Investment policy
It might sound a bit simplistic, but before we attempt to find and analyze any investment manages, we should first have a very clear idea of what we are trying to achieve by hiring the manager. This way we will be able to put each investment product in its proper perspective. A value manager can be reviews in the context of the value style and can be properly compared to a universe of other value managers. Likewise, a short term domestic fixed income portfolio can be compared to the appropriate benchmark and peer group. This practice will save time and make the process much more efficient.
Investment guidelines come in two primary stages : (1) the investment policy statement and (2) the investment portfolio guidelines. The former concerns the overall portfolio or fund, while the latter is targeted toward each manager hired to fulfill specific objectives within the overall portfolio or fund. As common sense dictates, all investment guidelines should be well thought out and should cover every aspect of the investment process, from risk or return expectations to manager selection to portfolio monitoring. In addition, manager guidelines should leave nothing open to interpretation. Fiduciaries charged with hiring investment managers as well as the investment managers themselves should understand the guidelines and willingly agree to them. This avoids potential headaches down the road.
INVESTMENT POliCY STATEMENT .
An investment policy statement sets the framework for all of the investment decisions that follow. When well written, the investment policy statement helps to ensure that the decision making process with respect to the management of the total portfolio will be consistent and will serve as a beacon to aid navigation through unexpected market fluctuations and sometimes tumultuous economic conditions, enabling all parties to concentrate on what they were hired to do. A well written investment policy statement typically addresses, but is not limited to, the following issues:
- Philosophy or purpose.
- Return or risk objectives, including thresholds.
- Time horizon.
- Type of plan or portfolio.
- Status of plan funding.
- Actuarial assumptions, including clearly stated reasoning behind the return or risk objectives.
- Cash flow needs or liquidity.
- Strategy being employed to meet the investment objectives.
- Permissible investments.
- Restricted investments.
- Asset allocation ranges.
- Benchmarks for each individual component of the total portfolio.
- Plan or portfolio responsibilities.
- Policies regarding external hires, such as consultants and investment managers.
- Portfolio and performance evaluations.
- Benchmarks and rebalancing policies.
- Diversification.
- Portfolio execution and trading strategy.
- Operational issues.
However, the investment policy statement should not be written in a vacuum. Economic and market conditions evolve. As they do, it is imperative that the investment policy statement be reviewed at least yearly on a strategic level and perhaps more often on a tactical level so that the portfolio has a chance to evolve along with the market.
Many pension plans currently conducting searches for alternative investment managers, such as hedge funds, only recently changed their investment policy statements to allow investments in this segment of the market. These adjustments reflect the ever changing nature of the investment industry. Just keep in mind that all change is not necessarily good. What might be a beneficial change for some might be detrimental to others.
INVESTMENT OBJECTIVES .
This section is a critical element in the investment policy statement document because it sets the tone for everything that follows. It is here where the portfolio's return and risk expectations are listed. Whenever the investment policy statement is reviewed, the ultimate goal is to ensure that the return and risk objectives have been achieved. As you can imagine, the objectives should be realistic and based on long term assumptions. Many corporate pension plans got caught up in the bull market and increased their pension plans return expectations far beyond what they could reasonably expect to achieve. This resulted in faulty pension assumptions that have had a detrimental impact on many companies, financial statements and in the case of some publicly traded companies, the prices of their underlying stocks.
For pension plans, return and risk objectives may be stated in absolute terms or relative terms. A basis point represents 1/100th of a percent.
Funds of funds may also state their return and risk objectives in absolute or relative terms. However, because funds of funds are, in effect, individual investment products themselves, they tend to have a much more narrow investment focus. A fund of funds investment statement is typically called a "prospectus" or "offering memorandum". Because there are legal requirements, investment policy statements and prospectuses tend to have different formats.
Responsibilities .
Once the objectives have been decided upon, it is important to clearly state who will be responsible for making sure that all the goals are accomplished. This is an important section because it specifies who is responsible for every aspect of the portfolio's management. This includes boards, trustees, internal employees, external investment manages, consultants, legal advisers and others.
This section offers guidance not only to outsiders looking to establish contact, but also among co-workers who share portfolio analysis and management responsibilities. It is basically a detailed organizational chart that sets the pecking order within an organization.
Asset allocation .
Asset allocation is the subject of entire books, so simply state here that it comes in several levels. First, there is strategic asset allocation. This form of asset allocation is long term in nature and is seldom changed or altered. Changes to asset allocation that occur due to short term shifts in economic or market conditions are most often referred to as tactical asset allocation. For a pension plan, the strategic asset allocation decision is .
Investment Restrictions .
This list is a compilation of any financial instruments or investment strategies that are not allowed. Restrictions can cover entire asset classes, specific transactions, countries or exchanges or can be taken to the individual company or organization level. Other examples include restrictions based on social, political or religious reasons .
Operational Issues .
Any number of things can be placed in this section, such as legal, accounting, custodial, administrative and other issues. In addition, this section can also contain language that addresses the issue of proxy voting. Some organizations place that decision entirely with the underlying investment managers, while others place specific restrictions on particular issues that may arise. For example, a pension plan may specify that all proxy votes are to voted as the company management sees fit, with the exception of issues relating to movement of labour from the United States to countries overseas.
CONCLUSION .
The investment policy statement is a critical element in the ongoing management of any pension plan or investment fund. The guidelines set the tone for all the underlying investment manager searches and play a key role in the actual due diligence performed on any investment managers under review. The more explicit the investment policy statement, the easier it will be to actually manage the underlying pension plan or investment fund. In addition, because the risk or return objectives should be clearly stated in the investment policy statement, it is easier to evaluate the success or failure of the underlying pension plan or investment fund.
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