1 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.

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 Introduction u 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) u Investment management is the practice of attempting to achieve the objectives while staying within the established constraints

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

5 Example of A Policy Statement

6 The Purpose of Investment Policy u Outline Expectations and Responsibilities u Identify Objectives and Constraints u Outline Eligible Asset Classes and Their Permissible Use u Provide a Mechanism for Evaluation

7 Outline Expectations and Constraints u Investment policy is the responsibility of the client e.g., a individual, an endowment fund’s board u Investment management is the responsibility of the money manager e.g., a bank trust department, a brokerage firm

8 Responsibilities and Knowledge Needs of Informed Clients uThe 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 uThe client must define long-range objectives appropriate to the fund A short-term focus may lead to suboptimal investment performance

9 Responsibilities and Knowledge Needs of Informed Clients (cont’d) uThe 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

10 The Investment Manager’s Responsibilities uEducate the client about infeasible objectives uDevelop an appropriate asset allocation and investment strategy uCommunicate the essential characteristics of the portfolio to the client

11 The Investment Manager’s Responsibilities (cont’d) uMonitor 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

12 The Investment Manager’s Responsibilities (cont’d) uEnsure 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

13 Identify Objectives and Constraints u Objective setting should include: A target return An appropriate level of risk

14 Individual Investors u Bailard, Biehl, and Kaiser classification: Careful Impetuous Confident Anxious IndividualistAdventurer Guardian Celebrity Source: Thomas E. Bailard, David L. Biehl, and Ronald W. Kaiser, Personal Money Management, 5 th ed. (Chicago: Science Research Associates, Inc., 1986).

15 Individual Investors (cont’d) u Guardians take forever to make a decision and then worry constantly about it Stability of principal or income are appropriate objectives u Celebrities make decisions quickly Like investment fads and worry about being left out

16 Individual Investors (cont’d) u Adventurers make decisions quickly and feel good about them Often have substantial stock market experience Seek capital appreciation u Individualists are both careful and confident Will listen to advice, read research reports, and investigate investment alternatives u Straight arrows move between the two dimensions

17 Charitable Portfolios u 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. u 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

18 Charitable Portfolios (cont’d) u 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

19 Institutional Portfolios u Insurance companies and pension funds have special needs: e.g., defined benefit retirement plans must ensure they will be able to meet payments

20 Other Considerations in Setting Effective Objectives u Real Risk u Emotional Reactions u Investment Committee’s Knowledge u Other Capital or Income Resources u Legal Restrictions u Unanticipated Consequences of Interim Fluctuations

21 Real Risk u The consequences of a loss vary widely, depending on the circumstances e.g., a professional in his peak earning years versus a retired widow

22 Emotional Reactions u BBK taxonomy e.g., a guardian is unable to ignore a loss in portfolio value

23 Investment Committee’s Knowledge u The investment committee: Should differentiate between fact and opinion Should be honest in assessing the committee’s ability and seek professional assistance when appropriate

24 Other Capital or Income Resources u 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

25 Legal Restrictions u Some states have a legal list outlining permissible investment e.g., insurance companies may not buy corporate bonds without an investment-grade rating

26 Unanticipated Consequences of Interim Fluctuations u 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

27 Outline Eligible Asset Classes and Their Permissible Uses u 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

28 Outline Eligible Asset Classes and Their Permissible Uses u An asset class is a logical subgroup of the set of investment alternatives e.g., equities, bonds, and cash u Asset allocation is the relative proportion of money distributed across the various asset classes

29 Provide A Mechanism for Evaluation u The Dual Aspects of Evaluation u Choosing the Benchmark

30 The Dual Aspects of Evaluation u 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

31 The Dual Aspects of Evaluation (cont’d) u 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

32 Choosing the Benchmark u Determining the benchmark is an integral part of setting investment policy u A benchmark can be absolute e.g., a 10% rate of return u A benchmark can be relative e.g., top quarter

33 Choosing the Benchmark (cont’d) u 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

34 Elements of A Useful Investment Policy u Return u Risk u Constraints

35 Reasonable and Unreasonable Return Objectives u 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

36 Reasonable and Unreasonable Return Objectives (cont’d) u 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

37 Reasonable and Unreasonable Return Objectives (cont’d) u 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

38 A Note on Total Return u 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

39 Investment Policies and Risk u Professional managers cannot get rid of risk, but they can manage it u 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

40 Investment Policies and Risk (cont’d) u 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

41 Views of Risk u Relative market risk A portfolio beta more or less than 1 Dynamic because it implies a concern with periodic fluctuations in portfolio value u Dispersion around the average outcome Measure historical mean returns and standard deviations for your asset allocation

42 Views of Risk (cont’d) u Dispersion around a target return e.g., a sure percentage versus some fluctuation in return u Likelihood of failing to achieve a certain level of return e.g., minimize the probability that the return falls below the average inflation rate

43 The Manager’s View of Risk u 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

44 Constraints u Time Horizon u Tax Situation u Liquidity Needs u Legal Considerations u Unique Needs and Special Circumstances

45 Time Horizon u 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

46 Tax Situation u 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

47 Liquidity Needs u 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

48 Legal Considerations u 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

49 Unique Needs and Special Circumstances u 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

50 Risk and Return Considerations: Different Investors u 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

51 Individual Investors’ Range of Requirements u 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

52 Individual Investors’ Portfolio Integration with Other Assets u 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

53 Institutional Investors u Mutual Funds u Endowment Funds u Pension Funds u Life Insurance Companies u Property and Casualty Insurance Companies

54 Mutual Funds u A mutual fund is an existing portfolio of assets into which someone can invest directly u All mutual funds have a stated investment objective The prospectus is the legal document that describes the fund’s purpose and investment policy

55 Mutual Funds (cont’d) u 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

56 Endowment Funds u An endowment fund is a long-term investment portfolio designed to assist the organization in carrying out its charitable purpose u An endowment fund has three purposes: Help maintain operating independence Provide operational stability Provide a margin of excellence

57 Endowment Funds (cont’d) u Endowment funds frequently have an established payout rate based on the average level of fund assets u 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

58 Pension Funds u 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

59 Pension Funds (cont’d) u 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

60 Life Insurance Companies u Life insurance companies are regulated by state insurance commissioners u Life insurance companies seldom have more than 10 percent of their assets in equities

61 Life Insurance Companies (cont’d) u 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

62 Property and Casualty Insurance Company u 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 u Liquidity is especially important at a property and casualty company

63 Critiquing and Revising the Investment Policy Statement u Characteristics of a Good Statement u Revising the Policy

64 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

65 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

66 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

67 Procedures for Modifying the Statement u Changes should be made: When necessary When legally required Carefully and sparingly u 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