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Chapter 4

Investment Policy

Portfolio Construction, Management, & Protection, 5e, Robert A. StrongCopyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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We investment professionals also need to keep in mind that some who participate in our investment decisions

will be younger and less experienced than we are; some, perhaps the most influential, will be older and more powerful but may be far less experienced with

investing. They may care greatly about the fund being discussed but may not be expert in investing. We, as

professionals, must manage their understanding.

Charles D. Ellis

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Introduction Investment policy is a statement about the

objectives, risk tolerance, and constraints the portfolio faces• A statement of investment policy is required in

several instances (e.g., ERISA) Investment management is the practice of

attempting to achieve the objectives while staying within the established constraints

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Introduction (cont’d) This chapter addresses:

• Why an investment policy statement is important

• How you go about creating one

• What should be in it

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Example of A Policy Statement

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The Purpose of Investment Policy

Outline Expectations and Responsibilities Identify Objectives and Constraints Outline Eligible Asset Classes and Their

Permissible Use Provide a Mechanism for Evaluation

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Outline Expectations and Constraints

Investment policy is the responsibility of the client• e.g., a individual, an endowment fund’s board

Investment management is the responsibility of the money manager• e.g., a bank trust department, a brokerage firm

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Responsibilities and Knowledge Needs of Informed Clients

The client must set explicit investment policies consistent with his objectives

• Set the investment objective

• Understand how the policy statement promotes the accomplishment of the objectives

The client must define long-range objectives appropriate to the fund

• A short-term focus may lead to suboptimal investment performance

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Responsibilities and Knowledge Needs of Informed Clients (cont’d) The client must ensure the managers are

following the investment policy• Clients need an interest in understanding

their own objectives• Clients need an appreciation of the

fundamental nature of capital markets• Clients need the discipline to work out the

basic policies that will succeed in achieving their realistic investment objectives

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The Investment Manager’s Responsibilities

Educate the client about infeasible objectives

Develop an appropriate asset allocation and investment strategy

Communicate the essential characteristics of the portfolio to the client

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The Investment Manager’s Responsibilities (cont’d)

Monitor and revise the portfolio as necessary

• Clients are entitled to progress reports from the investment manager

• It is periodically necessary to revise the portfolio because of changes in market conditions

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The Investment Manager’s Responsibilities (cont’d)

Ensure there is a mechanism for learning when a client’s needs change

• e.g., marriage, children, health expenditures

• A material change in an investor’s situation may require substantial changes in the portfolio asset allocation, the time horizon, the risk tolerance, or the return requirements

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Identify Objectives and Constraints

Objective setting should include:• A target return

• An appropriate level of risk

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Individual Investors Bailard, Biehl, and Kaiser classification:

Careful Impetuous

Confident

Anxious

Individualist Adventurer

Guardian Celebrity

Source: Thomas E. Bailard, David L. Biehl, and Ronald W. Kaiser, Personal Money Management, 5th ed. (Chicago: Science Research Associates, Inc., 1986).

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Individual Investors (cont’d) Guardians take forever to make a decision

and then worry constantly about it• Stability of principal or income are appropriate

objectives

Celebrities make decisions quickly• Like investment fads and worry about being left

out

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Individual Investors (cont’d) Adventurers make decisions quickly and feel good

about them• Often have substantial stock market experience

• Seek capital appreciation

Individualists are both careful and confident• Will listen to advice, read research reports, and

investigate investment alternatives

Straight arrows move between the two dimensions

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Charitable Portfolios An endowment fund is a perpetual portfolio

designed to benefit both current citizens and future generations• e.g., churches, the public library, the YWCA,

environmental groups, etc.

A foundation is an organization designed to aid the arts, education, research, or welfare in general• Organizes as either a trust or as a nonprofit corporation

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Charitable Portfolios (cont’d) Creative tension between the needs of

current beneficiaries and the future beneficiaries for an endowment fund• Avoid short-term thinking when portfolio needs

are long term– Myopic loss aversion: investors are more sensitive

to losses than to gains

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Institutional Portfolios Insurance companies and pension funds

have special needs:• e.g., defined benefit retirement plans must

ensure they will be able to meet payments

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Other Considerations in Setting Effective Objectives

Real Risk Emotional Reactions Investment Committee’s Knowledge Other Capital or Income Resources Legal Restrictions Unanticipated Consequences of Interim

Fluctuations

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Real Risk The consequences of a loss vary widely,

depending on the circumstances• e.g., a professional in his peak earning years

versus a retired widow

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Emotional Reactions BBK taxonomy

• e.g., a guardian is unable to ignore a loss in portfolio value

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Investment Committee’s Knowledge

The investment committee:• Should differentiate between fact and opinion

• Should be honest in assessing the committee’s ability and seek professional assistance when appropriate

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Other Capital or Income Resources

How important is the particular portfolio to the client’s overall financial position?• There is no requirement that an investor keep

all of his money with one brokerage firm, trust department, or money manager

• The client may be diversified even if it does not appear so

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Legal Restrictions Some states have a legal list outlining

permissible investment• e.g., insurance companies may not buy

corporate bonds without an investment-grade rating

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Unanticipated Consequences of Interim Fluctuations

Fluctuations may not matter in the short run in theory, but this may not be the case in practice• e.g., an endowment fund that needs to generate

money for annual scholarships

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Outline Eligible Asset Classes and Their Permissible Uses

There is substantial evidence that the asset allocation decision is the single most important investment decision investors make• Affects long-term rates of return more than

security selection, market timing, or taxes

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Outline Eligible Asset Classes and Their Permissible Uses

An asset class is a logical subgroup of the set of investment alternatives• e.g., equities, bonds, and cash

Asset allocation is the relative proportion of money distributed across the various asset classes

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Provide A Mechanism for Evaluation

The Dual Aspects of Evaluation Choosing the Benchmark

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The Dual Aspects of Evaluation An effective performance evaluation

should:1) Confirm that the manager managed in a way

he was hired to manage– e.g., an equity manager should not be 75 percent

in cash

– e.g., a Treasury bond fund manager should not have corporate bonds in their portfolio

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The Dual Aspects of Evaluation (cont’d)

An effective performance evaluation should:

2) Evaluate how well the manager did it– How well did the portfolio do relative to other

portfolios comparable in risk and security composition?• e.g., a stock portfolio that loses 2 percent when the

market is down 15 percent performed well

• Do not automatically assume unusually good performance will persist

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Choosing the Benchmark Determining the benchmark is an integral

part of setting investment policy

A benchmark can be absolute• e.g., a 10% rate of return

A benchmark can be relative• e.g., top quarter

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Choosing the Benchmark (cont’d)

A good benchmark should:• Be investable

– It should be a viable investment alternative

• Be specified in advance– e.g., median manager performance is not known until the end

of the evaluation period: this is not a good benchmark

• Be unambiguous– The securities that comprise the benchmark and the relative

proportion each occupies should be known

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Elements of A Useful Investment Policy

Return Risk Constraints

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Reasonable and Unreasonable Return Objectives

The investment policy statement should say something specific about a target return• The level of performance the fund seeks to

obtain

• The chosen target should be feasible and consistent with the marketplace

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Reasonable and Unreasonable Return Objectives (cont’d)

Examples of feasible return objectives:• A long-term average rate of return of 10 percent

• Over a five-year period, achieve a rate of return of at least 80 percent of the S&P 500 index

• Generate a cash flow of $25,000 in the following 12 months, with subsequent annual cash flows growing at a 2.5 percent annual rate

• Reach a terminal value of $1 million by a certain future time

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Reasonable and Unreasonable Return Objectives (cont’d)

Examples of infeasible return objectives:• Maintain purchasing power with 100 percent

probability• Earn at least a 10 percent rate of return each

calendar year• Ensure that the value of the fund never falls

below the principal and produce an annual yield of 7 percent

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A Note on Total Return Total return is a function of both income

received and realized or unrealized gains on the portfolio components• In the past, some portfolios allowed only

interest and dividends to be spent• Most states have adopted the Uniform

Management of Institutional Funds Act, which allows an institution to spend income plus a “prudent” portion of capital gains

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Investment Policies and Risk Professional managers cannot get rid of

risk, but they can manage it

Managers may use a relative determination• Less risk than average, more risk than average,

or normal risk– Requires measuring risk using beta or return

variance

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Investment Policies and Risk (cont’d)

Long-term investors can assume above average risk because:• Over the long run, more risk leads to better

returns• Some investors are unable to take a long-term

perspective because of liquidity needs or other constraints

– There may be an extra return increment for those who are able to supply long-term capital

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Views of Risk Relative market risk

• A portfolio beta more or less than 1• Dynamic because it implies a concern with

periodic fluctuations in portfolio value

Dispersion around the average outcome• Measure historical mean returns and standard

deviations for your asset allocation

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Views of Risk (cont’d) Dispersion around a target return

• e.g., a sure percentage versus some fluctuation in return

Likelihood of failing to achieve a certain level of return• e.g., minimize the probability that the return

falls below the average inflation rate

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The Manager’s View of Risk Tversky and Kahneman’s fear of regret

says that managers do not like having to apologize to clients, so they avoid risk• Managers should manage the client’s

investment risk, not the risk to their own egos• One fiduciary duty requires the investment

manager to act in the sole best interest of the client

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Constraints Time Horizon Tax Situation Liquidity Needs Legal Considerations Unique Needs and Special Circumstances

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Time Horizon The length of time the investment will be at

work is critical to proper asset allocation• In the long run, daily fluctuations in security

values do not matter

• The growth of earnings is most important in the long run

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Tax Situation Taxes are the largest component of trading

costs for many investors• Federal, state, and local taxes can exceed 50

percent combined– Investors may avoid taxable bonds and stocks with a

high dividend yield

– Fund managers should carefully consider the sale of a losing stock to accompany the sale of stock that would result in a realized (taxable) capital gain

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Liquidity Needs Some portfolios must produce a steady

stream of income to the owner or to a set of beneficiaries• The manager must ensure the required funds

are available in a timely fashion

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Legal Considerations Some types of investment portfolios face a

legal list of eligible assets• e.g., restricted to investment-grade bonds or a

minimum payout ratio of fund assets to maintain tax-exempt status

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Unique Needs and Special Circumstances

Social investing• e.g., clients may not want to invest in tobacco

stocks or in electric utilities using nuclear power sources

• Empirical evidence on whether or not social investing influences realized investment returns is mixed

• Legally, a fiduciary cannot justify mediocre performance by alleged social benefits

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Risk and Return Considerations: Different Investors

Suitability is important in developing appropriate investment policy statements• Refers to the general “fitness” of a particular

investment vehicle or investment approach to a particular investor

• Investment recommendations should be made with full recognition of the suitability of individual investments for different situations

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Individual Investors’ Range of Requirements

Individual investors have a wider range of requirements than institutional investors• The investment manager must refine:

– The investor’s needs

– The investor’s risk tolerance

– The investor’s comprehension of the realities of the marketplace

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Individual Investors’ Portfolio Integration with Other Assets

A manager who is responsible for the investor’s entire portfolio may face a substantially different set of constraints than a manager who handles only part of the investor’s assets• The presence of other assets may change the

appropriate return and level of risk tolerance

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Institutional Investors Mutual Funds Endowment Funds Pension Funds Life Insurance Companies Property and Casualty Insurance

Companies

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Mutual Funds A mutual fund is an existing portfolio of

assets into which someone can invest directly

All mutual funds have a stated investment objective• The prospectus is the legal document that

describes the fund’s purpose and investment policy

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Mutual Funds (cont’d) Mutual funds seek to earn the best return

consistent with the requirements and constraints of the fund prospectus• For a chosen level of risk, the fund manager

seeks to maximize the total return

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Endowment Funds An endowment fund is a long-term

investment portfolio designed to assist the organization in carrying out its charitable purpose

An endowment fund has three purposes:• Help maintain operating independence• Provide operational stability• Provide a margin of excellence

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Endowment Funds (cont’d) Endowment funds frequently have an

established payout rate based on the average level of fund assets

Endowments usually have at least 50 percent of their assets in equities• The typical national asset mix is 60 percent

equities and 40 percent bonds

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Pension Funds There are two main types of pension funds:

• In defined contribution plans, the employer establishes a set dollar contribution to be made on the employee’s behalf

– The employee makes the asset allocation decision

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Pension Funds (cont’d) There are two main types of pension funds:

• In defined benefit plans, the employer guarantees a specific level of retirement benefits regardless of the performance of the market

– e.g., when the employee reaches age 65, the firm will pay its retirees 75 percent of the average of their three highest earning years annually

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Life Insurance Companies Life insurance companies are regulated by

state insurance commissioners

Life insurance companies seldom have more than 10 percent of their assets in equities

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Life Insurance Companies (cont’d)

Investment policy at a life insurance company is liability driven• The performance of the capital markets is

secondary• The principal investment objective is to earn a

competitive return on the surplus

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Property and Casualty Insurance Company

Property and casualty companies differ significantly from life insurance companies:• Disasters strike without warning and vary in

scope• With many policies, there is never a claim

Liquidity is especially important at a property and casualty company

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Critiquing and Revising the Investment Policy Statement

Characteristics of a Good Statement Revising the Policy

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Characteristics of A Good Statement

1) It is realistic• The return objectives are reasonably

attainable in ordinary market conditions

• The target return and the statements about risk should be logically consistent

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Characteristics of A Good Statement (cont’d)

2) It should be unambiguous to an outsider• Specify what return and yield mean

• Scrutinize words like normal, average, or ordinary

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Characteristics of A Good Statement (cont’d)

3) It should have been sustainable over the past

• A statement should not contain language that everyone fully expects to be ignored periodically

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Procedures for Modifying the Statement

Changes should be made:• When necessary• When legally required• Carefully and sparingly

An annual policy review provides a useful mechanism for discussing possible changes• It may be necessary to accelerate the policy review if there are

material changes in the client’s financial situation• Joint responsibility of the client and the investment manager