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Once objectives and constraints are determined, an investment policy that suits the investor can be formulated. That policy must reflect an appropriate risk-return profile as well as needs for liquidity, income generation, and tax positioning. Institutional investors such as pension plans and endowments often must issue formal statements of their investment policy. These policy statements should be based on, and often make explicit, the objectives and constraints of the investment fund.

The investment policy statement serves as a strategic guide to the planning and implementation of an investment program.2 When implemented successfully, the IPS anticipates issues related to governance of the investment program, planning for appropriate asset allocation, implementing an investment program with internal and/or external managers, monitoring the results, risk management, and appropriate reporting. The IPS also establishes accountability for the various entities that may work on behalf of an investor. Perhaps, most importantly, the IPS serves as a policy guide that can offer an objective course of action to be followed during periods of disruption when emotional or instinctive responses might otherwise motivate less prudent actions.

The nearby box suggests desirable components of an investment policy statement for use with individual and/or high-net-worth investors. Not every component will be appropriate for every investor or every situation, and there may be other components that are desirable for inclusion reflecting unique investor circumstances.

The following is an example of a portion of a policy statement for a defined benefit pension plan.

The Plan should emphasize production of adequate levels of real return as its primary return objective, giving special attention to the inflation-related aspects of the plan. To the extent consistent with appropriate control of portfolio risk, investment action should seek to maintain or increase the surplus of plan assets relative to benefit liabilities over time. Five-year periods, updated annually, shall be employed in planning for investment decision making; the plan's actuary shall update the benefit liabilities breakdown by country every three years.

The orientation of investment planning shall be long term in nature. In addition, minimal liquidity reserves shall be maintained so long as annual company funding contributions and investment income exceed annual benefit payments to retirees and the operating expenses of the plan. The plan's actuary shall update plan cash flow projections annually. Plan administration shall ensure compliance with all laws and regulations related to maintenance of the plan's tax-exempt status and with all requirements of the Employee Retirement Income Security Act (ERISA).

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The most important portfolio decision an investor makes is the proportion of the total investment fund allocated to risky as opposed to safe assets. This choice is the most fundamental means of controlling investment risk.

It follows that the first decision an investor must make is the asset allocation decision. Asset allocation refers to the allocation of the portfolio across major asset categories such as:

Only after the broad asset classes to be held in the portfolio are determined can one sensibly choose the specific securities to purchase.

Investors who have relatively high degrees of risk tolerance will choose asset allocations more concentrated in higher-risk investment classes, such as equity, to obtain higher expected rates of return. More conservative investors will choose asset allocations with a greater weight in bonds and cash equivalents.

Asset allocation also will depend on expectations for capital market performance in the coming period. (Look back at Figure 22.1 and Table 22.1, and you will see that the CFA Institute classifies this part of the planning process as the formation of “capital market expectations.”) Given the risk-return positioning of the investor and the set of expectations, an optimal asset mix may be formed (see step II, Execution, in Table 22.1).

Top-Down Policies for Institutional Investors

Individual investors need not concern themselves with organizational efficiency. But professional investors with large amounts to invest must structure asset allocation activities to decentralize some of the decision making.

A common feature of large organizations is the investment committee and the asset universe. The investment committee includes top management officers, senior portfolio managers, and senior security analysts. The committee determines investment policies and verifies that portfolio managers and security analysts are operating within the bounds of specified policies. A major responsibility of the investment committee is to translate the objectives and constraints of the company into an asset universe, an approved list of assets for each of the company's portfolios.

Thus, the investment committee has responsibility for broad asset allocation. While the investment manager might have some leeway to tilt the portfolio toward or away from one or another asset class, the investment committee establishes the benchmark allocation that largely determines the risk characteristics of the portfolio. The task of choosing specific securities from the approved universe is more fully delegated to the investment manager.

Figure 22.2 illustrates the stages of the portfolio choice process for Palatial Investments, a hypothetical firm that invests internationally. The first two stages are asset allocation choices. The broadest choice is in the weighting of the portfolio between U.S. and Japanese securities. Palatial has chosen a weight of 75% in the United States and 25% in Japan. The allocation of the portfolio across asset classes may now be determined. For example, 15% of the U.S. portfolio is invested in cash equivalents, 40% in fixed income, and 45% in equity. The asset-class weights are, in general, a policy decision of the investment committee, although the investment manager might have some authority to alter the asset allocation to limited degrees based on her expectations concerning the investment performance of various asset classes. Finally, security selection within each country is determined by the portfolio manager from the approved universe. For example, 45% of funds held in the U.S. equity market will be placed in IBM, 35% in GE, and 20% in ExxonMobil. (We show only three securities in the figure because of space limitations. Obviously a $1 billion fund will hold securities of many more firms.)

Asset allocation and security selection for Palatial Investments

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These ever-finer decisions determine the proportion of each individual security in the overall portfolio. As an example, consider the determination of the proportion of Palatial's portfolio invested in ExxonMobil, 6.75%. This fraction results from the following decisions: First, the United States receives a weight of 75% of the overall portfolio, and equities comprise 45% of the U.S. component of the portfolio. These are asset allocation choices. ExxonMobil comprises 20% of the U.S. equity component of the portfolio. This is a security selection choice. Therefore, ExxonMobil's weight in the overall portfolio is .75 × .45 × .20 = .0675, or 6.75%. If the entire portfolio is $1 billion, $67,500,000 will be invested in ExxonMobil. If ExxonMobil is selling for $90 a share, 750,000 shares must be purchased. The bottom line in Figure 22.2 shows the percentage of the overall portfolio held in each asset.

This example illustrates a top-down approach that is consistent with the needs of large organizations. The top managers set the overall policy of the portfolio by specifying asset allocation guidelines. Lower-level portfolio managers fill in the details with their security selection decisions.

Active versus Passive Policies

One choice that must be confronted by all investors, individual as well as institutional, is the degree to which the portfolio will be actively versus passively managed. Recall that passive management is based on the belief that security prices usually are close to “fair” levels. Instead of spending time and other resources attempting to “beat the market,” that is, to find mispriced securities with unusually attractive risk-return characteristics, the investor simply assumes that she will be fairly compensated for the risk she is willing to take on and selects a portfolio consistent with her risk tolerance.3

Passive management styles can be applied to both the security selection and the asset allocation decisions. With regard to asset allocation, passive management simply means that the manager does not depart from his or her “normal” asset-class weightings in response to changing expectations about the performance of different markets. Those “normal” weights are based on the investor's risk and return objectives, as discussed earlier. For example, an asset allocation for a 45-year-old investor of 65% equity, 20% bonds, and 15% cash equivalents would be considered fairly conventional. A purely passive manager would not depart from these weights in response to forecasts of market performances. The weighting scheme would be adjusted only in response to changes in risk tolerance as age and wealth change over time.

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Next consider passive security selection. Imagine that you must choose a portfolio of stocks without access to any special information about security values. This would be the case if you believed that anything you know about a stock is already known by the rest of the investors in the market and therefore is already reflected in the stock price. If you cannot predict which stocks will be winners, you should broadly diversify your portfolio to avoid putting all your eggs in one basket. A natural course of action for such an investor would be to choose a portfolio with “a little bit of everything.”

This reasoning leads one to look for a portfolio that is invested across the entire security market. We saw in Chapter 4 that some mutual fund operators have established index funds that follow just such a strategy. These funds hold each stock or bond in proportion to its representation in a particular index, such as the Standard & Poor's 500 stock price index or the Barclays Capital Aggregate Bond Index. Holding an indexed portfolio represents purely passive security selection in that the investor's return simply duplicates the return of the overall market without making a bet on one or another stock or sector of the market.

In contrast to passive strategies, active management assumes an ability to outguess other investors and to identify either securities or asset classes that will shine in the near future. Active security selection for institutional investors typically requires two layers: security analysis and portfolio choice. Security analysts specialize in particular industries and companies and prepare assessments of their particular market niches. The portfolio managers then sift through the reports of many analysts. They use forecasts of market conditions to make asset allocation decisions and use the security analysts' recommendations to choose the particular securities to include within each asset class.

The choice between active and passive strategies need not be all-or-nothing. One can pursue both active security selection and passive asset allocation, for example. In this case, the manager would maintain fixed asset allocation targets but would actively choose the securities within each asset class. Or one could pursue active asset allocation and passive security selection. In this case, the manager might actively shift the allocation between equity and bond components of the portfolio but hold indexed portfolios within each sector. Another mixed approach is called a passive core strategy. In this case, the manager indexes part of the portfolio, the passive core, and actively manages the rest of the portfolio.

Is active or passive management the better approach? It might seem at first blush that active managers have the edge because active management is necessary to achieve outstanding performance. But remember that active managers start out with some disadvantages as well. They incur significant costs when preparing their analyses of markets and securities and incur heavier trading costs from the more rapid turnover of their portfolios. If they don't uncover information or insights currently unavailable to other investors (not a trivial task in a nearly efficient market), then all of this costly activity will be wasted, and they will underperform a passive strategy. In fact, low-cost passive strategies have performed surprisingly well in the last few decades, as we saw in Chapters 4 and 8.

Classify the following statements according to where each fits in the objective-constraints-policies framework.

The result of this analysis can be summarized in an investment policy statement (IPS) addressing the topics specified in Table 22.2. In the next sections we elaborate on the steps leading to an IPS. We start with the planning phase, the top panel of Table 22.1.

Table 22.1 indicates that the management planning process starts off by analyzing one's investment clients—in particular, by considering the objectives and constraints that govern their decisions. Portfolio objectives center on the risk-return trade-off between the expected return the investors need (return requirements in the first column of Table 22.3) and how much risk they are willing to assume (risk tolerance). Investment managers must know the level of risk that can be tolerated in the pursuit of higher expected return. Investors also must deal with various constraints on their portfolio choice that derive from considerations such as liquidity needs, regulations, or tax concerns. The second column of Table 22.3 lists the more important constraints.

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On the MARKET FRONT

HOW TO BECOME A CHARTERED FINANCIAL ANALYST

The CFA Institute is a nonprofit international organization with a mission of serving investors by educating investment professionals and setting high standards for ethical practice. The Institute also has established a Code of Ethics and Standards of Professional Conduct that lays out guidelines of practice for investment professionals.

The CFA Institute was established in January 1990 through the combination of the previously existing Financial Analysts Federation and the Institute of Chartered Financial Analysts. The CFA Institute administers the program through which an investment professional can be designated as a Chartered Financial Analyst (CFA).

INVESTOR CONSTRAINTS

Even with identical attitudes toward risk, different households and institutions might choose different investment portfolios because of their differing circumstances. These circumstances include tax status, requirements for liquidity or a flow of income from the portfolio, or various regulatory restrictions. These circumstances impose constraints on investor choice. Together, objectives and constraints determine investment policy.

As noted, constraints usually have to do with investor circumstances. For example, if a family has children about to enter college, there will be a high demand for liquidity because cash will be needed to pay tuition bills. Other times, however, constraints are imposed externally. For example, banks and trusts are subject to legal limitations on the types of assets they may hold in their portfolios. Finally, some constraints are self-imposed. For example, social investing means that investors will not hold shares of firms involved in ethically objectionable activities. Some criteria that have been used to judge firms as ineligible for a portfolio are involvement in countries with human rights abuses, production of tobacco or alcohol, and participation in polluting activities.

Five common types of constraints are described below.

Liquidity

Liquidity is the speed and ease with which an asset can be sold and still fetch a fair price, or the price discount necessary to achieve an immediate sale. It is a relationship between the time dimension (how long it will take to sell) and the price dimension (the discount from fair market price) of an investment asset.

When an actual concrete measure of liquidity is necessary, one thinks of the discount when an immediate sale is unavoidable.1 Cash and money market instruments such as Treasury bills and commercial paper, where the bid–ask spread is a small fraction of 1%, are the most liquid assets, and real estate is among the least liquid. Office buildings and manufacturing structures in extreme cases can suffer a 50% liquidity discount.

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Both individual and institutional investors must consider how likely they are to require cash at short notice. From this likelihood, they establish the minimum level of liquid assets they need in the investment portfolio.

Investment Horizon

This is the planned liquidation date of the investment. Examples of an individual's investment horizon could be the time to fund a college education or the retirement date for a wage earner. For a university or hospital endowment, an investment horizon could relate to the time to fund a major construction project. Horizon dates must be considered when investors choose between assets of various maturities. For example, the maturity date of a bond might make it a more attractive investment if it coincides with a date on which cash is needed. This idea is analogous to the matching principle from corporate finance: Strive to match financing maturity to the economic life of the financed asset.

Regulations

Only professional and institutional investors are constrained by regulations. First and foremost is the prudent investor rule. That is, professional investors who manage other people's money have a fiduciary responsibility to restrict investment to assets that would have been approved by a prudent investor. The law is purposefully nonspecific. Every professional investor must stand ready to defend an investment policy in a court of law, and interpretation may differ according to the standards of the times.

Also, specific regulations apply to various institutional investors. For instance, U.S. mutual funds may not hold more than 5% of the shares of any publicly traded corporation.

Sometimes, “self-imposed” regulations also affect the investment choice. We have noted several times, for example, that mutual funds describe their investment policies in a prospectus. These policy guidelines amount to constraints on the ability to choose portfolios freely.

Tax Considerations

Tax consequences are central to investment decisions. The performance of any investment strategy should be measured by its rate of return after taxes. For household and institutional investors who face significant tax rates, tax sheltering and deferral of tax obligations may be pivotal in their investment strategy.

Unique Needs

Virtually every investor faces special circumstances. Imagine husband-and-wife aeronautical engineers holding high-paying jobs in the same aerospace corporation. The entire human capital of that household is tied to a single player in a rather cyclical industry. This couple would need to hedge the risk of a deterioration in the economic well-being of the aerospace industry.

Similar issues would confront an executive on Wall Street who owns an apartment near work. Because the value of the home in that part of Manhattan probably depends on the vitality of the securities industry, the individual is doubly exposed to the vagaries of the stock market. Because both job and home already depend on the fortunes of Wall Street, the purchase of a typical diversified stock portfolio would actually increase the exposure to the stock market.

These examples illustrate that the job, or more generally, human capital, is often an individual's biggest “asset,” and the unique risk profile that results from employment can play a big role in determining a suitable investment portfolio.

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Other unique needs of individuals often center around their stage in the life cycle, as previously discussed. Retirement, housing, and children's education constitute three major demands for funds, and investment policy will depend in part on the proximity of these expenditures.

Institutional investors also face unique needs. For example, pension funds will differ in their investment policy, depending on the average age of plan participants. Another example of a unique need for an institutional investor would be a university whose trustees allow the administration to use only cash income from the endowment fund. This constraint would translate into a preference for high-dividend-paying assets.

Table 22.5 presents a matrix of constraints for various investors. As you would expect, liquidity and tax constraints for individuals are variable because of wealth and age differentials.

A particular constraint for mutual funds arises from investor response to the fund's performance. When a mutual fund earns an unsatisfactory rate of return, investors often redeem their shares—they withdraw money from the fund. The mutual fund then contracts. The reverse happens when a mutual fund earns an unusually high return: It can become popular with investors overnight, and its asset base will grow dramatically.

Pension funds are heavily regulated by the Employee Retirement Income Security Act of 1974 (ERISA). This law revolutionized savings for retirement in the United States and remains a major piece of social legislation. Thus, for pension funds, regulatory constraints are relatively important. Also, mature pension funds are required to pay out more than young funds and hence need more liquidity.

Endowment funds, on the other hand, usually do not need to liquidate assets, or even use dividend income, to finance payouts. Contributions are expected to exceed payouts and increase the real value of the endowment fund, so liquidity is not an overriding concern.

Life insurance companies are subject to complex regulation. The corporate tax rate, which today is 35% for large firms, also applies to insurance company investment income, so taxes are an important concern.

Property and casualty insurance, like term life insurance, is written on a short-term basis. Most policies must be renewed annually, which means property and casualty insurance companies are subject to short-term horizon constraints.

The short horizon constraint for banks comes from the interest rate risk component of the interest rate spread (i.e., the risk of interest rate increases that banks face when financing long-term assets with short-term liabilities).

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DESIRABLE COMPONENTS OF AN INVESTMENT POLICY STATEMENT FOR INDIVIDUAL INVESTORS

SCOPE AND PURPOSE

· Define the context.

· Define the investor.

· Define the structure.

GOVERNANCE

· Specify responsibility for determining investment policy.

· Describe process for review of IPS.

· Describe responsibility for engaging/discharging external advisers.

· Assign responsibility for determination of asset allocation.

· Assign responsibility for risk management.

INVESTMENT, RETURN, AND RISK OBJECTIVES

· Describe overall investment objective.

· State return, distribution, and risk requirements.

· Describe relevant constraints.

· Describe other relevant considerations.

RISK MANAGEMENT

· Establish performance measurement accountabilities.

· Specify appropriate metrics for risk measurement.

· Define a process by which portfolios are rebalanced.