Wealth Management Portfolio Construction - Term Paper Example

Wealth Management Portfolio Construction Introduction Different people have different financial needs as well as goals and objectives. The differences in needs arise from the varying situations of clients. For instance, different people have different levels of risk tolerance. There are risk averse people, risk neutral and risk takers. Among the risk takers there could be those who have low risk tolerance, middle risk tolerance and high risk tolerance. Another factor that could affect the financial needs of an individual is the time factor. People have different financial needs at different times. There are times when they need a lot of money while at other times they need relatively low amounts of money. Time factor goes hand in hand with the cash needs. The investment objective could be another reason as to why the financial needs of individual may be different. These are the reasons as to why an individual is willing to invest. The goals that they want to achieve by investing. The most common investment objectives include; growth of capital, safety, income as well as tax minimization and marketability/ liquidity among others. The above named factors coupled with the other personal needs which are specific to various individuals create the variances in financial needs. A portfolio manager will have to acquire this information in order to be able to come up with a portfolio that is specific to the customer and that is within their risk profile (Fabozzi & Markowitz, 2011). The portfolio manager would also need to know the amount of money or other the amount of capital that the client needs to invest. This will help him in determining the combination of securities that should be acquired for the various clients. The objective of the portfolio or wealth manager is to create a portfolio that has the highest possible profitability for their clients. The financial market today has become highly competitive and difficult to predict. Therefore, for any investor to be able to make profits they need to have a portfolio that is well maintained. It is important that the portfolio manager knows the best way to determine asset allocation that will best conform to the various individual goals as well as strategies of the investor (Fabozzi & Markowitz, 2011). He should make sure that the asset allocation and the portfolio created is able to meet the future needs for the capital invested and at the same time maximize the satisfaction of the investor. This paper is a project that will focus on the objectives of portfolio. It will explain the process that a wealth manager should follow in selecting a portfolio as well as describe in details the objectives of a portfolio. It will include any relevant portfolio calculations. Portfolio Construction In constructing our portfolio, we chose the allocation of money in two assets; equity and fixed income (bonds). Our aim was to blend capital growth with a degree of income and it is for this reason that we opted for a balanced portfolio. The portfolio was spread as follows; equity 60% of the investment and fixed income 40% of the investment. The reason as to why we preferred to put more money on equity is because of the recent economic changes that have influenced the growth of equity as compared to bonds. The balance sheets and dividends of most corporates are strong and this is a sign of good performance of their shares in the stock market. However, we also put a significant amount on bonds since this is a safe asset where the interest rates are almost guaranteed. It is less risky as compared to equity. According to the comments by Investec Wealth & Investment manager, the global equities have risen by 6.6%. Bonds on the other hand also increased but the prices were down by 0.9% on a total return basis. The total amount that we hand for investment was $250,000. 60% of this was invested in equity and 40% on fixed income. Therefore, the investment portfolio was as follows; 60% of $250,000 = $150,000 – amount invested on equity 40% of $250,000 = $100,000 – amount invested in bonds If one share costs $150 then given the global increase in value of 6.6%, the value of the share would rise to $159.9. The total number of shares that can be bought with $150,000 is 1000. Therefore, 1000 × $159.9 = $159,900. This is an increase in capital of $9,900. The trend in the market at the currently is positive as the economic recovery continues. Therefore, chances are that the portfolio investment is viable and that it is likely to increase capital. The fixed income assets are risk free and hence we will be guaranteed of interest income which has also been on the increase. On 30th September 2013, the fixed interest rate was 4.0%. Therefore, assuming that each bond is $100, then the interest earned per bond will be 4% * $100 = $4. For the 1000 bonds, total income will be $4 * 1000 = $4,000. This is a guaranteed amount as it has no risk. Therefore Total capital growth from the above risk portfolio as at this moment would be $4,000 + $9,900 = $13,900. Below is a chart and a graph showing the increase in interest rates in the various regions. Steps followed in building a portfolio for wealth management The aim of portfolio management is to reduce as much as possible or to eliminate completely any possible apparent risk. In fact, in creating a portfolio, risk is the mist critical decision that the manager is required to address. For a less risk, the manager will need to create a more conservative portfolio. A high risk will be associated with a less conservative portfolio. The steps that the wealth manager will follow in determining the investment portfolio should address all the needs of a client in order to ensure maximum satisfaction in that the portfolio will meet the needs of the client (Baker & Filbeck, 2013). The wealth manager may need to come up with a blend of Exchange Traded Fund (ETF), mutual funds as well as accounts managed separately. There has been much research that is associated with the steps to be followed in selecting an investment portfolio. It has been broken into five major steps that create a kind of a virtuous circle which are all aimed at improving and enhancing the potential returns from the investment. The steps are; strategic asset allocation, tactical asset allocation, investment selection, portfolio review, and portfolio construction. Most important however will be the acquirement of the clients’ information. Steps that were followed in building the portfolio It is imperative to note that there are a various ways in which a manager can build a portfolio. Following are the steps that the wealth manager followed in building a portfolio for the clients in this project. First, the wealth manager will need to know their customers. The step is dubbed Know Your Customer (KYC). The wealth management will need to interact with their customers in order to capture their basic information. It helps the organization to know the names of their clients, the locations of their clients, their address and contacts among other details (Snopek, 2012). This might be important since the organization might want to contact the client regarding the portfolio at any time. With such kind of information, it is easy to identify the specific clients and contact them. The management may also be interested in capturing information on the client’s source of funds. The organizations that act as the regulator of all the financial activities in the United Kingdom, Financial Conduct Authority (FCA) requires as a basic principle that the wealth management knows their customer. Know Your Customer is a principle that benefits the wealth manager for a number of reasons. First, it helps in determining the eligibility of the client for the investment. Certain clients may not be suitable for certain investments and at the same time, there are products that are not suitable for certain clients. Secondly, the bank will be able to know the risk profile of the client as well as the level of returns that the client expects. As it has been mentioned earlier in this article, different clients have different affinities for risk. There are those clients who will only invest in securities that are risk free. Others are neutral in that their decision on whether to invest or not to invest on certain assets is indifferent. Similarly, there are clients who do not fear risk and will be okay to invest in any assets regardless of its risk as long as it will give returns. It should be noted that risk takers are the people who are likely to make high profits as projects deemed risky normally have high returns. It is said that risk and returns go hand in hand when it comes to investments (Baker & Filbeck, 2013). Anti Money Laundering (AML) could also be defined under the Know Your Customer principle. The wealth management will be able to determine the legal controls that are required to prevent vices such as money laundering and also detect them in the event they occur. Anti Money Laundering regulations became globally recognized following the establishment of the Financial Action Task Force (FATF). The second step would be to classify the clients into various classes. There are clients who are high net worth. It is a description that explains the amount of wealth that an individual holds. It should be emphatically stated that the definition of the term richness is not precise since it depends on many factors. There is no specific level of richness that an individual should reach in order to qualify to be in the category of individuals with high net worth. The term is however quoted on the basis of liquid assets of a certain figure. The amount differs with various financial institutions (Mayer & Levy, 2004). The reasons as to why the wealth management may need to know the net worth of an individual is to enable him categorize them on the various investments and come up with the right blend of portfolio. The individuals with a high net worth have the necessary qualifications for separately managed investment accounts while those with a relatively lower net worth qualify for regular mutual funds (Maude, 2006). Normally, individuals with liquid financial assets of up to $1 million have been categorized as high net worth individuals while those with liquid financial assets of between $100,000 and $1 million are described as affluent. At times, these individuals are referred to as sub- high net worth individuals. Very high net worth individuals are those with liquid financial assets of up to or above $5 million while those with over $50 million are ultra high net worth individuals. Affluent clients qualify for regular mutual funds. They are mostly family offices and standard private clients. In most cases, the clients who qualify for separately managed investment accounts are institutional clients (Collardi, 2012). They may include banking institutions, insurance companies, pension funds as well as any other institution that is trusted with the responsibility of managing funds on behalf of other firms and individuals. The other step that the wealth management will need to execute is evaluation of the clients risk return. It is an important step that helps the risk manager to build a portfolio for the client. As it has been mentioned earlier in this article, different people have different affinities for risk. Therefore, different people will need different portfolios depending on their risk affinities and return expectations. He will need to know the amount of time that the investor is willing to invest as well as the time when he or she will need their money back. This will enables the wealth manager to make a decision on the assets in which to invest in. in the event that the client wants the money back in a relatively short time, the wealth manager will have to invest in a short term portfolio so that by the time the clients wants the money back, the investment will have given the returns (Goel, 2009). On the other hand, if the client wants the money after a relatively long period of time, the wealth manager is at liberty to invest in a log term asset(s). The amount available for investment will also be used in determining the kind of investment that the wealth manager is going to invest in. the amount available for investment will go hand in hand with the return expected. If the return expected is high, the amount available for investment will also be high. If the amount available for investment is low, then the return expected will also be low. The same case will apply for availability of medium amount. In addition to all the above consideration, the risk appetite for the client will be a very important factor in evaluating the risk return and determining the assets in which to invest in. for instance, when a client doesn’t want a risky investment, chances are that the investment will have relatively lower returns. The capital required might also be relatively lower although this will depend on the specific investment in that there are investments which carry no risk but they need a high capital layout while others need a low capital. There are other clients who have high volatility risk appetite. Such clients will invest in a project which has risk. They will be willing to take risk as long as the returns are high. A high risk portfolio requires high capital and hence the investor should have a high amount of money available for investment. In fact, the risk takers in most cases are the wealthy people who are considered as high net worth individuals. Their return expectations will be high (Goel, 2009). Such clients might be willing to invest in a short term project or in a long term project depending on the urgency in which they need the money back and the reasons why they need the money. The wealth management should be very keen when developing a risk portfolio so as to ensure the level of risk in the event that it occurs is very low and if possible it is eradicated completely. The aim of the wealth manager is to ensure that the client gets the highest possible return for their investment. Therefore, managers dealing with a high risk portfolios are under a relatively high pressure. In the case of risk takers, there are clients who can tolerate a high level of risk. Such clients in most cases will have a high amount of money for investing and will be expecting a high return. There are other risk takers who can only tolerate a lower level of risk. Their expected return will be relatively lower and their amounts available for investment is also relatively lower (Salacuse, 2010). Those whose risk tolerance is medium will similarly expect a medium amount of return and their amount available for investment is also medium. They could be either the affluent clients or the high net worth individuals. It should be noted that this step is the most important since it is the step where the wealth manager will get the relevant information which can be used to make the final decision on the portfolio to invest in. therefore, keen attention should be taken when one is collecting this kind of information. Making the wrong investment decision will not only hurt the customer but will also be harmful to the wealth management company and might negatively affect its goodwill. Once the investment decision has been made and the portfolio has been decided, the next step would be to determine or to decide on the investment mandate. There are clients who would just leave the entire management of the portfolio to the wealth managers. Such a client will only put up the money that should be invested and then wait for the return at the agreed time. In such a case, the clients will only give the money to the wealth manager. The manager will then make a decision on the portfolio to invest in without necessarily having to seek the consent of the client. Any decision that needs to be made, the manager will have the authority to make it. In the event that the manager feels that the assets should be sold, he or she will just sell it. He will be at liberty to decide the level of risk to take in the portfolio (Fabozzi & Wickard, 1997). However, there are situations whereby the client will set the guidelines on the assets that the manager should invest on. Despite this, the client remains passive during the investment period. It is considered les risky for a client to seek a professional guidance in his or her asset allocation and portfolio selection (Brunel, 2006). When a client gives the wealth managers a discretionary mandate, such portfolios are actively managed and they are designed in such a manner that they optimize the returns across the entire spectrum ranging from conservative allocations to the aggressive allocation. Clients will be receiving reports regarding the proceeding and the performance of the portfolio. They can also be as involved as they wish although decision making will lie mostly on the wealth managers. In such a mandate, the client can invest in a high risky portfolio as the wealth managers are professionals and they are able to make the right decisions on behalf of the customer. Advisory mandate on the other hand is where an investor/ client manage his or her own investment portfolio. However, they seek advice from the wealth manager on how to manage and on the process they should follow in making decisions. Under this kind of mandate, investors are not likely to select a portfolio that is highly risky. This is because they may not have the experience required to reduce the occurrence of risk. However the client needs to be well conversant with the financial markets. Advisory mandate is normally highly dynamic and interactive as the client will keep close contact with the investment manager in order to be given the advice required to maximize returns. In addition, the client will actively participate on the investment decisions and processes (Bines & Thel, 2004). They need to have the most tailored investment recommendations across the entire portfolio apart from just making the financial and investment decisions on oneself. In most cases, people who seek advisory mandate do not invest a lot of money and they have a lower appetite for risk. However, it is still possible for some clients to invest a lot of money in a risky portfolio and seek advisory mandate. Such clients have much experience on the financial markets. Investment objectives; Various people invest for various reasons. The objectives for investment will determine the amount of money that the investor will put up on a given asset. It will also influence the level of risk that the investor can tolerate (Essvale Corporation, 2008). In addition, the objectives of the investment will determine the portfolio to be selected and the amount of time that the client is willing to invest. There are a number of investment objectives as discussed below. The objectives were considered wen making a decision for selecting the investment for this project. Short term investment objective; this is where the client wishes to invest for a short period of time. A client with a short term investment objective will invest in short term projects. Therefore, the wealth manager in this case will select a portfolio that gives returns within a short period of time. The portfolio should be preferably relatively low risk so that in the even of risk, the client will not have lost their money. This is an investment that takes a maximum of one year. Medium term investment objective; this is where the investor wishes to get back the money after a period of 1 to 5 years. He or she may invest in a portfolio that is not long term and at the same time is not short term ((Fabozzi & Wickard, 1997). Such people may either be risk takers or risk averse. The wealth manager will select a portfolio that has the ability to give returns within the time stipulated by the client. Long term investment objective; it is the kind of investment whereby the client expects to get back the money after a long period of time. In such a case, the life time of the investment is over 5 years. The investment could either be high risk or low risk depending on the risk appetite of the client. The value of an investment is another objective that may influence the selection of an investment portfolio. The investor may want a high value return for the investment. This means that the wealth manager will have to come up with a portfolio that will give high returns. In most cases, such portfolios may carry a high level of risk but the wealth manager should have a way of reducing the chances of risk occurring. Growth of the investment is another significant objective. Clients may wish to invest in a portfolio that grows at a high rate or at a low rate (Fabozzi & Wickard, 1997). This will depend on their returns expectation. Defensive objective is where the client’s investment objective is to invest in a project that has no risk. The client in this case is willing to defend his or her money from getting lost. A moderate objective however is for risk neutral investors. These are investors whose objective is to invest in either a risky on risk free portfolio depending on the return expected. Finally, aggressive objective is where clients want to invest in a portfolio that is not conservative. Such assets may be risky but have a high return. Implementation strategy After the above named steps were well adhered to and a portfolio selected, implementation strategy was essential in ensuring the success of the investment. The portfolio selected was a high risk one with a high return expectation with the time for investment expected to be medium term. Due to the high uncertainties in the market efficiency, a discretionary mandate was thought to be the best for this investment. Therefore, the implementation was definitely going top be passive. This is the implementation strategy that includes market portfolio, index tracker and Exchange Traded Fund among others. The Exchange Traded Fund was applied in this case. This is where the assets are held and traded close to their net asset value throughout the trading period. The ETF normally tracks an index like the bond index or the stock index. The reason as to why ETF was selected is due to the fact that it has a low cost and is tax effective. Its features have mire similarities with stocks and hence it is easy to implement and monitor. In addition, the ETF has the ability to combine the valuation features of a mutual fund or of a unit investment trust. Display risk factors Beta; beta of any portfolio is the measure of the related risk. When the beta value is more the 1, this means that the asset is volatile and that its prices are highly correlated with the market. The price moves up and down the market. A beta below 1 means that the investment has a lower volatility as compared to the market and that the prices are not correlated with the market. When the beta value is equal to 1, the implication is that the stock has a risk equal as that of the market. Beta can be calculated using regression method. It will be the covariance of the stocks return divided by the variance of the market return (Hitchner, 2010). β =  Covariance of Market Return with Stock Return Variance of Market Return β =  Correlation Coefficient  ×  Standard Deviation of Stock Returns Between Market and Stock Standard Deviation of Market Returns Supposing the correlation coefficient between a market and the price of shares of a company is 0.75. The standard deviation of the market is 12%. The standard deviation of the share price is 8%. The beta of such a portfolio would be = 0.75 × 0.08/ 0.12 0.75 × 0.666 β = 0.5 Alpha; alpha is a figure that is used to compare the performance of an investment relative to a benchmark. It is written in form of an annualized return percentage. Recommendation From the calculation of the beta above, it can be deduced that the price of the asset is not correlated to the market. This means that it is not easy to make a conclusion on the investment judging from the trends in the market. The investment is a high risk one and the expected returns are high. It is therefore advisable to rely on the wealth management information for any decision considering the fact that the managers have more experience. Reference List Baker, H. K., & Filbeck, G. (2013). Portfolio theory and management. New York: Oxford University Press. Bines, H. E., & Thel, S. (2004). Investment management law and regulation. New York: Aspen Publishers. Brunel, J. L. P. (2006). Integrated wealth management: The new direction for portfolio managers. London: Euromoney Books. Collardi, B. F. J. (2012). Private banking: Building a culture of excellence. Singapore: John Wiley & Sons Singapore. Essvale Corporation. (2008). Business knowledge for IT in private wealth management: A complete handbook for IT professionals. London: Essvale Corporation Ltd. Fabozzi, F. J., & Markowitz, H. (2011). The theory and practice of investment management: Asset allocation, valuation, portfolio construction, and strategies. Hoboken, N.J: John Wiley & Sons. Fabozzi, F. J., & Wickard, M. B. (1997). Credit union investment management. New Hope, Pa: Frank J. Fabozzi Associates. Goel, M. S. (2009). Wealth management: The new business model. New Delhi, India: Global India Pub. Hitchner, J. R. (2010). Financial valuation: Applications and models. Hoboken, N.J: Wiley Maude, D. (2006). Global private banking and wealth management: The new realities. Chichester, England: John Wiley & Sons. Mayer, R. H., & Levy, D. R. (2004). Financial planning for high net worth individuals. Washington, DC: Beard Books. Salacuse, J. W. (2010). The law of investment treaties. Oxford: Oxford University Press. Snopek, L. (2012). The complete guide to portfolio construction and management. Chichester: John Wiley & Sons. Read More