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LM04 Basics of Portfolio Planning and Construction 2025 Level I Notes © IFT. All rights reserved 1 LM04 Basics of Portfolio Planning and Construction 1. Introduction ...................................................................................................................................................... 2 2. Portfolio Planning, the IPS and Its Major Components .................................................................... 2 2.1 The Investment Policy Statement ...................................................................................................... 2 2.2 Major Components of an IPS ................................................................................................................ 2 3. IPS Risk and Return Objectives .................................................................................................................. 2 3.1 Return Objectives ..................................................................................................................................... 4 4. IPS Constraints ................................................................................................................................................. 5 5. Gathering Client Information ...................................................................................................................... 6 6. Portfolio Construction and Capital Market Expectations ................................................................ 6 6.1 Capital Market Expectations ................................................................................................................ 7 7. The Strategic Asset Allocation .................................................................................................................... 7 8. Steps toward an Actual Portfolio and Alternative Portfolio Organizing Principles .............. 9 8.1 New Developments in Portfolio Management ...........................................................................10 9. ESG Considerations in Portfolio Planning and Construction ......................................................10 Summary ..............................................................................................................................................................11 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM04 Basics of Portfolio Planning and Construction 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This reading addresses the following topics:  What is an investment policy statement (IPS) and what does it contain?  The portfolio construction process.  How is asset allocation done for a client? 2. Portfolio Planning, the IPS and Its Major Components 2.1 The Investment Policy Statement Portfolio planning can be defined as a program developed in advance of constructing a portfolio that is expected to satisfy the client’s investment objectives. The written document governing this process is the investment policy statement (IPS). It defines a plan for investment success given the client’s situation and requirements. The IPS should be reviewed on a regular basis. 2.2 Major Components of an IPS The major components of an IPS are:  Introduction: Describes the investment objectives, circumstances, and state of client.  Statement of Purpose: Covers the scope of the IPS.  Statement of Duties and Responsibilities: Applies to investment manager, client, and other parties involved.  Procedures: Methodologies to tackle various circumstances and updating the IPS.  Investment Objectives: Desired rate of return and the amount of risk the client is willing to take.  Investment Constraints: Liquidity, legal, taxes, time horizon, and other unique constraints.  Investment Guidelines: Specifies permitted classes, selection of asset classes, use of leverage, asset allocation, and rebalancing, etc.  Evaluation of performance: Specifies the benchmark portfolio to compare investment results with, the frequency of evaluation, and other related information.  Appendices: Contains information on specific guidelines like permitted deviations, strategic asset allocation, rebalancing strategies, statement of policy concerning hedging risks such as currency risk and interest rate risk, etc. 3. IPS Risk and Return Objectives Risk Objectives A client’s risk tolerance is generally expressed qualitatively as high, moderate, or low. Two factors determine the overall risk tolerance: ability and willingness to take risk:  Ability to take risk is based on wealth, time horizon, and expected income. etc. It is relatively easy to determine. Risk tolerance is usually expressed in both terms: ability
LM04 Basics of Portfolio Planning and Construction 2025 Level I Notes © IFT. All rights reserved 3 and willingness. For example, a salaried person close to retirement with modest savings has low ability to take risk.  Willingness to take risk is more subjective and is based on the client’s psychology. For example, a client who has recently lost his job may not be willing to take a risk, even though he has the ability to do so, as job loss has a huge psychological impact. Risk Tolerance The interactions between willingness to take risk and ability to take risk are shown in the table below: Willingness to Take Risk Ability to Bear Risk Below Average Above Average Below Average Below-average risk tolerance Resolution needed Above Average Resolution needed Above-average risk tolerance Source: CFAI When the ability to take risk and willingness to take risk are consistent, selecting an appropriate level of risk is easy. If the investor’s willingness to take risk is high, but his ability to take risk is low, the low ability will dominate and the advisor should select a low risk level. If the investor’s willingness to take risk is low, but his ability to take risk is high, the advisor should attempt to educate the investor and clear any misconceptions about investment risk. If the investor is still not willing to take more risk, the advisor should select a low risk level. For some clients, the risk objective might be defined quantitatively. Quantitative risk objectives can be expressed in absolute or relative terms.  Absolute risk objective example: Portfolio should not suffer more than a 5% loss in any 12-month period. Practically, this could be stated as: with 95% probability, portfolio should not lose more than 5% value in any 12-month period. Absolute risk measures are not related to market performance. They are expressed in terms of standard deviation, variance, or value at risk.  Relative risk objective example: The risk objective is expressed relative to a benchmark. For example, return should be within 4% of the S&P 500 index return. Example Your client has a portfolio worth 10 million. He cannot handle losing more than 1 million over the next 12 months. Is this an absolute or relative risk objective? How can this be stated in practical terms? Solution: This is an absolute risk objective. In practical terms, it can be stated as: with 95% probability, portfolio should not lose more than 10% in the next 12 months.
LM04 Basics of Portfolio Planning and Construction 2025 Level I Notes © IFT. All rights reserved 4 Example Another client specifies a risk objective of achieving returns within 4% of the BSE 100. Is this an absolute or relative risk objective? Identify a measure for quantifying the risk objective. Solution: This is a relative risk objective as it is relative to BSE 100 (market) performance. A measure for tracking a relative risk objective is tracking the risk. 3.1 Return Objectives Return objectives can be stated on an absolute or a relative basis.  Absolute: Absolute return is the return a portfolio must achieve over a certain period of time. For example, a client wants to achieve a return of 9% or inflation-adjusted (real) return of 2%. The objective is to deliver a positive return over time, irrespective of how good or bad the market performance is. No index or benchmark is used to measure the performance. Many strategies may be employed to generate absolute return, the success of which depends on the skills of the manager.  Relative: A relative return objective will be stated relative to a benchmark. Examples: return 3% greater than 12-month LIBOR or return equal to the S&P500 index return. The return objective can be stated before or after fees, and pre- or post-tax. The fee structure must be clear and understood by both the parties, i.e., the investment manager and the client. If there is a required return that must be met for the client to meet a specific goal, such as down payment of $100,000 for a house next year or $20,000 for college education for a child next year, then it must be mentioned. Stated risk and return must be compatible. For example, it would be unrealistic to expect a very high return with low risk tolerance. Example Your client is 35 and wishes to retire in 30 years. His salary meets current and expected future expenses. He has 100,000 in savings of which he wants to put aside 10,000 as an emergency fund to be held in cash. You estimate that 300,000 in today’s money will be sufficient to fund your client’s retirement income needs. Expected inflation is 2% over the next 30 years. How much money must your client have in nominal terms to fund his retirement? What is the required return objective? Solution: First, let us calculate how much money the client must have in nominal terms after 30 years, at his retirement. You can solve it two ways: Using the formula: 300,000 to grow at 2% for 30 years = 300,000 ∗ (1.02) 30 = 543,408 Using a financial calculator: N = 30, I/Y = 2, PV = -300,000, PMT = 0, CPT FV. FV = 543,408