1. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 Investment Process 1.Establish client-advisor relationships. 2.Gather client data and determine objectives and expectations. 3.Analyze the client’s financial status, current investments, and special needs. 4.Develop and present the Investment Policy Statement. 5.Implement the Investment Policy Statement. 6.Monitor the portfolio.

2. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 Investment Process The first four steps in the process involve gaining an understanding of the client and developing an appropriate investment policy to assist the client in meeting his objectives. The actual decision as to what investments to purchase comes much later. –You must know your client before implementing an investment strategy.

3. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 Client Lifecycle Analysis There are common themes that impact the creation of an investment policy statement. One key theme is that people’s needs and resources change over time. –An investment policy must first identify these needs and then reflect these changes. The investor life cycle is considered to run through three phases. –Accumulation phase –Consolidation phase –Spending phase

4. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 Client Lifecycle Analysis Accumulation phase –The client is accumulating assets: saving and investing for the future –Typically a long time horizon –Clients in this phase are often able to accept more risk since they have time to accumulate wealth. Consolidation phase –the client’s income outpaces expenses and wealth accumulates more rapidly. –still has a relatively long time horizon –the client typically can tolerate moderate to higher risk in order to achieve higher returns.

5. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 Client Lifecycle Analysis Spending Phase –Income (such as wages) ends and investment income is needed from accumulated retirement and non-retirement funds to meet living expenses. –The time horizon is shorter than the previous phases, but not necessarily short. Due to life expectancies –The client typically has a desire for lower risk and higher investment income during this period.

6. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 Client Lifecycle Analysis

7. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 Client Risk Tolerance A client’s willingness to accept risk is a function of a number of factors: –Willingness to undertake risk Ex. Past experiences influencing behavior –Ability to take risk Ex. The presence of alternative sources of income and/or wealth such as a potential inheritance –Investment time horizon Generally, the longer the investment time horizon, the greater the ability to incur risk.

8. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 Client Risk Tolerance Risk tolerance could also be interpreted in terms of an investor’s utility function: –Risk neutral. –Risk seeking. –Risk averse. Utility is the satisfaction that an individual gets from consuming goods and services and, in terms of wealth, the satisfaction conferred by a given level of wealth.

9. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 Client Risk Tolerance: Risk Neutral

10. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 Client Risk Tolerance: Risk Seeking

11. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 Client Risk Tolerance: Risk Averse

12. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 Client Risk Tolerance For most goods and services, economists assume diminishing marginal utility –The more a person has of a good, the less satisfaction he gets from each additional unit. –Results in a risk-averse utility function. Problems with Utility: –Cannot be measured. –Research on the behavior of individuals indicates that these utility functions do not capture the subtlety of human utility functions.

13. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 Client Risk Tolerance Kahneman and Tversky’s research on Prospect Theory concluded that individuals’ utility functions appear to be concave for gains (risk averse) and convex for losses (risk seeking). William Droms developed a questionnaire, The Global Portfolio Allocation Scoring System, to categorize investors into risk tolerance categories in order to develop an investment policy statement. –Droms and Strauss modified the scoring system to consider the interaction of risk tolerance and time horizon. –Droms and Stauss stress that the risk tolerance questionnaire is only a starting point in understanding the client in order to develop an appropriate investment policy statement.

14. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 Investment Policy Statement The investment policy statement should be developed in accordance with: –The client’s objectives desired return level of risk –The client’s constraints liquidity time horizon taxes legal or regulatory restrictions unique client circumstances and self-imposed client restrictions.

15. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 Investment Policy Statement Client Objectives: desired return and level of risk Determining the objectives for risk and return must be done simultaneously due to their interrelatedness. –A starting point is to determine the return necessary to meet the investor’s objectives. –The next issue is whether that return can be achieved at a risk level appropriate for the investor. The investor’s desired rate of return should be obtainable and consistent with risk tolerance.

16. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 Investment Policy Statement: Risk Considerations Risk is often measured as the standard deviation of returns (a measure of total risk). –Individual investors may perceive potential losses to be more important than potential gains. –Standard deviation includes both upside and downside deviations.

17. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company17 Investment Policy Statement: Risk Considerations Consider the historical return data for selected index funds from 1996 to 2005: Source: Based on data obtained from Morningstar for the years 1996-2005 Vanguard Mutual Fund Average Return Standard Deviation Proportion of years with a loss 500 Index (VFINX) 10.65%18.49%30.00% Total Bond Index (VBMFX) 5.95%3.61%10.00% Short-Term Treasury (VFISX) 4.99%2.88%0.00%

18. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company18 Investment Policy Statement: Risk Considerations The data exhibit the expected positive relationship of risk and returns. –The funds with the highest return had the highest risk measured based on both standard deviation and proportion of years with a loss. Historic returns do not necessarily predict future returns, but they do provide guidance as to what is possible. –If an investor desires a long-term compound return of 15% with a standard deviation of 5% and no negative returns, this is not likely achievable given the historical data. Other considerations of the data: –Historical index returns are not achievable since they do not include fees and expenses. –If current or expected inflation differ at the time the investment policy is being developed, consideration should be given to using real (inflation-adjusted) returns.

19. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company19 Investment Policy Statement Client constraints –Liquidity The client’s desire to maintain a certain level of liquid assets. Ex. Maintain cash holdings for immediate access –Time Horizon The timing of expected withdrawals. A long time horizon generally allows the investor to accept more risk. –Taxes Ex. If the account is taxable, tax favored investment returns such as long-term gains and dividends should be considered.

20. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company20 Investment Policy Statement Client constraints –Legal or Regulatory Ex. If the client has a trust, the trust document must be examined. –Unique Circumstances or Preferences Ex. The investor may wish to avoid tobacco or military-industrial stocks

21. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company21 Investment Policy Statement Once the client’s objectives and constraints are determined, they should be put in writing as an Investment Policy Statement to guide asset allocation and security selection for the client’s accounts. To evaluate and monitor the portfolio’s return, a geometric return or time-weighted return will better measure the performance of the portfolio manager, although all other measures described earlier in the course are available. Time-Weighted Return: R p = [(1 + R 1 )(1 + R 2 )(1 + R 3 )…(1 + R N )] 1/N - 1

22. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company22 However, the best method of evaluating the performance of a manager involves risk-adjusted measures, in which the return is compared to the risk of the portfolio. –An important component of portfolio performance is the amount of risk taken to achieve the return. Risk-adjusted performance measures include: –Sharpe Ratio –Treynor Ratio –Information Ratio –Jensen’s Alpha Risk-Adjusted Performance Measures

23. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company23 Sharpe Ratio: (R p -R f ) /  p, –Where the numerator represents a portfolio’s excess return over the risk-free rate. The denominator measures the portfolio’s risk as the standard deviation of portfolio returns (total risk) –Measures the excess return of a portfolio relative to risk –The higher the Sharpe Ratio, the better the performance. Treynor Ratio: (R p -R f ) / β p, –Measures the excess return relative to risk –Substitutes standard deviation for Beta. Risk-Adjusted Performance Measures

24. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company24 Information Ratio: (R p -R B ) /  Excess, –Measures the excess return of a portfolio relative to the benchmark portfolio, and risk is measured as the standard deviation of the excess return. Jensen’s Alpha: α = R p -[R f + β p (R m -R f )], –Where alpha measures return in excess of CAPM. –The Beta of the market is assumed to be 1. Note that for risk-adjusted measures using Beta, a diversified portfolio is assumed. Standard deviation measures total risk and does not assume a diversified portfolio. The Sharpe and Treynor ratios will provide similar rankings for well diversified portfolios. Risk-Adjusted Performance Measures

25. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company25 Risk-Adjusted Performance Measures Beta vs. Standard Deviation. Sharpe and Treynor.

26. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company26 Exercise Let the risk-free rate be 3.6%. Calculate the Sharpe Ratio, the Treynor Ratio, and the Jensen’s alpha for Portfolio P. Refer to the following information concerning Portfolio P and its benchmark: Portfolio PBenchmark Annual return 12.5% 13.7% Standard deviation 15.3% 17.5% Beta 1.06

27. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company27 Appropriate benchmark selection should follow naturally from the investment planning process. –Once the client’s preferences, constraints, risk tolerance, and return requirements are established and a mix of assets is selected to accomplish these goals, a benchmark should be chosen that reflects the same goals. Examples –a published index –a custom composite of assets or indexes –a peer group of similar funds or managers. Selecting an Appropriate Benchmark

28. Portfolio Management and Measurement Chapter 37 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company28 Selecting an Appropriate Benchmark The CFA Institute and other global investment bodies generally agree that it should meet the following criteria: –Representative of the asset class or mandate –The benchmark should be investible This means that the investor should be able to invest in the benchmark as an alternative to hiring an active manager. –Should be constructed in a disciplined and objective manner –Formulated from publicly available information –Acceptable by the manager as the neutral position –Consistent with the investor’s status regarding taxes, time horizon, etc. Overall, the benchmark should reflect both the client’s needs and the manager’s style.