A Guide to Creating the Investment Policy Statement and Building Portfolios
The foundation of portfolio planning is a thorough understanding of the client's needs, circumstances, and constraints. This understanding is formalized in the Investment Policy Statement (IPS), a crucial document that serves as the roadmap for the entire portfolio management process.
A well-drafted IPS should be a clear and comprehensive document that typically includes:
A description of the client and the purpose of the IPS.
A statement of duties and responsibilities for all parties (investment manager, custodian, client).
The investment objectives (risk and return).
The investment constraints.
Investment guidelines and a list of permissible asset classes.
The strategic asset allocation and rebalancing policy.
The benchmark to be used for performance evaluation.
Procedures for updating the IPS.
The investment objectives section of the IPS defines the client's goals in terms of risk and return. These two objectives are inseparable and must be consistent with each other.
The risk objective specifies how much risk the client is willing and able to take. It can be stated in absolute or relative terms.
Stated independently of market performance, e.g., "The portfolio shall not experience a loss of more than 5% in any 12-month period."
Stated in relation to a benchmark, e.g., "The portfolio's tracking risk should not exceed 2% relative to the S&P 500."
The return objective specifies the desired rate of return. Like risk, it can be absolute or relative.
Stated as a specific target, e.g., "Achieve a nominal return of 8% per year" or a real return of "inflation + 3%."
Stated in relation to a benchmark, e.g., "Outperform the benchmark by 1.5% annually."
A client's overall risk tolerance is a function of two factors:
An objective assessment based on financial circumstances like wealth, time horizon, and income needs. A longer time horizon and greater wealth generally mean a higher ability to take risk.
A subjective assessment of the client's psychological attitude towards risk, often determined through questionnaires.
If a conflict arises (e.g., high willingness but low ability), the investment approach should conform to the lower of the two. The advisor's role is to educate the client and find a suitable middle ground.
Constraints are limitations or preferences that must be considered when constructing the portfolio.
The need to access cash from the portfolio on short notice. High liquidity needs may restrict investment in illiquid assets like private equity or hedge funds.
The length of time over which the portfolio is expected to generate returns. Generally, a longer time horizon allows for a higher risk tolerance and investment in less liquid assets.
The tax treatment of various investment returns (e.g., capital gains vs. dividends) can significantly impact portfolio decisions. The focus should be on after-tax returns.
Any laws or regulations that constrain investment choices, such as rules governing trusts or corporate pension plans.
Any specific preferences or restrictions unique to the client, such as ethical considerations (ESG), religious beliefs, or a desire to avoid certain industries.
Once the IPS is complete, the manager begins constructing the portfolio. This is a multi-step process.
This is the long-term, target allocation of capital across permissible asset classes, based on the IPS. It is the primary determinant of a portfolio's risk and return characteristics. The goal is to use asset classes with low correlation to each other to maximize diversification.
This involves making short-term, temporary deviations from the SAA to capitalize on perceived market opportunities.
This is the process of selecting individual securities within each asset class to be included in the portfolio.
This involves setting an overall risk limit for the portfolio and then allocating that risk across the different levels of decision-making (strategic, tactical, and security selection).
Environmental, Social, and Governance (ESG) factors are increasingly being integrated into the portfolio planning process, often as part of the "Unique Circumstances" constraint or as a core part of the investment strategy.
| Category | Examples of Issues |
|---|---|
| Environmental | Climate change, pollution, energy efficiency, water scarcity, deforestation. |
| Social | Data protection, gender equality, human rights, labor standards, community relations. |
| Governance | Board composition, executive compensation, political contributions, whistleblower schemes. |