An investment policy statement provides a plan for achieving investment success. It is developed after a fact-finding discussion with the client aimed at obtaining information about risk tolerance and specific circumstances (in case of individual clients), and asset-liability management, liquidity needs, tax considerations, etc. (in case of institutional clients).

A typical IPS includes a client’s investment objectives and constraints. Investment objectives list return requirements and risk tolerance, while constraints refer to the overall restrictions on investments arising from liquidity requirements, taxes, laws, etc. For example, a high return cannot be achieved without allowing higher risk tolerance, etc. Constraints include factors that need to be taken into account when constructing a portfolio. These include liquidity requirements, time horizon, regulatory requirements, tax status, and unique needs.

Formulation of an IPS is a legal and regulatory requirement in some countries. It may also contain additional information, particularly in the case of institutional investors, such as details about the governance structure of the institution and its investment committee. An IPS should be reviewed and updated regularly and whenever there is a material change in a client’s circumstances.

Components of an IPS

A typical IPS includes the following sections: (a) an introduction of the client, (b) a statement of purpose of the IPS, (c) a statement of duties and responsibilities of the client, the custodian of the client’s assets, and the investment managers, (d) procedures to keep the IPS updated and address any contingencies, (e) investment objectives, (f) investment constraints, (g) investment guidelines (regarding usage of leverage and derivatives, assets to be excluded, etc.), and (h) guidance on obtaining feedback on investment results. An IPS may have appendices specifying, for example, the strategic asset allocation, the investor’s policy with respect to rebalancing asset class weights, hedging of risks, etc.

Sections dealing with investment objectives (risk and return requirements) and constraints are the most important. Return objectives must be consistent with risk tolerance, and both must be reasonable keeping in view the constraints. In recent years, there is an increased focus on sustainable investing and ESG which makes constraints section particularly important.

Risk objectives

Risk objectives are specifications for a portfolio that reflects the investor’s risk tolerance, either in absolute terms, relative terms or a combination thereof. For example, if an investor states that he does not want to lose more than 5% of his capital in any given 12-month period, it is an absolute risk tolerance statement. Alternatively, his risk preference may be expressed with reference to some benchmark, in which case it would be a relative risk objective. Institutional investors may base their relative risk tolerance on their liability positions. For example, standard deviation and value at risk are absolute risk measures while tracking error is a measure of relative risk.

Risk tolerance: ability vs willingness

An investor’s risk tolerance depends on both his ability and willingness to take risks.

If an investor has above-average ability to take risk and above-average willingness, it has above-average risk tolerance and vice versa. However, if his capacity to take risk is above-average but willingness is below-average, the difference must be reconciled, and risk tolerance should ideally be based on the lower of the two. However, the investment advisor must explain the consequences of taking a low risk to a client with low willingness but high ability to take risk. Such a conflict is not limited only to individual investors, but can also be faced by institutional investors. For example, trustees of a pension fund may be inclined to take low risk but the sponsor may want to take high risk so that he may have to contribute fewer funds in the future.

The ability to take risks can be measured based on objective factors such as time horizon, expected income, current wealth level relative to liabilities, etc., but willingness is a subjective measure based on each investor’s unique psychology. An assessment can be made by discussing risk with the client or through psychometric tests.

Return objectives

An investor’s return objective states its target return, and it may be quoted in absolute terms or relative terms.

Absolute return objective

An absolute return objective states a target percentage growth in investment expressed either in nominal terms or real terms. A relative return objective specifies a spread by which the portfolio return must exceed the benchmark, which should ideally be investible.

Relative return objective

A relative return may be defined with reference to a peer group or universe of managers. For example, an endowment may aim to earn a return falling in the top quartile of the endowment investment landscape. However, such a return objective is ambiguous because we might not know the actual returns earned by all other similar investors, they might have different strategies or return calculation methods, etc.

Further, a return objective may be specified either before or after fees, pre-tax or post-tax, in which case appropriate adjustments must be made when making comparisons.

In any case, the return objective must be realistic keeping in view the risk tolerance, current capital market expectations, and constraints. When an investor has unrealistic expectations, the investment advisor must counsel him about what is achievable.

Liquidity requirement

The IPS must specify what is the extent, nature, and timing of any funds needed out of the portfolio. An individual investor may require funds for expenses. Similarly, an endowment may need to liquidate assets to meet spending goals of the institutions, etc. If such a requirement is present, a sufficient amount must be invested in liquid assets, assets that can be easily converted to cash, and which have low risk.

Time horizon

An IPS must specify the time horizon, the period for which the investments are likely to be made. The time horizon is dictated by the time when the investor would withdraw funds or when the circumstances would change so materially that a drastic change in the portfolio would be needed. The time horizon is important because it directly affects an investor’s ability to take risk.

Tax concerns

An IPS must state the tax status of the client because taxes can significantly impact a portfolio’s ultimate return. In many jurisdictions, income and gains may be taxed differently, i.e. gain may be taxed only when they are realized, but incomes taxed right away. In such a situation, it would be beneficial to defer realization of gains. A tax-exempt investor would ignore any such considerations.

Legal and regulatory factors

Some investors, such as pension funds, endowments, etc. may be subject to legal restrictions on their investment allocations, distributions, etc. Such restrictions and limits may be imposed by the fund sponsors. Such considerations are listed under the legal and regulatory factors section of the constraints. It may also list investments which must be avoided due to the investor’s related party relationship, etc.

Unique circumstances

Unique circumstances may list an investor’s religious, ethical, and/or ESG (environmental, social and governance) values and convictions which can impact the portfolio. An investor may want to exclude certain investments (such as investments in stocks of tobacco companies) in what is called negative screening. Other relevant concepts include best-in-class investing, shareholders engagement, thematic investing, and impact investing. Some investors may go as far as to integrate ESG considerations into their investment process. Unique circumstances may also list other important considerations.

For example, if the portfolio managed by an investment advisor is only part of the client’s total wealth, it must manage the portfolio such that an investor’s overall risk does not increase. An employee of a technology company must reduce exposure of the portfolio to IT companies because his lifetime earnings are already ‘invested’ in IT.

Gathering information about clients

Gathering information about a client is not just a legal requirement in some jurisdictions, it is critically important for formulation of a good IPS. Hence, a fact-finding exercise with the client is necessary, which should aim at obtaining information about the client’s family, employment, health, current wealth level, etc.

The process may be either informal or through structured interview and analysis of data. However, all interactions and decisions must be documented because they might be needed when any aspect of the relationship come under dispute.

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