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Chapter 5 Investment Policy
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  1. Chapter 5Investment Policy

  2. 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

  3. 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

  4. 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

  5. Introduction (cont’d) • A statement of investment policy may be required in many cases • E.g., ERISA

  6. Introduction (cont’d) • This chapter addresses: • Why an investment policy statement is important • How you go about creating one • What should be in it

  7. Example of A Policy Statement

  8. 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

  9. Outline Expectations and Responsibilities • Introduction • Responsibilities and knowledge needs of informed clients • The investment manager’s responsibilities

  10. Introduction • 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. Identify Objectives and Constraints • Introduction • Individual investors • Charitable portfolios • Institutional portfolios • Other considerations

  18. Introduction • Objective setting should include: • A target return • An appropriate level of risk

  19. Individual Investors • Bailard, Biehl, and Kaiser classification: Confident Individualist Adventurer Impetuous Careful Guardian Celebrity Anxious

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. Other Considerations • Real risk • Emotional reactions • Investment committee’s knowledge • Other capital or income sources • Legal restrictions • Unanticipated consequences of interim fluctuations

  26. 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

  27. Emotional Reactions • BBK framework • E.g., a guardian is unable to ignore a loss in portfolio value

  28. 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

  29. 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

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

  31. 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

  32. 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

  33. 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

  34. Provide A Mechanism for Evaluation • The dual aspect of evaluation • Choosing the benchmark

  35. 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

  36. 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

  37. 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

  38. 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

  39. Elements of A Useful Investment Policy • Return • Risk • Constraints

  40. Return • Reasonable and unreasonable objectives • A note on total return

  41. 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

  42. 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

  43. 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

  44. 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

  45. Risk • Introduction • Views of risk • The manager’s view of risk

  46. 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

  47. 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

  48. 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

  49. 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

  50. 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