There is a generally accepted 5-step
investment process used in professional portfolio management:
1. Investment Policy
Statement (IPS) (click to expand)
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
- Risk Tolerance Assessment
- Investment Objectives
- Investment Expectations by
Investment, Asset, and Aggregate Portfolio
- Performance Measurement and Control
- Adoption of Plan
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
The asset classes appropriate to
the investor's situation are then identified and combined into an
efficient portfolio.
Asset Selection
- Time horizon: Investments commensurate
with the investor's investment time horizon are identified and selected.
- Risk tolerance: Investments that, when
combined into a diversified portfolio, are commensurate with the
investor's risk tolerance are identified and selected. It should be
noted that high volatility investments are not necessarily excluded as
when combined with other asset categories, they may function to reduce
the volatility of the overall portfolio.
Optimization Process
- Method of optimization: The
mathematical structure most resembling the investor's investment
objectives is identified and utilized in the process (objective
function).
- Constraints: The investor's minimum
return and maximum risk constraints are utilized to provide the
appropriate boundaries.
Asset Allocation
- Strategic: The strategic or benchmark
allocation to each asset class is identified.
- Tactical (optional): Enhanced returns
can be attempted through the use of tactical asset allocation. The range
in which each asset class is allowed to fluctuate around the strategic
allocation is identified. The parameters by which the asset allocation
is tactically managed within the range are then determined.
Rebalancing Parameters
- Periodic: Rebalancing of the asset
allocation can occur on a periodic basis. Example: Rebalancing every 3
months.
- Threshold: Rebalancing can occur on an
"as-needed" basis by establishing an acceptable threshold of variation,
and then rebalancing when the allocation of any asset surpasses the
threshold.
- Combination: These methods can be
combined, for example: Rebalancing will occur when the current
allocation is greater than ±5%
from the strategic allocation but not less than every 6 months.
Asset Location
- Taxable investment accounts: Asset
classes are selected for taxable accounts that minimize the tax
liability over the long-term.
- Non-taxable accounts: Asset classes
are selected for non-taxable or deferred-tax accounts that normally
incur the highest tax liability under normal investment conditions.
Expected Long-Term Benchmark Portfolio
Results
- Periodic: The strategic asset
allocation, the benchmark portfolio, will have an expected periodic
(annual) range of returns and an investment time horizon. The issues are
1.) what will the average annual return be and 2.) how many investment
periods are required before the average expected returns are achieved?
Normally this is graphically depicted through the use of a "trumpet"
graph.
- Cumulative: The long-term accumulation
of the periodic range of returns can result in a wide range of potential
wealth outcomes. Normally this is demonstrated through the use of a
"tulip" graph.
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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