Section V.C. Investment Policy

3.Investment-related concepts to cover in investment policy statement

investment and tax management strategies rebalancing approach passive to active spectrum location of assets

Investment Policy

1. Asset allocation methodology 2. Client-specific concepts to cover in an investment policy statement 3. Investment-related concepts to cover in an investment policy statement 4. Governance and ethics-related concepts to cover in an investment policy statement

The Employee Retirement Income Security Act (ERISA)

1. Plans must provide participants with regular and automatic communication regarding funding and features. 2. Sets minimum standards for participation, vesting, benefit accrual and funding. 3. Requires accountability of plan fiduciaries. 4. Grants participants the right to sue for breaches of fiduciary duty. 5. Guarantees payment if a defined benefit (DB) plan is terminated through the PBGC. 6. Protects the plan from mismanagement and misuse of asset through fiduciary provisions.

Investment Policy Statement (IPS) Described

A document between an investment professional (e.g., advisor, manager or consultant) and his or her client that defines objectives, rules and guidelines for the portfolio ***Specifics regarding asset allocation, risk tolerance and parameters, time horizon, cash-flow needs and liquidity are typically clarified in the IPS.

Which of the following laws or acts is best known for defining "fair and reasonable" distributions?

A) ERISA B) UPAIA C) UPIA D)UPMIFA Answer: B The Uniform Principal and Income Act (UPAIA) first defined distributions considered "fair and reasonable."

Which of the following is (are) not expected to be included in an investment policy statement? I. standards and appropriate benchmarks for performance evaluation II. guidelines for choosing a brokerage or custodian and appropriate fees III. fund manager selection IV. target allocation ranges for portfolios or plans using strategic asset allocation methods

A) I and III only B)IV only C)II and IV only D) III only Answer: D All of the following are typically found in an investment policy statement: standards and appropriate benchmarks for performance evaluation, guidelines for choosing a brokerage or custodian and appropriate fees, and target allocation ranges for portfolios or plans using strategic asset allocation methods. The selection of specific fund managers is not usually included in an IPS.

The risk management section of an Investment Policy Statement for institutional investors does not typically contain which of the following below? I. performance measurement accountability II. asset allocation decisions III. duration IV. manager search constraints

A) I, II, and III only B) III and IV only C) II and IV only D)I and II only The risk management section of an Investment Policy Statement for institutional investors typically contains acceptable downside (negative) performance, performance measurement accountability, metrics for risk measurement (e.g., standard deviation, VaR, etc.), duration, and the rebalancing process.

All of the following may be included as investment policy statement "addendums" so that the Investment Committee has the authority to make necessary changes without needing a full vote of the Board of Trustees? I. asset allocation adjustments II. investment manager changes III. spending policy revisions IV. fees and compensation disclosure

A) III and IV only B) I and II only C) II, III, and IV only D) IV, I, and II only Answer: D Fees and compensation disclosure, investment manager changes, and even asset allocation adjustments may be included in addendums so that the board does not need to vote to allow these changes. Spending policy however would need the vote of a board of trustees.

When preparing for an upcoming Department of Labor audit of a qualified plan you manage, which of the following would not be required to confirm that the plan's investment guidelines and standards have been identified and are being met? I. details regarding brokerage and custodian relationships II. asset classes and investment styles allowed III. performance metrics based on IWI or CFA Institute standards IV. performance reporting on at least a quarterly basis

A) III only B) III and IV only C) I and II only D) IV only Answer: B Details (guidelines) regarding brokerage and custodian dealings, and a list of asset classes and investment strategies allowed or disallowed would be helpful in showing that the plan investment guidelines were being met. Performance measurement would be helpful to demonstrate proper management and monitoring, but these metrics are not required to fall under any one organization's recommendations; and while quarterly reporting would be preferred to annual reporting, it is not required under the DOL.

Alicia Parker is an investment consultant who has been retained by We Care, LLC (a local non-profit) to help them manage their $10 million retirement account. The members of the organization's investment committee do not have significant experience managing investment funds but did perform due diligence before hiring Ms. Parker. Despite their best effort to hire the best talent available, Ms. Parker makes several strategic investment mistakes which lead to large losses in the portfolio. According to several complaints made against Ms. Parker on file with state and national regulators, she may be guilty of gross negligence in performing her duties as consultant to the We Care, LLC and other clients. Which of the following statements is accurate according to UPMIFA?

A) We Care, LLC is allowed to recoup their losses in court because of the gross negligence cited. B) The investment committee's decision to delegate authority of investment management would likely be found imprudent under these circumstances. C) The board of directors will not likely be held personally responsible for actions of the investment consultant. D) The investment consultant was not acting in a principal-agent relationship. Answer: B The investment committee will not likely be held personally responsible for actions of the investment consultant as they performed the necessary due diligence in selecting her. We Care, LLC may be able to recoup losses in a court based on fraud or gross negligence but there is no guarantee of such recovery.

All of the following, except for which item below, may be included as investment policy statement "addendums" so that the Investment Committee has the authority to make necessary changes without needing a full vote of the Board of Trustees?

A) asset allocation adjustments B) investment manager changes C)fees and compensation disclosure D) spending policy revisions Fees and compensation disclosure, investment manager changes, and even asset allocation adjustments may be included in addendums, so that the board does not need to vote to allow these changes. Spending policy however would need the vote of a board of trustees.

The first step a pension fund should take before beginning to invest is to ___________________________________________.

A) decide on a spending and rebalancing policy B) establish plan investment goals and objectives C) determine asset allocation guidelines D) interview investment consultants or advisors Answer: B The first step for any investor is to determine the goals and objectives of the portfolio. All subsequent steps in the investment process follow.

According to Modern Portfolio Theory and strategic asset allocation, risk reduction of the overall portfolio is largely determined by what?

A) semi-standard deviations B) correlations C) returns D) standard deviations Answer: B Low positive and/or negative correlations are the key to risk reduction according to Modern Portfolio Theory and the implementation of strategic asset allocation models. Standard deviations and semi-standard deviations are also measurements of risk. This is a great example of a question you might see on the exam where three answer choices are accurate to some degree, but you need to pick the best answer choice. Low and negative correlations among assets within a portfolio help drive down the risk of the portfolio. Standard deviations and semi-standard deviations are, in part, a result or product of the correlation effect. Thus, correlations is the best answer choice.

Which ranking of the following criteria for evaluating hedge funds is listed in the correct order of importance?

A) suitability, correlations, performance B)correlations, risk, fees, and expenses C)performance, risk, liquidity D) transparency, liquidity, suitability There is certainly debate over the priority of criteria for evaluating and selecting hedge funds. It does, however, seem clear from IWI material that suitability should always be first; and performance is somewhere near the bottom of the list.

Which of the following is not a standard consideration in a portfolio rebalancing mandate for strategic asset allocation portfolios?

A) tax efficiency B) collars C) volatility D) performance​​​​​​​ Answer: D Performance may cause the necessity to rebalance, but it is not one of the considerations.

Which of the following situations or relationships is least likely to result in a fiduciary standard being owed, assuming appropriate due diligence and oversight are performed?

A)qualified retirement plan manager B)an investment consultant or advisor C)family trustee of a family trust D) outside investment committee member Answer D Trustees of family trusts, including family members, are expected to serve in a fiduciary capacity. Investment consultants and advisors are usually held to a fiduciary standard. Individuals who serve on a board of directors may be held to a fiduciary standard although those on an outside investment committee may be held to a lesser standard if they follow appropriate due diligence and oversight. Qualified retirement plan administrators and managers are usually held to a fiduciary standard although some may not be if they only have limited responsibilities.

Taxation of Bond Interest Income

Bond Type Federally Taxable State Taxable Corporate/Taxable Muni. YES YES U.S. Treasury Bonds YES NO Municipal Bonds NO* YES**

Asset Location

Defined an exercise in which investors place certain assets and investments, based on tax status and preferences, into different accounts (e.g., taxable, tax-deferred, or tax-exempt) in order to minimize taxes during the growth and distribution phases of each account Note - on your exam... they will have to give you a fair amount ofinformation/detail regarding any investment for which they are asking you to place in different (taxable or tax-deferred accounts) in order to build the optimal tax-efficient portfolio.Candidates report this as low probability to show up on yourCIMA certification exam.

Core and Satellite Strategy

Examples: - Core includes passively management funds included in a strategic asset allocation framework while active funds are considered satellite - Core includes domestic investments while satellite investments include all non-domestic investments - Core includes a mix of traditional investments while the satellite includes only alternative investments

Goals & Objectives and Client's Risk Tolerance

Identify and prioritize client goals and objectives. Establish accurate and appropriate expectations. Differentiate between a client's ability to take on risk and his or her tolerance for risk.

Which of the following are not considered a prohibited transaction by ERISA?

I. A 30-day loan for an amount under $10,000 is approved by the plan to be made to Johnson Financial Corp., a subsidiary of the administration company that services the plan. II. A qualified plan extends credit to Summit Leasing, LLC whose CFO is the first cousin of Jason King who sits on the investment committee. III. Mike Powers, an investment consultant with discretionary but only limited trading power of attorney over the plan account, is allowed to pay what otherwise would be considered unreimbursed expenses for parking at an event he is required to attend from plan funds. IV. The local fire department plan and trust donates unwanted furniture to a former investment committee member's charity. Correct Answer A) II and IV only B)III and II only C)I and III only D)IV and I only Answer: A

Review the IPS for compliance at least annually and modify as necessary

Internal policies and procedures Inside and outside audits Regulatory oversight

1. Asset allocation methodology

Spending policy and its implications on asset allocation Strategic vs. tactical asset allocation Core and satellite strategy Total return

The Employee Retirement Income Security Act (ERISA)

The Employee Retirement Income Security Act, passed in 1974, established law and guidelines for pension plans, fiduciaries and investment managers as they relate to managing retirement and pension assets

Investment Time Horizon

The time period over which money will be invested Some consider investment time horizon to mean the average length of time the money will be invested while others believe it to mean the date at which the money will be needed

Reducing Portfolio Risk

While standard deviation is a measure of total (or overall) risk and a helpful metric to be sure; ***we're primarily looking for low correlations between assets and between any single asset to the portfolio to lower the overall "portfolio risk" when considering adding any new asset or investment to a portfolio.

4. Governance and ethics-related concepts to cover in an investment policy statement

a. liability policy b. disclosures c. duties and responsibilities such as proxy voting and monitoring requirements

2. Client-specific concepts to cover in an investment policy statement

goals and objectives risk tolerance time horizon asset class descriptions and allocation range active and passive methodologies diversifying concentrations tax concerns liquidity target rate of return

Dynamic Asset Allocation

used to describe several asset allocation methodologies • commonly refers to an asset allocation strategy that maintains equity exposure but also protects against loss of capital • example: CPPI - constant proportion portfolio insurance) ***• DAA offers more opportunity for risk management than SAA and a more tightly defined methodology compared to TAA

Uniform Prudent Management of Institutional Funds (UPMIFA)

• A uniform act, adopted by 49 states (as of 2012) that provides guidance on investment management and endowment expenses for nonprofit and charitable organizations • A significant revision per this act allows the fund to determine a spending policy that will preserve capital of the fund over the long-term, as opposed to limiting spending with regard to "historic dollar value"

Total Return (Strategies)

• Also called "absolute return" • an absolute return strategy is one that employs multiple strategies (e.g., long/short, leverage, arbitrage, etc.) in order to achieve positive returns in the entire portfolio on a regular (e.g., annual) basis

Uniform Principal in Income Act (UPAIA)

• Completed by the Commissioners on Uniform State Laws in 1997 and amended in 2000 • Ensures protection of creator's and decedent's rights by establishing procedures by which trustees and estate administrators must allocate receipts and payments of principal and income • Defines "fair and reasonable" distributions The Uniform Principal and Income Act (UPAIA) first defined distributions considered "fair and reasonable."

Governance of funds:

• ERISA • Uniform Prudent Investor Act • Uniform Principal and Income Act • Uniform Prudent Management of Institutional Funds Act (UPMIFA)

Components of an investment policy statement

• Fund objectives • Allowable asset classes • Target asset allocation and benchmarks • Risk metrics and constraints • Special restrictions and tax concerns • Rebalancing protocol Note: specific funds and fund managers are not typically identified in the IPS

Taxation of Capital Assets (U.S.)

• Gains/losses on sales of capital assets held more than one year qualify for preferential long-term capital gain treatment. • Gains/losses on sales of capital assets held one year or less are treated as short-term and are subject to ordinary income tax rates.

IRD (Income in Respect of a Decedent)

• IRD refers to income that a deceased person had a right to receive during life, but which was not received until after death. • The estate, beneficiary or person who inherits the IRD must declare the IRD as taxable income in the same year in whichthe decedent or estate received it. • The character of the IRD is maintained. • capital gains are treated as capital gains • salary and rental income are treated as ordinary income • IRD amounts are also included in the estate for estate tax purposes. • BUT, if estate tax is paid, the person/entity declaring the IRD as income tax may also deduct estate tax paid on the IRD as an itemized deduction.

Taxation of Variable Annuities

• Non-qualified variable annuity contributions are made with after-tax dollars (i.e., no income tax deduction). • Earnings or growth in a variable annuity are tax-deferred (i.e., no tax until withdrawal if conditions are met). • The first withdrawals are taxable income until all earnings are fully distributed. • Any additional withdrawals are a return of principal up to the amount fully invested (aka: the basis). • If annuitized to receive an income stream, each payment is a combination of a nontaxable return of principal and earnings taxed as ordinary income based on an IRS "exclusion ratio" formula. • Financial companies calculate and report the taxable portion of a distribution on Form 1099-R. • Distributions before age 59½ are subject to a 10% penalty on the taxable portion of the withdrawal.

Strategic Asset Allocation

• SAA relies mostly on the benefits of low correlations and diversification to minimize risk as measured by standard deviation. • SAA needs a relatively long-term time horizon to raise the odds of success. • SAA requires an investor to show patience when bear markets persist and resist the temptation to sell assets declining in value.

Traditional asset-based allocation strategies

• Strategic Asset Allocation • Tactical Asset Allocation • Dynamic Asset Allocation

Tactical Asset Allocation

• TAA relies on the investor (or advisor) to make tactical, short-term decisions, to help manage risk. • TAA offers a greater opportunity for risk management and better risk-adjusted returns but there is no guarantee. • TAA carries an implicit risk of opportunity cost compared to SAA if one experiences poor results.

The taxation position status of the client (non-profit or taxable) and estimated horizon period tax rate

• Tax status of the investor or entity • Tax rates and laws • Tax expectations ***Exam Note: candidates have been reporting fewer and fewer tax-related questions on the CIMA certification exam. It's possible you will see no tax-related questions on your exam.

More Asset Location

• Taxable accounts - Index and other passive funds - Growth funds with low turnover - Tax-managed funds - REITs (could be better for either type of account) - Municipal bonds • Tax-deferred accounts - Dividend stocks - Most taxable bonds - Actively management, high turnover funds - Partnerships "IF" they avoid UBTI

Uniform Prudent Investor Act

• The Uniform Prudent Investor Act updated trust investment law with several changes including a new standard for prudence in the context of the entire portfolio, not just individual issues • These new standards made it possible manage funds legally using tenants from MPT such as diversification (into assets such as derivatives, commodities, and futures) • The new standards also allowed trustees to delegate investment management functions

Correlation Effects

• The amount of possible risk reduction through diversification depends on the correlation. • The risk reduction potential increases as the correlation approaches -1. - If r = +1.0, no risk reduction is possible. - If r = 0, σP may be less than the standard deviation of either component asset. - If r = -1.0, a riskless hedge is possible.

Core and Satellite Strategy

• an investment strategy in which a large part of the portfolio (i.e., the "core") is invested in traditional assets and/or investment strategies • alternative investments, often make up a minority (i.e., "satellite") of the portfolio • one of the purposes of this strategy is to build a strong foundation within the core but allowing for additional risk-taking or additional diversification in the smaller, satellite position

Tactical Asset Allocation

• similar to strategic asset allocation, tactical asset allocation allows for a more active investment approaching including the concept of market timing • example: the portfolio manager may attempt to take advantage of asset class or sector price anomalies or mispricing through reallocation and rebalancing

Strategic Asset Allocation

•an investment strategy based on MPT and the benefits of diversification where an optimal mix of asset classes is identified and modeled through a portfolio • periodic rebalancing is necessary to ensure asset classes and investments remain within reasonable target limits • the level of risk for the portfolio (usually described based on the percentage of equity exposure) is based on the client's goals and objectives, tolerance for risk, and time horizon