The investment policy: Sarbanes-Oxley 'first line of defense'; A properly structured investment policy serves as a roadmap for pursuing a company's investment objectives. But, often these documents contain vague and contradictory language and do not reflect current risk tolerance and liquidity requirements. A cash management expert provides insights on updating your investment policy.

• Author: Saperstein, Richard
• Position: Investments

The Sarbanes-Oxley Act of 2002 dictates that companies establish "an adequate internal control structure and procedures for financial reporting." In the context of cash management, the most important internal control is the formal investment policy, which defines in precise terms how cash is to be managed. In formulating the investment policy, the objective is to provide the internal or external cash manager with clearly-stated guidelines for structuring and monitoring a portfolio that possess the potential for generating maximum returns within stated risk tolerance levels and without compromising liquidity requirements.

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Portfolio Management Strategies

Prior to drafting the investment policy, a company must first determine which of two basic cash management strategies it wishes to pursue. This decision is largely driven by the company's overall investment objectives. Depending on those objectives, companies will typically adopt either an active or a passive portfolio management strategy.

In an actively-traded portfolio, managers often sell securities prior to maturity for various reasons. They might wish to rebalance the portfolio to take advantage of anticipated shifts in the yield curve, or they may elect to adjust the combination of securities to either mimic or diverge from a specific index. This strategy is appropriate for companies seeking above-benchmark returns through more active trading, while being in a position to tolerate capital gains and losses.

When pursuing a passive, or "buy and hold" strategy, portfolio managers generally hold securities to final maturity. While duration and security selections within the portfolio may evolve, the evolution is gradual. Sales of securities prior to maturity typically are executed only in

response to a decline in credit quality or an unanticipated liquidity requirement.

In a passive portfolio management program, every decision the portfolio manager makes must be driven by the three fundamentals of prudent cash management: safety, liquidity and yield, with safety of the cash as the first priority. (For a more comprehensive analysis of these two strategies, see "Choosing the Best Compensation Program," which appeared in the October 2004 issue of Financial Executive. The article is also online at bearcorpcash.com.)

Common 'Mistakes'

Deficiencies within the investment policy often result in issues companies are required to address and resolve as a result of the independent audit process. These include:

Using Vague...