CISI IAD Portfolio Construction and Management 2 — Questions and Answers
Question 1: What is the purpose of an 'investment policy statement' (IPS) for a client?
- A document signed by the client acknowledging they have been charged a fee
- A formal document outlining the client's investment objectives, risk tolerance, time horizon, constraints, and the agreed investment strategy — serving as a blueprint for managing the portfolio (Correct answer)
- A legal contract between the client and the FCA
- A marketing document summarising the adviser's investment philosophy
Correct answer: A formal document outlining the client's investment objectives, risk tolerance, time horizon, constraints, and the agreed investment strategy — serving as a blueprint for managing the portfolio
An IPS documents the agreed investment mandate — the client's objectives, risk profile, time horizon, income needs, tax position, liquidity requirements, and any ethical or ESG constraints. It guides portfolio construction and provides a basis for performance evaluation.
Question 2: What is 'ESG investing' and what do the letters stand for?
- Earnings, Solvency, and Governance — a financial analysis framework
- Environmental, Social, and Governance — an approach that incorporates non-financial factors into investment analysis and decision-making to assess sustainability and ethical impact (Correct answer)
- Equity, Securities, and Growth — a portfolio allocation framework
- Exchange, Settlement, and Growth — a market infrastructure framework
Correct answer: Environmental, Social, and Governance — an approach that incorporates non-financial factors into investment analysis and decision-making to assess sustainability and ethical impact
ESG investing considers Environmental (carbon emissions, resource use), Social (labour practices, community impact), and Governance (board composition, shareholder rights) factors alongside financial analysis. It aims to identify risks and opportunities not captured by traditional financial metrics.
Question 3: What is 'liquidity management' in a portfolio context?
- Managing the fund manager's personal bank accounts
- Ensuring a portfolio holds sufficient liquid assets to meet anticipated cash flow needs without being forced to sell illiquid assets at unfavourable prices (Correct answer)
- Maximising the proportion of cash held at all times to eliminate market risk
- Limiting investments to those trading more than £1 million per day
Correct answer: Ensuring a portfolio holds sufficient liquid assets to meet anticipated cash flow needs without being forced to sell illiquid assets at unfavourable prices
Liquidity management involves ensuring sufficient liquid assets (cash, short-dated bonds, listed equities) are held to meet near-term cash requirements — such as income withdrawals or capital needs — without having to sell illiquid holdings (property, private equity) at a discount.
Question 4: What is a 'benchmark-aware' versus a 'benchmark-agnostic' investment approach?
- Benchmark-aware funds use futures; benchmark-agnostic funds use physical holdings
- Benchmark-aware managers construct portfolios with reference to an index, aiming to outperform with controlled tracking error; benchmark-agnostic managers invest without regard to index weights, pursuing best absolute returns (Correct answer)
- Benchmark-aware managers charge performance fees; benchmark-agnostic managers do not
- Benchmark-agnostic funds are only available to institutional investors
Correct answer: Benchmark-aware managers construct portfolios with reference to an index, aiming to outperform with controlled tracking error; benchmark-agnostic managers invest without regard to index weights, pursuing best absolute returns
Benchmark-aware managers use an index as their reference point, managing tracking error and aiming to add alpha within controlled deviations. Benchmark-agnostic (or absolute return) managers have no fixed reference index — they aim for positive returns regardless of market conditions, with greater freedom to deviate significantly from any benchmark.
Question 5: What is 'performance attribution' in investment management?
- The process of attributing past returns to luck versus skill
- An analysis that decomposes a portfolio's return relative to its benchmark to identify which decisions (asset allocation, stock selection, currency) contributed to outperformance or underperformance (Correct answer)
- The process of attributing the fund manager's bonus based on performance
- An analysis of how fees have reduced client returns over time
Correct answer: An analysis that decomposes a portfolio's return relative to its benchmark to identify which decisions (asset allocation, stock selection, currency) contributed to outperformance or underperformance
Performance attribution breaks down the difference between a portfolio's return and its benchmark return into component decisions — typically allocation effect (being over/underweight an asset class), selection effect (stock picking), and interaction effect — to identify the source of alpha or underperformance.
Question 6: What is 'drawdown' as a risk metric?
- The process of withdrawing from a pension in retirement
- The peak-to-trough decline in a portfolio's value over a specified period, measuring the magnitude of losses an investor experiences from a market peak (Correct answer)
- The annual income withdrawn from a portfolio as a percentage of its value
- The difference between gross and net returns after fees
Correct answer: The peak-to-trough decline in a portfolio's value over a specified period, measuring the magnitude of losses an investor experiences from a market peak
Drawdown measures the percentage fall from a portfolio's highest value (peak) to its lowest subsequent value (trough) within a given period. Maximum drawdown is commonly used as a risk metric, showing the worst loss an investor would have experienced if they invested at the peak.
CISI IAD Portfolio Construction and Management 2
What is the purpose of an 'investment policy statement' (IPS) for a client?