Investment Policy (posted 27 Feb 99)

Investment policy is an all-encompassing term to describe an institutional or individual investor's overall approach to management of their portfolio: goals, asset mix, stock selection and investment strategy. As our investment policy guru Charles Ellis describes it in his classic book on the subject, 'Investment policy, wisely formulated by realistic and well-informed clients with a long-term perspective and clearly defined objectives, is the foundation upon which portfolios should be constructed and managed over time and through market cycles.'

The central point of investment policy is that different investors are in very different situations and have very different objectives. So whether acting for themselves or employing an agent, they should carefully think through the implications of their situation and objectives for the way their portfolio is to be managed. And once they have formulated the appropriate investment policy, taking account of what potential achievements are realistic, they should stick with it.

Guru of investment policy: Charles Ellis

Charles Ellis is one of the world's most prodigious workers. He never stops. His attaché case is always with him. And he writes. And he writes. And he writes.

Ellis has written more than a dozen investment books, sends countless notes daily to people exhorting them to do something, and runs an investment consulting firm he founded. On the last point, he is at pains to remind friends and colleagues that he does not run this firm and never has. It has such great people: it does not need running. But he is the role model at least and more than that involves himself in everything.

The idea of Greenwich Associates was to survey users of financial services to find out what they wanted, what they thought of what they were getting and from whom, and distill the data into information that could be prescriptive for vendors of services. Not very unusual although there were important differences from the norm. Senior people did the interviews, which were highly structured, and the emphasis was not on the data but on the action plans that followed. And Ellis never let any one of his clients forget that action was the important part. His notes goaded people to move.

Ellis's intensity is a way of life. He writes about the parallel between defensive tennis as a winning strategy to winning portfolios. But his tennis is anything but defensive. It is hard, determined, and 'exploitative of the opponent' tennis. And it wins not by flash but by never letting up for one minute. He never displays a weakness that the opponent could charge.

He is the model of the goal-oriented person. His short book on investment policy proclaims boldly that here is all you need to know in about ninety pages. And then he proceeds to demonstrate that he is correct: it is all you need to know. He sets targets for each day, each month, each year and pulls himself up to it or beyond. If he overshoots, it is because, in his opinion, he was not tough enough on himself at the beginning.

Dean LeBaron, one of this book's co-authors, says: 'I can call Charley one of a tiny group of my most treasured friends. We have worked together (I was one of his clients for a long time), vacationed together on river rafts and other challenging pursuits, helped students, been fund directors and shared mutual inspirational times when we both started companies about the same time. He never, ever flagged.'

Ellis's classic book Investment Policy, first issued in 1985, sums up certain fundamental truths for institutional investors. His central point is that investment has become a loser's game rather like amateur tennis, where you win by putting the ball into the net less often than your opponent. So simply by avoiding mistakes, you will come out ahead. His basic advice: make a long-term commitment to equities and stay invested.

In 1998, Ellis repackaged his book for the individual investor as Winning the Loser's Game, which debunks any idea of investment wizardry among the professionals. He is especially hard on market timing, the idea that you can hope to buy the market when it is cheap and sell near the top later on. While this sounds simple, it does not work: markets move too fast, and even stock selection is very hard. The key to long-term success is understanding investment risks: general market risk and specific stock risk. Indexing carries only market risk while trying to beat the market carries extra risks.

Ellis writes: 'The best way to achieve long-term success is not in stock-picking and not in market timing and not even in changing portfolio strategy. Sure, these approaches all have their current heroes and 'war stories', but few hero investors last for long and not all war stories are entirely true. The great pathway to long-term success comes via sound, sustained investment policy: setting the right asset mix and holding onto it.'

'There are three levels of decision for the investor to make and whereas most investors take investment services as a blended package, services can be unbundled into three separate components or levels:

· Level One - the optimal proportion of equities as the 'policy normal' for the investor's portfolio.

· Level Two - equity mix, policy normal proportions in various types of stocks (growth versus value, large capitalization versus small capitalization, domestic versus international).

· Level Three - active versus passive management.'

'Investment counseling on asset mix and on equity mix is inexpensive and needed only once every few years. (An individual investor with $1 million can buy this service from an expert for less than $5,000 once every five or ten years. An institution with $10 billion might pay $250,000.) Active management can cost - for the management and the transactions - about 1% of the $1 million investor's assets.'

'The irony is that the most value-adding service available to investors - that is, investment counseling - although demonstrably valuable and cheap, is in very little demand. Active management, though usually not successful at adding value, comes at a high cost.'

Counterpoint

Investment managers 'run' money. They 'achieve' results. They 'identify' errors and 'correct' them. All these macho steps should produce superior, controlled investment results. But is that really how the investment world works? The physical world does not.

Instead, we may be in an iterative game of chance during which we can assess the odds used by other participants in this game and, when we find variance with 'reality,' attempt to exploit the hypocrisy or stupidity of our opponents. All in real time. No wonder investment management was once described as 'an exercise where you make major decisions on the basis of flimsy information in a system largely governed by chance, when you may be wrong slightly more than 50% of the time, publicly, and... you have to go back and do it again.' Most sensible people do not expose their careers to such a capricious system.

So investment policy may not be the enduring truth Charles Ellis supposes it to be. Rather it is a function of a stable, growing system where past successes can be replicated for more success to come. It does not deal with turbulence, outliers of statistical events and major changes. Policy is sluggish by its nature. Since policy is most often formulated by committees, it is hardly flexible in response to new conditions, suffers from group norm patterns, which predetermine a less than outstanding outcome, and holds its merit in preventing unconventional failure.

And policy can be discussed over and over safely with sage agreement supporting its assertions. Sturdy investment policy will triumph when conditions are more stationary than anticipated, when conventional wisdom triumphs and when group norms are respected.

The Harvard Business School had an investment case called Vassar College, which was taught in the 1960s when Charles Ellis and Dean LeBaron were students. Vassar had an investment policy rooted in history with the support of some of the best minds of Wall Street to buy bonds in the period following the Second World War when yields were just a few percent. And when yields rose, and the value of the bond portfolios went down, the policy dictated, as it would, buy more bonds - until bonds yielded in the teens and Vassar's portfolio was a fraction of its original value. Policy had its costs.

In the climate of the late 1990s, investment policy, founded as it is on a long-term commitment to equities, looks fine after a long bull market. But the conventional wisdom that equities always outperform other investments eventually drives prices up to a level from which, finally, they will fail to do so. At what point does it make sense to pull back on the equity commitment?

And does investment policy as formulated by Ellis fail to take adequate account of the new opportunities of the 1990s and the next millennium, previously undreamed of? Global investing, emerging markets, internet investing - all discussed elsewhere in this book - were only a relatively short time ago never conceived of as investment ideas.

Where next?

Charles Ellis defines three ways to try and achieve superior investment results, which provide a useful way to think about which way you invest. One is intellectually difficult, one physically difficult and one emotionally difficult, as he describes:

'Intellectually difficult investing is pursued by those who have a deep and profound understanding of the true nature of investing, see the future more clearly and take long-term positions that turn out to be remarkably successful.'

'Most of the crowd is deeply involved in the physically difficult way of beating the market. In every way they can, they put enormous energy into trying to beat the market by outworking the competition. What they don't seem to recognize is that so is almost everyone else.'

'Being incapable of doing the intellectually difficult, and reluctant about the physically difficult, I have set about the emotionally difficult approach to investing. This straightforward, untiring approach is simply to work out the long-term investment policy that's truly right for you and your particular circumstances and is realistic given the history of the capital markets, commit to it, and - here is the emotionally difficult part - hold on.'

A high-tech alternative to Ellis's vision might be tailored investment management portfolios, where individuals could express their preferences, their psychological makeup, look at portfolios, their characteristics, and implement them, all by machine. This idea got started from indexing; then into automated trading; then stock screening and portfolio optimization; then understanding something about mechanical asset allocation and strategic analysis of investment options with a dose of risk management. And finally you are down to the final nub of a personality preference.

Could this all be put together into one seamless stream to build customized, personal portfolios for individuals, on-the-fly, continuously, at virtually zero implementation cost? Fifteen years or so ago, there was a project to do this. Yes, there were legal barriers, but they could have been overcome. And yes, there were barriers of feeling that you needed to have a personal contact, the 'know your client' aspect, but they could have probably been overcome. In any event, for better or worse, this project did not continue through to fruition.

But others are taking it up now. Rational Investors of Cambridge, Massachusetts and Financial Engines, a firm founded by Nobel Laureate Bill Sharpe, are both working on applications of automated plans for 401(k), although they will claim it is not investment management. Perhaps the model to look at is the tailoring of clothes by machine. Landsend.com takes your measurements, puts you in an avatar on the screen so you can select your clothes, perfectly tailored, made to order for you - no inventory at Land's End. It is a tailored portfolio of clothes. Why has it taken us so long to do it for investments?

Read on

In print

The Future of Investment Management - the presentations from four 1998 AIMR seminars, including one by Charles Ellis entitled 'Lessons from the Warwick and Chateau Chambord'
Charles Ellis, Investment Policies of Large Corporate Pension Funds
Charles Ellis, Winning the Loser's Game: Timeless Strategies for Successful Investing
Charles Ellis with James Vertin, The Investor's Anthology: Original Ideas from the Industry's Greatest Minds

Online

www.financialengines.com - Bill Sharpe's site for Financial Engines
www.landsend.com - for the experience of 'mass customized' tailored clothes, perhaps a precursor of tailored portfolios
www.rationalinvestors.com - Rational Investors' site