended to specify and
document the presumptions upon which all discussions will be based.
- Defines the process: There is a
structured and ordered process to investment management. The IPS
specifies and documents that process.
- Communicates to all those involved:
The IPS is a communication device between those currently involved in
the process and those that will be involved in the future.
Risk Tolerance Assessment
- Definition of risk: How does the
investor define investment risk and how should the investor do so?
- Market downturns (severity and
duration): How does the investor perceive market downturns? Do they see
a 20% decline over 2 years the same as a 20% decline over 2 months? What
is their response to either scenario?
- Understandings of capital markets:
What is the investor's understanding of how the capital markets work and
the opportunities that the markets offer?
- Aversion to taxes: What is the
investor's attitude towards taxes and his/her current marginal and
average tax rates?
- Feelings about money: Does the
investor have any distinct feelings or moral issues about money?
- Previous investment experience: How
much investment experience has the investor had and was it positive or
negative?
- Level of company loyalty: Do employer
based political issues or company loyalty have any influence on how the
investor views any investments that the investor might have in the
securities of the investor's employer?
- Ok to be different: Are they
comfortable having investments different than others in their circle of
influence?
- Defining investment success: What
would investment success look like to the investor?
Investment Objectives
- Identification of investment priority:
Is the investor's priority to maximize return or minimize risk? The
priority probably changes from maximizing return to minimizing risk once
some level of return is achieved. At what level is that?
- Acknowledgement of opportunity costs:
When favoring one priority over another, we must identify and
acknowledge that there does exist a cost. When the priority is return,
there is a cost of risk. Conversely, when the priority is risk
reduction, there is a cost of return. Having a priority is not wrong;
ignoring the opportunity cost of that priority is wrong.
- Time horizon of investment: How long
does the investor expect to invest in the assets? When will they need to
receive disbursements from the assets, at what level, and for how long?
- Inflation: How will inflation impact
the investor and the investments? Probably not in the same ways at the
same times.
- Sunk costs: What is the investor's
understanding of sunk costs and their response to it?
- Expenses: How does the investor view
investment expenses? Where do they see value added?
- Active management expectations: What
does the investor expect from their actively managed investments?
- Passive management expectations: What
does the investor expect from their passively managed investments?
- Liquidity requirements: Periodic cash
flow requirements and liquidity requirements are identified and
structured.
- Priority of residual wealth: Focus on
increasing current income or future asset value?
Investment Expectations by Investment,
Asset, and Aggregate Portfolio
- Returns (absolute and relative): What
dispersion of returns should the investor expect to see in each
investment, asset class, and the portfolio in the aggregate?
- Risk (type and severity): Translate
the dispersion of returns into the risks, both their type and severity
that the investor should expect to see. Document actions to be taken
during normal and abnormal market environments.
- Time horizon: Appropriate time horizon
of each investment.
- Correlation/diversification: Identify
correlation of each element of portfolio to determine each element's
contribution to portfolio diversification.
- Opportunities for active management:
Establish the appropriate performance expectation from active management
in each investment strategy?
- Anticipated costs: Document expected
costs of investment management by element and portfolio in the
aggregate.
Performance Measurement and Control
- Performance and risk constraints
- Underperformance defined: Severity,
duration, and responses
- Communications required
Adoption of Plan
- Acknowledgement of duties and
responsibilities of both parties
- Action plan for the next investment
period
2. Capital Markets
Expectations (click to expand)
In order to select and combine the various investments into an effective
portfolio, we must make certain assumptions about the performance
characteristics of each asset class.
- Parameters to Estimate
- Asset Classes on Which to Estimate
Parameters
3. Asset Allocation and
Location (click to expand)
The asset classes appropriate to
the investor's situation are then identified and combined into an
efficient portfolio.
- Asset Selection
- Optimization Process
- Asset Allocation
- Rebalancing Parameters
- Asset Location
- Expected Long-Term Benchmark
Portfolio Results
4. Implementation
(click to expand)
While the asset allocation
process determines what asset exposure the investor needs, the
implementation process determines how that asset exposure is
achieved.
- Active vs. Passive Management
- Strategies
- Action Calendar
5. Performance Monitoring
and Control (click to expand)
The final step is establishing
the process by which all previous activities are monitored and controlled.
- Performance Measurement
- Underperformance Defined
- Communications Required
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