PORTFOLIO CONSTRUCTION PROCESS

PORTFOLIO CONSTRUCTION PROCESS (Part 1)

• Definition: The portfolio construction process involves a set of integrated activities undertaken in a logical, orderly, and consistent manner to create and maintain an optimum portfolio.
• Importance: The asset allocation decision is a crucial investment decision that majorly influences the performance of investment portfolios.

Key Concepts

• Asset Allocation: The process of deciding how to distribute an investor's wealth into different asset classes for investment purposes.
• Asset Class: A collection of securities that have similar characteristics, attributes, and risk/return relationships.
• Correlation: Measures the strength and direction of the relationship between two variables, with coefficients ranging from -1 to +1.
• Investment Objectives: Identified in relation to risk-return-liquidity, and may include preservation of capital, regular income, and capital appreciation.
• Investment Constraints: Limitations on investors to take exposure to certain investment opportunities, including liquidity needs, time horizon, and unique needs and preferences.

Steps in Portfolio Construction Process

• Development of Policy Statement: Identifies investor's risk appetite, defines investment objectives, goals, and investment constraints.
• Study of Current Financial Conditions: Involves forecasting future trends and analyzing the investor's financial position.
• Construction of the Portfolio: Takes into consideration the policy statement, investor's objectives, risk appetite, and horizon.
• Performance Measurement and Evaluation: Involves periodic review and rebalancing of the portfolio.

Investment Policy Statement (IPS)

• Definition: A road map that guides the investment process, specifying investment objectives, goals, constraints, preferences, and risks.
• Importance: Helps investors understand their requirements, reduces the possibility of making inappropriate decisions, and provides a framework for portfolio managers' evaluation.
• Constituents: Includes goals, priorities, investment objectives, time horizon, risk/return profile, liquidity constraints, and preferred asset classes.

Investment Constraints

• Liquidity Constraint: Relates to investors' liquidity needs, including emergency cash, near-term goals, and investment flexibility.
• Regulatory Constraints: Includes regulations that constraint investment choices, such as the Liberalised Remittance Scheme (LRS) in India.

PORTFOLIO CONSTRUCTION PROCESS (Part 2)

• Insider Trading: Trading of securities on the basis of information that is not publicly known is prohibited, especially for company insiders.
• Tax Constraint: Tax plays a crucial role in portfolio management and drives investment decisions, with different investments and income types taxed differently.
• Liberalised Remittance Scheme: Allows resident individuals to remit up to USD 2,50,000 per financial year for permissible current or capital account transactions.

Exposures Limits to Different Sectors, Entities, and Asset Classes

• SEBI PMS Regulations 2020: Requires the agreement between the portfolio manager and investor to include the investment approach, type of securities, and permissible instruments.
• Exposure Limits: Set to avoid concentration risk, taking into account the investor's objective, risk appetite, liquidity needs, tax, and regulatory constraints.

Unique Needs and Preferences

• Idiosyncratic Concerns: Investors may have personal, social, ethical, cultural, or preference-based beliefs that influence their investment decisions.
• Sustainable Investing: Considers environmental, social, and governance (ESG) criteria while selecting investments to generate financial returns and positive social impact.
• Ethical Investing: Selects investments based on moral or ethical principles, often avoiding "sin" areas like gambling, alcohol, or firearms.

Assessments of Needs and Requirements of Investor

• Goal-Based Investing: Investors have various goals and objectives, which are critical in making investment decisions.
• Goal Sheet: A proforma to create a goal sheet, including priority, time period, and amount needed for each goal.

Analysing the Financial Position of the Investor

• Personal Financial Statements: Constructing statements, including a balance sheet and income-expense statements, to organize financial data.
• Net Worth Calculation: Calculating net worth by recording assets and liabilities, then subtracting liabilities from assets.

Psychographic Analysis of Investor

• Behavioural Traits: Investor's personality characteristics and behavioural traits play a crucial role in setting their risk profile.
• Psychographic Frameworks: Frameworks like Bailard, Biehl & Kaiser (BB&K) classify investor personalities based on confidence and method of action.
• Investor Personality Characteristics: Five personalities, including Adventurer, Celebrity, Individualist, Guardian, and Straight-Arrow, each with unique characteristics and investment approaches.

PORTFOLIO CONSTRUCTION PROCESS (Part 3)

• Life Cycle Analysis: Understanding the various stages in an investor's life cycle is crucial as it impacts their risk appetite. The life cycle of investing can be broken into phases:
  • Accumulation Phase: Characterized by a long time horizon and a potentially growing stream of income, allowing for high-return, high-risk investments.
  • Consolidation Phase: Income exceeds expenses, and investors may start looking for capital preservation, balancing high-capital gain investments with lower-risk assets.
  • Decumulation/Spending Phase: Living expenses are covered by accumulated assets, focusing on stability and investments that generate dividend, interest, and rental income.
  • Gifting Phase: The final phase, where investments are made to leave a legacy or support a charitable cause.
• Forecasting Risk and Return: Establishes the expected risk-return opportunities available to investors, requiring the listing and forecasting of various investment opportunities and their potential deviations.
• Benchmarking the Client's Portfolio: Involves selecting a benchmark portfolio that matches the composition of the investor's portfolio to evaluate performance, ensuring "apple-to-apple" comparisons.
• Asset Allocation Decision: Culminates from the interaction between investor information and risk-return forecasts, deciding the optimal mix of assets to achieve after-tax returns.
• Portfolio Construction Principles: Follows from the investor's requirements, goals, and time period, with principles including:
  • Selecting Equity Portfolios: Balancing risk and stability, considering large cap, mid, and small cap exposures.
  • Selecting Debt Portfolios: Matching investment horizon with maturity, choosing instruments based on goals and time available.
  • Selecting Hybrid Portfolios: Ensuring stability and potential upside, used for long-term goals or smooth transitions.
  • Other Portfolios: Including assets like gold, precious metals, or alternative investments for diversification and risk reduction.
• Strategic versus Tactical Asset Allocation:
  • Strategic Asset Allocation (SAA): Long-term asset allocation decision, translating the investment policy statement into asset weights.
  • Tactical Asset Allocation (TAA): Short-term decision, taken within the SAA framework, to exploit market opportunities and temporarily shift assets.
• Importance of Asset Allocation Decision: Empirically supported as the major determinant of risk and return, with studies suggesting it explains a significant portion of portfolio return variability.
• Rebalancing of Portfolio: Necessary due to price changes in holdings, changes in investor goals, or risk tolerance, requiring periodic monitoring and rebalancing to maintain the portfolio's original risk-and-return characteristics.

PORTFOLIO CONSTRUCTION PROCESS (Part 4)

Rebalancing and Tolerance for Deviation

• Rebalancing Trade-off: The decision to rebalance a portfolio involves weighing the cost of rebalancing against the cost of not rebalancing.
• Cost of Rebalancing: Includes transaction costs (e.g., research, brokerage, time) and tax costs (e.g., capital gains tax).
• Challenges in Rebalancing:
  • Illiquid Investments (e.g., private equity, real estate): Higher transaction costs make rebalancing more difficult.
  • Liquid Assets (e.g., listed equities, government bonds): Easier to rebalance due to lower transaction costs.
• Rebalancing Strategy:
  • Selling appreciated assets and buying depreciated assets to maintain target asset allocation.
  • Setting price targets for buying and selling securities, which may attract tax liability.
• Opportunity Cost: The potential loss of returns from switching from one asset class to another (e.g., moving from equity to debt when equity may still perform well).