By Barb Shegog
The genesis of all good investment decisions is a solid investment policy.
The investment policy is the roadmap that drives all investment decisions. Even if the initial step into investment management is some type of fund, corporations need an Investment Policy to guide decision makers. We often hear, “we only invest in funds, we do not need a policy.” This is never the case and whatever the investments—even money market funds—every company needs an investment policy. You never know what could be lurking in that fund. Without an investment policy liquidity needs might not be met, risk levels in portfolio might be too high, or even too low, leaving money on the table.
Setting up the Policy
A good investment policy outlines the objectives of the investment portfolio as well as the risk tolerances. The policy should have clear objectives such as liquidity or capital preservation. Another objective for the funds could be total return or adding investment income.
Objectives drive the risk parameters. For example, a portfolio to be built for immediate liquidity would have a much different risk profile than a portfolio maximizing investment income. One important test to perform when setting investment parameters is to review how much volatility is associated with each instrument at various shock levels to the system. If interest rates rise by 100 basis points and the investment portfolio would see a negative 1 percent impact, this might be too much volatility for the portfolio. Simple scenario analysis should be performed to judge the impact and ability to wait out negative performance.
Components to be outlined
It is important that the investment policy have a high level of detail. The following areas should be addressed:
The more detail that can be provided the less grey areas there are for interpretation. This list can also be used for investment the criteria outlined above. This is now possible as a result of the greater transparency in funds.
Work is not finished
Once the investment policy is set up the work is not done. Now you must switch to monitoring investments for compliance with the policy and determine how you might change the policy to react to changing market conditions.
Authority to make changes
Markets can change rapidly and the investment program must be able to react quickly to these changes. It is very important that the investment policy designate a person or group with the ability to make changes. A portfolio built for immediate liquidity has different risk profile than a portfolio maximizing investment income.
For most corporations this responsibility is given to an investment or finance committee. The committee usually includes several senior management positions including the treasurer and the CFO. An important consideration is the ability to gather this group quickly. For changes such a hiring a new manager, most corporations give this authority to the treasurer.
Monitoring , Monitoring , Monitoring
An investment policy is useless if no one is watching for compliance. A process should be in place to monitor compliance daily if possible. The sooner you catch a compliance breach, the easier it will be to remedy the mistake.
The best solution would be a check above the manager’s compliance programs. Leaving compliance monitoring to the investment managers (whether internal or external) is like the proverbial fox watching the hen house. Monthly and quarterly reporting requirements should also be outlined in the investment policy statement. Setting up a good investment policy can be a bit daunting. But the exercise forces you to think about all the parameters that surround the investment portfolio.
Having a well-articulated and detailed policy will insure everyone is on the same page and help avoid costly mistakes or confusion. This will be most important in challenging and volatile markets.