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The previous section introduced the expected utility approach as a simple and yet flexible approach to modeling risk-return objectives of asset owners. This section discusses the typical set of constraints that must be taken into account when trying to select the investment strategy that maximizes the expected utility of the asset owner.

1.6.1 Investment Policy Internal Constraints

Internal constraints refer to those constraints that are imposed by the asset owner as a result of its specific needs and circumstances. Some of these internal constraints can be incorporated into the objective function previously discussed. For example, we noted how the constraint that allocations with positive skewness are preferred could be incorporated into the model. However, there are other types of constraints that may be expressed separately. Some examples of these internal constraints are:

LIQUIDITY. The asset owner may have certain liquidity needs that must be explicitly recognized. For example, a foundation may be anticipating a large outlay in the next few months and therefore would want to have enough liquid assets to cover those outflows. This will require the portfolio manager to impose a minimum investment requirement for cash and other liquid assets. Even if there are no anticipated liquidity events where cash outlays will be needed, the asset owner may require maintaining a certain level of liquidity by imposing minimum investment requirements for cash and cash-equivalent investments, and maximum investment levels for such illiquid assets as private equity and infrastructure.

TIME HORIZON. The asset owner's investment horizon can affect liquidity needs. In addition, it is often argued that investors with a short time horizon should take less risk in their asset allocation decisions, as there is not enough time to recover from a large drawdown. This impact of time horizon can be taken care of by changing the degree of risk aversion or by imposing a maximum limit on allocations to risky assets. Time horizon may impact asset allocation in other ways as well. For instance, certain asset classes are known to display mean reversion in the long run (e.g., commodities). As a result, an investor with a short time horizon may impose a maximum limit on the allocation to commodities, as there will not be enough time to enjoy the benefits of potential mean reversion.

SECTOR AND COUNTRY LIMITS. For a variety of reasons, an asset owner may wish to impose constraints on allocations to certain countries or sectors of the global economy. For instance, national pension plans may be prohibited from investing in certain countries, or a university endowment may have been instructed by its trustees to avoid investments in certain industries.

Asset owners may have unique needs and constraints that have to be accommodated by the portfolio manager. However, it is instructive to present asset owners with alternative allocations in which those constraints are relaxed. This will help asset owners understand the potential costs associated with those constraints.

1.6.2 Investment Policy and the Two Major Types of External Constraints

External constraints refer to constraints that are driven by factors that are not directly under the control of the investor. These constraints are mostly driven by regulations and the tax status of the asset owner.

TAX STATUS. Most institutional investors are tax exempt, and therefore allocation to tax-exempt instruments are not warranted. Because these investments offer low returns, the optimization technique selected to execute the investment strategy should automatically exclude those assets. In contrast, family offices and high-net-worth investors are not tax exempt, and therefore the impact of taxes must be taken into account. For example, constraints can be imposed to sell asset classes that have suffered losses to offset realized gains from those that have increased in value.

REGULATIONS. Some institutional investors, such as public and private pension funds, are subject to rules and regulations regarding their investment strategies. In the United States, the Employee Retirement Income Security Act (ERISA) represents a set of regulations that affect the management of private pension funds. In the United Kingdom, the rules and regulations set forth by the Financial Services Authority impact pension funds. In these and many other countries, regulations impose limits on the concentration of allocations in certain asset classes.