Chapter 5

Investment Policy

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

Introduction (contd)
A

statement of investment policy may be required in many cases

E.g., ERISA

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

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

Introduction
Responsibilities

and knowledge needs of

informed clients The investment managers responsibilities

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

1) 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

2) 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)

4) 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)

5) 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

Careful Guardian
Anxious Celebrity

Impetuous

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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.

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:

1) 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:

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% 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 benchmark can be absolute
benchmark can be relative
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A
A

E.g., a 10% rate of return E.g., top quarter

Choosing the Benchmark (contd)

A

good benchmark should:

It should be a viable investment alternative

Be investable

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 S&P 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 may use a relative determination

Managers

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
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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Endowments

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 insurance companies seldom have more than 10 percent of their assets in equities

Life

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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
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company

Critiquing and Revising the Investment Policy Statement

Characteristics

of a good statement Revising the policy

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Characteristics of A Good Statement

1) 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)

2) 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)

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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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

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