Chapter 4
Investment Policy
Portfolio Construction, Management, & Protection, 5e, Robert A. Strong
Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
1
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
2
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
3
Introduction (cont’d)
 This
chapter addresses:
• Why an investment policy statement is
important
• How you go about creating one
• What should be in it
4
Example of A
Policy Statement
5
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
6
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
7
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
8
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
9
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
10
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
11
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
12
Identify Objectives and
Constraints
 Objective
setting should include:
• A target return
• An appropriate level of risk
13
Individual Investors
 Bailard,
Biehl, and Kaiser classification:
Confident
Individualist
Adventurer
Impetuous
Careful
Guardian
Celebrity
Anxious
Source: Thomas E. Bailard, David L. Biehl, and Ronald W. Kaiser, Personal Money Management, 5th ed. (Chicago: Science Research
Associates, Inc., 1986).
14
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
15
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
16
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
17
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
18
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
19
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
20
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
21
Emotional Reactions
 BBK
taxonomy
• e.g., a guardian is unable to ignore a loss in
portfolio value
22
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
23
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
24
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
25
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
26
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
27
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
28
Provide A Mechanism for
Evaluation
 The
Dual Aspects of Evaluation
 Choosing the Benchmark
29
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
30
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
31
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
32
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
33
Elements of A Useful
Investment Policy
 Return
 Risk
 Constraints
34
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
35
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
36
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
37
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
38
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
39
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
40
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
41
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
42
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
43
Constraints
 Time
Horizon
 Tax Situation
 Liquidity Needs
 Legal Considerations
 Unique Needs and Special Circumstances
44
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
45
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
46
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
47
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
48
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
49
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
50
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
51
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
52
Institutional Investors
 Mutual
Funds
 Endowment Funds
 Pension Funds
 Life Insurance Companies
 Property and Casualty Insurance Companies
53
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
54
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
55
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
56
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
57
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
58
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
59
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
60
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
61
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
62
Critiquing and Revising the
Investment Policy Statement
 Characteristics
of a Good Statement
 Revising the Policy
63
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
64
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
65
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
66
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
67