The CFA Institute divides the process of investment management into three main elements that constitute a dynamic feedback loop: planning, execution, and feedback. Figure 28.1 and Table 28.1 describe the steps in that process. As shorthand, you might think of plan- ning as focused largely on establishing all the inputs necessary for decision making. These include data about the client as well as the capital market, resulting in very broad policy guidelines (the strategic asset allocation). Execution fleshes out the details of optimal asset allocation and security selection. Finally, feedback is the process of adapting to changes in expectations and objectives as well as to changes in portfolio composition that result from changes in market prices.
The result of this analysis can be summarized in an Investment Policy Statement addressing the topics specified in Table 28.2 . In the next sections we elaborate on the steps leading to such an Investment Policy Statement. We start with the planning phase, panel A of Table 28.1 .
Objectives
Table 28.1 indicates that the management planning process starts off by analyzing one’s investment clients—in particular, by considering the objectives and constraints that gov- ern their decisions. Portfolio objectives center on the risk–return trade-off between the expected return the investors want ( return requirements in the first column of Table 28.3 ) 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 a higher expected rate of return.
Figure 28.1 CFA Institute investment management process
Portfolio policies and strategies
Capital market expectations
Planning Execution Feedback
Specification and quantification of investor objectives, constraints,
and preferences
Relevant economic, social, political, and sector considerations
Portfolio construction and revision Asset allocation, portfolio optimization,
security selection, implementation, and
execution
Monitoring economic and market input
factors Monitoring investor- related input factors
Attainment of investor objectives Performance measurement
Here is an example of a short quiz which may be used by financial institutions to help estimate risk tolerance.
WORDS FROM THE STREET
Question 1 Point 2 Points 3 Points 4 Points
1. I plan on using the money I am investing:
Within 6 months. Within the next 3 years.
Between 3 and 6 years. No sooner than 7 years from now.
2. My investments make up this share of assets (excluding home):
More than 75%. 50% or more but less than 75%.
25% or more but less than 50%.
Less than 25%.
3. I expect my future income to:
Decrease. Remain the same or grow slowly.
Grow faster than the rate of inflation.
Grow quickly.
4. I have emergency savings:
No. — Yes, but less than I’d like
to have.
Yes.
5. I would risk this share in exchange for the same probability of doubling my money:
Zero. 10%. 25%. 50%.
6. I have invested in stocks and stock mutual funds:
— Yes, but I was uneasy
about it.
No, but I look forward to it.
Yes, and I was c omfortable with it.
7. My most important investment goal is to:
Preserve my original investment.
Receive some growth and provide income.
Grow faster than in flation but still provide some income.
Grow as fast as possible. Income is not important today.
Add the number of points for all seven questions.Add one point if you choose the first answer, two if you choose the second answer, and so on. If you score between 25 and 28 points, consider yourself an aggressive investor. If you score between 20 and 24 points, your risk tolerance is above average. If you score between 15 and 19 points, consider
yourself a moderate investor. This means you are willing to accept some risk in exchange for a potential higher rate of return. If you score fewer than 15 points, consider yourself a conservative investor. If you have fewer than 10 points, you may consider yourself a very conservative investor.
Source: Securities Industry and Financial Markets Association.
The nearby box is an illustration of a questionnaire designed to assess an investor’s risk tolerance. Table 28.4 lists factors governing return requirements and risk attitudes for each of the seven major investor categories we will discuss.
Individual Investors
The basic factors affecting individual investor return requirements and risk tolerance are life-cycle stage and individual preferences. A middle-aged tenured professor will have a different set of needs and preferences from a retired widow, for example. We will have much more to say about individual investors later in this chapter.
Personal Trusts
Personal trusts are established when an individual confers legal title to property to another person or institution (the trustee) to manage that property for one or more ben- eficiaries. Beneficiaries customarily are divided into income beneficiaries, who receive the interest and dividend income from the trust during their lifetimes, and remainder- men, who receive the principal of the trust when the income beneficiary dies and the trust is dissolved. The trustee is usually a bank, a savings and loan association, a lawyer, or
an investment pr ofessional. Investment of a trust is subject to trust laws, as well as “pru- dent investor” rules that limit the types of allowable trust investment to those that a prudent person would select.
Objectives for personal trusts normally are more limited in scope than those of the indi- vidual investor. Because of their fiduciary responsibility, personal trust managers typically
I. Planning
A. Identifying and specifying the investor’s objectives and constraints B. Creating the Investment Policy Statement (See Table 28.2.) C. Forming capital market expectations
D. Creating the strategic asset allocation (target minimum and maximum class weights) II. Execution: Portfolio construction and revision
A. Asset allocation (including tactical) and portfolio optimization (combining assets to meet risk and return objectives) B. Security selection
C. Implementation and execution III. Feedback
A. Monitoring (investor, economic, and market input factors) B. Rebalancing
C. Performance evaluation Table 28.1
Components of the investment management process
Source: John L. Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto, “The Portfolio Management Process and the Investment Policy Statement,” in Managing Investment Portfolios: A Dynamic Process, 3rd ed . (CFA Institute, 2007) and co rrespondence with Tom Robinson, head of educational content.
Table 28.2
Components of the investment policy statement 1. Brief client description
2. Purpose of establishing policies and guidelines
3. Duties and investment responsibilities of parties involved 4. Statement of investment goals, objectives, and constraints 5. Schedule for review of investment performance and the IPS 6. Performance measures and benchmarks
7. Any considerations in developing strategic asset allocation 8. Investment strategies and investment styles
9. Guidelines for rebalancing
Table 28.3
Determination of portfolio policies
Objectives Constraints Policies
Return requirements Liquidity Asset allocation Risk tolerance Horizon Diversification
Regulations Risk positioning Taxes Tax positioning Unique needs Income generation
are more risk averse than are individual investors. Certain asset classes such as options and futures contracts, for example, and strategies such as short-selling or buying on margin are ruled out.
Mutual Funds
Mutual funds are pools of investors’ money. They invest in ways specified in their pro- spectuses and issue shares to investors entitling them to a pro rata portion of the income generated by the funds. The objectives of a mutual fund are spelled out in its prospectus.
We discussed mutual funds in detail in Chapter 4.
Pension Funds
Pension fund objectives depend on the type of pension plan. There are two basic types:
defined contribution plans and defined benefit plans. Defined contribution plans are in effect tax-deferred retirement savings accounts established by the firm in trust for its employees, with the employee bearing all the risk and receiving all the return from the plan’s assets.
The largest pension funds, however, are defined benefit plans. In these plans the assets serve as collateral for the liabilities that the firm sponsoring the plan owes to plan benefi- ciaries. The liabilities are life annuities, earned during the employee’s working years, that start at the plan participant’s retirement. Thus it is the sponsoring firm’s shareholders who bear the risk in a defined benefit pension plan. We discuss pension plans more fully later in this chapter.
Endowment Funds
Endowment funds are organizations chartered to use their money for specific nonprofit purposes. They are financed by gifts from one or more sponsors and are typically managed by educational, cultural, and charitable organizations or by independent foundations estab- lished solely to carry out the fund’s specific purposes. Generally, the investment objectives of an endowment fund are to produce a steady flow of income subject to only a moderate Table 28.4
Matrix of objectives
Type of Investor Return Requirement Risk Tolerance
Individual and personal trusts Life cycle (education, children, retirement) Life cycle (younger are more risk tolerant)
Mutual funds Variable Variable
Pension funds Assumed actuarial rate Depends on proximity of payouts
Endowment funds Determined by current income needs and need for asset growth to maintain real value
Generally conservative Life insurance companies Should exceed new money rate by sufficient
margin to meet expenses and profit objectives; also actuarial rates important
Conservative
Non–life insurance companies No minimum Conservative
Banks Interest spread Variable
degree of risk. Trustees of an endowment fund, however, can specify other objectives as dictated by the circumstances of the particular endowment fund.
Life Insurance Companies
Life insurance companies generally try to invest so as to hedge their liabilities, which are defined by the policies they write. Thus there are as many objectives as there are distinct types of policies. Until the 1980s, there were for all practical purposes only two types of life insurance policies available for individuals: whole-life and term.
A whole-life insurance policy combines a death benefit with a kind of savings plan that provides for a gradual buildup of cash value that the policyholder can withdraw at a later point in life, usually at age 65. Term insurance, on the other hand, provides death benefits only, with no buildup of cash value.
The interest rate that is embedded in the schedule of cash value accumulation promised under a whole-life policy is a fixed rate, and life insurance companies try to hedge this liability by investing in long-term bonds. Often the insured individual has the right to bor- row at a prespecified fixed interest rate against the cash value of the policy.
During the inflationary years of the 1970s and early 1980s, when many older whole-life policies carried contractual borrowing rates as low as 4% or 5% per year, policyholders borrowed heavily against the cash value to invest in money market mutual funds paying double-digit yields. In response to these developments the insurance industry came up with two new policy types: variable life and universal life. Under a variable life policy the insured’s premium buys a fixed death benefit plus a cash value that can be invested in a variety of mutual funds from which the policyholder can choose. With a universal life policy, policyholders can increase or reduce the premium or death benefit according to their needs. Furthermore, the interest rate on the cash value component changes with mar- ket interest rates. The great advantage of variable and universal life insurance policies is that earnings on the cash value are not taxed until the money is withdrawn.
Non–Life Insurance Companies
Non–life insurance companies such as property and casualty insurers have investable funds primarily because they pay claims after they collect policy premiums. Typically, they are conservative in their attitude toward risk. As with life insurers, non–life insurance compa- nies can be either stock companies or mutual companies.
Banks
The defining characteristic of banks is that most of their investments are loans to busi- nesses and consumers and most of their liabilities are accounts of depositors. As investors, the objective of banks is to try to match the risk of assets to liabilities while earning a prof- itable spread between the lending and borrowing rates.