Chapter 5 Investment Policy

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Chapter 5Investment Policy
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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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Outline

• Introduction
• The purpose of investment policy
• Elements of a useful investment policy
• Risk and return considerations different
  investors
• Critiquing and revising the investment policy
  statement

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Introduction

• Investment policy is a statement about the
  objectives, risk tolerance, and constraints the
  portfolio faces
• Investment management is the practice of
  attempting to achieve the objectives while
  staying within the established constraints

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Introduction (contd)

• A statement of investment policy may be required
  in many cases
• E.g., ERISA

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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 uses
• Provide a mechanism for evaluation

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Outline Expectations and Responsibilities

• Introduction
• Responsibilities and knowledge needs of informed
  clients
• The investment managers responsibilities

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Introduction

• 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 statement promotes the
  accomplishment of the objectives

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Responsibilities and Knowledge Needs of Informed
Clients

• 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

• 3) The client must ensure the managers are
  following the investment policy
• Clients need an interest in understanding their
  own interest
• 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, risk
  tolerance, or return requirements

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Identify Objectives and Constraints

• Introduction
• Individual investors
• Charitable portfolios
• Institutional portfolios
• Other considerations

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Introduction

• 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
Impetuous
Careful
Guardian
Celebrity
Anxious
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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)

• 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

• Real risk
• Emotional reactions
• Investment committees knowledge
• Other capital or income sources
• 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 framework
• 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 committee
  ability and seek professional assistance when
  appropriate

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Other Capital or Income Sources

• 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

• Some states have a legal list outlining
  permissible investment
• E.g., insurance companies may not buy junk bonds

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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 aspect of evaluation
• Choosing the benchmark

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The Dual Aspect of Evaluation

• An effective performance evaluation should
• Confirm that the manager managed in a way he was
  hired to manage
• E.g., an equity manager should not be 75 in cash

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The Dual Aspect of Evaluation (contd)

• An effective performance evaluation should
• 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 when the
  market is down 15 performed well

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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
• 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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Return

• Reasonable and unreasonable objectives
• A note on total return

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Reasonable and Unreasonable Objectives

• The investment policy statement should specify 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 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 SP 500 index
• Reach a terminal value of 1 million by a certain
  future time

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Reasonable and Unreasonable 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

• Total return is a function of both income
  received and realized or unrealized gains on the
  portfolio components
• In the past, come portfolios allowed only
  interest and dividends could be spent
• Most states have adopted the Uniform Management
  of Institutional Funds Act, which allows an
  institution to spend income plus a prudent
  portfolio of capital gains

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Risk

• Introduction
• Views of risk
• The managers view of risk

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Introduction

• 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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Introduction (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 of 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 long-term growth of earnings is 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 stock, resulting 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

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Risk Return Considerations Different Investors

• Introduction
• Individual investors
• Institutional investors

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Introduction

• 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
  recognition of the suitability of individual
  investments for different situations

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Individual Investors

• Range of requirements
• Portfolio integration with other assets
• Risk education

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Range of Requirements

• Individual investors 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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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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Risk Education

• Some aspects of risk are not immediately logical
• Complicates decision making by the client

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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 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 Companies

• PC 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 PC 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

• It is realistic
• The return objectives are reasonable 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)

• It is 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)

• 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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Revising the Policy

• Procedures for modifying the statement
• Changes in the clients financial condition

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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

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Changes in the Clients Financial Condition

• It may be necessary to accelerate the policy
  review if there are material changes in the
  clients financial situation
• The joint responsibility of the client and the
  investment manager