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CHAPTER 28
Investment Policy and the
Framework of the CFA Institute
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McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Four Stages of the
Investment Process
1. Specifying objectives
2. Specifying constraints
3. Formulating policy
4. Monitoring and updating portfolio
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Specifying Objectives
• Investment managers
must assess the level
of risk investors can
tolerate in pursuit of
higher returns.
• Objectives and risk
tolerance differ by
type of investor.
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Figure 28.1 CFA Institute Investment
Management Process
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Table 28.1 Components of the Investment
Management Process
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Table 28.2 Components of the Investment
Policy Statement
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Table 28.3 Determination of Portfolio
Policies
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Table 28.4 Matrix of Objectives
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Specifying Constraints on
Investment Policies
• Liquidity
– Ease (speed) with which an asset can
be sold and created into cash
• Investment horizon - planned liquidation
date of the investment
• Regulations
– Prudent investor rule
• Tax considerations
• Unique needs
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Table 28.5 Matrix of Constraints
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Policy Statements
• The Policy Statement (IPS) provides for:
– Governance of the investment program,
– The appropriate asset allocation,
– Roles of internal and/or external managers,
– Monitoring the results,
– Risk management,
– Appropriate reporting,
– Accountability
– A course of action in case of market turmoil
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Asset Allocation
• By far the most
important part of
policy determination
is asset allocation,
that is, deciding how
much of the portfolio
to invest in each
major asset category.
1. Specify asset
classes
2. Specify capital
market expectation
3. Derive the efficient
portfolio frontier.
4. Find the optimal
asset mix.
5. Manage taxes.
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Managing Portfolios of
Individual Investors
• Human capital and insurance
• Investment in residence
• Saving for retirement and the
assumption of risk
• Retirement planning models
• Manage your own portfolio or rely on
others?
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Tax Sheltering for
Individual Investors
• Tax-deferral option - controlling the
timing of gains on investments.
• Tax-deferred retirement plans
– IRAs
– Keogh plans
• Deferred annuities
– Fixed
– Variable
• Variable and universal life insurance
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Pension Funds
• Defined contribution plans
– Investment policy is essentially the
same as for a tax-qualified individual
retirement account
• Defined benefit plans
– Contractual arrangement setting out the
rights and obligations of all parties
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Pension Funds
• The tax status of pension funds
makes them favor assets with the
largest spread between pretax and
after-tax rates of return.
• Pension funds make use of
immunization.
• Investing in equities occurs for both
correct and wrong reasons.
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Investments for the Long Run
• Advice from the mutual fund industry:
• Don’t try to outguess the market by moving
your money in and out. Buy and hold instead.
• Diversify to reduce risk.
• Put money in stocks, bonds, and money
market mutual funds.
• Avoid keeping 401(k) money in a company’s lowrisk default investment scheme.
• Be wary of investing a large percentage of your
401(k) in your company’s stock.
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Investments for the Long Run
• Investment horizon determines which
risk-free rate to choose.
• Make simple investment choices such as
TDRFs (target date retirement funds).
• Inflation risk and long-term investors:
– TIPS are helpful but not really risk-free.
– Market value can fluctuate.
– Reinvestment rate risk
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