Foundation — Asset allocation, correlation, the five-step process, the IPS, objectives and constraints

15.1 Asset allocation — the decision that matters most

And the companion definition:

Examples of asset classes are bonds, equities, cash and cash-like securities. A broad asset class can be cut finer into sub-asset classes. "Bonds" divides into Treasury bonds, corporate bonds and junk bonds. Equity divides further into large cap, mid cap and small cap.

Now the four claims the workbook makes about why this decision matters, all of which are examinable:

1. Asset allocation is a very important investment decision.
2. It is the starting point for the investor as they set out to achieve their goals.
3. Professional investment experience has been suggesting that in the long run the asset-allocation decision majorly influences the performance of investment portfolios.
4. The asset allocation decision is not an isolated decision; it is a component of the overall portfolio management process.

And the sentence that settles the great debate between allocation and stock-picking:

Note the wording carefully. It does not say product choice is irrelevant. It says it is relevant but contributes less. An option that says stock selection does not matter at all overstates the workbook.

Think of a thali. Deciding how much rice, how much dal, how much sabzi and how much sweet goes on the plate is the allocation decision. Whether the dal is toor or moong is the product choice. Both matter — but if you fill the whole plate with sweets, no amount of care about the variety of sweet will save the meal.

15.2 Correlation across asset classes and securities

A value of +1 indicates a perfect positive relationship and a value of −1 a perfect negative relationship between the two variables.

• A positive relationship means the two variables move together in the same direction, either in an upward trend or a downward trend.
• A negative relationship means the opposite.
• The value of the correlation coefficient indicates the strength of the relationship.

So the sign tells you direction, the magnitude tells you strength.

Now the rule that makes correlation useful for allocation:

This is why holding twelve banking stocks is not really diversification. All twelve are sensitive to the same interest rate cycle, the same credit cycle, the same regulatory announcements. They are one asset class wearing twelve name plates.

And then the warning, which is the most examinable line in 15.2:

The workbook adds a practical footnote: financial services data integrators like Bloomberg and Capital IQ provide information on correlation coefficients between various assets and securities; alternatively users can calculate correlation coefficients using simple Excel functions.

Why does the warning matter in practice? Because correlations tend to rise exactly when you need them to stay low. In an ordinary year, mid caps and large caps may correlate at 0.6. In a panic, everything gets sold at once and the correlation jumps towards 1. The diversification you thought you had bought evaporates on the day you need it. That is why the workbook refuses to let you rely on historical correlation alone.

15.3 Steps in the portfolio construction process

Four words to notice — integrated, logical, orderly, consistent.

The workbook then gives three elements and five steps. Learn both, because questions have been set on each.

The three elements: PLANNING, EXECUTION and EVALUATION.

The five steps:

1. Development of a policy statement for the portfolio. It is a road map that identifies the investor's risk appetite and defines investment objectives, goals and investment constraints.
2. Study of current financial conditions and forecast of future trends.
3. Construction of the portfolio, after taking into consideration the policy statement and the investor's objectives, risk appetite and horizon. Because investor needs and financial market forecasts are dynamic, the portfolio requires continuous monitoring and rebalancing.
4. Performance measurement and evaluation.
5. Periodic review — once a portfolio is constructed it needs to be reviewed, whether it is consistent with the objectives and whether there is any significant change in the conditions of the investor or any particular fund.

And the closing summary line:

Note that the workbook uses the word feedback in that summary sentence while naming the third element evaluation. Both appear; do not let either wording throw you.

15.3.1 The Investment Policy Statement

Who writes it? Either investors or their investment advisers draft the IPS, specifying their investment objectives, goals, constraints, preferences and the risks they are willing to take.

All investment decisions are based on the IPS, considering the investor's goals and objectives, risk appetite and so on. And crucially: since investors' requirements change over a period of time, the IPS also needs to be updated and revised periodically. The IPS is a living document, not a form signed once at account opening.

Then a sentence that links this chapter back to 15.16:

15.3.2 Why the IPS matters

IPS is an important planning tool which helps investors understand their requirements and also helps portfolio managers in creating and maintaining optimum portfolios. Preparation of the IPS inculcates a disciplined system and process in managing investments. It reduces the possibility of making inappropriate decisions.

There are four important purposes the policy statement serves:

1. It enables investors to have realistic return expectations from their investments.
2. It enables the portfolio manager to make effective investment decisions in line with the objectives of the investor.
3. It provides a framework for the portfolio manager's evaluation with respect to the investments.
4. It protects the investor against the portfolio manager's inappropriate investment decisions or unethical behaviour.

Look at what that list does. Purpose 1 protects the investor from himself — from expecting 30 per cent a year. Purposes 2 and 3 discipline the manager. Purpose 4 protects the investor from the manager. A single document facing in three directions.

In summary, a well-defined policy portfolio goes a long way in serving the investor's interest. It enables construction of an optimal investment portfolio.

15.3.3 What goes into the IPS

Since the IPS is the most important document, it needs to be prepared with caution. The workbook places duties on both sides:

• The investor has to be upfront with the investment adviser or portfolio manager with regard to their financial situation, requirements and risk-bearing temperament.
• The adviser or manager preparing the IPS is also required to show utmost patience to obtain a deep understanding of the investor's profile.

The contents, in order:

• The goals of the investor along with their priorities
• The investment objectives along with the time horizon — and clarity on this front is essential because the portfolio manager can then frame strategies accordingly
• A clear mention of the risk/return profile of the investor
• The liquidity constraints
• Preferred asset classes, and even those asset classes that need to be AVOIDED
• A systematic review process, which will allow the investor to remain on track to achieve their goals

Section 15.7 adds more that the IPS may include: reporting requirements, portfolio rebalancing schedules, frequency of performance communication, investment strategy and styles.

15.4 Investment objectives

Investors may state their objectives in terms of desired return in an absolute or relative sense — "I want 12 per cent" is absolute; "I want to beat the Nifty by 2 per cent" is relative.

Two relationships must be kept in mind, and they run in opposite directions:

• Risk and return typically have a POSITIVE relationship. Higher the risk, higher the return.
• Liquidity has an INVERSE relationship with return. Relatively illiquid investments require a premium for being less liquid, that is, an ILLIQUIDITY RISK PREMIUM.

That second one catches candidates. More liquidity means lower return; less liquidity is compensated by a premium. It is why a listed bond yields less than an identical unlisted one.

Generally, investors invest for three things: PRESERVATION OF CAPITAL, REGULAR INCOME and CAPITAL APPRECIATION.

The investment objectives lead to an asset allocation decision:

Memorise that third row with its three examples. It is a favourite one-mark question.

15.5 Investment constraints

The chapter then details three: liquidity, regulatory and tax.

15.5.1 Liquidity constraint

Different investors have different liquidity requirements. Younger people usually have lesser liquidity requirements than older people. Some may have health or medical concerns requiring liquid funds; others have college fees or a wedding in the family. Generally investors prefer liquid funds to meet day-to-day expenses, plus some liquidity to meet contingency requirements like sudden medical expenses.

Learn all three, and especially the third — candidates remember emergency cash and near-term goals but forget that opportunity itself is a reason to hold liquidity.

To meet such requirements, some portion of the portfolio should be in cash or cash-like securities. The adviser must make a detailed assessment, because the error runs both ways:

• Keeping too much money for liquidity may hit the overall portfolio return.
• Not maintaining sufficient liquidity will lead to inconvenience and selling of other investments untimely.

The liquidity constraints of the investor need to be clearly specified in the IPS.

15.5.2 Regulatory constraints

Generally individual investors do not have many regulatory constraints. But if there are any, they need to be followed. Regulations can also constrain the investment choices available to investors.

The workbook gives two examples.

First, the Liberalised Remittance Scheme (LRS). As per the Reserve Bank of India's notification, an Indian resident individual can only invest up to USD 250,000 overseas per year. Indian resident individual investors cannot make investments greater than the amount specified by the regulator.

The footnote adds detail worth knowing: under the LRS, all resident individuals, INCLUDING MINORS, are allowed to freely remit up to USD 2,50,000 per financial year (April to March) for any permissible current or capital account transaction or a combination of both. Resident individuals can also avail foreign exchange facility for the purposes mentioned in Para 1 of Schedule III of the FEM (CAT) Amendment Rules 2015, dated May 26, 2015, within the same limit. The Scheme was introduced on February 4, 2004, with a limit of USD 25,000, and has been revised in stages consistent with prevailing macro and micro economic conditions.

Two details there trip people up: the limit is per financial year, April to March, not per calendar year; and it covers minors too.

Second, insider trading. Another example is the sale or purchase of securities on the basis of information that is not publicly known. Usually, people who have access to such information are insiders of the company and they are prohibited from trading on the basis of insider information.

15.5.3 Tax constraint

Three separate points are made:

1. Different investments and different kinds of income are taxed differently.
2. Return in the form of income — interest, dividend and rents — versus return in the form of capital appreciation are taxed differently.
3. The same form of return may attract different tax liability depending on the tax bracket the recipient belongs to.

Hence a thorough understanding of the tax laws applicable to the investor needs to be part of the IPS.

That third point is the subtle one. Two investors can hold the identical bond and keep different amounts of it, purely because they sit in different slabs. This is why a good adviser never recommends a product without knowing the client's tax bracket — the correct answer genuinely differs from person to person.