Prudent Investment Management Process
There are five distinct steps in the prudent process. However, they are all related and should be followed in order. Additionally, the process is a constant evolution and each step should be revisited periodically. The fiduciary and investor who follows these steps can substantially improve their investment satisfaction.Step 1 - Analyze Current Positions
Information is gathered and analyzed on the client's current position, including legal constraints, written policies, money management structure, custodial and brokerage relationships, and accounting assumptions. Careful consideration should be given to the goals of the client as well as the objectives for the overall portfolio.
In addition to these factors, we thoroughly analyze client's current spending habits. There are a number of ways to calculate the appropriate level of spending. One method relies on spending income only. Another, bases spending off the total return. In this case the equilibrium spending rate is calculated based on the total return less inflation, less a factor for cost increases (cost increases above the rate of inflation). Policies are fine tuned by incorporating smoothing approaches to factor in differences between the expected and actual rates of return. These include moving averages and preset increases over the prior year. Sensitivity studies, which test certain assumptions in varying market conditions, are useful.
Step 2 - Design Optimal Portfolio
The key to a successful investment portfolio is diversification. This is fundamental to the management of risk, regardless of the level of safety an individual investment offers. Asset allocation decisions are the critical aspect of a sound investment strategy and the starting point on formulating a plan of diversification.
Asset optimization models are designed to provide an understanding of the trade-offs between investment risk and return. At Infinity Financial Corporation we utilize sophisticated technology in determining the optimal asset allocation strategy. Asset class (i.e. stocks, bonds, money markets) diversification is important, but our use of the three-factor model represent the latest empirical evidence on the art of optimizing portfolios.
Step 3 - Formalize Investment Policy
All investors should establish and maintain a written statement of investment policy. This is one way a client can measure the results of the portfolio. When the objectives and purposes of the plan are specified, it provides standards against which individual investments can be judged. Importantly, the investment policy statement ensures continuity of the investment strategy among different market cycles.
The investment policy statement is an invaluable strategic planning tool for intelligent investment management. As a working document, the statement includes portfolio objectives, asset allocation parameters, investment guidelines and a due diligence process for selecting and monitoring investment managers. This document does not have to be overly complex as long as the objectives are specific enough to meet the fund's needs and objectives.
Step 4 - Implement Policy
Once a strategic plan is in place, it becomes necessary to implement the policy with specific vendors or products. Since most individuals do not have the assets or experience to research and purchase individual securities, it is prudent to delegate management of individual securities. Proper selection of professional money managers provides clients with an additional layer of investment management.
A prudent search follows a formal, multi-step approach which provides documentation and insight required to make informed implementation decisions. Investment managers and funds should meet rigorous qualitative and quantitative factors such as manger style, assets under management, length of track record, performance history, quality of track record, fees, risk statistics and correlation. Qualitative factors under consideration include manager type, client base profile, personnel, client service/communication and success with similar clients.
Evaluation of managers must be performed in an objective and unbiased manner. It is equally, if not more important, to find a manager that is a good fit with other pieces of the portfolio as well as the preference of the client. Some common mistakes made during implementation include:
Step 5 - Monitoring and Supervising
Regular review of investment performance is vital. Performance evaluation measures the absolute and relative performance results of the portfolio structure. Summaries relate performance to similarly constructed portfolios comparing every manager's performance with that of their peers and stated benchmarks. In addition, the portfolio's overall performance should be measured relative to stated investment objectives. The review enables the fiduciaries to determine why results were achieved and to identify adjustments which periodically become necessary to maintain performance and manage volatility.