LITMIR.BIZ

Скачать книгу

countries or sectors of the global economy. For instance, national pension plans may be prohibited from investing in certain countries, or a university endowment may have been instructed by its trustees to avoid investments in certain industries.

      Asset owners may have unique needs and constraints that have to be accommodated by the portfolio manager. However, it is instructive to present asset owners with alternative allocations in which those constraints are relaxed. This will help asset owners understand the potential costs associated with those constraints.

      1.6.2 Investment Policy and the Two Major Types of External Constraints

      External constraints refer to constraints that are driven by factors that are not directly under the control of the investor. These constraints are mostly driven by regulations and the tax status of the asset owner.

      

TAX STATUS. Most institutional investors are tax exempt, and therefore allocation to tax-exempt instruments are not warranted. Because these investments offer low returns, the optimization technique selected to execute the investment strategy should automatically exclude those assets. In contrast, family offices and high-net-worth investors are not tax exempt, and therefore the impact of taxes must be taken into account. For example, constraints can be imposed to sell asset classes that have suffered losses to offset realized gains from those that have increased in value.

      

REGULATIONS. Some institutional investors, such as public and private pension funds, are subject to rules and regulations regarding their investment strategies. In the United States, the Employee Retirement Income Security Act (ERISA) represents a set of regulations that affect the management of private pension funds. In the United Kingdom, the rules and regulations set forth by the Financial Services Authority impact pension funds. In these and many other countries, regulations impose limits on the concentration of allocations in certain asset classes.

      1.7 Preparing an Investment Policy Statement

      The next step in the process is to develop the overall framework of the asset allocation by preparing an investment policy statement (IPS)3.

      1.7.1 Seven Common Components of an Investment Policy Statement

      The policy may include a recommended strategic allocation as well. The following is an outline of a typical IPS based on seven common components.

      1. BACKGROUND. A typical IPS begins with the background of the asset owner and its mission. It reminds all parties who the beneficiaries of the assets are.

      2. OBJECTIVE. The overall goals of the asset owner are described. For instance, the IPS of a foundation may state that the broad objectives are to (1) maintain the purchasing power of the current assets and all future contributions, (2) achieve returns within reasonable and prudent levels of risk, and (3) maintain an appropriate asset allocation based on a total return policy that is compatible with a flexible spending policy while still having the potential to produce positive real returns. The IPS may also provide additional details about the level of risk tolerance, the investment horizon, and the level of expected return that is needed to meet certain liabilities.

      3. ASSET CLASSES. This segment will include a list of asset classes that the portfolio manager is allowed to consider for allocation. It may provide additional information about how each asset class will be accessed. For instance, the asset owner may decide to use a passive approach to allocations to traditional asset classes and then use active managers for alternative asset classes.

      4. GOVERNANCE. The organizational structure of the fund is described here. The responsibilities of various parties who are involved in the investment process (e.g., the portfolio manager, investment committee, administrator, and custodian) are carefully explained.

      5. MANAGER SELECTION. This section describes the basic framework that the asset owner will follow in selecting outside managers. For example, it may state that all hedge fund managers will need to have three years of experience with at least $100 million in assets under management.

      6. REPORTING AND MONITORING. The IPS describes the reporting requirements for the portfolio manager (e.g., frequency, type of reports, and disclosures).

      7. STRATEGIC ASSET ALLOCATION. The IPS may include the long-run allocation of the fund during normal periods. The statement may include upper and lower limits for each asset class as well. Further details about strategic asset allocation are discussed in the next section.

      1.7.2 Strategic Asset Allocation: Risk and Return

      The central focus of strategic asset allocation (SAA) is to create a portfolio allocation that will provide the asset owner with the optimal balance between risk and return over a long-term investment horizon. The SAA not only represents the long-run normal allocation of the investors' assets but also serves as the basis for creating a benchmark that will be used to measure the actual performance of the portfolio. The SAA also serves as the starting point of the tactical asset allocation process, which will adjust the SAA based on short-term market forecasts.4 (Tactical asset allocation will be discussed in the next chapter.)

      SAA is based on long-term risk-return relationships that have been observed in the past and that, based on economic and financial reasoning, are expected to persist under normal economic conditions into the future. While historical risk-return relationships are used as the starting point of generating the inputs needed to create the optimal long-run allocation, these historical relationships should be adjusted to reflect fundamental and potentially long-lasting economic changes that are currently taking place. For example, although long-term historical returns to investment-grade corporate bonds were once high, the prevailing yields on those instruments would indicate that the long-run return from this asset class should be adjusted down.

      In developing long-term risk-return relationships for major asset classes, it is important to begin with fundamental factors affecting the economy. Macroeconomic performance of the global economy is the driving force behind the performance of various asset classes. The expected return on all asset classes can be expressed as the sum of three components:

      (1.11)

      The real short-term riskless rate of interest is believed to be relatively stable and lower than the real growth rate in the economy.5 Typically, there is a lower bound of zero for this rate. Therefore, if the global economy is expected to grow at 3 % per year going forward, the short-term real riskless rate is expected to be somewhere between zero and 1 %. In turn, population growth and increases in productivity are known to be the major drivers of economic growth. Long-term expected inflation is far less stable, as it depends on central banks' policies as well as long-term economic growth. Historically, it was believed that long-term expected inflation would depend on the growth rate in the supply of money relative to the real growth rate in the economy. For instance, it was believed that long-term inflation would be around 5 % if the money supply were to grow at 8 % in an economy that is growing at 3 %. However, this long-term relationship has been challenged by empirical observations following the 2008–9 financial crisis.

      Once long-term estimates of the short-term real riskless rate and expected inflation have been obtained, the next step involves the estimation of the long-term risk premium of each asset class. At this stage, one may assume that historical risk premiums would prevail going forward. This would be particularly appropriate if we believe that historical estimates of volatilities, correlations, and risk exposures of various asset classes are likely to persist into the future. For instance, if the long-term historical risk premium on small-cap equities has been 5 %, then, assuming 2 % expected inflation and a 1 % short-term real riskless rate, one could assume an 8 % expected long-term return from this asset class.

      For several reasons, long-term returns from alternative asset classes could be more difficult to estimate. First, while alternative assets such as real estate and commodities have a long history, some of the more modern alternative asset classes (e.g.,

Скачать книгу