Risk and Return Objectives

The investment objectives and investment constraints are arguably the key components of the IPS. The two elements outline the risk and return objectives. Return objectives and expectations must be consistent with the risk objectives and constraints that apply to a portfolio.

Risk Objectives

The IPS should clearly state a client’s risk tolerance. Risk objectives are the specifications for portfolio risk and can be stated as absolute or relative measures using quantitative metrics. Absolute metrics may be around the probability of loss of portfolio capital over a particular time frame, whereas relative risk objectives would key off a particular benchmark, such as the S&P 500 or LIBOR, to measure risk. For institutional clients, the benchmark may be linked to some kind of liability the institution has. For instance, a pension plan must be able to meet its payment obligations when they are due. When a policy portfolio has been specified, the risk objective may be for the portfolio to remain within a certain bandwidth around that policy allocation.

A client’s overall risk tolerance is a function of their ability to bear risk and their willingness to take on risk. When there is consistency between risk willingness and ability, the investment task is made easier. Where the two are in conflict, the advisor should seek to explain the conflict and its implications. However, they should not aim to try and change the client’s willingness to take a risk if the decision is not a result of misperception. The prudent approach is to reach a conclusion about risk tolerance that is the lower of the two factors – ability and willingness.

Return Objectives

Return objectives may be stated on an absolute or relative basis. An absolute return objective may state the desired returns in nominal or real terms while a relative return objective could be an outperformance, relative to an index or even a peer group. However, a good benchmark should be investable and have the capacity to make return objectives relative to peers or other managers and institutions less appropriate.

The return objective should be clearly classified either as before or after fees and pre or post-tax. The return objective must be consistent with the client’s risk objective and appropriate with respect to the market and economic environment.

Question

Which of the following best demonstrates an absolute risk objective and a relative return objective?

A. Target a maximum annual portfolio volatility of 1.5x the S&P 500 and returns of ±4% of the S&P 500 annual return.

B. Target a maximum portfolio drawdown of 10% with 95% confidence and annual returns of 12%.

C. Target a maximum portfolio loss of $100 000 with 95% confidence and annual returns within 2% of the MSCI World Index.

Solution

The correct answer is C.

An absolute objective does not key off a benchmark or index whereas a relative objective is with respect to a benchmark, index or peer group.