Investment principles and risk

This chapter focuses on the application of the investment advice process, paying particular attention to the princip...

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...ion areas. This presentation will be of most benefit to those learning about this area for the first time:

 

As we have discussed in previous chapters, asset allocation is the process by which a portfolio is divided between different asset classes in order to achieve the client’s needs and objectives.

There are two main approaches to asset allocation:

Theoretical - using modern portfolio theory (MPT)

Pragmatic - using historical data and knowledge of investment markets

In practice, most investment advisers use a combination of these two approaches.

Theoretical asset allocation

We discussed modern portfolio theory in chapter 4. It uses mathematical analysis to obtain a trade-off between risk and reward, representing the maximum return consistent with a given level of volatility, or the lowest volatility given a desired rate of return. Application of the theory enables optimum portfolios to be constructed from different asset classes using ...

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... the correlation factor between the different asset classes converged. Research has shown that using MPT during normal conditions works reasonably well, but it does not work in a crisis. By using relatively short data (three years in the case of volatility) MPT can result in allocating too much or too little capital to an asset class. A purely pragmatic approach, however, is subject to the risk of bias for and against asset classes based on subjective estimations and projected returns. This can also lead to a portfolio presenting a much higher risk than anticipated.

A combination of these techniques - using MPT as a base and applying a judgment of the likely returns from each asset class - can address these issues.

Research has shown that Modern Portfolio Theory does not work very well under what circumstances?

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With a multi-asset portfolio, if alternative portfolios are plotted on a graph with expected returns measured against risk (standard deviation), the possible portfolios fall on and below a curve known as the “efficient frontier”. The efficient frontier is the group of portfolios that offer the maximum return for any given level of risk.

Inputs into the optimisation model

Three sets of data are needed for the optimisation model to run:

Returns for each asset class

Standard deviations or risk of each asset class

Correlations between each pair of asset classes

Historic risk and correla...

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...ortfolio in respect of returns and volatility

The results are usually presented in graphical format with the most likely outcome represented by a wide central band and progressively narrower bands representing the less likely outcomes.

Stochastic models are even more reliant on assumptions than optimisation models and should be used with caution. Often, a very small change in one of the inputs can result in a significant change in the resulting asset allocation.

Many product providers offer portfolio planning tools using stochastic modelling.

What is stochastic modelling?

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To create a suitable portfolio, the investment adviser must clearly understand the client’s investment objectives, in terms of:

The timeframe

Annualised target return

Maximum permitted loss

The client’s risk profile

Whether investing for capital growth, income or a combination of both

Any constraints such as ethical or regulatory requirements

Assumptions to be used for inflation etc

Once these h...

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...s based on an investment adviser’s assessment of current economic conditions and outlook. This places much more onus on the adviser to monitor and make tactical recommendations. Discretionary fund managers generally use this approach.

It is also possible to combine the two approaches, where some of the portfolio is allocated strategically for the long term and another portion is managed on a tactical basis.

 

Active management will involve the portfolio manager using skill to select the appropriate investments to meet the client’s objectives. A strategy of this type will usually involve the manager trying to achieve returns over and above those achieved by a benchmark index.

There are two main approaches to active management:

Top down management  - various classes of asset are initially selected, for instance, equities, bonds, cash, etc. From there the manager will consider appropriate sectors within those asset classes and then finally decide on which is the most appropriate security

Bottom up management  - securities are selected on their own merits and their class or sector is not relevant. These strategies tend to apply where the investment objectives of a fund make asset selection irrelevant e.g. unit trusts investing in American Smaller Companies

Top down management

Using the principle of top down management, these are the stages in planning the investment portfolio:

Asset allocation - this entails deciding what percentages of the overall portfolio is to be held in each main asset classes e.g. shares, fixed interest securities, property, cash, etc. This largely depends upon the client’s requirements in terms of the level of risk they are prepared to take for the required returns

Allocate geographical distribution – decide how much should be invested in UK, North America, Europe, etc

Choose sector weightings – e.g. mining, pharmaceuticals, finance, etc

Individual Stock Selection

Stock Selection

This is the final stage of design and can take on two types of investment analysis in order to arrive at the appropriate stocks for the portfolio:

Fundamental Analysis

Technical Analysis

Fundamental analysis is a detailed analysis of the company concerned and the industry or sector in which it trades, in order to decide whether the shares are over or undervalued. Fundamental analysis uses techniques such as:

Ratio analysis, e.g. P/E ratios, EPS for...

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...ory that the average opinion is usually wrong and that high returns can be achieved by going against the trend. Correctly judging the point where a trend has reached a point of extreme optimism or pessimism is difficult and risky and is often the style adopted by hedge fund managers

Some fund managers have a defined style while others adopt a blend of different styles depending on the objectives and structure of the fund.

Derivatives and hedging

The latest trends in portfolio construction use derivatives to separate the market related returns (beta) from the specific returns (alpha). A fund may also aim to lock in positive returns by purchasing index put options, thus limiting the potential downside.

Managers often apply such strategies as overlays, where a core portfolio is held and derivatives are used to alter market and currency exposure.

Use of structured products

An alternative to the use of funds is the use of structured products, which typically limit the capital risk of equity investments in return for locking up the capital for a period of up to six years. Structured products use derivatives to secure returns and will therefore include counterparty risk.

Different products provide different levels of hard and soft guarantees and therefore it is difficult to accommodate these products within a conventional asset allocation model.

While they provide the benefit exposure to relatively risky asset classes with limited downside risk, they also have their limitations:

Liquidity

Timescales of a structured product may not meet a client’s timescales, and cannot be changed if the client objectives change

It may be expensive to buy the downside protection

The structures can be complex

Which management style seeks to combine the benefits of both growth investing and value investing to find individual stocks, by looking for companies that are showing consistent earnings growth above broad market levels, and excluding companies that have very high valuations?

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Clients may require income or growth or a combination of the two from their actively- managed investment portfolios.

These are the  main issues to consider in fund selection.

Fund objective – investment managers should be aware of the aims of the selected fund, the extent of diversification of stocks within it and the level of portfolio turnover.

Costs – The main costs are the:

AMC

Ongoing Charges Figure (the most common method of comparing ongoing charges incurred by investors but does not include initial charge, exit costs or certain fund expenses like dealing costs)

Performance fees

Total cost of ownership (the true cost of an investment including the cost of the service, the product, any third party charge and any transaction that might affect total return)

Initial charges

Bid-offer spread

Stamp duty and stamp duty reserve tax (although  fund managers do  not  pay SDRT when investors surrender unit trusts or OEICS)

Turnover or brokerage costs

Firms must provide a full breakdown of all the costs and charges that impact investments, breaking it down into ongoing fund charges, one-off fees, incidental fees and transaction fees.

Fund’s management – some funds have “star” managers whose reputation gives the funds a marketing edge, attrac...

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... measures risk-adjusted returns, but as returns are not normally distributed (as with highly active funds), results may be misleading

Sharpe ratio – a measure of risk-adjusted returns used for comparing investments to see which offers the best return for a given amount of risk

Alpha – this is a measure of the manager’s stock picking skill independent of the market and is a measure of the value added by the fund manager

Passively managed funds

An alternative to the use of actively managed funds is to use passive funds that simply replicate the performance of an index representing the chosen asset class. There are index tracker funds for nearly all major asset classes (and sub-classes), which are usually structured as ETFs. However, they can be structured as investment trusts, unit trusts and OEICs as well.

The two key aspects of passive fund selection are:

Index selection - For most asset classes, several indices are available. In some cases, the differences are slight, though in others, they are large and have had major effects on returns

Structure - ETFs may be ‘physical’, in which case they hold stocks to replicate an index, or ‘synthetic’, in which case they use derivatives to match an index

What does the information ratio evaluate?

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The selection of tax wrapper should be made following the decisions on asset allocation and fund selection. Selection should be based on the client’s individual tax and financial circumstances and the underlying assets that are to be held in the wrapper.

The main wrappers are:

Collective investments such as OEICs and unit trusts

ISAs

Personal pensions and SIPPs

UK life assurance bonds

Offshore life assurance bonds

Collective investments

Collectives are a simple way to hold equity investments. Dividends are taxed in the normal way and gains are subject to CGT. Individual’s investors can set their annual CGT exempt amount against any gains as well as any unrelieved capital losses.

Authorised investment funds are particularly advantageous to higher and additional rate taxpayers who pay income tax rates of 40% and 45% as the fund pays no CGT on disposals within the fund, and gains in the investor’s hands are only taxed at 10% and 20%, which are lower ratees than income tax rates. Also, dividend income in excess of the dividend allowance is taxed at lower rates than savings income. Also, expenses can be offset against unfranked income and any rema...

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...he higher charges that normally apply can sometimes erode any benefit from the tax advantages of gross roll up.

VCTs, EISs and SEISs

The tax advantages of these wrappers need to be carefully weighed up with their higher risk profile. These investment schemes offer substantial tax relief, including income tax reductions, capital gains tax deferral, and inheritance tax benefits. However, their higher volatility and illiquidity demand a thorough consideration of individual risk tolerance and long-term financial goals.

Discretionary fund management

Discretionary portfolio management may be for a general portfolio management or a specialised service in venture capital or alternative assets such as forestry. In some cases, audited historic returns that are available for collective funds may not be available. Discretionary managers often provide samples of client portfolios to illustrate historic returns. Care must be taken in evaluating this data and establishing exactly what is being reported and how well this matched what clients will be offered.

What are the three ratios that can be useful in assessing funds and past performance?

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Where advisers are choosing UK providers of regulated investment products, the regulatory framework should ensure that their capital is not at risk from fraud or theft. However, while this is generally the case, there have been instances of products that incurred losses despite apparently having strong institutional backing. An important aspect of due diligence in product selection is to ensure that the provider has insulated clients (as far as possible) from any adverse consequenc...

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... is there to protect investors when a company is unable to meet its financial obligations, provided that the investment falls under the terms of the scheme. For most investments this is clear, but care needs to be exercised with certain structured products as the underlying investment company may be not necessarily be within the scope of the FSCS.

Which Government agency provides protection for investors if a product provider is insolvent?

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Whether the investor is managing their own investments or receiving advice from an adviser, the investments chosen need to be suitable for their needs an...

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... the suitability report together with recommendations for ongoing reviews to check suitability throughout the term of the products in question.

 

These allow investors to combine their financial planning products into one account.

In doing this the investor can obtain a consolidated report covering all of their financial products in one place. This adds ease of administration and ongoing dealing with a combined fee being charged for the service.

The investments may be grouped by class or type or may be held in a tax-efficient wrapper such as an ISA or a pension.

Depending on the scope of the platform, investors will be able to see all of their investments in one place and make decisions that can impact on all or any one of them such as changes to asset allocation or risk strategy. With the ability to track the account online it makes it easier for the investor to keep track of all aspects of their portfolio.

The platform char...

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... adviser or investor that can support tax returns. It also makes it easier for the adviser to complete transactions, including taking charges as they fall due.

For all platforms, whilst dealing charges may be lower than normal (in the range of 0.25% to 0.5%), there are other charges to be considered such as:

An administration charge for the platform

Exit charges for bringing new investments in or transferring existing ones out

Ongoing investment charges for the particular products held on the platform

Adviser charges for any advice given

Investors should also be aware of any potential conflicts of interest within the provision of the platform or the products recommended within it.

What is the main administrative benefit of a platform?

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Your results and the estimated s...

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...ate.

Estimated study time 4.1 hours