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Constraints provide some discipline in the fulfilment of a client’s objectives. Constraints, which may loosely be defined as those items that may hinder or prevent the portfolio manager from satisfying the client’s objectives, are often not given the importance they deserve in the policy formation process. Perhaps this is because objectives are a more comforting concept to dwell on than the discipline of constraints.

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A major factor in the design of a good portfolio is how well it reflects the time horizon of its goals. Fundamentally, the time horizon is the period of time from the present until the next major change in the client’s circumstances. In other words, just because a client is 25 years of age and normal retirement is at age 60, this does not necessarily mean the time horizon is 35 years. Clients go through various events in their life, each of which can represent a time horizon and a need for a complete rebalancing of their portfolio. For example, finishing university, planning for a career change, the birth of a child, the purchase of a home, and many other events besides retirement represent the end of one time horizon and the beginning of a new one.

While some major events in a client’s life cannot be predicted, such as a serious health problem or loss of employment, a client’s time horizon should still be the period of time from the present to the next major expected change in circumstances.

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In portfolio management, liquidity means the amount of cash and near-cash in the portfolio. While there are no set rules in portfolio management, a rough guide is that wealthy, risk-tolerant clients should have about 5% of their portfolio in cash and very risk-averse clients with more modest accounts should hold approximately 10% in cash.

This is not to say that the cash component in a portfolio never rises above 10%. Typically, 10% may be held for liquidity purposes (payment of fees and unexpected expenses). The cash component could be higher during certain parts of the market cycle, such as when securities are judged to be overpriced or too risky for that client, or when the yield curve is inverted and the returns on cash are high.

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An investor’s marginal tax rate will dictate, in part, the proportion of income that should be received as dividends, which are eligible for a tax credit, versus other types of income. Different marginal tax rates will help to dictate the proportion invested in preferred shares versus other fixed-income securities such as bonds. Taxation levels and rates will also guide the choice of tax- advantaged securities such as some limited partnerships, as well as the choice of tax deferral plans such as RRSPs and others. High tax rates, which significantly erode the final return on more

traditional investments like GICs, are often a reason for a client to seek out the higher returns available from securities.

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Certainly any investment activity that contravenes an act, by-law, regulation, rule or the Criminal

Code must be considered a constraint. For example, a client must be married (or living common

law) in order to participate in a spousal registered retirement savings plan (RRSP). Also, a client may be an insider or own a control position of a publicly-traded company. These types of clients must comply with all applicable regulatory guidelines. RRSP rules preclude certain transactions, and institutions and corporate charters may pose additional limits. Persons under the age of majority also pose important potential problems. Possible legal constraints are numerous, and would include proper use of margin accounts, good delivery, settlement, and many other matters covered in CSI’s Conduct and Practices Handbook Course.

All firms have compliance personnel and many have legal counsel on staff. It is recommended that the investment advisor consult these resources when there is any question about legal issues. 5.)15%

Unique circumstances are specific to each client and must be considered in the creation of an effective investment policy. Examples of unique circumstances include the desire for ethically and socially responsible investing, among others discussed below. It is clear that client preferences are a legitimate concern and must be taken into account.

Moral and ethical considerations: Some transactions and investment activities may not be against

the law, but should invariably be treated by the portfolio manager as if they are. While clients may have preferences for certain types of securities, they may also have strong aversions to certain others. For example, perhaps because of personal convictions, a client may instruct that no alcohol or tobacco stocks be purchased.

Emotional factors: As full an assessment as possible should be made of the client’s temperament.

Through discussion and active listening, the advisor can fulfil much more of the Know Your Client requirements than if this area is given only cursory treatment. One consideration is investment knowledge. Should a certain strategy be followed if the client clearly does not understand it? For example, writing covered options or using protective puts and other positions may be warranted by the client’s circumstances, but the client may not understand them, and particularly will not if they end up losing money! However, serious discussion with the client, coupled with active listening, can result in a clearer definition of what may be bought and what must be excluded.

Another aspect of the client’s personality is risk tolerance. Although risk was mentioned above in the context of market volatility, here it relates to the client’s level of comfort with volatility in income and volatility in principal. If a client is invested only in Government bonds and makes worried calls several times a day for a quote, chances are that this product is not appropriate for this client. An extra 1% return annually is not worth it if the client cannot sleep in the meantime because of the extra risk involved. On the other hand, a client may be quite comfortable with complicated options strategies and speculative positions, because of much higher risk tolerance.

Market timing: Two approaches to investing include the buy-and-hold approach and the market

timing approach. As the name indicates, buy-and-hold means long holding periods through various market cycles for long-term growth and income. Market timing involves timing the short-

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term entry and exit points in the market in pursuit of quick trading gains over and above the commissions incurred. Clients generally have a preference for one of these approaches over the other. Some clients enjoy the excitement of trading for gains very much, and will increase their risk tolerance to accommodate this desire.

Income requirements: A key constraint is the basic minimum level of current income required or

expected from the portfolio. Suppose a client has living expenses that are not covered by salary, pension and other income. The client requires $10,000 per year in cash flow from the portfolio to meet these expenses. The portfolio should be structured to generate a good total return, but it must also be designed to ensure that there is $10,000 in current income available from the portfolio or the client will not be able to live on the income.

There are two caveats to this point. The first is that the hypothetical $10,000 is current income generated by the portfolio. The required $10,000 is not expected to be met by liquidating securities and thereby eroding the portfolio value. The second caveat is that the current

income should be spaced so that it matches as closely as possible the client’s needs for spending throughout the year, rather than have cash flowing in at only one or two points in the year. Both the fixed-income and equity components of a portfolio can usually be structured to provide a fairly even monthly income if this is desirable.

Realism: An advisor will attempt to provide as realistic an approach to investing as possible. When

the desires of a client are unrealistic, it is incumbent on the IA to point this out to the client. For example, in the discussion on basic minimum income outlined above, a hypothetical $10,000 in current income was used as an example of what the client desired to support the basic cost of living. If the client’s total portfolio was valued at only $50,000, it would be very unlikely that current income of $10,000 could realistically be generated from the portfolio. The client should be advised to reconsider objectives and perhaps spending patterns. Unfortunately, part of good communication sometimes involves saying “no” to a client.

In addition to having unrealistic expectations about the amount of current income that could be generated from a portfolio, a client could have expectations of extraordinary returns from the portfolio. In addition, a client could reveal a lack of investment knowledge by professing too low a level of risk tolerance.

Other objectives and constraints: Questions related to each of the points above can reveal a

great deal about the client’s attitudes and constraints. However, there is also a place for a final overall question, such as, “Is there anything else that we haven’t yet talked about, which might be important?” It is surprising what can come from such a question. The client might reveal pertinent facts such as a family member who is an insider (legal constraint), the presence of a serious illness (income and time horizon implications), the size of the account (very small or a huge lottery winning) or a pending marital breakup, which somehow did not get uncovered in previous conversation.

Clients usually do not communicate their goals to their advisors in terms of return, risk, etc. Instead, primary investment goals might be stated as a desire to retire at a certain age, the

acquisition of a business, vacation property or sailboat, or the pursuit of some other tangible goal. With care and explanation to the client, the IA can translate such events into the objectives above with the client’s full agreement and understanding.