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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

  • 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
  • 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
introduction cont d
Introduction (cont’d)
  • A statement of investment policy may be required in many cases
    • E.g., ERISA
introduction cont d6
Introduction (cont’d)
  • This chapter addresses:
    • Why an investment policy statement is important
    • How you go about creating one
    • What should be in it
the purpose of investment policy
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
outline expectations and responsibilities
Outline Expectations and Responsibilities
  • Introduction
  • Responsibilities and knowledge needs of informed clients
  • The investment manager’s responsibilities
  • 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
responsibilities and knowledge needs of informed clients
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
responsibilities and knowledge needs of informed clients12
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
responsibilities and knowledge needs of informed clients13
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
the investment manager s responsibilities
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
the investment manager s responsibilities cont d
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
the investment manager s responsibilities cont d16
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, risk tolerance, or return requirements
identify objectives and constraints
Identify Objectives and Constraints
  • Introduction
  • Individual investors
  • Charitable portfolios
  • Institutional portfolios
  • Other considerations
  • Objective setting should include:
    • A target return
    • An appropriate level of risk
individual investors
Individual Investors
  • Bailard, Biehl, and Kaiser classification:









individual investors cont d
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
individual investors cont d21
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
charitable portfolios
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
charitable portfolios cont d
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
institutional portfolios
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
other considerations
Other Considerations
  • Real risk
  • Emotional reactions
  • Investment committee’s knowledge
  • Other capital or income sources
  • Legal restrictions
  • Unanticipated consequences of interim fluctuations
real risk
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
emotional reactions
Emotional Reactions
  • BBK framework
    • E.g., a guardian is unable to ignore a loss in portfolio value
investment committee s knowledge
Investment Committee’s Knowledge
  • The investment committee:
    • Should differentiate between fact and opinion
    • Should be honest in assessing the committee ability and seek professional assistance when appropriate
other capital or income sources
Other Capital or Income Sources
  • 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
legal restrictions
Legal Restrictions
  • Some states have a legal list outlining permissible investment
    • E.g., insurance companies may not buy junk bonds
unanticipated consequences of interim fluctuations
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
outline eligible asset classes and their permissible uses
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
outline eligible asset classes and their permissible uses33
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
provide a mechanism for evaluation
Provide A Mechanism for Evaluation
  • The dual aspect of evaluation
  • Choosing the benchmark
the dual aspect of evaluation
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
the dual aspect of evaluation cont d
The Dual Aspect of Evaluation (cont’d)
  • 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
choosing the benchmark
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
choosing the benchmark cont d
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
    • Be unambiguous
      • The securities that comprise the benchmark and the relative proportion each occupies should be known
  • Reasonable and unreasonable objectives
  • A note on total return
reasonable and unreasonable objectives
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
reasonable and unreasonable objectives cont d
Reasonable and Unreasonable 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
    • Reach a terminal value of $1 million by a certain future time
reasonable and unreasonable objectives cont d43
Reasonable and Unreasonable 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
a note on total return
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
  • Introduction
  • Views of risk
  • The manager’s view of 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
introduction cont d47
Introduction (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
views of risk
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
views of risk cont d
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
the manager s view of risk
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 of their own egos
    • One fiduciary duty requires the investment manager to act in the sole best interest of the client
  • Time horizon
  • Tax situation
  • Liquidity needs
  • Legal considerations
  • Unique needs and special circumstances
time horizon
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
tax situation
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
liquidity needs
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
legal considerations
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
unique needs and special circumstances
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
risk return considerations different investors
Risk & Return Considerations: Different Investors
  • Introduction
  • Individual investors
  • Institutional 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 recognition of the suitability of individual investments for different situations
individual investors59
Individual Investors
  • Range of requirements
  • Portfolio integration with other assets
  • Risk education
range of requirements
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
portfolio integration with other assets
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
risk education
Risk Education
  • Some aspects of risk are not immediately logical
    • Complicates decision making by the client
institutional investors
Institutional Investors
  • Mutual funds
  • Endowment funds
  • Pension funds
  • Life insurance companies
  • Property and casualty insurance companies
mutual funds
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
mutual funds cont d
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
endowment funds
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
endowment funds cont d
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
pension funds
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
pension funds cont d
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 their three highest earning years annually
life insurance companies
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
life insurance companies cont d
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
property and casualty insurance companies
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
critiquing and revising the investment policy statement
Critiquing and Revising the Investment Policy Statement
  • Characteristics of a good statement
  • Revising the policy
characteristics of a good statement
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
characteristics of a good statement cont d
Characteristics of A Good Statement (cont’d)
  • It is unambiguous to an outsider
    • Specify what return and yield mean
    • Scrutinize words like normal, average, or ordinary
characteristics of a good statement cont d76
Characteristics of A Good Statement (cont’d)
  • It should have been sustainable over the past
    • A statement should not contain language that everyone fully expects to be ignored periodically
revising the policy
Revising the Policy
  • Procedures for modifying the statement
  • Changes in the client’s financial condition
procedures for modifying the statement
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
changes in the client s financial condition
Changes in the Client’s Financial Condition
  • It may be necessary to accelerate the policy review if there are material changes in the client’s financial situation
    • The joint responsibility of the client and the investment manager