Clark Galvan
An investment policy statement (IPS) is a strategic document that outlines the rules and guidelines a portfolio manager must follow when managing a client's investment program. It is an agreement between the portfolio manager and the client, providing a framework for investment decisions and helping to keep emotions from driving unwise investment choices. The IPS includes details such as the client's financial goals, investment objectives, asset allocation, risk tolerance, and liquidity requirements. It also specifies the roles and responsibilities of the portfolio manager and any other parties involved in managing the portfolio. The purpose of the IPS is to align the investor and investment manager, providing a clear roadmap for successful investing and helping to prevent potential mistakes. By having a well-constructed IPS in place, both the manager and the investor can stay focused on the long-term objectives, even during periods of market volatility or when facing lifestyle changes.
| Characteristics | Values |
|---|---|
| Purpose | To outline the rules and guidelines for managing a client's portfolio |
| Creation | Drafted by a portfolio manager or financial advisor in collaboration with the client |
| Components | Scope and purpose, governance, investment, return and risk objectives, risk management |
| Content | Client's investment goals and objectives, strategies to achieve objectives, asset allocation, risk tolerance, liquidity requirements, time horizon, monitoring and reporting procedures |
| Function | Provides guidance to portfolio managers, helps clients avoid emotional decisions, serves as a roadmap for investment decisions, prevents unwise investment decisions |
What You'll Learn
Investment goals and objectives
An investment policy statement (IPS) is a document drafted between a portfolio manager and a client that outlines the client's investment goals and objectives. It provides an overview of the client's financial goals and objectives while outlining the strategies that the manager should employ to meet these objectives.
The IPS should include specific information such as the client's risk tolerance, liquidity requirements, and asset allocation preferences. It should also outline the time horizon for the investment objectives, such as an individual wanting to have the option to retire by the time they are 60 years old.
The IPS serves as a roadmap for the portfolio manager, providing guidance on portfolio decisions and helping to keep the client committed to a long-term investment strategy. It is a dynamic document that may evolve as market conditions and the client's needs change.
The client, Juan Martinez, age 55, has a conservative risk profile and a long-term investment horizon of more than five years. The primary investment goals are long-term growth and capital preservation, with a target rate of return of 6% per year based on historical rates.
To achieve these objectives, the financial advisor will employ the following strategies:
- Confer with the client to create an asset allocation plan that aligns with their risk tolerance and financial goals.
- Select a mix of assets, including stocks and fixed-income investments, to provide sufficient diversification of risk and returns.
- Monitor investment options, control and report investment costs, and regularly value portfolio holdings.
- Rebalance the portfolio annually to maintain the desired asset allocation while minimising tax consequences of asset sales.
- Compare the performance of each investment with its related benchmark and peer group funds to identify any deviations or poor performance.
- Ensure that total costs do not exceed 1% of all investable assets.
- Review the overall portfolio at least annually to assess progress towards the client's goals and make any necessary adjustments.
This section of the IPS outlines the client's investment goals and the strategies that the financial advisor will employ to achieve them. It provides a clear framework for both parties to follow and helps to keep the client focused on their long-term objectives.
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Risk tolerance and management
Risk tolerance refers to the degree of risk that an investor is willing to accept, given the potential volatility in the value of their investments. It is influenced by various factors, including age, investment goals, income, future earning capacity, and the presence of other assets. For example, an aggressive investor with a high-risk tolerance may be willing to risk more money in pursuit of potentially better returns, while a conservative investor seeks investments with guaranteed returns and low volatility.
When creating an IPS, it is crucial to assess the client's risk tolerance accurately. This involves understanding both their ability and willingness to take on risk. While quantifiable aspects such as age, investment portfolio size, and expected retirement date provide insight into their ability to take on risk, personality typing tools can help advisors gauge their clients' willingness to take risks and their behavioural tendencies. By considering these factors, advisors can design investment strategies that align with the client's risk tolerance.
The IPS should include specific information on risk management, such as naming asset classes to be avoided or preferred, as well as any security or sector-related restrictions. It should also establish monitoring and control procedures, such as the frequency of monitoring and benchmarks for portfolio returns. Additionally, the IPS can help protect trustees from making unwise decisions during times of financial crisis by serving as a shield against short-term market volatility.
A well-crafted IPS enables both the manager and the investor to stay focused on their long-term objectives, even during periods of market instability. It provides a framework for making informed investment decisions and helps prevent potential mistakes. By clearly outlining the client's risk tolerance and management strategies, the IPS ensures that the investment approach is tailored to the client's comfort level and financial goals.
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Investment, return and risk objectives
The investment, return and risk objectives of an Investment Policy Statement (IPS) are a crucial part of the document. This section outlines the client's financial goals and expectations, providing a clear picture of what they hope to achieve through their investment portfolio.
The investment objectives should be specific and measurable, with desired performance outcomes. For example, a client may state that they want to have the option to retire by the time they are 60, with an annual return of $65,000 in today's dollars, adjusted for inflation. Another example could be a target allocation between stocks and bonds, such as 60% stocks and 40% fixed-income assets.
The return objectives are also outlined, with the desired rate of return specified. For instance, a client may seek a return of 2.5-3.5% above inflation, net of fees and costs. This return objective is crucial in determining the investment strategy and the level of risk the client is willing to take.
Risk objectives are a vital component of the IPS, as they outline the client's risk tolerance and capacity for losses. This is usually stated as a percentage and helps the portfolio manager understand the boundaries within which they can operate. For example, a client may state their risk tolerance as a maximum aggregate loss of 5% over a one-year period.
The IPS should also specify the target allocation across different asset classes, such as equities, fixed income, alternatives, and real assets. This allocation is based on the client's risk profile and investment objectives, with the goal of optimising risk-adjusted returns using different strategies.
Additionally, the IPS should outline any constraints or limitations relevant to the investment strategy. This includes liquidity requirements, tax considerations, legal restrictions, and any other unique circumstances that may impact the portfolio.
By clearly outlining the investment, return, and risk objectives, the IPS provides a comprehensive framework that guides the portfolio manager's decision-making process and helps to keep the client focused on their long-term financial goals.
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Monitoring parameters
Frequency of Monitoring
It is recommended to monitor the overall portfolio at least annually. However, it is essential to strike a balance between regular reviews and avoiding excessive adjustments. Less frequent monitoring, such as on a monthly or quarterly basis, can help maintain a long-term perspective and avoid the potential negative impact of short-term market fluctuations.
Benchmark Comparison
Each index mutual fund's or exchange-traded fund's return should be compared to its relevant benchmark. Any significant deviation from the benchmark, such as a one-year deviation of more than 1%, should trigger further evaluation and discussion.
Peer Group Comparison
In addition to benchmark comparisons, it is beneficial to compare the portfolio's performance with peer group funds. This helps contextualise the performance relative to similar investment strategies.
Cost Monitoring
Costs and fees associated with the portfolio should be monitored regularly to ensure they do not exceed a certain threshold, such as 1% of all investable assets. This helps maintain the cost-efficiency of the investment strategy.
Performance Evaluation
The IPS should establish clear performance metrics and reporting accountabilities. These metrics should be regularly evaluated to assess whether the portfolio is meeting its stated goals and objectives.
Rebalancing Criteria
The IPS should specify the criteria for rebalancing the portfolio, including the target asset allocation ranges for each asset class. For example, if the target range for equities is 65%-75%, rebalancing would occur if the actual allocation deviates below 65% or above 75%.
Risk Management
Risk management is a critical aspect of monitoring. The IPS should outline any maximum maturity limits, approved financial instruments, and concentration limits to manage risk effectively. Regular reviews should assess whether the portfolio remains within the defined risk parameters and make adjustments as necessary.
Client Communication
In summary, monitoring parameters within an IPS provide a structured framework for evaluating the performance of the investment portfolio, ensuring it remains aligned with the client's financial goals, risk tolerances, and long-term objectives. Regular reviews, performance evaluations, and rebalancing decisions are essential components of effective monitoring.
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Investment selection criteria
For example, an investor might set criteria such as a minimum category rating, a minimum total return percentage category rank over various periods, a maximum bear-market rank, a maximum expense ratio, or a minimum manager tenure. Criteria for stocks might include a maximum price for each stock, a minimum return on equity, or a minimum revenue growth rate.
When selecting stocks, investors should consider a company's financial fundamentals, including earnings, operating margins, and cash flow. These factors can indicate a company's current financial health and its profitability in the short and long term. It's also important to look at earnings momentum—whether earnings are slowing or accelerating from one period to the next.
Other considerations include a company's asset utilization ratio, which measures efficiency, and its capital structure, or how a company funds its business operations using debt and equity.
A well-conceived set of investment selection criteria enables both the manager and the investor to stay focused on long-term objectives.
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Frequently asked questions
An IPS is a document drafted by a portfolio manager or financial advisor and their client, outlining the rules and guidelines that the portfolio manager must follow when managing the client's money. It provides a framework for decision-making and helps to keep the client focused on their long-term objectives.
An IPS includes information about the client's investment horizon and objectives, risk tolerance, specific requirements and/or restrictions, and the strategies the portfolio manager will use to achieve the client's objectives. It may also include details such as the client's current assets, one-year loss limit, time horizon, and long-term rate of return expectation.
An IPS is important because it helps to ensure that the client's portfolio is managed in accordance with their stated parameters and provides a framework for consistent decision-making and ongoing monitoring. It also helps to prevent emotional decisions by the client and keeps all parties involved accountable to the client.
Creating an IPS involves gathering information on topics such as investment goals, risk tolerance, time horizon, liquidity needs, and any specific constraints. The portfolio manager then uses this information to develop a plan that outlines the strategies they will use to achieve the client's objectives.
