Basics of Portfolio Planning and Construction

In this reading, we have discussed construction of a client’s investment policy statement, including discussion of risk and return objectives and the various constraints that will apply to the portfolio. We have also discussed the portfolio construction process, with emphasis on the strategic asset allocation decisions that must be made.

• 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.
• The IPS can take a variety of forms. A typical format will include the client’s investment objectives and also list the constraints that apply to the client’s portfolio.
• The client’s objectives are specified in terms of risk tolerance and return requirements.
• The constraints section covers factors that need to be considered when constructing a portfolio for the client that meets the objectives. The typical constraint categories are liquidity requirements, time horizon, regulatory requirements, tax status, and unique needs.
• Clients may have personal objections to certain products or practices, which could lead to the exclusion of certain companies, countries, or types of securities from the investable universe as well as the client’s benchmark. Such considerations are often referred to as ESG (environmental, social, governance).
• ESG considerations can be integrated into an investment policy by negative screening, positive screening, ESG integration, thematic investing, engagement/active ownership, and impact investing.
• Risk objectives are specifications for portfolio risk that reflect the risk tolerance of the client. Quantitative risk objectives can be absolute, relative, or a combination of the two.
• The client’s overall risk tolerance is a function of both the client’s ability to accept risk and the client’s “risk attitude,” which can be considered the client’s willingness to take risk.
• The client’s return objectives can be stated on an absolute or a relative basis. As an example of an absolute objective, the client may want to achieve a particular percentage rate of return. Alternatively, the return objective can be stated on a relative basis—for example, relative to a benchmark return.
• The liquidity section of the IPS should state what the client’s requirements are to draw cash from the portfolio.
• The time horizon section of the IPS should state the time horizon over which the investor is investing. This horizon may be the period during which the portfolio is accumulating before any assets need to be withdrawn.
• Tax status varies among investors, and a client’s tax status should be stated in the IPS.
• The IPS should state any legal or regulatory restrictions that constrain the investment of the portfolio.
• The unique circumstances section of the IPS should cover any other aspect of a client’s circumstances that is likely to have a material impact on portfolio composition. Certain ESG implementation approaches may be discussed in this section.
• Asset classes are the building blocks of an asset allocation. An asset class is a category of assets that have similar characteristics, attributes, and risk–return relationships. Traditionally, investors have distinguished cash, equities, bonds, and real estate as the major asset classes.
• A strategic asset allocation results from combining the constraints and objectives articulated in the IPS and capital market expectations regarding the asset classes.
• As time goes on, a client’s asset allocation will drift from the target allocation, and the amount of allowable drift as well as a rebalancing policy should be formalized.
• In addition to taking systematic risk, an investment committee may choose to take tactical asset allocation risk or security selection risk. The amount of return attributable to these decisions can be measured.
• ESG considerations may be integrated into the portfolio planning and construction process. ESG implementation approaches require a set of instructions for investment managers with regard to the selection of securities, the exercise of shareholder rights, and the selection of investment strategies.