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1 Investment Management Policy

Investment management policy for the various categories of institutional investors can be divided into the following stages:

  • Identification of objectives and constraints,

  • Formalisation of the investment strategy,

  • Implementation of the financial strategy,

  • Periodic rebalancing of the portfolio, and

  • Performance assessment and risk control.

The level of detail and structure of each stage of investment management policy varies depending on the category of the institutional investor, size of the portfolio, complexity of the management model adopted, and relative regulation.

2 Identification of Objectives and Constraints

The starting point for setting up an investment management policy is the identification of the objectives and obligations of the investor. In general terms, the objectives of such a policy for an institutional investor are those of achieving efficient risk-return combinations on a given time horizon, bearing in mind any constraint or return guarantee to the final investors. More specifically, there is a fundamental difference between institutional investors that need to implement investment policies based on asset-liability management and those that can adopt asset-only investment policies.Footnote 1

In the first case, the investment policy must consider and assess the liabilities that correspond to the performance obligations guaranteed to the final investors. In other words, the same investment policy serves to guarantee performance to the final investors within the specified contractual terms and conditions. This obliges the institutional investor to perform a strict and dynamic control of the surplus or deficit between the total amount of investments at a certain date and the current value of the liabilities and obligations in existence at that date, in order to promptly intervene in case of excessive deviation between the two total values.

In the second case, lacking any predefined performance obligation, the institutional investor can adopt an investment policy that exclusively focuses on optimal asset allocation, while maintaining the necessary caution with regard to the liquidity needs required by the adopted management model. Compared to the former case, the latter entails a less strict risk control, at least in relative terms, and in effect, for a given risk level, the investment policy has only an indirect impact on the performances provided to the final investors, in the form of failed performance maximisation.

Constraints of the investment policy include a series of factors that exercise a direct or indirect influence on the definition of the objectives of the investment policy. Moreover, in the case of an institutional investor, these constraints can be traced back to the following factors:

  • Liquidity requirements,

  • Reference time horizon,

  • Tax treatment of financial instruments,

  • Legislative-regulatory obligations, and

  • Specific factors related to individual institutional investors.

Each of these factors has an impact on the investment policy, but the first two, in particular, influence the ability of the institutional investor to support risks and, therefore, have a direct influence on the identification of the most appropriate risk-return combination. The first significant factor is the need for the institutional investor to have access to cash flows during the life of the investment, in order to honour requests for reimbursements or performance obligations, whether expected or unexpected.Footnote 2 This requirement is connected to liquidity risk, which has a significant impact on the definition of the investment policy and varies depending on the type of institutional investor and, above all, depending on the reimbursement, more or less discretionary, of the capital provided by final investors.Footnote 3

A second factor that has a significant impact on the definition of the investment policy is the reference time horizon adopted by the investor. This factor assumes significance under two different aspects: the effect that it has on the ability of the investor to bear risks and impact it has on the actual construction of the portfolio. In this regard, the traditional principle that is widely accepted by operators, albeit not without criticism, consists of the so-called time diversification, on the basis of which, as the time horizon adopted by the investor increases, so does the weight potentially assignable to assets with a higher risk.Footnote 4

The third factor able to influence investment policy, in particular the security selection stage, is the tax treatment of the different financial instruments. In this case, tax legislation for each category of institutional investor must be analysed in relation to the income provided by the different financial instruments, with the objective of establishing an investment policy that can achieve an optimisation of the tax burden, while complying with other conditions.

Moreover, the fourth factor affecting the investment policy of institutional investors involves legislative-regulatory constraints, which may be more or less stringent depending, in particular, on the type of final investors.Footnote 5 These constraints may include restrictions to the overall composition of the portfolio, in terms of the categories of financial instruments and/or homogenous asset classes of financial instruments; restrictions to risk concentration; restrictions to the holding of voting rights, resulting in maximum thresholds for participation in the companies’ equity capital; and general prohibitions that identify the type of operations that cannot be made by a particular category of institutional investors.

Lastly, the final factor is represented by non-regulatory restrictions that are set by the institutional investor. One example is the constraint, which is not prescribed by law, of implementing socially responsible investment policies, where not only the risk-return combination of the individual investment is assessed, but also the ethical, social, and environmental impact that it generates. Therefore, the constraints individually set by each institutional investor have a significant impact on the concrete realisation of the investment policy.Footnote 6

3 Formalisation of the Investment Policy

Once the objectives and constraints of the investment policy have been defined, institutional investors need to identify the financial strategy they intend to implement, in order to achieve efficient risk-return combinations from the resources invested during a given period of time. This stage—beyond any regulatory requirement—demands the formalisation of the following:

  • Objectives to achieve using the investment policy,

  • Criteria to follow in its implementation,

  • Tasks and responsibilities of the subjects involved in the process, and

  • Control and assessment system of the results obtained.

In order to reach these objectives, the investor must identify:

  • The approach underlying the investment policy;

  • Financial instruments in which to invest, and the associated risks;Footnote 7

  • Ex ante constraints to risk exposure;Footnote 8

  • Management style adopted;

  • Management method, whether internal or delegated, to adopt when such a choice is possible; and

  • Organisational division of tasks and responsibilities of the various subjects involved in the investment process.

The financial strategy must be subjected to periodical review, in order to assess its effective congruence with the objectives and requirements of the investor.

4 Implementation of the Financial Strategy

The next stage of investment management policy involves the implementation of the financial strategy, which depends on specific factors regarding the investor, as well as on economic and market factors. The approaches underlying the investment decisions are based on two alternative methods:

  • The bottom-up approach, and

  • Top-down approach.Footnote 9

In the bottom-up approach, the investment process starts directly with the selection of single securities in which to invest, on the basis of a sector analysis, an analysis of the company fundamentals, a quantitative analysis, or any other selection criterion deemed reliable. The resulting overall investment portfolio is, therefore, given by the sum of the single securities chosen during the initial stage.

In contrast, a top-down approach focuses, first, on the strategic allocation of the investor’s portfolio, identifying the division between macro-classes of financial assets, consistent with the objectives of medium-long-term investments, and only later concentrates on the selection of individual financial instruments. In the case of institutional investors, it is usual and, in some cases, compulsory to follow the top-down approach, in which the investor starts by dividing the portfolio into different investment classes and, in the final stage, selects individual financial instruments. This preference is linked to three factors.

The first factor is the hypothesis that the forecast of the expected return of the homogenous asset classes of financial instruments may be subject, on average, to more limited margins of error, if compared to the forecast of the return expected from each single security. If the specific risks of the single security included in a homogenous asset class are mutually offset, it would undoubtedly seem more rational and less complex to concentrate only on the forecast of the variables that are the source of total risk which cannot be diversified. The second factor is an improvement of the diversification effect, due to an easier forecast of the risks, at least in relative terms, and, above all, of the correlations between homogenous asset classes, instead of between single securities. Finally, the third factor is a better adaptation of the top-down approach to hierarchical decision-making structures and allocation of tasks, with the identification of the subjects responsible for each stage of the investment policy.Footnote 10

The most well-known model for realising a top-down investment approach is Markowitz’s mean-variance optimisation, which, after decades, still constitutes one of the most applicable methods for reconciling methodological rigour with practical feasibility today.Footnote 11 As you will read, Chap. 4 is dedicated to the analytical presentation of the model in the logic of strategic asset allocation, its theoretical assumptions, the problems associated with its practical application, and the relative solutions.Footnote 12 Based on a top-down approach, the management of an investment portfolio may be broken down into three consecutive stages:

  • Strategic asset allocation,

  • Tactical asset allocation (or market timing), and

  • Stock picking.

4.1 Strategic Asset Allocation

Strategic asset allocation consists of the identification of the weights that the different asset classes must keep within the portfolio in the medium to long term. It is derived from the forecasts of the real and financial trends of each market sector, and from the consequent assessment of comparative convenience, bearing in mind the investor’s objectives and constraints. Therefore, the target weights obtained with strategic asset allocation define the structure that the portfolio must maintain, within the time period assumed by the investor.

At the first level, strategic asset allocation envisages the identification of different asset classes in which to divide the investment universe, where each asset class represents a group of financial assets with a certain degree of homogeneity, in terms of risk-return combination. The significance of the identification of the asset classes is obvious, if we note that the market variables forecasting process is achieved via the formulation of expectations regarding the evolution of the general economic scenario, in order to obtain forecasts on the future of the single-market sectors, which are specifically distributed into as many asset classes.

As mentioned, it is obvious that the creation of a connection between macroeconomic forecasts and the return of a single share or bond is a difficult task, given that the return of each security is significantly influenced by the specific factors associated with each company. However, if we consider an entire asset class consisting of a range of securities with homogenous characteristics, the specific factors tend to mutually compensate and disappear, thereby tightening the connection between formulated economic forecasts and asset-class trends.Footnote 13

The composition criteria vary according to whether we consider equity, bond, or money-market asset classes; however, in all three cases, it is essential that the selected asset classes satisfy the following three requirements:

  • Completeness,

  • Internal consistency, and

  • External differentiation.

The first requirement entails that the selected asset classes be able to completely represent the investment universe. The second requirement imposes that each asset class consist of financial instruments that are as homogenous as possible, and similarly exposed to systematic risk factors. Lastly, the third requirement posits that the different asset classes have different exposure levels to the various macroeconomic and political factors, or sources of systematic risk.

Table 3.1 provides the possible segmentation criteria for equity, bond, and money-market asset classes.

Table 3.1 Identification of asset classes
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At the second level, we need to identify a benchmark index suitable for representing each asset class, and on which to formulate forecasts of the optimisation process inputs.Footnote 14 Each benchmark can play a key role in strategic asset allocation via two distinct methods. They can represent:

  • A portfolio to replicate, in case of indexed management, and

  • A reference portfolio to beat, in case of active management.

As mentioned in Chap. 2, financial theory does not agree on which investment strategy is preferable between indexed and active management, since there are valid arguments in support of both.Footnote 15 A somewhat hybrid approach, which is able to grasp, albeit partially, the strengths of both management styles, is the so-called core-satellite strategy. This strategy divides the portfolio into two sub-portfolios: the core portfolio and satellite portfolio. The core portfolio is managed using an indexed (or semi-indexed) strategy, with the objective of minimising both benchmark-related risk and costs. The satellite portfolio is managed with an active management strategy, which aims to reach an over-performance, with respect to the benchmark, and, consequently, with respect to the core portfolio.Footnote 16

At the third level, we need to determine whether the investment strategy is constrained to the long-only investment approach, or whether the long-short approach is possible. In the first case, even in a situation of highly negative forecasts for a given market sector, it would not be possible to open short positions because of the long-only constraint; moreover, it is only possible to zero the weight of that asset class in the portfolio. In the second case, by removing the no-short-selling constraint, it is possible to open short positions for a given sector, for which there are highly negative forecasts.Footnote 17

Numerous empirical verifications have demonstrated how strategic asset allocation and the medium-long-term weights of the corresponding strategic benchmarks are able to explain most of the variability in the returns of an investment portfolio over time, conversely leaving a marginal role to market timing and stock picking, in explaining the variance of an investment portfolio’s historical returns.Footnote 18

4.2 Tactical Asset Allocation

Tactical asset allocation (or market timing) entails a temporary overweight/underweight of some asset classes, depending on short-term expectations. Therefore, it is composed of the set of actions to manage, in the short term, the portfolio established during the strategic asset allocation, in order to take advantage of the best market opportunities offered by the evolution of the economic outlook in the near term. In other words, tactical asset allocation refers to the possibility of deviating from the medium-long-term portfolio strategy for short or very short periods, with the objective of achieving over-performance with respect to the market.

The possibility of achieving a positive differential return with respect to the benchmark depends on the ability to correctly predict the timing of the upward or downward trends of the market, and the consequent variation of the portfolio’s exposure to systematic risk. Operationally, tactical asset allocation involves the fixing of admissible fluctuation bands, with respect to the medium-long-term weight defined at the strategic asset allocation stage. In the short term, therefore, an overweight/underweight is allowed, with respect to the medium-long-term strategic weights, in compliance with the range of predefined fluctuations.Footnote 19 Thus, this is valid for the active management approach. However, in the case of indexed management, there is no form of market timing, and deviations from the strategic benchmark are not sought.

The impact of tactical asset allocation on costs and risk requires attention. Of course, management costs increase as the intensity of the use of market-timing policies increases. Since it is one of the levers available to the active manager to beat the reference benchmark, the use of market timing takes us back to the issue of comparative convenience between costs, market efficiency, and, finally, the investor’s degree of risk tolerance.

In terms of risk, market timing may increase or decrease the total risk, depending on the type of choices made, while it increases, in any case, the relative risk in relation to the benchmark.

A model that is able to simultaneously manage strategic asset allocation—on the basis of a Bayesian approach—and tactical asset allocation—via the use of absolute or relative views, in relation to the evolution expected for the various market sectors in the short term, and the identification of a degree of trust associated with each estimate—is that developed by Black and Litterman. This model is described in Chap. 4.

4.3 Stock Picking

Stock picking, also known as security selection, consists of the identification of the individual financial instruments to be included in each asset class. The degree of complexity involved in this activity varies according to the type of management strategy used, whether indexed or active.

With indexed management, the selection activity is conducted by reproducing the risk-return combination of the benchmark of each asset class, with the objective of minimising replication errors.Footnote 20 At the same time, the need to contain transaction costs may prompt the indexed manager to not acquire all of the financial instruments included in the benchmark—in the same proportion with which they compose that benchmark according to the full-replication approach—but may persuade him to operate using the mimicking portfolio approach, with the objective of more economically replicating the benchmark’s risk-return combination. There are many methods for creating mimicking portfolios, and they all have the same objective of saving the portfolio’s trade-related costs, with respect to the full-replication method. These methods range from the acquisition of only a sample of securities, which are able to create a portfolio that is sufficiently similar to the benchmark, to the use of derivatives, which are able to reproduce the risk-return combination of the same benchmark.

With active management, the manager attempts to create value added via an efficient selection of securities due to his skill in acquiring undervalued securities and avoiding overvalued ones.Footnote 21 The selection criteria vary according to the market; in the bond markets, criteria are based mainly on forecasts on the evolution of interest rates, their volatility, and credit spreads, while in the equity markets, they are based on fundamental, technical, or quantitative analysis.Footnote 22

5 Periodic Portfolio Rebalancing

An investment policy must necessarily define the methods that guide the portfolio’s periodic rebalancing, which is aimed at aligning the proportions of the single asset classes to the original weights from the strategic asset allocation. A periodic rebalancing action may also be required solely because of the effect of the portfolio’s natural deviation from its strategic combination, due to the higher performance of some asset classes over others. In this situation, the implementation of periodic rebalancing could be interpreted as a so-called contrarian strategy, since it comprises a reduction in the weight of the asset classes subject to relative appreciation and an increase in the weight of those that recorded relative depreciation, with the consequent temptation to opt for a non-rebalancing strategy.

The holding of a non-rebalanced portfolio for a preset time horizon is known as the buy-and-hold strategy, also known as the do-nothing strategy. In this situation, which does not occur very frequently, especially with institutional investors, the investment policy concentrates on the definition of an initial optimum portfolio, identifying the weights of the different asset classes, without any further intervention. Although having the advantage of limiting portfolio trade-related costs, due to the absence of a periodic rebalancing activity, this strategy has three significant consequences on the portfolio:

  • Redistribution of the weights of the asset classes with respect to the original asset allocation target;

  • Lack of consideration of the risk control function implicit in the rebalancing action; and

  • Incoherence between the investor’s risk aversion and exposure of the portfolio to market volatility, which is increasingly more concentrated in the highest performing asset classes.

In support of periodic rebalancing, it is also worth considering the broad quantitative analysis that documents a mean-reverting behaviour of the asset classes, which is, therefore, in contrast with the idea of the indefinitely high or low returns of a single asset class.Footnote 23

Thus, the information that has been presented supports the expediency of periodic rebalancing, through the implementation of a constant-mix strategy (also known as do-something strategy), where interventions to the portfolio are periodically made, in order to restore the weights of each asset class to the original asset allocation target.

From the operational perspective, the adoption of a constant-mix strategy requires the definition of the periodical rebalancing timing and methods. These are important aspects, given that each rebalancing intervention involves transaction costs, which have an inevitable effect on the overall performance. With regard to rebalancing timing, there are three main alternative methods available for implementing a constant-mix strategy:Footnote 24

  • Periodic rebalancing (calendar rebalancing) with a predefined time interval (monthly, quarterly, etc.);

  • Periodic rebalancing, based on exceeding the predefined thresholds (percent range rebalancing), which determines a restoration of the original asset mix when the set fluctuation bands are exceeded; and

  • Rebalancing of the intervals within an allowed range (rebalancing to the allowed range), which, like the previous case, requires fixing restoration once the set bands have been exceeded; however, in this case, restoration does not re-establish the original asset mix, but restores the upper or lower limit of the threshold.Footnote 25

An alternative rebalancing method to the above is the so-called constant-proportion strategy, which cannot be considered simply a method for realising periodic rebalancing, but part of a greater framework of strategies aimed at seeking a dynamic form of protection for the investment portfolio value. This strategy is summarised in Table 3.2. It is useful to note that a periodic rebalancing action is not a tactical asset-allocation activity, but consists in the elimination of the active positions created by the market, or deriving from previous choices that were aware of the overweight/underweight of some of the asset classes, even though its implementation requires the simultaneous consideration of the choices made during tactical asset allocation.

Table 3.2 The constant-proportion portfolio insurance strategy
Full size table

6 Performance Assessment and Risk Control

The final stage of the investment process is performance assessment, its breakdown, and risk control. The first step in performance assessment is the calculation of returns, which requires the identification of the most appropriate measure for the objective pursued among the methods of calculation available. As you will see in Chap. 7, the alternatives are:

  • Simple, compounded, and continuous returns;

  • Arithmetical and geometrical returns;

  • Time- and money-weighted returns; and

  • Gross and net returns.

As such, the formulation of an opinion on portfolio performance requires the identification of the risk of that investment portfolio in its different forms of absolute, asymmetric, and relative risk, and the calculation of the consequent risk-adjusted performance measures, which will enable us to assess the efficiency of the portfolio asset manager, with respect to the benchmark, competitors, and ex ante risk limits.

When comparing the performance of competitors, it is essential that homogenous peer groups be created, consisting of portfolios with the same management approach. To this end, the most common operational solution is to create a peer group, based on the “investment style” adopted using a deductive approach founded on the so-called style analysis. Based on this logic, the mimicking portfolio is obtained with a regression of the portfolio returns, with respect to the returns of a series of benchmark indices that are representative of the investment universe, setting the benchmark weights inside the portfolio as unknown quantities, and putting two constraints, so that the sum of the weights is equal to one and each weight has an admissible value between zero and one.Footnote 26 This approach is described further in Chap. 8.

With the non-indexed strategy, performance assessment requires the evaluation of the ability to realise an effective stock-picking activity via the selection of the best market securities taken as reference. To this end, we have to identify the most suitable measuring model, which, as is discussed in Chap. 7, depends upon the simultaneous presence or absence of a tactical asset-allocation activity.

Where simultaneous activities of stock picking and market timing occur, it is essential to jointly measure both the ability to realise an effective securities selection and to realise a profitable tactical asset allocation that is able to temporarily overweigh the asset classes designated to over-perform the market and, at the same time, to underweight the asset classes that will underperform the market.Footnote 27

However, a separate measurement of the two abilities could be misleading and confuse the results of the first activity with those of the second. An in-depth ex post performance assessment requires the identification of the most appropriate performance attribution model, aimed at shedding light on those management choices that generated the gap between the overall result of the portfolio and benchmark, breaking down relative performance into its determinants, and attributing it to the various factors that contributed to its generation. This is discussed further in Chap. 9.

Therefore, the performance assessment activity must be framed within a suitable control system, aimed at verifying that the results of the actions set by the different subjects involved in the investment process are in line with the established financial objectives.Footnote 28 The control system must refer to management parameters and risk thresholds formalised ex ante at the portfolio level, and, in the case of delegated management, at the manager level.

Finally, the consistency between the established investment policy and investor’s financial objectives must be verified, bearing in mind the constraints and assessing any adjustments that may be required, including those due to changes in external circumstances and financial market trends.