LCASTOL

CHAPTER 2
THE ASSET ALLOCATION DECISION
 LCASTOL
LEARNING OBJECTIVES
CH. 2 – The Asset Allocation Process

Learning Objectives
• Identify the four steps in the portfolio management process
• Learn the role of asset allocation in investment planning
• Know the importance of policy statement to the planning
process
• Enumerate and explain objectives and constraints that are
detailed in a policy statement
• Explain why investment goals change over a person’s lifetime
 WHAT IS ASSET ALLOCATION?

Definition
Asset Allocation
• It is the process of deciding how to distribute an
investor’s wealth among different countries and asset
classes for investment purposes.
Asset Class
• It refers to the group of securities that have similar
characteristics, attributes, and risk/return relationships.
• Types: Cash, equities, fixed-income, commodities,
derivatives & alternative investments
Investor
• Depending on the type of investors, investment
objectives and constraints vary ( individual and
institutional investors)
 INDIVIDUAL INVESTOR LIFE CYCLE
Types of Investing
Growth – earnings are kept in the asset to
allow investment to grow faster
Income – wants cashflows from
investments (i.e. dividends & interest)

General Guidelines
• Always consider current income vs
current expenses.
• Investors in the accumulation phase
usually can afford more growth
strategies and take a higher amount of
risk than in other phases
• Investors in the spending phase can
likewise focus on growth if focused on
beneficiaries
 PURPOSE OF INSURANCE & OTHER PLANS
Purpose
• Provide cash during unfortunate, unforeseen
events.
• Pay for Estate taxes
Financial Plan Preliminaries
• Life Insurance: Providing death benefits and,
possibly, additional cash values
• Term life and whole life insurance
• Universal and variable life insurance
• Non-life Insurance
• Health insurance & Disability insurance
• Automobile insurance & Home/rental
insurance
• Others
• Educational plans
• Cash Reserve
• To meet emergency needs
• Equal to six months living expenses
 PORTFOLIO MANAGEMENT PROCESS

Study Current & Construct the

Policy Statement Monitor & Update
Future Trends Portfolio
• Specifies investment • Determine strategies to • Allocate available funds • Evaluate portfolio
goals and acceptable meet goals to minimize investor’s performance
risk levels • Requires monitoring and risks and meet • Monitor investor’s needs
• Should be reviewed updating investment goals and market conditions
periodically • Revise policy statement as
• Guides all investment needed
decisions • Modify investment strategy
accordingly
 INVESTMENT POLICY STATEMENT / SUITABILITY
Always consider the appropriateness and suitability an investment and match this up against the needs and
circumstances of the particular client. KNOW YOUR CLIENT!!!

Write an investment policy statement & plan and periodically update it!
IDENTIFY THE
RETURN OBJECTIVES
CLIENT
Identify the type and nature of Income requirements, growth
clients, and the existence of in principal, maintenance of
separate beneficiaries.. purchase power.

RISK TOLERANCE OTHER CONSTRAINTS

Suitability & stability of Know the liquidity needs, time
values. Appetite to take losses. horizon, tax & legal
considerations, regulatory and
unique preferences
 POLICY STATEMENT
Understand Investor Needs
• What are the real risks of an adverse financial
outcome, and what emotional reactions will I have?
• How knowledgeable am I about investments and the
financial markets?
• What other capital or income sources do I have? How
important is this particular portfolio to my overall
financial position?
• What, if any, legal restrictions affect me?
• How would any unanticipated portfolio value change
might affect my investment policy?
 POLICY STATEMENT
Sets standards for evaluating portfolio
performance
Common Benchmarks Used in the Philippines
• The statement provides a comparison standard in
judging the performance of the portfolio manager. Type of UITF or Mutual Benchmark
Fund
• A benchmark portfolio or comparison standard is used
to reflect the risk an return objectives specified in the 91-day Tbill, PH 3-mo.
Money market funds TD Rate
policy statement.
• It should act as a starting point for periodic portfolio Equity funds PSEi
review and client communication with the manager BPI Local Bond Index,
Bond funds Bloomberg Sovereign
Other Benefits Bond Index
• It helps reduces the possibility of inappropriate or
Combination of PSEi &
unethical behavior on the part of the portfolio manager. Balanced funds a bond index
• It also provides the framework to help resolve any
Appropriate benchmark
potential disagreements between the client and the Foreign funds (i.e. MSCI, S&P500, etc)
manager.
• A clearly written policy statement will help create
seamless transition from one money manager to
another without costly delays.
 INVESTOR OBJECTIVES
Risk Objectives
• Risk objective should be based on investor’s ability to take risk and willingness to take risk.
• Risk tolerance depends on an investor’s current net worth and income expectations and age.
• More net worth allows more risk taking
• Younger people can take more risk
• A careful analysis of the client’s risk tolerance should precede any discussion of return objectives.
• Example of questionnaire: https://www.hsbc.com.ph/content/dam/hsbc/ph/docs/risk-profile-questionnaire.pdf
Return Objectives
• The return objective may be stated in terms of an absolute or a relative percentage return.
• Capital Preservation: Minimize risk of real losses
• Capital Appreciation: Growth of the portfolio in real terms to meet future need
• Current Income: Focus is in generating income rather than capital gains
• Total Return: Increase portfolio value by capital gains and by reinvesting current income with moderate risk
exposure
 INVESTMENT CONSTRAINTS
Liquidity Needs
• Vary between investors depending upon age, employment, tax status, etc.
• Planned vacation expenses and house down payment are some of the liquidity needs.
Time Horizon
• Influences liquidity needs and risk tolerance.
• Longer investment horizons generally requires less liquidity and more risk tolerance.
• Two general time horizons are pre-retirement and post-retirement periods.
Tax Concerns
• Tax position
• Capital gains or losses: Taxed differently from income
• Unrealized capital gains: Reflect price appreciation of currently held assets that have not yet been
sold
• Realized capital gains: When the asset has been sold at a profit
• Trade-off between taxes and diversification: Tax consequences of selling company stock for
diversification purposes (importance of listed shares)
• Estate planning
 INVESTMENT CONSTRAINTS
Legal & Regulatory Factors
• Limitations or penalties on withdrawals (i.e. Bank LTNCDs, pooled fund policies)
• Fiduciary responsibilities (“Prudent Investor Rule” normally apply)
• Investment laws prohibit insider trading (i.e. corporate insiders, investment bankers, govt officials)
• Institutional investors deserve special attentions since legal and regulatory factors may affect them quite
differently (e.g. banks vs. endowment funds vs. insurance).
Unique Needs & Preferences
• Personal preferences such as socially conscious investments could influence investment choice (Green
Investing).
• Time constraints or lack of expertise for managing the portfolio may require professional management
• Large investment in employer’s stock may require consideration of diversification needs
• Institutional investors needs deserve special attentions since legal and regulatory factors may affect them quite
differently (e.g. banks vs. endowment funds).
 POLICY STATEMENT - EXAMPLE
Objective: Retire by 45. This will require saving 60% of after-tax
income and earning an average of 7% after inflation from
investments
Philosophy and risk tolerance: Accept market returns and
minimize management and transaction fees to come out ahead in
the long-term. Client can accept moderate to high risk and
volatility.
Time Horizon: Client is 23 and has 22 years prior to planned
retirement.
Preferences: Purchase low-cost mutual index funds through a
discount broker
Target Allocation: 100% stocks (60% domestic / 40%
international). 100% Vanguard 500 Index Fund Shares (VFIAX).
For employer-sponsored accounts invest in Fidelity or Putnam
funds.
 POP QUIZ
Joyce Realon, age 50, has recently retired after several years of working as a Finance professor in Eng Bee University. She is happily
married to Kent, age 55, who is a retired professional dance instructor. They have two children who both are now grown-ups and have
begun to have their own families. They have saved PhP5 million in their portfolio in which PhP3.5 million has been contributed by
Joyce. Because of her profession, Joyce considers herself as an individualist who is confident in her ability to make investment
decisions. Thus, she doesn’t disallow any specific investments in their portfolio.

Both believe they have comfortable portfolio level just enough to meet their annual living expenses. They plan to spend PhP200,000
over the next year for renovating their home. In addition, Joyce wants to provide educational support of PhP100,000 per year to each
of her two grandchildren over the next ten years and to offer scholarship grants to two of her previous students in Eng Bee University.

Using the information provided above, which of the following is the most appropriate description of Joyce Realon’s risk objective?

Willingness to take Risk Ability to take Risk

a. Above Average Above Average
b. Above Average Average
c. Average Average
Answer: B d. Average Above Average
LIQUIDITY RISK – AN EXAMPLE (Investing P100K)

12,000
shares
 IMPORTANCE OF ASSET ALLOCATION
Four Decisions in Investment Strategy
• What asset classes to consider for investment?
• What policy weights to assign to each eligible class?
• What allocation ranges are allowed based on policy
weights?
• What specific securities to purchase for the portfolio?
According to research studies, most (90%) of the overall
investment return is due to the first two decisions, not the
selection of individual investments
Key Learnings in Asset Allocation
• Policy statement determines types of assets to include
in portfolio
• Asset allocation determines portfolio return more than
stock selection
• Over long time periods, sizable allocation to equity
will improve results
• Risk of a strategy depends on the investor’s goals and
time horizon
 ECONOMIC CYCLES
GNP/GDP Growth (1961 -2020)
15.0% Public sector fixed Credit upgrades, BPO &
investment program EDSA Tiger
OFW growth
euphoria economies
10.0% of Asia

5.0%
Sub-prime
Oil crisis
Crisis
0.0%
6 1 6 4 6 7 7 0 7 3 7 6 7 9 8 2 8 5 88Severe91 power 94 997 Asian
00 003 006 009 012 015 018
19 19 19 19 19 19 19 19 19 1 9 1 9 1 9 1 2 0 2 2 2 2 2 2
shortage Financial
-5.0%
Crisis

Debt moratorium &

-10.0% Covid-19
Aquino assassination
Pandemic
-15.0%

Source: BSP General Behavior of Asset Classes

• Stocks and commodities do well in periods of recovery and expansion
• Bonds perform well during contraction or downward trends in GDP. This is because
of expectations of an expansionary monetary policy
 ASSET ALLOCATION
PSEi (Jan. 1990 – present)

Credit upgrades, BPO &

OFW growth

Tiger
BPO &
economies
OFW growth
of Asia
EDSA
Covid-19
euphoria
Pandemic
Sub-prime
Crisis
Asian
Financial
Severe power Crisis
shortage Key Takeaways
Source: Market Watch • Stock market performance is highly correlated to economic growth
expectations
• In the long-run, stocks can provide superior returns
 ASSET ALLOCATION
10YR BVal

Covid pandemic

Source: Bloomberg
Key Takeaways
• Interest rates drop (bond prices increase) during times of contraction
because of of expansionary monetary policy expectations from the BSP
 IMPORTANCE OF ASSET ALLOCATION
Returns and Risks of Different Asset Classes
• Historically, small company stocks have
generated the highest returns, so have the
volatility
• Inflation and taxes have a major impact on
returns
• Returns on Treasury Bills have barely kept
pace with inflation
• Measuring risk by the probability of not
meeting your investment return objective
indicates risk of equities is small and that of
T-bills is large because of their differences in
expected returns
• Focusing only on return variability as a
measure of risk ignores reinvestment risk
RISK-REWARD TRADE-OFF
 RISK-REWARD TRADE-OFF
Return potentially rises with an increase in risk. Using this principle, individuals associate low levels of
uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns.

RISK RETURN
Uncertain economic/political conditions. Lower Higher interest rate. Higher price
credit rating. Uncertain earnings. Less liquidity. upside.
Longer tenor/duration (for fixed-income)
 POP QUIZ
East West Bank is looking to buy P100 million worth of securities. They currently have a negative tax
position of more than a billion pesos, meaning their taxable expenses exceed their taxable income. Which
of the following securities should they buy, if yield is their primary consideration?

a. A 10-year FXTN with a yield of 6.0% (FXTNs are subject to a 20% FWT)
b. A 10-year Ayala Corp corporate note with a yield of 5.5% (income from corporate notes are
taxable)
c. A 10-year tax-exempt PSALM bond with a yield of 5.25%, fully guaranteed by the national
government
d. Callable FGEN preferred shares with a dividend yield of 5.25% (tax on dividend income to
individuals is 10% and to corporations = 0%)

Answer: B
Effective yields
FXTN = 4.8% (6.0% * 0.8)
AC Corp Note = 5.5%
PSALM bond = 5,25%
FGEN Preferred = 5.25%
 INSTITUTIONAL INVESTORS

Endowment Funds Pension Funds Insurance Companies Banks

Mutual/Pooled Funds • They represent • Receive contributions Life Insurance Companies • Must attract funds in a
contributions from the firm, its • Earn rate in excess of competitive interest
• Pool investors funds and made to employees, or both and actuarial rate rate environment
invests them in financial charitable or invests • Fiduciary principles • Try to maintain a
assets as per its educational • Defined Benefit – limit the risk tolerance positive difference
investment objective institutions promise to pay retirees a • Liquidity needs between their cost of
specific income stream Non-life Insurance funds and their return
after retirement • CF less predictable on assets
• Defined Contribution – • Fiduciary responsibility • Need substantial
do not promise a set of • Risk exposure low to liquidity to meet
benefits. Employees’ moderate withdrawals and loan
retirement income is not demands
• Liquidity concerns
an obligation of the firm • Face regulatory
• Less regulation
constraints (reserves,
agri-agra, etc)