Investment Policy Statement (IPS) - Financial Edge (2024)

What is an Investment Policy Statement?

The official document that defines the objectives and guidelines for managing an institutional or personal investment portfolio is called an investment policy statement (IPS). The document is drafted based on conversations between the portfolio manager and client, and typically includes detailed information about the client’s:

• Risk tolerance
• Investment time horizon
• Preferences and restrictions
• Specific goals and objectives

In addition, the IPS lays out the strategies the portfolio manager can employ to meet these objectives. A robust IPS helps ensure consistent management by providing a framework for decision-making and ongoing monitoring.

How Does Investment Policy Statement Work 

The IPS serves as a strategic guide for creating and implementing an investment program. It defines the relationships between all parties involved and how all are accountable to the client. It is a highly customized document, so standard templates are a great starting point for creating an IPS, but every document will be tailored to the specific client needs. Access the IPS template that outlines the key elements you would find in an IPS.

A strong IPS has at its core the PM’s understanding of the client’s objectives, risk tolerance, and specific needs. Therefore, the language used should be appropriate for both parties. Below are some practical steps in creating an investment policy statement:

Stage 1

This stage involves a lot of information gathering on topics such as investment goals, risk tolerance, time horizon, liquidity needs, and any specific constraints.

Stage 2

This is the legal part of the process and involves input from compliance and legal before the IPS becomes and official document.

Stage 3

At this stage, the investment manager is responsible for executing trades and constructing a portfolio consistent with the IPS. At this stage, trading costs are likely to be higher than usual since more trades must be made. This will have been made clear during Stage 1.

Stage 4

The official document outlines how the portfolio will be monitored, including the frequency of reviews and criteria for rebalancing and making further investments. Deviations from IPS parameters (whether in performance, risk or asset allocation drift) must be reported immediately, while regular portfolio reviews are also taking place.

Objectives and Constraints of an Investment Policy Statement

Why Is an Investment Policy Statement Important?

A well-designed and written IPS is crucial for individual and institutional investors alike as it is the central point of reference between the client and the portfolio manager throughout the entire investment lifecycle. While some components like the setup and structure may remain static, the primary components such as asset allocation and ongoing management should be dynamic. This requires both parties to understand the aspects that will evolve over time, such as return expectations, and how are they influenced by prevailing market conditions.

For example, between 2009 and 2022, the S&P 500 index returned c.14.7% annually, but over the next 20 years, it is anticipated that US equities will deliver an average of 8.3% per annum (according to Morgan Stanley’s Capital Market Assumptions). This further highlights the importance of regular reviews and achievable objectives. There are various other considerations that are unique to the client and may trigger a review, including a change in cash flows or spending needs. Therefore, a robust IPS will ensure that, although some of the components may evolve over time, the decision-making process and continuous management of client funds will remain consistent with expectations and established goals.

Components of an Investment Policy Statement

The chart below shows some of the key components featured in an IPS.

While an IPS is individually tailored to client needs and circ*mstances, we explore below some best practices for creating in IPS.

Governance

As a first step in drafting the IPS, the client and investment manager should define the scope and arrangements between the two parties, as well as establish procedures for managing conflicts of interest. Tax and legal position must also be reviewed.

Investment Goals and Objectives

Defining the client’s investment objectives and aspirations is key and these must be clearly stated.

Here is a theoretical example of a high-net-worth individual:

1. The client wants to achieve capital growth over the long term (this should be clearly stated in years as in the example below).

2. They want to also receive regular income payments of approximately 5% of the total sum invested.

3. 5% of the overall portfolio should be held in highly liquid assets such as cash or money market funds to meet unexpected redemption demands.

4. They also have ethical considerations and do not want funds allocated to companies involved in activities harmful to the environment, such as oil and gas exploration.

Risk Tolerance and Management

Clearly state the client’s risk tolerance and capacity for losses. This can be estimated on an absolute or relative (against a pre-determined benchmark) basis and will give the portfolio manager boundaries. For example, for every 10% loss in the MSCI-All World Index (used as a proxy for the broader equity market), how much loss can the client accept? 50-70% of it, may indicate a higher risk tolerance where a loss of 5-7% for every 10% would be considered a low-risk profile. Risk is typically measured as volatility of returns (standard deviation) and drawdowns.

Asset Allocation

This step involves specifying the target allocation across different asset classes such as equities, fixed income, alternatives, and/or real assets based on the client’s risk profile and investment objectives. The goal is to achieve optimal risk-adjusted returns using different strategies.

Performance Monitoring

Defining the criteria and benchmarks for assessing performance and setting expectations for regular reporting and review. For example, a UK-based client might use the Retail Price Index +3% per annum as a benchmark. Other guidelines such as the frequency of portfolio rebalancing should also be included.

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Technical Example

Below are the monthly returns for a client portfolio.

This example asks us to calculate the annualized return and standard deviation and determine whether it is in line with the benchmark +3% performance target achieved with lower volatility.

Step 1: calculate the Annualised Return for both the portfolio and the benchmark using the “=PRODUCT” formula as outlined below.

=PRODUCT(1+(range)/100)^(12/COUNT(range))-1

Step 2: calculate the Volatility (i.e., Standard Deviation) for both the portfolio and the benchmark using the “=STDEV” formula.

=STDEV.S(range)

Step 3: calculate the Annualised Volatility for both investments: Volatility multiplied by the square root of the number of periods observed.

=volatility*SQRT(COUNT(range))

Step 4: determine whether relative performance and risk are within the agreed parameters, I.e, portfolio returns at least 3% higher and risk being lower compared to the benchmark.

Here you can see the portfolio delivered excess return of 13.1%, which is above its target of +3% annually. This has been achieved with lower volatility and therefore both criteria have been met.

Investment Policy Statement Examples

College Example

Below is the most recent Investment Policy Statement that sets out the principles governing management of investments held by Gonville & Caius College, University of Cambridge. The University holds total assets of approximately £3.5 billion across all its colleges and has one of the largest university endowments in Europe.

This is an example of an institutional IPS, where all aspects of the “components of an investment policy statement” are addressed. For example, the college has strict liquidity requirements.

Looking at some of the unique considerations, the endowment has very clear responsible investment parameters. This is typical for such funds as their investment horizon is very long and allows the adoption of policies that are socially beneficial and, while may not produce an immediate financial return, will contribute to societal goals and deliver strong performance over the long term. One such consideration is climate change and energy transition, regarding which the college has stated its requirements as part of its ethical considerations:

Individual Client’s Fund Example

Another example that concerns the management of individual client funds.

Personal client portfolios are typically much smaller in size than institutional portfolios and there may be notable differences. The risk assessment process is typically done by the individual client’s advisor and must be documented in the IPS, an example of which is given in section 3.c.

Another crucial aspect of an IPS is the preferred asset mix used to achieve the client’s objectives. While this may vary at times based on market conditions, any strategic (i.e., larger deviation from initially established parameters) changes should be discussed and approved before implemented. An example of an asset allocation frame is given in section 6.

Conclusion

Overall, the IPS is intended to guide portfolio managers while protecting client interests. The IPS outlines principles and strategies a portfolio manager should follow in managing client assets. It includes information about the client’s investment horizon and objectives, risk tolerance, specific requirements and/or restrictions. The IPS ensures decisions are made independent of subjective interpretations of success and failure and supports better communication regarding the client’s investment objectives.