A document that outlines the rules and guidelines governing asset allocation in a client’s portfolio
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An investment policy statement (IPS), a document drafted between a portfolio manager and a client, outlines the rules and guidelines that the portfolio manager must follow when considering asset allocation in the client’s portfolio. In other words, an investment policy statement outlines how a portfolio manager is to manage the client’s money.
Summary
- An investment policy statement is a document drafted between a portfolio manager and a client that outlines the client’s portfolio objectives and information relevant to achieving the objectives.
- The components of an investment policy statement are scope and purpose, governance, investment, return and risk objectives, and risk management.
- An IPS provides guidance to portfolio managers when making portfolio decisions and helps keep clients from making emotional decisions related to their portfolio.
Understanding an Investment Policy Statement
An investment policy statement provides guidance to portfolio managers when making portfolio decisions. Asset allocation decisions, client risk tolerance, leverage, liquidity requirements, and foreign security investment restraints are some examples of issues that are addressed in an IPS.
A well-constructed investment policy statement provides a framework for investment decisions made by the portfolio manager and also helps commit the client to a long-term investment strategy. Emotional decisions made by the client to the portfolio can be avoided – an IPS acts to remind clients regarding the overarching goals and strategies of the portfolio.
Components of an Investment Policy Statement
Referencing a document published by the CFA Institute, the components of an investment policy statement are as follows:
1. Scope and Purpose
- Establishing and building context regarding the investor’s source of wealth
- Identifying and defining the investor
- Setting forth roles and responsibilities of the portfolio manager
- Identifying a risk management structure
- Assigning responsibility for portfolio monitoring and reporting
2. Governance
- Specifying responsibilities in determining, executing, and monitoring the results of the implementation of the investment policy statement
- Describing the process related to reviewing the updating the IPS
- Describing authority in the hiring and firing of vendors associated with the portfolio
- Assigning responsibility in determining the asset allocation of the portfolio, including inputs used and the criteria used to develop the inputs
- Assigning responsibility for risk management monitoring and reporting
3. Investment, Return, and Risk Objectives
- Describing the overall investment objective
- Stating the return, risk, and spending assumptions (outflows in the portfolio)
- Defining the investor’s risk tolerance
- Describing relevant constraints (liquidity requirements, tax considerations, restrictions on certain investments, legal constraints)
- Describing any other considerations that may be relevant to the investment strategy
4. Risk Management
- Establishing performance measurements and reporting accountabilities
- Specifying metrics used to measure and evaluate risk
- Defining the process for portfolio rebalancing and target asset allocations
Theoretical Example
Following is a theoretical example of how an investment policy statement might prevent emotional decisions.
In 2018, an elderly client drafted an IPS with her portfolio manager. The investment policy statement outlines, among other things, that the portfolio is restricted from investing in high-risk speculative investments.
With the impending legalization of cannabis in Canada and seeing the buzz created by cannabis stocks, the client meets with her portfolio manager and outlines her idea to shift the entire equity asset allocation of the portfolio into cannabis stocks to ride the wave. The client believes that the industry will continue to rise and outperform other industries.
With a drafted IPS, the portfolio manager indicates to the client that the portfolio is restricted from investing in high-risk speculative investments. The portfolio manager outlines that cannabis stocks are highly speculative as they include revenue growth assumptions that are unrealistic and are currently trading at extreme valuation multiples.
Additionally, the portfolio manager states that while marijuana stocks may perform well in the short term due to constant headlines, it would significantly increase the portfolio risk and potentially jeopardize the portfolio from achieving its long-term goal.
Understanding the facts presented by the portfolio manager, the client decides to follow along with the portfolio’s investment policy statement and to avoid the cannabis space.
More Resources
Thank you for reading CFI’s guide on Investment Policy Statement (IPS). To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:
- Dynamic Asset Allocation
- Investing: A Beginner’s Guide
- Prospectus
- Types of Due Diligence
- See all capital markets resources
- See all wealth management resources
