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
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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 (contd)
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 funds 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 (contd)
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 Managers
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 Managers
Responsibilities (contd)
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 Managers
Responsibilities (contd)
Ensure there is a mechanism for learning
when a clients needs change
e.g., marriage, children, health expenditures

A material change in an investors 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:
Confident

Individualist Adventurer

Careful Impetuous
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 (contd)
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 (contd)
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 (contd)
Creativetension 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
Insurancecompanies 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 Committees Knowledge
Other Capital or Income Resources
Legal Restrictions
Unanticipated Consequences of Interim
Fluctuations
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 Real Risk
Theconsequences 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 Committees
Knowledge
The investment committee:
Should differentiate between fact and opinion

Should be honest in assessing the committees

ability and seek professional assistance when
appropriate

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 Other Capital or
Income Resources
How important is the particular portfolio to
the clients 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
Somestates 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
TheDual 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
(contd)
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 (contd)
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 (contd)
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 (contd)
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
Totalreturn 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 (contd)
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 (contd)
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 Managers View of Risk
Tversky and Kahnemans fear of regret
says that managers do not like having to
apologize to clients, so they avoid risk
Managers should manage the clients
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
Individualinvestors have a wider range of
requirements than institutional investors
The investment manager must refine:
The investors needs

The investors risk tolerance

The investors 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
investors entire portfolio may face a
substantially different set of constraints than
a manager who handles only part of the
investors 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 funds purpose and investment
policy
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 Mutual Funds (contd)
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 (contd)
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 employees behalf
The employee makes the asset allocation decision

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 Pension Funds (contd)
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 (contd)
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
Characteristicsof 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 (contd)
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 (contd)
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 clients financial situation
Joint responsibility of the client and the investment manager

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