Basics of Portfolio Planning and Construction

This reading explains why a written investment policy statement matters, what it contains, and how to set risk and return objectives and judge willingness and ability to take risk. It then covers the five investment constraints, the specification of asset classes, the roles of strategic and tactical asset allocation, security selection and risk budgeting, and ESG approaches in portfolio planning.

LOS 90.a — Why a written investment policy statement matters

The investment policy statement (IPS) is the written plan that starts the portfolio management process. Before any security is bought, the manager and client agree in writing on what the client needs, what the client can and will tolerate, and how results will be judged.

A written IPS is valuable for three main reasons:

• It forces discipline. The client must articulate circumstances, objectives and constraints instead of reacting to the market mood of the day.
• It keeps goals realistic. High return and low risk are popular wishes but usually incompatible, so the IPS makes the client reconcile return expectations with risk tolerance.
• It sets a yardstick. Performance is judged against a stated benchmark rather than with hindsight.

An IPS does not pick individual stocks or time the market. It works at the level of objectives, constraints, asset classes and policy.

LOS 90.b — Major components of an IPS

A typical IPS contains the following sections:

The bare minimum. Even a short IPS must contain (1) a clear statement of the client's circumstances and constraints, (2) an investment strategy based on them and (3) a benchmark for evaluating performance. Detailed update procedures are common but are not part of that minimum. Nor is a precise annual target return, although return objectives may still be stated in the IPS, for example as a percentage.

The manager's fee schedule is not one of the IPS components listed above.

LOS 90.c — Risk and return objectives

Risk objectives translate the client's risk tolerance into specific limits on portfolio risk. Return objectives usually follow from a future financial goal, such as a target level of retirement income. Both can be stated in absolute or relative terms, and a return objective may be set as a percentage or as a currency amount.

• Stating a risk objective as the probability of a given loss does not make it relative. It is relative only if it refers to a benchmark.
• A return of "inflation plus x%" is still an absolute (real) objective. A limit measured against a market interest rate, such as never earning less than the three-month Treasury bill rate over a calendar year, is a relative risk objective, because that rate serves as the benchmark.
• Very strict absolute risk objectives, such as no loss in any year, push the portfolio toward guaranteed instruments such as Treasury bills.
• Peer-group benchmarks (for example, "top quartile of endowments") are not investable: nobody can build that portfolio in advance.
• Risk and return objectives must be set together and must be compatible. The client's risk tolerance determines which returns are realistically attainable, and a return-only objective can push the client into far too much risk.

LOS 90.d — Willingness versus ability (capacity) to take risk

An investor's overall risk tolerance combines two separate assessments: how much risk the investor wants to take and how much risk the investor's finances can bear.

Large near-term spending needs reduce the ability to bear risk, because the portfolio must reliably fund a fixed obligation. The expected rate of return, the level of inflation and the client's tax bracket are not inputs to risk tolerance. Expected return follows from risk tolerance, inflation matters for the return objective, and taxes are a constraint.

The table shows how the two assessments combine into overall risk tolerance.

Willingness \ Ability	Below-average ability	Above-average ability
Below-average willingness	Below-average risk tolerance (no conflict)	Conflict: educate the client; usually conform to the lower (below average)
Above-average willingness	Conflict: ability prevails (below average)	Above-average risk tolerance (no conflict)

When the two conflict, the lower assessment governs. With high willingness and low ability, ability prevails, and a portfolio tilted toward bonds rather than equities is appropriate. With low willingness and high ability, the adviser may educate the client and correct misconceptions but should not try to change the client's personality; a portfolio the client is clearly uncomfortable with is unlikely to end well.

1. Sort the facts. Job security, wealth relative to needs and the long horizon are financial circumstances, so they bear on ability. Her reaction to a 10% fall is an attitude, so it bears on willingness.
2. Rate each dimension. Ability is high; willingness is low.
3. Combine them. The two conflict and willingness is the lower one. The adviser explains how a 25-year horizon can absorb short-term losses, but if her attitude does not change, the portfolio conforms to her low willingness and overall risk tolerance is below average.

LOS 90.e — Investment constraints

The five constraint categories are:

• Liquidity: the need to turn assets into spendable cash quickly without large price concessions, for example for regular withdrawals, tuition, a planned purchase or insurance claims. High liquidity needs call for cash and short-term bonds; illiquid hedge funds or private equity are unsuitable.
• Time horizon: often the period until withdrawals begin. Longer horizons allow more risk and less liquidity. A short horizon points to low-risk, liquid assets such as government securities or bank deposits. Short horizons and liquidity needs usually go together.
• Tax concerns: the investor's marginal tax rate, the different treatment of income and capital gains, and whether accounts are taxable, tax-deferred or tax-exempt. In a fully taxable account, an investor in a high tax bracket may prefer tax-exempt bonds (in the US) or equities whose return is expected to come mainly from capital gains, because gains are commonly taxed more lightly than income. Fully taxed income (corporate bond interest, for example) is best placed in tax-deferred accounts, while long-term capital gains, tax-exempt interest and (where they are taxed favorably) dividends suit accounts without tax deferral. Portfolio choices should compare expected after-tax returns with risk. Selling holdings to diversify can trigger capital gains tax.
• Legal and regulatory factors: constraints imposed by law or regulators, such as trust and pension rules, minimum payout requirements imposed by statute, limits on asset types or percentages, and restrictions on trading by corporate insiders.
• Unique circumstances: client-specific preferences or restrictions, often non-financial. Examples are responsible investing exclusions (tobacco, weapons, gambling), religious restrictions (for example, no interest-bearing securities), avoiding a competitor's shares, or diversifying away from an employer's industry.

A handy checklist for a whole IPS is R-R-T-T-L-L-U: Risk, Return, Time horizon, Tax, Liquidity, Legal, Unique. The first two are objectives; the last five are constraints.

LOS 90.f — Specifying asset classes

An asset class is a group of assets with similar risk and return behavior. For strategic asset allocation the classes should be defined so that:

• returns are highly correlated within each class, because its members behave alike;
• returns have low correlation between classes, which is what produces diversification benefits;
• taken together, the classes approximate the universe of permissible investments in the IPS.

Specify the type of security first, then subdivide. Equities can be split into domestic and foreign, large-cap and small-cap, developed and emerging; bonds into government and corporate, investment grade and high yield, or by maturity. A label such as "emerging markets" or "technology sector" alone is incomplete because it does not say whether the assets are equities or bonds. The traditional classes are equities, bonds, cash and real estate. Alternative investments include hedge funds, private equity, commodities, artwork and intellectual property.

The manager then gathers expected returns, standard deviations and correlations for each class.

LOS 90.g — Portfolio construction and the role of asset allocation

1. Estimate return, risk and correlation for each asset class and build an efficient frontier of asset-class portfolios.
2. Choose the efficient portfolio that best matches the objectives and constraints in the IPS. Its weights are the strategic asset allocation (the policy portfolio), the long-term baseline. Rebalancing later moves drifted weights back to these targets; it is not an active strategy and not a tactical decision.
3. Decide how much active management to add:
   • Tactical asset allocation is a temporary deviation from strategic weights to exploit perceived short-term mispricing between asset classes. For example, a 10% real estate target might currently be held at 13% because property looks cheap.
   • Security selection is a deviation from the index weights of individual securities within a class. For classes without investable indexes (hedge funds, individual properties, art), selection is unavoidable.
4. Each active strategy may add return, but it also adds risk compared with a passive portfolio of asset-class indexes. Risk budgeting sets a total risk limit and allocates it among strategic allocation risk, tactical allocation risk and security selection risk.

Using several active managers against the same benchmark creates two problems:

• Their positions may offset, with one overweighting what another underweights. Net active risk is then below gross active risk, and the risk budget is underused.
• Combined trading may be excessive and tax-inefficient.

A core-satellite approach addresses both. Most of the portfolio (the core) is held passively in index funds, and a smaller satellite portion is actively managed. The success of tactical allocation and security selection depends on real opportunities and on manager skill.

LOS 90.h — ESG considerations in portfolio planning

Environmental, social and governance (ESG) approaches:

• A negatively screened portfolio should be judged against an index that excludes the same kinds of companies. A broad market index is not an appropriate benchmark for it.
• Positive screening, thematic and impact approaches need customized portfolios and benchmarks, and often specialist managers.
• Under active ownership, clarify whether clients will vote their own shares or have the manager vote according to specified ESG factors. Either arrangement is acceptable.
• The effect on returns is uncertain. A smaller universe and research costs may reduce returns, while good governance and lower ESG risks may raise them.