Professional Documents
Culture Documents
Chapter Five
Investment Policy
ANSWERS TO QUESTIONS
1. Investment policy is a statement about the objectives, risk tolerance, and constraints
the portfolio faces. Investment management is the practice of attempting to achieve
the objectives consistent with the established constraints.
2. It should
a.
b.
c.
d.
5. An individualist is deliberate in making decisions, but having made them does not
immediately second guess them or worry that they might have been wrong. A
celebrity makes decisions quickly, often consistent with the choices others are
making, but frequently worries about what they have done (or have failed to do).
6. Someone might be a social gadfly, into everything, concerned with fashion and fads,
and horrified of the possibility that they might be out of touch with the current rage.
With their investments, however, they might be thoroughly afraid of the stock market
and overly fearful of losing money. As a consequence they keep it all in the bank.
Investment Policy
Investment Policy
14. In some years the return will be negative. You cannot reasonably expect an
endowments administration to give money back in a down year. The prior years
distribution has certainly been spent.
15. In a defined benefit plan the company specifies a sum that the retiree will receive,
often based on a percentage of the persons salary in their final few years of
employment. In a defined contribution plan the employer makes a contribution to the
employees retirement fund, but it is up to the employee how these funds are invested.
The company makes no warranty on the performance of the employees account.
16. With a defined contribution plan, the employer makes the contribution and that is the
end of the employers responsibility (other than record keeping). In a defined benefit
plan the calculations are much more involved. A change in salary likely means a
change in future benefits and a change in the funding scheme. In this case the
employer also can be adversely affected by poor market performance. This could
result in the company having to make additional contributions to the fund to make up
the difference.
17. Investment policy at a life insurance company is liability driven. The company is
most concerned with ensuring they have sufficient assets to pay off the insurance
policies as account holders die. Their principal objective is to earn a competitive
return on their surplus.
18. Life expectancies, and consequently insurance payouts, are relatively stable. Property
insurance claims, on the other hand, can occur all at once. This means that liquidity is
a primary concern at a property and casualty company.
ANSWERS TO PROBLEMS
1 3. Student responses.
4. CFA Guideline Answer (reprinted with permission from the CFA Study Guide,
Association for Investment Management and Research, Charlottesville, VA. All
Rights Reserved.
A. Key constraints are important in developing a satisfactory investment plan in
Greens situation, as in all investment situations. In particular, those constraints
involving investment horizon, liquidity, taxes, and unique circumstances are
especially important to Green. His investment policy statement fails to provide an
adequate treatment of the following key constraints:
1. Horizon. At age 63 and enjoying good health, Green still has an
intermediate to long investment horizon ahead. When considered in the
light of his wish to pass his wealth onto his daughter and grandson, the
Investment Policy
Investment Policy
allocation. These are important needs in this situation given the intermediate to
long investment horizon and his estate-disposition plans.
Risk. Green does not appear to have a high tolerance for risk, as shown by his
concern about capital preservation and the avoidance of large losses. Yet, he
should have a moderate degree of equity exposure to protect his estate against
inflation and to provide growth in income over time. A long time horizon and the
size of his assets reflect his ability to accept such risk. He clearly needs
counseling in this area because the current risk level is too high given his
preferences.
5. CFA Guideline Answer (reprinted with permission from the CFA Study Guide,
Association for Investment Management and Research, Charlottesville, VA. All
Rights Reserved.
The surplus in BIs defined benefit pension plan declined despite the return achieved.
The surplus will fall when the present value of plan liabilities rises faster than the
market value of plan assets. Assuming no other changes, if the discount rate declines,
the present value of plan liabilities will rise by an amount about equal to the decline
times the duration of the liabilities. As Table 1 shows, long-term bonds of 10-year
duration (the same duration as the plans liabilities) had a 19.0 percent total return for
the year (composed of a 7.0 percent income return element and a 12.0 percent gain
element). Much of that return (the 12.0 percent gain element) was a direct result of a
decline in the general level of interest rates over the period, which implies that plan
liabilities with a similar 10-year duration would also have increased about 12 percent.
Because this rate of increase was greater than the total return (some 10.0 percent) on
the asset side, Constant Proportion Strategy the funded ratio declined and surplus was
reduces. (Note: wording error in the original text)
Alternatively, when the duration of the liabilities is 10 years, an interest rate change of
only 1 percent will cause a 10 percent change in liabilities (ignoring convexity and
assuming parallel interest rate changes). Any interest rate change greater than 100
basis points would cause a decline in the funded ratio if the return on the portfolio was
10 percent for the same period.
6. CFA Guideline Answer (reprinted with permission from the CFA Study Guide,
Association for Investment Management and Research, Charlottesville, VA. All
Rights Reserved.
A. Perhaps the single most important factor in any investment program is the holding
period of the assets (i.e., the period for measuring and judging results). The
investment time horizon is a primary determinant of the level of risk an investor
can tolerate. If time is shorter, high-risk assets should be avoided and vice versa.
Investment Policy
(ii)
Investment Policy
and constraints for the Funds operation. These guidelines control and
limit the actions of the Funds investment managers. The disciplines
established in the policy help prevent panicky response to short-term
market fluctuations.
(iii)
7. CFA Guideline Answer (reprinted with permission from the CFA Study Guide,
Association for Investment Management and Research, Charlottesville, VA. All
Rights Reserved.
A. Four shortcomings of the existing HFS Investment Policy Statement, and an
explanation of why these policy aspects should be reviewed, follow.
1.
2.
Investment Policy
3.
4.
It is unclear whether the four asset classes in which the foundation is not
invested represent the only classes considered. In any event, the asset
mix policy should permit inclusion of more asset classes, including
nontraditional assets.
5.
The limits within which HFSs manager(s) may tactically allocate assets
should be specified in the Policy Statement.
6.
B. A new Investment Policy Statement for HFS should include the following
statements:
Objectives:
Return Requirement. In order to maintain its ability to provide inflationadjusted scholarships and its tax-exempt status, HFS requires a real rate of
return of 5 percent. The appropriate definition of inflation in this context
is the 5 percent rate at which full scholarship costs per student is expected
to increase.
Risk Tolerance. Given its very long time horizon, HFS has the ability to
take moderate risk, with associated volatility in returns, in order to
maintain purchasing power, as long as undue volatility is not introduced
into the flow of resources to cover near-term scholarship payments.
As Swensen indicates in Endowment Management, a balance between preserving
purchasing power and providing a stable flow of funds to operating needs can be
achieved by determining a sensible long-term target rate of spending and applying this
rate to a moving average of endowment (fund) market values.
Constraints
Investment Policy
0% - 5%
2%
20% - 35%
30%
Investment Policy
Real Estate
0%- 10%
8%
30% - 50%
40%
5% - 20%
20%
Investment Policy
funding. Managing surplus risk implies the pension fund should be viewed as an
independent, stand-alone financial institution.
B. Managing Corporate Risk Exposures
One reason a pension fund might adopt an investment policy that seeks to manage
corporate risk exposures (incorporating the operational, economic, or financial risk
characteristics and exposures of the corporation into the pension fund investment
policy equation) is the belief that the pension plans asset allocation policy should
recognize the financial interdependence of the companys financial affairs and the
pension fund. This approach to pension fund investment management allows
corporate managers to control pension fund risk at the corporate level instead of
considering risk at the pension fund level in isolation.
A second reason for controlling corporate risk exposures is the attempt to increase
the probability that if the firm is called upon to increase its support for the plan, it
will be in a position to do so. The strategy would focus on managing plan assets
to maintain funded status relative to underlying corporate strength. Plan assets
would be managed to optimize returns while reducing the probability that
significant adverse developments would accompany a requirement to significantly
increase corporate contributions to the plan.
A third reason is that the pension fund should be viewed as a wholly owned
subsidiary of the plan sponsor.
C. Illustration of Managing Corporate Risk Exposure
An asset allocation strategy incorporating risk exposures of the corporation would
avoid assets that are expected to underperform when the company is
underperforming. For example, if the experience of the 1970s is a guide, a sudden
surge in inflation will cause liabilities to rise more rapidly than assets for most
plans because of inflations positive effect on wages and negative effect on most
asset values and returns. The main business/pension plan integration question is:
How does this sudden surge in inflation affect the pension plan? If the main
business revenues are closely tied to inelastic product price inflation (as is the case
for oil companies), the rising required contribution rate might not be a major
concern. On the other hand, if the main business costs are more likely than
revenues to be affected by elastic price inflation (as is the case for consumer
products companies), a requirement to put more money into the pension plan
could aggravate an already serious cash flow situation. Therefore, the plan
sponsor in this situation should emphasize acquiring inflation-hedged pension
assets. Stock portfolios can be constructed that are expected to outperform when
the rate of inflation is above its expected value and underperform when it is below.
Investment Policy
Investment Policy
Investment Policy