Formulate an Appropriate Investment Policy

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 38

PORTFOLIO MANAGEMENT

Formulate an Appropriate Investment Policy:

The determination of portfolio policies--referred to as the investment policy statements is

the first step in the investment process. It summarizes the objectives, constraints, and

preferences for the investor. A recommended approach in formulating ah investment policy

statement is simply to provide information, in the following order, for any investor

individual or institutional:

Objectives:

Return requirements

Risk tolerance

Followed by:

Constraints and Preferences:

o Liquidity

o Time horizon

o Laws and regulations

o Taxes

o Unique preferences and circumstances

Objectives:

Portfolio objectives are always going to center on return and risk, because these are the two

aspects of most interest to investors. Indeed, return and risk are the basis of all financial

decisions in general and investing decisions in particular. Investors seek returns, but must

assume risk in order to have an opportunity to earn the returns.

Furthermore, an individual can be a composite of these stages at the same time. The four

stages are:

1. Accumulation Phase: In the early stage of the life cycle, net worth is typically small,

but the time horizon is long. Investors can afford to assume large risks.

2. Consolidation Phase: In this phase, involving the mid-to-late career stage of the life

cycle when income exceeds expenses, an investment portfolio can be .accumulated.

A portfolio balance is sought to provide a moderate trade-off between risk and

return.

3. Spending Phase: In this phase, living expenses are covered from accumulated assets

rather than earned income. Although some risk taking is still preferable, the

emphasis is on safety, resulting in a relatively low position on the risk-return trade-

off.

4. Gifting Phase: In this phase, the attitudes about the purpose of investments changes.

The basic position on the trade-off remains about the same as in phase 3.

Establishing a Portfolio Risk Level:

Investors should establish a portfolio risk level that is suitable for them, and then seek the

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highest returns consistent with that level of risk. We will assume here that investors have a

long-run horizon. If not, they probably should avoid stocks, or at least minimize any equity

position.

Assuming you are a long-term investor, and that you own an S&P 500-type portfolio, ask

yourself what is the worst that is likely to happen to you as an investor in stocks. Ignoring

the Great Depression, which hopefully will not occur again, consider the worst events that

have, occurred. During the bear market of 1973 to 1974, investors could have lost about 37

percent of their investment in S&P 500 stocks. During the bear market of 2000 to 2002,

investors could have lost over 40 percent. Therefore, it is reasonable to assume that with a

long-time horizon, investors will face one or more bear markets with approximately 40

percent declines. This is in line with the long-term standard deviation of S&P 500 returns of

about 20 percent with two standard deviations on either side of the mean return

encompassing 95 percent of all returns.

If an investor can accept a loss (at least on paper) of approximately 40 percent once or twice

in an investing life time, and in otherwise optimistic about the economy and about stocks,

the investor can assume the risk of U.S. stocks. On the other hand, if such a potential

decline is unacceptable, an investor will have to construct a portfolio with a lower risk

profile. For example, a portfolio of 30 percent stocks and 50 percent Treasury bills would

cut the risk in half. Other alternatives consisting of stocks and bonds would also decrease

the risk.

Inflation Considerations:

An investment policy statement often will contain some statement about inflation-adjusted

returns because of the impact of inflation on investor results over long periods of time. For

example, a wealthy individual's policy statement may be stated in terms of maximum. After

tax, inflation-adjusted total return consistent with the investor's rise profile, whereas another

investor's primary return objective may be stated as inflation-adjusted capital preservation,

perhaps with a growth-oriented mix to reflect the need for capital growth over time.

Inflation is clearly a problem for investors. The inflation rate of 13 percent in 1979 to-1980

speaks for itself in terms of the awful impact it had on investors' real wealth. But even with

a much lower inflation--say, 3 percent--the damage is substantial. It can persist steadily,

eroding values. At a 3 percent inflation rate, for example, the purchasing power of a dollar

is cut in half in 10s than 25 years. Therefore, someone retiring at age 60 who lives to

approximately age 85 and does not protect him or herself from inflation will suffer a drastic

decline in purchasing power over the years.

The very low inflation rates of the late 1990s and early 2000s probably lulled many

investors into thinking that inflation is no longer a serious problem, and that they did not

need to consider this issue as being very important. However, for the last 80 or so years, the

compound annual rate of inflation has been approximately 3 percent. It is reasonable to

assume that in the future inflation will| be higher than it has been recently, and therefore this

is an issue that investors need to consider.

Constraints and Preferences:

To complete the investment policy statement, these items are described for a particular

investor as the circumstances warrant. Since investors vary widely in their constraints and

preferences, these details may also vary widely. Time Horizon Investors need to think about

the time period involved in their investment plans. The objectives being pursued may

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require a policy statement that speaks to specific planning horizons. In the case of an

individual investor, for example; this could well be the investor's expected lifetime. In the

case of an institutional investor, the time horizon can be quite long. For example, for a

company with a defined benefit retirement plans whose employees are young; and which

has no short-term liquidity needs, the time horizon can be quite long.

Liquidity Needs:

Liquidity is the ease with, which an asset can be sold without a sharp change in price as the

result of selling. Obviously, cash equivalents (money market securities) have high liquidity,

and are easily sold at close to face value. Many stocks also have great liquidity, but the price

at which they are sold will reflect their current market valuations.

Investors' must decide how likely they are to sell some part of their portfolio in the

short run. As part of the asset allocation decision, they must decide how much of their

funds to keep in cash equivalents.

Tax Considerations:

Individual investors, unlike some institutional investors, must consider the impact of taxes

on their investment programs. The treatment of ordinary income as opposed to capital gains

is an important issue, because typically there is a differential tax rate. Furthermore, the tax

laws in United States have been changed several times, making it difficult for investors to

forecast the tax rate that will apply in the future.

In addition to the differential tax rates and their changes over time, the capital gains

component of security returns benefits from the fact that the tax is not payable until the gain

is realized. This tax deferral is, in effect a tax-free loan that remains invested for the benefit

of the taxpayer. As -explained below, some securities become "locked up" by the reluctance

of investors to pay the capital gains that will result from selling the securities.

Retirement programs offer tax sheltering whereby any income and/or capital gains taxes are

avoided until such time as the funds are withdrawn. Investors with various retirement and

taxable accounts must grapple with the issue of which type of account should hold stocks as

opposed to bonds (given that bonds generate higher current Income).

Legal and Regulatory Requirements:

Investors must obviously deal with regulatory requirements growing out of both common

law and the rulings and regulations of state and federal agencies. Individuals are subject to

relatively few such requirements, whereas a particular institutional portfolio, such as an

endowment fund of a pension fund, is subject to several legal and regulatory requirements.

With regard to fiduciary responsibilities, one of the most famous concepts is the Prudent

Man Rule. This rule, which concerns fiduciaries, goes back to 1830, although it was not

formally stated until more than 100 years later. Basically, the rule states that a fiduciary, in

managing assets for another party shall act like people of prudence, discretion and

intelligence act in governing their own affairs.

The important aspect of the Prudent Man Rule is its flexibility; because interpretations of

the rule can change with time and circumstances. Unfortunately, some judicial rulings have

specified a very strict interpretation, negating the, value of flexibility for the time period and

circumstances involved. Also unfortunately, in the case of state laws governing private

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trusts the standard continues to be applied to individual investments rather than the portfolio

as a whole which violates all of the portfolio-building principles.

One of the important pieces of federal legislation governing institutional investors is the

Employment Retirement Income Security Act, referred to as ERISA. This act, administered

by the Department of Labor, regulates employer-sponsored retirement plans. It requires that

plan assets be diversified and that the standards being applied under the act be applied to

management of the port/olio as a whole.

The investment policy thus formulate is an operational statement. It clearly specifies the

actions to be taken to try to achieve the investor's goals, or objectives, given the preferences

of the investor and any constraints imposed. Although portfolio investments consider aliens

are often of a qualitative nature, they help to determine a quantitative statement of return

and risk requirements that are specific to the needs of any particular investor.

Unique Needs and Circumstances:

Investors often face a variety of unique circumstances. For example, a trust established on

their behalf may specify that investment activities be limited to particular asset classes, or

even specified assets. Or in individual may feel that their life span is threatened by illness

and wish to benefit within a certain period of time.

Determine and Quantify Capital Market Expectations:

Having considered their objective's and constraints, the next step is to determine a set, of

investment strategies based on the policy statement. Included here ape such issues as asset

allocation portfolio diversification and the impact of taxes. Once the portfolio strategies are

developed, they are used along with the investment manager's expectations' fit the capital

market and' for individual assets to choose a portfolio of assets. Most importantly, the asset

allocation decision must be made.

Forming Expectations:

The forming of expectations involves two steps:

1. Macroexpectational factors: These factors influence the market for bonds, stocks

and other assets on both a domestic and international basis. These are expectations

about the capital markets.

2. Microexpectational influences: These factors invoke the cause agents that underlie

the desired return and risk estimates and influence the selection of a particular asset

for a particular portfolio.

Rate of Return Assumptions:

Most investors base their actions on some 'assumptions about the rate of return expected

from various assets, obviously it is important to investors to plan their investing activities

on realistic rate of return assumptions.

Investors should study carefully the historical rates of return available in such sources as the

data provided by Ibbotson Associates or the comparable data. We know the historical mean

returns, both arithmetic and geometric, and the standard deviation of the returns for major

asset classes such as stocks, bonds and bills.

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Asset Allocation:

The asset allocation decision involves .deciding the percentage of investable funds to be

placed in stocks, bonds, and cash equivalents. It is the most important investment decision

made by investors, because it is the basic determinant of the return and risk taken.

The returns of a well-diversified portfolio within a given asset class are highly correlated

with the returns of the asset class itself. Within an asset class, diversified portfolios will tend

to produce similar returns over time. However, different asset classes are likely to produce

results that ire quite dissimilar. Therefore, differences in asset allocation will be the key

factor over time causing differences in portfolio performance.

The Asset Allocation Decision:

Factors to consider in making the asset allocation decision include the investor's return

requirements (current income versus future income), the investor's risk tolerance, and the

time horizon. This is done in conjunction with the investment manager's expectations about

the Capital markets and about individual assets.

How asset allocation decisions are made by investors remains a subject that is not fully

understood. It is known that actual allocation decisions often differ widely from how

investors say they will allocate assets.

Types of Asset Allocation:

William Sharpe has outlined several types of asset allocation. If all major aspects of the

process have been considered, the process is referred to as integrated asset' allocation. These

include issues specific to an investor, particularly the investor's risk tolerance, and issues

pertaining to the capital markets, such as predictions concerning expected returns, risks, and

correlations. If some of these steps are omitted, the asset allocation approaches are more

specialized. Such approaches include:

1. Strategic asset allocation: This type of .allocation is usually done once every few

years; using simulation procedures to determine the likely range of outcomes

associated with each mix. The investor considers the range of outcomes for each

mix; and chooses the preferred one, thereby establishing a long-run or strategic asset

mix.

2. Tactical asset allocation: This type of allocation is performed routinely, as part of

the ongoing process of asset management. Changes in asset mixes are driven by

changes in predictions concerning asset returns. As predictions of the expected

returns on stocks, bonds, and other assets change, the percentages of these assets

held in the portfolio changes. In effect, tactical asset allocation is a market timing

approach to portfolio management intended to increase exposure to a particular

market when its performance is expected to be good and decrease exposure when

performance is expected to be poor.

Changes in Investor's Circumstances:

An investor's circumstances can change for several reasons. These can be easily organized

on the basis of the framework for determining portfolio policies outlined above.

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1. Change in Wealth: A change in wealth may cause an investor to behave differently,

possibly accepting more risk in the case of an increase in wealth, or becoming more

risk averse In the case of, a decline in wealth.

2. Change in Time Horizon: Traditionally, we think of investors aging and becoming

more conservative in their investment approach.

3. Change in Liquidity Requirements: A need for more current income could increase

the emphasis on dividend-paying stocks, whereas a decrease in current income

requirements could lead to greater investment in small stocks whose potential payoff

may be, years in the future.

4. Change in Tax Circumstances: An investor who moves to a higher tax bracket may

find municipal bonds more attractive. Also, the timing of the realization of capital

gains can become more important.

5. Change in Legal / Regulatory Considerations: Laws affecting investors change

regularly, whether tax laws or laws governing retirement accounts, annuities, and so

forth.

6. Change in Unique Needs and Circumstances: Investors face a number of possible

changes during their life depending on many economic, social, political, health; and

work-related factors.

Rebalancing the Portfolio:

Even the most carefully constructed portfolio is not intended to remain intact without

change. Portfolio managers spend much of their time monitoring their portfolios and doing

portfolio rebalancing. The key is to know when arid how to do such rebalancing because a

trade-off is involved the cost of trading versus the cost of not trading.

The cost of trading involves commissions, possible impact on market price, and. the time

involved in deciding to trade. The cost of not trading involves holding positions that are not

best suited for the portfolio's owner, holding positions that violate the asset allocation plan,

hording a portfolio that is no longer adequately diversified and so forth.

One of the problems involved in rebalancing is the "lock-up" problem. This situation arises

in taxable accounts subject to capital gains taxes. Even at low level of turnover the tax

liabilities generated can be larger than the gains achieved by the active management driving

the turnover. In the absence of taxes, such, as with tax deferred IRA and 401(k) plans,

investors would simply seek to hold those securities with the highest risk adjusted expected,

rates of return.

Performance Measurement:

The portfolio management process is designed to facilitate making investment decisions in

an organized, systematic manner. Clearly, it is important to evaluate the effectiveness, of the

overall decision-making process. The measurement of portfolio performance allows

investors to determine the success of the portfolio management process and of the portfolio

manager. It is a key part of monitoring the investment strategy that was based on investor

objectives, constraints and preferences.

Performance measurement is important to both those who employ a professional portfolio

manager, on their behalf as, well as to those who invest personal funds. It allows investors

to evaluate the risks that are being taken, the reasons for the success or failure of the

investing program; and the costs of any restrictions that may have been placed on the

investment manager.

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Unresolved issues remain in performance measurement despite the development of an entire

industry to provide data and analyses of expost performance. Nevertheless, it is a critical

part of the investment management process, and the logical capstone in its, own right of the

entire study of investments.

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