Chapter 28 – Investment Policy and the Framework of the CFA Institute
28-1
CHAPTER 28: INVESTMENT POLICY AND
THE FRAMEWORK OF THE CFA INSTITUTE
PROBLEM SETS
1. You would advise them to exploit all available retirement tax shelters, such as 403b, 401k,
Keogh plans and IRAs. Since they will not be taxed on the income earned from these
2. a. The least risky asset for a person investing for her child’s college tuition is an account
denominated in units of college tuition. Such an account is the College Sure CD
offered by the College Savings Bank of Princeton, New Jersey. A unit of this CD
b. The least risky asset for a defined benefit pension fund with benefit obligations that
have an average duration of ten years is a bond portfolio with a duration of ten years
and a present value equal to the present value of the pension obligation. This is an
c. The least risky asset for a defined benefit pension fund that pays inflation-protected
benefits is a portfolio of immunized Treasury Inflation-Indexed Securities with a
3. a. George More’s expected accumulation at age 65:
n
i
PV
PMT
FV
Fixed income
25
3%
$100,000
$1,500
FV = $264,067
Common stocks
25
6%
$100,000
$1,500
FV = $511,484
b. Expected retirement annuity:
n
i
PV
FV
Fixed income
15
3%
$264,067
0
Common stocks
15
6%
$511,484
0
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c. In order to get a fixed-income annuity of $30,000 per year, his accumulation
at age 65 would have to be:
n
i
PMT
FV
Fixed income
15
3%
$30,000
0
His annual contribution would have to be:
n
i
PV
FV
Fixed income
25
3%
$100,000
-$358,138
This is an increase of $2,580 per year over his current contribution of
$1,500 per year.
4. a. The answer to this question depends on the assumptions made about the investor’s
effective income tax rates for the period of accumulation and for the period of
withdrawals. First, we assume that (i) tax rates remain constant throughout the entire
time horizon; and, (ii) the investor’s taxable income remains relatively constant
throughout. Consequently, the investor’s effective tax rate does not change, and we find
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b. For the Roth IRA, contributions are made with after-tax dollars, so the tax rate is
known (and taxes are paid) during the accumulation period; the tax rate for
withdrawals at retirement from a Roth IRA is zero, and is therefore also known
with certainty. On the other hand, contributions to a conventional IRA during the
accumulation period are tax-free, but the tax rate for withdrawals is not known
Chapter 28 – Investment Policy and the Framework of the CFA Institute
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CFA PROBLEMS
1. a. i. Return Requirement: IPS Y has the appropriate language. Since the Plan is currently
under-funded, the primary objective should be to make the pension fund financially
stronger. The risk inherent in attempting to maximize total returns would be
inappropriate.
ii. Risk Tolerance: IPS Y has the appropriate language. Because of the fund’s under–
funded status, the Plan has limited risk tolerance; should the fund incur a substantial
loss, payments to beneficiaries could be jeopardized.
iii. Time Horizon: IPS Y has the appropriate language. Although going-concern
b. The current portfolio is the most appropriate choice for the pension plan’s asset
allocation. The current portfolio offers:
i. An expected return that exceeds the Plan’s return requirement;
ii. An expected standard deviation that only slightly exceeds the Plan’s target; and,
iii. A level of liquidity that should be sufficient for future needs.
The higher expected return will ameliorate the Plan’s under-funded status somewhat,
and the change in the fund’s risk profile will be minimal. The portfolio has significant
allocations to U.K. bonds (42 percent) and large-cap equities (13 percent) in addition
The Graham portfolio offers:
i. An expected return that is slightly below the Plan’s requirement;
Chapter 28 – Investment Policy and the Framework of the CFA Institute
The Michael portfolio offers:
i. An expected return that is substantially above the Plan’s requirement;
4. a. An approach to asset allocation that GSS could use is the one detailed in the chapter. It
consists of the following steps:
1. Specify asset classes to be included in the portfolio. The major classes usually
considered are the following:
2. Specify capital market expectations. This step consists of using both historical
3. Derive the efficient portfolio frontier. This step consists of finding portfolios that
achieve the maximum expected return for any given degree of risk.
4. Find the optimal asset mix. This step consists of selecting the efficient portfolio
b. A guardian investor typically is an individual who wishes to preserve the purchasing
power of his assets. Extreme guardians would be exclusively in AAA short term
28-7
2. Liquidity.
Generally, endowment funds have long time horizons, and little liquidity is needed in
excess of annual distribution requirements. However, the JU endowment requires
liquidity for the upcoming library payment in addition to the current year’s contribution
to the operating budget. Liquidity needs for the next year are:
Library Payment +$200 million
Operating Budget Contribution +$126 million
Annual portfolio income =
(0.04 × $40 million) + (0.05 × $60 million) + (0.01 × $300 million)
3. Taxes. U.S. endowment funds are tax-exempt.
4. Legal/Regulatory.
U.S. endowment funds are subject to predominantly state (but some federal)
regulatory and legal constraints, and standards of prudence generally apply.
5. Unique Circumstances.
Only 25 percent of donated Bertocchi Oil and Gas shares may be sold in any one-year
b. U.S. Money Market Fund: 15% (Range: 14% – 17%)
Liquidity needs for the next year are:
Library payment +$200 million
Operating budget contribution +$126 million
Total liquidity of at least $297 million is required (14.85 percent of current endowment
assets). Additional allocations (more than 2 percent above the suggested 15 percent)
would be overly conservative. This cushion should be sufficient for any transaction
needs (i.e., mismatch of cash inflows/outflows).
Intermediate Global Bond Fund: 20% (Range: 15% – 25%)
To achieve a 10 percent portfolio return, the fund needs to take above average risk
(e.g., 20 percent in Global Bond Fund and 30 percent in Global Equity Fund). An
allocation below 15 percent would involve taking unnecessary risk that would put
Chapter 28 – Investment Policy and the Framework of the CFA Institute
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Global Equity Fund: 30% (Range: 25% – 35%)
To achieve a 10 percent portfolio return, the fund needs to take above average risk
(e.g., 30 percent in Global Equity Fund and 20 percent in Global Bond Fund). An
allocation above 35 percent would involve taking unnecessary risk that would put the
There is a single issuer concentration risk associated with the current allocation, and a 25
percent reduction ($100 million), which is the maximum reduction allowed by the donor,
The suggested allocations (point estimates) would allow the JU endowment fund to
meet the 10 percent return requirement, calculated as follows:
Asset
Suggested
Allocation
Expected
Return
Weighted
Return
U.S. Money Market Fund
0.15
4.0%
0.60%
Intermediate Global Bond Fund
0.20
5.0%
1.00%
Global Equity Fund
0.30
10.0%
3.00%
Bertocchi Common Stock
0.15
15.0%
2.25%
Direct Real Estate
0.10
11.5%
1.15%
Venture Capital
0.10
20.0%
2.00%
Total
1.00
10.000%
The allowable allocation ranges, taken in proper combination, would also be
consistent with the 10 percent return requirement.
6. a. Overview. Fairfax is 58 years old and has seven years until a planned retirement. She has
a fairly lavish lifestyle but few money worries. Her large salary pays all current expenses,
and she has accumulated $2 million in cash equivalents from savings in previous years.
Her health is excellent, and her health insurance coverage will continue after retirement
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OBJECTIVES
• Return Requirement. Fairfax’s need for portfolio income begins seven years from now, at
the date of retirement. The investment focus for her Savings Portfolio should be on
growing the portfolio’s value in the interim in a way that provides protection against loss
of purchasing power. Her 3% real, after-tax return preference implies a gross total return
If the market value of Reston’s stock does not change, and if she is able to earn a
10.8% return on the Savings Portfolio (or 7% nominal after-tax return), then, by
retirement age, she should accumulate:
• Risk Tolerance. The information provided indicates that Fairfax is quite risk averse; she
does not want to experience a decline of more than 10% in the value of the Savings
Portfolio in any given year. This would indicate that the portfolio should have below
average risk exposure in order to minimize its downside volatility. In terms of overall
wealth, Fairfax could afford to take more than average risk, but because of her
preferences and the non-diversified nature of the total portfolio, a below-average risk
objective is appropriate for the Savings Portfolio. It should be noted, however, that truly
CONSTRAINTS
• Time Horizon. Two time horizons are applicable to Fairfax’s life. The first time
horizon represents the period during which Fairfax should set up her financial
situation in preparation for the balance of the second time horizon, her retirement
Chapter 28 – Investment Policy and the Framework of the CFA Institute
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• Taxes. Fairfax’s taxable income (salary, taxable investment income, and realized capital
gains on securities) is taxed at a 35% rate. Careful tax planning and coordination with
investment planning is required. Investment strategy should include seeking income that
Person Rule will come into play, including the responsibility for investing in a
diversified portfolio. Also, she has a need to seek estate planning legal assistance, even
though there are no apparent gift or bequest recipients.
• Unique Circumstances and/or Preferences. The value of the Reston stock dominates the
value of Fairfax’s portfolio. A well-defined exit strategy needs to be developed for the
stock as soon as is practical and appropriate. If the value of the stock increases, or at least
does not decline before it is liquidated, Fairfax’s present lifestyle can be maintained after
retirement with the combined portfolio. A significant and prolonged setback for Reston
Industries, however, could have disastrous consequences. Such circumstances would
When added to the Savings Portfolio, total portfolio value would be $5,250,000. For this
portfolio to generate $658,000 in income, a 12.5% return would be required.
Synopsis. The policy governing investment in Fairfax’s Savings Portfolio will put
emphasis on realizing a 3% real, after-tax return from a mix of high-quality assets with
less than average risk. Ongoing attention will be given to Fairfax’s tax planning and legal
Chapter 28 – Investment Policy and the Framework of the CFA Institute
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b. Critique. The Coastal proposal produces a real, after-tax expected return of
approximately 5.18%, which exceeds the 3% level sought by Fairfax. The expected
return for this proposal can be calculated by first subtracting the tax-exempt yield from
the total current yield: 4.9% − 0.55% = 4.35%
Finally, the 4% inflation rate is subtracted to produce the expected real after-tax return:
This result can also be obtained by computing these returns for each of the individual
holdings, weighting each result by the portfolio percentage and then adding to derive a
total portfolio result.
From the data available, it is not possible to determine specifically the inherent
degree of portfolio volatility. Despite meeting the return criterion, the allocation is
neither realistic nor, in its detail, appropriate to Fairfax’s situation in the context of an
investment policy usefully applicable to her. The primary weaknesses are the
following:
• Allocation of Equity Assets. Exposure to equity assets will be necessary in order to
achieve the return requirements specified by Fairfax; however, greater diversification
of these assets among other equity classes is needed to produce a more efficient,
potentially less volatile portfolio that would meet both her risk tolerance parameters
and her return requirements. An allocation that focuses equity investments in U.S.
large-cap and/or small-cap holdings and also includes smaller international and Real
• Cash allocation. Within the proposed fixed-income component, the 15% allocation
to cash is excessive given the limited liquidity requirement and the low return for
this asset class.
• Corporate/Municipal Bond Allocation. The corporate bond allocation (10 percent) is
inappropriate given Fairfax’s tax situation and the superior after-tax yield on municipal
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• Lack of Risk/Volatility Information. The proposal concentrates on return expectations
and ignores risk/volatility implications. Specifically, the proposal should have
nominal, pre-tax figures, which must be adjusted for both taxes and inflation in order to
ascertain which portfolios meet Fairfax’s return objective. A simple solution is to
subtract the municipal bond return component from the stated return, then subject the
resulting figure to a 35% tax rate, and then add back tax-exempt municipal bond income.
This produces a nominal, after-tax return. Finally, subtract 4% percent inflation to arrive
at the real, after-tax return. For example, Allocation A has a real after-tax return of 3.4%,
calculated as follows:
Alternatively, this can be calculated as follows: multiply the taxable returns by their
respective allocations, sum these products, adjust for the tax rate, add the result to the
product of the nontaxable (municipal bond) return and its allocation, and deduct the
inflation rate from this sum. For Allocation A:
Allocation
Return Measure
A
B
C
D
E
Nominal Return
9.9%
11.0%
8.8%
14.4%
10.3%
Real After-Tax Return
3.5%
3.1%
2.5%
5.3%
3.5%
Table 28G also provides after-tax returns that could be adjusted for inflation and then
used to identify those portfolios that meet Fairfax’s return guidelines.
Allocations A, B, D, and E meet Fairfax’s real, after-tax return objectives.
ii. Fairfax has stated that a worst case return of –10% in any 12-month period would
Allocation
Parameter
A
B
C
D
E
Expected Return
9.9%
11.0%
8.8%
14.4%
10.3%
Exp. Std. Deviation
9.4%
12.4%
8.5%
18.1%
10.1%
Worst Case Return
−8.9%
−13.8%
−8.2%
−21.8%
−9.9%
d. i. The Sharpe Ratio for Allocation D, using the cash equivalent rate of 4.5
percent as the risk-free rate, is: (0.144 − 0.045)/0.181 = 0.547
ii. The two allocations with the best Sharpe Ratios are A and E; the ratio for
each of these allocations is 0.574.
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e. The recommended allocation is A. The allocations that meet both the minimum real,
after-tax objective and the maximum risk tolerance objective are A and E. These
allocations have identical Sharpe Ratios and both of these allocations have large
positions in municipal bonds. However, Allocation E also has a large position in
7. a. The key elements that should determine the foundation’s grant-making (spending)
policy are:
1. Average expected inflation over a long time horizon;
3. The 5%-of-asset-value payout requirement imposed by tax authorities as a
condition for ongoing U.S. tax exemption, a requirement that is expected to
To preserve the real value of its assets and to maintain its spending in real terms, the
foundation cannot pay out more, on average over time, than the real return it earns from
its investment portfolio, since no fund-raising activities are contemplated. In effect, the
b. OBJECTIVES
Return Requirement: Production of current income, the committee’s focus before
Mr. Franklin’s gift, is no longer a primary objective, given the increase in the asset
base and the Committee’s understanding that investment policy must accommodate
long-term as well as short-term goals. The need for a minimum annual payout equal
to 5% of assets must be considered, as well as the need to maintain the real value of
Risk Tolerance: The increase in the foundation’s financial flexibility arising from Mr.
Franklin’s gift and the committee’s spending policy change have increased the
foundation’s ability to assume risk. The organization has a more or less infinite
expected life span and, in the context of this long-term horizon, has the ability to
Chapter 28 – Investment Policy and the Framework of the CFA Institute
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CONSTRAINTS
Liquidity Requirements: Liquidity needs are low, with little likelihood of
unforeseen demands requiring either forced asset sales or immense cash. Such
needs as exist, principally for annual grant-making, are known in advance and
relatively easy to plan for in a systematic way.
Taxes: Tax-exempt under present U.S. law if the annual minimum payout requirement
(currently 5% of asset value) is met.
Unique Circumstances: The need to maintain real value after grants is a key
consideration, as is the 5% of assets requirement for tax exemption. The real return
achieved must meet or exceed the grant rate, with the 5% level a minimum
requirement.
c. To meet requirements of this scenario, it is first necessary to identify a spending rate
that is both sufficient (i.e., 5% or higher in nominal terms) and feasible (i.e., prudent
and attainable under the circumstances represented by the Table 26H data and the
The allocation philosophy will reflect the foundation’s need for real returns at or
above the grant rate, its total return orientation, its above average risk tolerance, its
low liquidity requirements, and its tax exempt status. While the Table 26H data and
historical experience provide needed inputs to the process, several generalizations are
also appropriate:
1. Allocations to fixed income instruments will be less than 50% as bonds have
provided inferior real returns in the past, and while forecasted real returns from 1993
2. Allocations to equities will be greater than 50%, and this asset class will be the
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3. Within the equity universe there is room in this situation for small-cap as well as
4. Given its value as an alternative to stocks and bonds as a way to maintain real return
and provide diversification benefits, real estate could be included in this portfolio. In
An example of an appropriate, modestly aggressive allocation is shown below. Table
28H contains an array of historical and expected return data which was used to develop
real return forecasts. In this case, the objective was to reach a spending level in real
terms as close to 6% as possible, a level appearing to meet the dual goals of the
committee and that is also feasible. The actual expected real portfolio return is 5.8%.
Intermediate Term
Forecast of
Real Returns
Recommended
Allocation
Real Return
Contribution
Cash (U.S.) T bills
0.7%
*0%
Bonds:
Intermediate
2.3
5
0.115%
Long Treasury
4.2
10
0.420
Corporate
5.3
10
0.530
International
4.9
10
0.490
Stocks:
Large Cap
5.5
30
1.650
Small Cap
8.5
10
0.850
International
6.6
10
0.660
Venture Capital
12.0
5
0.600
Real Estate
5.0
10
0.500
Total Expected Return
100%
5.815%
*No cash is included because ongoing cash flow from the portfolio should
be sufficient to meet all normal working capital needs.
8. a. The Maclins’ overall risk objective must consider both willingness and ability to
take risk.
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Ability: The Maclins have an average ability to take risk. While their large asset base
and a long time horizon would otherwise suggest an above-average ability to take risk,
their living expenses (£74,000) are significantly greater than Christopher’s after-tax
b. The Maclins’ return objective is to grow the portfolio to meet their educational and
retirement needs as well as to provide for ongoing net expenses. The Maclins will
The after-tax return required to accumulate £2 million in 18 years, beginning with
an investable base of £1,235,000 (calculated below) and with annual outflows of
£26,000, is 4.427 percent. When adjusted for the 40 percent tax rate, this results in
a 7.38 percent pretax return: 4.427%/(1 − 0.40) = 7.38%
Annual Cash Flow = –£26,000
Christopher’s Annual Salary
80,000
Less: Taxes (40%)
–32,000
Living Expenses
–74,000
Net Annual Cash Flow
–£26,000
Asset Base = £1,235,000
Inheritance
900,000
Barnett Co. Common Stock
220,000
Stocks and Bonds
160,000
Cash
5,000
Subtotal
£1,285,000
Less One-time Needs:
Down Payment on House
–30,000
Charitable Donation
–20,000
Total Assets
£1,235,000
Note: No inflation adjustment is required in the return calculation because
increases in living expenses will be offset by increases in Christopher’s salary.
Chapter 28 – Investment Policy and the Framework of the CFA Institute
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c. The Maclins’ investment policy statement should include the following constraints:
i. Time horizon: The Maclins have a two-stage time horizon because of their
changing cash flow and resource needs. The first stage is the next 18 years. The
ii. Liquidity requirements: The Maclins have one-time immediate expenses (£50,000)
iii. Tax concerns: The U.K. has a 40 percent marginal tax rate on both ordinary income
and capital gains. Therefore there is no preference for investment returns from taxable
iv. Unique circumstances: The large holding of the Barnett Co. common stock
(representing 18 percent of the Maclins’ total portfolio) and the resulting lack of
diversification is a key factor to be included in evaluating the risk of the Maclins’
9. a. 1. The cash reserve is too high.
• The 15 percent (or £185,250) cash allocation is not consistent with the liquidity
2. The 15 percent allocation to Barnett Co. common stock is too high.
• The risk of holding a 15 percent position in Barnett stock, with a standard deviation
3. Shortfall risk exceeds the limitation of –12 percent return in any one year.
4. The expected return is too low (the allocation between stocks and bonds is not
7.38 percent.
Chapter 28 – Investment Policy and the Framework of the CFA Institute
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b. Note: The Maclins have purchased their home and made their charitable contribution.
Cash: 0% to 3%
The Maclins do not have an ongoing need for a specific cash reserve fund. Liquidity
Equities offer higher expected returns than bonds and also offer international
diversification benefits. The risk/return profile is also relatively more favorable than it is
for either U.K. Bonds or Barnett stock. Therefore the highest allocation to U.S. Equities
is most appropriate.
Barnett Co. Common Stock: 0% to 5%
The Maclins’ below average risk tolerance includes a shortfall risk limitation of –12
The following sample allocations are provided to illustrate that selected ranges
meet the return objective.
Sample allocation 1:
Asset Class
Weight (%)
Return (%)
Weighted
Return (%)
Cash
1
1.0
0.01
U.K. Corporate Bonds
55
5.0
2.75
U.K. Small-capitalization
Equities
10
11.0
1.10
U.K. Large-capitalization
Equities
10
9.0
0.90
U.S. Equities
20
10.0
2.00
Barnett Co. Common Stock
4
16.0
0.64
Portfolio Expected Return
7.40
Chapter 28 – Investment Policy and the Framework of the CFA Institute
Sample allocation 2:
Asset Class
Weight (%)
Return (%)
Weighted
Return (%)
Cash
1
1.0
0.01
U.K. Corporate Bonds
50
5.0
2.50
U.K. Small-capitalization
Equities
10
11.0
1.10
U.K. Large-capitalization
Equities
10
9.0
0.90
U.S. Equities
24
10.0
2.40
Barnett Co. Common Stock
5
16.0
0.80
Portfolio Expected Return
7.71