Investment policies are a headache if they are poorly written. I wrote my first in July of 2008. That’s right in the middle of the financial crisis. My then boss and I didn’t want to be perceived as a pair of rookies by the committee that oversaw the portfolio. We wanted to show prudence, professionalism, sophistication.
The result was an extremely verbose, timorous, and convoluted document that would haunt us for a long time. A mistake.
I’ve learned a little about investment policy statements for corporate investors. Here are some of my rules.
Rule #1 of an investment policy: Keep it simple
The purpose of a policy should be to demarcate the limits of the sandbox in which the investment team will be allowed to play. Nothing more. What happens inside the box is up to management (treasurer, CIO, or investment manager, as applicable).
Adding operational components to the policy (e.g., frequency of compliance checks) or overly cute nuances (e.g., limiting the eligible collateral of an asset-backed security) will only create nightmares down the road for you, your portfolio managers, and your boss.
I speak from experience, and the two examples I give are from real life.
Rule # 2: have an investable (“investible“?) set of investments
For efficient portfolio management, you will likely need to select an index as a benchmark. Your benchmark should be consistent with your organization’s risk tolerance, and your investment policy should allow you to create a portfolio that can track your benchmark.
Defining a list that is too restrictive will, at the very least, create performance measurement problems. At its worst, it will push your investment manager to either allocate funds to investments that don’t fit your risk tolerance, or to over-concentrate in specific assets.
Tip: once you have an idea of the asset classes you will invest in, investigate the various indices or benchmarks to better understand the sectors and type of securities that are available.
For example, if your portfolio will be fixed-income only, start by looking at the components of the Barclays U.S. Aggregate Bond Index.
Rule # 3: address the basic sources of risk
Risk. This is the most important section of an investment policy, particularly for corporate cash investors. Remember that the game you’re playing is an infinite game in which the objective is to keep playing. Smart risk management will increase your chances of staying in the game.
Your policy should address the basic sources of risk: interest rate, credit, and liquidity. For more information on this topic, keep reading.
Rule #4: asset allocation specificity depends on the governance structure
I recommend a risk/return optimization exercise once a year to set or calibrate the strategic asset allocation (SAA) of the portfolio. The question for the investment policy is: should I include a target asset allocation in the policy?
My answer: it depends.
It depends on the governance structure of your investment function. Specifically: your investment committee.
If your investment committee meets regularly (at least once a year) and is comprised of investment pros, then yes, include the SAA in the policy. You will receive valuable and informed feedback on it and you know that you’ll be able to make timely adjustments if needed.
Sometimes your investment committee is a collection of random figures that have little to sub-zero experience in investments. You may find endearing cases of perfect marriages of confidence and incompetence among its members. In this situations, don’t bother including the SAA in the policy. You will not trigger a constructive discussion and you may also find yourself unable to make changes to a stale SAA due to bureaucracy.
What do you think? Do you have any additional tips for writing clean, concise, and effective investment policies?
Continue on to Part 2 of this series to read about the building blocks of an investment policy.