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The Importance of an Investment Policy Statement

Many Institutional investors, such as pensions, endowments, and foundations have been using investment policy statements for a long time.  More recently, a growing number of sophisticated individual investors have started using this document as a way to govern their long-term investment programs.

So, what exactly is an IPS and how can it potentially help individual investors?  First, let me start out by saying what an IPS is not.  An IPS is not meant to be a legal document.  Its main purpose is to articulate the main elements of the investment management process:  planning, execution, and feedback.  An IPS does not include detail pertaining to specific securities, nor does it include forecasts about the short-term direction of the stock market.  Rather, an IPS emphasizes general asset allocation guidelines, which, if followed, attempt to satisfy some longer-term investment objective. 

The main benefits of an IPS are twofold.  First, it is transparent and can be easily referenced if there is disagreement between the advisor and the client.  In the absence of an IPS, how will differences be resolved?  An IPS is a great vehicle to manage age-old conflicts of interest between agent (financial advisor) and principal (client). Second, an IPS prevents ad hoc decisions that run counter to sound, long-term policy by helping to control very powerful behavioral biases that even the most sophisticated investors can succumb to when markets are under extreme duress or fluctuating significantly.  Many investors and advisors have an uncanny ability to make the wrong decisions at precisely the wrong moments.  A well defined IPS insulates the client and advisor from these behavioral biases by focusing attention on longer-term goals and by instilling much needed discipline.

So, what does an IPS look like?  IPS templates will differ from firm to firm but should contain these four basic sections:  an introduction and purpose, a section that documents client constraints and objectives, a strategic asset allocation schedule, and a calendar for rebalancing the portfolio. 

The introduction of an IPS will generally include basic client information, including names, ages, and the account(s) within the advisor-client relationship.  This basic information should include enough “who, what, when, where, and why”, so that any reasonable personal can immediately identify the document’s primary purpose as well as the parties involved in the relationship.

Following the introduction, an IPS will generally include the specification and documentation of various client objectives and constraints.  Investor return objectives may be stated in absolute terms but are usually expressed relative to some benchmark.  For instance, a very simple example of a return requirement may be stated as, “Mr. & Mrs. Jones require a long-term average annual return that is 3% above the average annual change in the Consumer Price Index.” 

The client and advisor may then begin to explore the concept of risk.   Accurately assessing a client’s risk tolerance is perhaps the most difficult task in IPS development.  Sometimes an investor will have an unusually high willingness to assume risk but must be counseled away from being too aggressive because he or she has a low ability to assume risk (unstable income, high career risk, low asset base, elderly, etc.).  On the other hand, some investors may have a very low willingness to assume risk but a very high ability to assume risk (significant asset base, high income in relation to expenses, young, large future inheritances, etc.).  In such cases, the advisor needs to illustrate the potential long-term effects of inflation on the purchasing power of dollars invested too conservatively.

Oftentimes, a risk objective is expressed in terms of the portfolio’s volatility, usually measured by a mathematical term called “standard deviation”.  Alternatively, a risk objective may also be stated more directly and in absolute terms, such as “Based on a risk-assessment interview with Mr. and Mrs. Jones on January 15, 2010, the financial advisor understands that an absolute loss in any 12-month period of more than 15% is intolerable.  A decline of 15% in one year requires the immediate implementation of policies and procedures to minimize further losses.”

Other investor objectives and constraints that should be addressed in an IPS include investment time horizon(s), liquidity constraints, and unique circumstances (e.g., the client’s desire for socially responsible investing).

Once all objectives and constraints have been clearly identified and documented, the advisor can proceed to produce a client-specific asset allocation policy.  This is the critical point in IPS development.  In this section, the advisor attempts to marry the client’s objectives to long-run capital market expectations.  The result should be asset class weightings that produce some desired long-term average annual return within the client’s risk tolerance level.  The IPS should clearly state all permissible asset classes as well as estimates of each asset classes’ long-term return and risk.  Asset classes should be mutually exclusive and diversifying. For example, the categories may include domestic equities, domestic fixed income, non-domestic equities, non-domestic fixed income, real estate, commodities, and cash and cash equivalents.    

Once specific asset class weightings have been determined, the advisor and client should agree to a schedule for rebalancing the asset class weights back to policy guidelines.  The advisor and client should also agree on a schedule for updating the investment policy statement for inevitable changes in client objectives, constraints, and circumstances, as well as changes in long-term capital market expectations.

The financial services industry is at an important fork in the road.  Sophisticated investors are looking for more transparent investment management solutions.  On the other side of the fence, financial advisors have become more defensive and less creative, spending too much time bracing for the implementation of additional regulations.  In such an environment of mistrust, an investment policy statement can be a simple but eloquent solution for clients and advisors alike.

Disclosure: no positions