To introduce the Formalize Step of Practices, the last post in our Spotlight on Practicesseries featured the hierarchy of decisions. At the top of that hierarchy, and the focus of Practice 2.1, is the identification of the investment time horizon.
Let's take a look at the Practice itself and the associated criteria:
Regardless of the type of portfolio being managed, the most fundamental concern is to appropriately align the cash that can be generated from the portfolio to the cash outflows that will be required to be withdrawn from the portfolio. Think of cash outflows as liabilities. Ideally, we are seeking to align the asset composition to the liabilities. If the expected near term liability stream is high, the time horizon is short. Conversely, if most liabilities are not expected to occur until many years in the future, the time horizon is considered long.
For all types of portfolios cash flow projections are critical. It is strongly recommended that cash flow projections be documented and included as an attachment to the investment policy statement. The second through fifth criteria above indicate special considerations necessary for the different portfolio types.
The final criteria calls upon the fiduciary to maintain sufficient liquidity to meet contingency plans. For portfolios where significant cash outflows are expected, a specific allocation to cash is recommended to minimize disruptive trading. If the portfolio is quite large and the timing and amount of cash flows is highly uncertain, the fiduciary should focus on protecting the value of invested positions rather than to hold a large amount of cash.
To learn more, consult the following resources:
- Complete text of Practice 2.1 from the Prudent Practices for Investment Stewards handbook
- Legal substantiation to Practice 2.1from ERISA, UPIA, UPMIFA and MPERS
- An SEC beginner's guide to asset allocation, diversification and rebalancing
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The Spotlight on Practices series highlights one of the Prudent Practices for Investment Fiduciaries in order each month. To learn more about the Practices, click "Spotlight on Practices" link in the categories list or visit the Practices page on fi360.com. If you have any questions or comments, leave them in the comments section below each post, or email us at blog@fi360.com.
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