CFA Institute

Editor's Corner: The Investment Policy Fizzle: Call for PapersAuthor(s): Richard M. EnnisSource: Financial Analysts Journal, Vol. 63, No. 4 (Jul. - Aug., 2007), pp. 6+8Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4480855 .

Accessed: 18/06/2014 08:07

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact support@jstor.org.

.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial AnalystsJournal.

http://www.jstor.org

This content downloaded from 195.34.79.54 on Wed, 18 Jun 2014 08:07:09 AMAll use subject to JSTOR Terms and Conditions

tIiitCFAITJ EDITOR'S CORNER A Publicatioj of CFA lsntute >Richard M. Ennis, CFA

Editor

The Investment Policy Fizzle: Call for Papers Thirty-five years ago, I quit a perfectly good job as an up-and-coming institutional portfolio manager to take up investment consulting-investment pol- icy consulting, to be specific. Having concluded I was insufficiently gifted to beat (or time) the market and unsure whether anyone truly was, I dedicated myself to the nascent field of helping institutional investors establish rational investment policies- ones appropriate to their circumstances and risk tolerance. If beating the market is unlikely, I rea- soned, determining how one ought to approach the market in terms of stock/bond/cash allocation would be the top priority of sophisticated investors.

It was a watershed time for this type of work. Quadratic portfolio optimization was just becom- ing computationally feasible. The landmark Uni- versity of Chicago (Fisher and Lorie) study of historical stock returns provided the first empirical basis for estimates of future return and risk.1 And the earliest applications of Monte Carlo simulation were used to map frequency distributions of poten- tial future return for alternative asset allocation policies into distributions of a more concrete nature for investors to compare and evaluate.

Those were heady days for the investment pol- icy pioneers. It was the dawning of an era, the launching of a quest to establish the logical basis of investment policy and to help investors identify optimal investment portfolios.

Alas, when we reflect fairly on the practice of devising institutional investment policy, accom- plishments of the last 35 years appear rather meager.

Symptoms. On what do we base this asser- tion? Asset allocation models abound, to be sure. And most institutions dutifully conduct investment policy studies every three years or so. It is also true that no self-respecting institutional investor today would be without an investment policy statement. Yet, there are signs indicating that institutional in- vestment policy development is an inchoate science.

M Failure to integrate. The number one lesson of portfolio theory is that, because of the potential for subportfolio risks to offset one another, total portfolio is what matters. Yet, in deciding invest- ment policy, institutional investors generally do not integrate the pension or endowment portfolio with the corporation's or institution's other assets and liabilities.

Fifteen years ago, Robert Merton outlined a method for integrating the investment policy of an educational endowment portfolio with the institu- tion's other assets.2 The concept is to devise a port- folio risk policy that is consonant with the institution's overall risk tolerance and the value and risk characteristics of its other assets, including the present value of future cash flows from various sources-e.g., tuition. In practice, it doesn't hap- pen. In establishing an endowment investment pol- icy, most colleges and universities give, at best, passing consideration to other assets and liabilities.

Fischer Black long ago described an optimal investment policy for corporate pension plans that integrates pension fund investment policy and corporate capital structure.3 The strategy that maximizes the value of the firm is a bond-only pension portfolio.

Other frameworks exist for establishing com- prehensive investment policy. In practice, however, they are all largely ignored.

Public pension funds in the United States reg- ularly conduct asset/liability studies. And yet, there is no relationship between the funded status of public pension plans and their allocation to equi- ties. On average, the most poorly funded state plans exhibit the same equity allocation as those that are exceptionally well funded. Moreover, attempts to integrate public pension fund invest- ment policy more broadly with a state's finances are unheard of.

In short, institutional investors have generally failed to integrate portfolio investment policy into the larger context of the circumstances of the bearer of investment risk. Why? Why have ostensibly sophisticated and well-advised institutions not heeded the first lesson of portfolio theory and inte- grated their risk decisions?

The Editor's Corner is a regularffeoture of the Financial Analysts Journal. It reflects the views of Richard M. Ennis, CFA, and does n1ot represent the official views of the FAJ or CFA Institute.

6 www.cfapubs.org ?2007, CFA Institute

This content downloaded from 195.34.79.54 on Wed, 18 Jun 2014 08:07:09 AMAll use subject to JSTOR Terms and Conditions

Financial Analysts Journal

E Herding and the adviser effect. In the absence of integration, investment policy takes shape in other ways. The asset allocation of large public pension funds in the United States-besides being invariant with respect to funded status-is remark- ably homogenous. The current norm is approxi- mately 75 percent equities and 25 percent fixed income. Diversification patterns among domestic equity, foreign equity, real estate, and private equity are also strikingly similar. Departures from the norm are typically small and getting smaller. It looks like herding to us.

When we look across the spectrum of institu- tional investment portfolios, we can often detect the influence of a particular adviser or consultant. It is manifest not only in typical equity allocations but in the role of bonds, the number and style of active managers, the use of passive investment, diversification strategies, and the use of alternative investments. Should policy prescriptions vary largely by adviser or by client circumstance? If investment policy advice varies more by adviser, is it not more art than science?

E Questionable resource allocation. Institu- tional investors know things that should help establish priorities and dictate resource allocation in managing a portfolio. One is that asset allocation policy is the overwhelming determinant of long- run return. Another is that investors generally don't beat the market; it beats them. One might, therefore, expect institutional investors to devote significant resources to investment policy research relative to the resources expended trying to beat the market. But in whatever way we might measure the balance-by staff time or fee expenditures- institutions allocate much more of their resources to active management than to policy research. The allocation of resources is inconsistent with com- mon investment knowledge.

Diagnosis. Four people-one in Mumbai, one in Tokyo, one in Berlin, and one in Los Angeles- enter a doctor's office or hospital complaining of the same symptoms. Unknown to any of the four at the outset, the symptoms indicate appendicitis. In all cases, physicians will listen to the symptoms and then examine the patients. Many problems are ruled out, and a similar battery of tests is ordered by each of the physicians. In relatively short order, all four physicians, following standard medical practice,

will almost certainly diagnose appendicitis. More- over, they are all likely to arrive at the same conclu- sion as to whether and when to operate. And when they do operate, all will execute the procedure in the same fashion. This describes the application of a well-developed professional method.

Practitioners lack a professional method for investment policy development. We have a rich literature and many eager practitioners but nothing that resembles a universally accepted, systematic application of process and accumulated knowledge to solve a common social science problem.

FAJ A Call for Papers Reflection on the state of investment policy research leads us to raise several questions: * If theory is impractical, can it be considered good

theory? * Alternatively, if formulation of rational invest-

ment policy is stymied by a thicket of agency issues, should the structure and governance of investing institutions be reformed?

* If a class of funds occupies a distinct investment policy habitat, irrespective of variation in circum- stance, what accounts for the selection of habitat? In other words, how does the herd determine where to locate itself?

* If decision makers are unable to ascribe utility to hypothetical future outcomes many years into the future when they don't have an inkling of the larger context in which those outcomes might occur, are multiperiod simulation models even relevant?

* Practitioners know how to evaluate portfolio per- formance. How does one evaluate the perfor- mance of an investment policy?

* Is it feasible to create a professional method for the development of investment policy? What would it look like?

* What role does CFA Institute have in advancing a professional method?

We would like to narrow the gap between theory and practice in investment policy research. In this spirit, we call for papers that might inform practitioners' thinking on the questions raised here and help ensure that, as a profession, we move in the direction of more science, less art in deciding institutional investment policy. Submit papers atfaj.allentrack.net.

Notes 1. Lawrence Fisher and James H. Lorie, "Rates of Return on

Investment Common Stocks: The Year-by-Year Record, 1926-1965," Journal of Business (July 1968):291-316.

2. See "Optimal Investment Policies for University Endow- ment Funds," ch. 21 in Merton's Continuous-Time Finance (Malden, MA: Blackwell, 1992).

3. Fischer Black, "The Tax Consequences of Long-Run Pen- sion Policy," Financial Analysts Journal (July/August 1980):21-28.

8 www.cfapubs.org ?2007, CFA Institute

This content downloaded from 195.34.79.54 on Wed, 18 Jun 2014 08:07:09 AMAll use subject to JSTOR Terms and Conditions