Introduction
Investment advice to individual investors dictates a number of concerns and preferences to be considered as part of the investment performance evaluation. The investment advisors must consider various investment concerns like investor’s risk and return objectives, investment constraints and responsibilities before making any investment strategy for the investors.
An investment policy statement (IPS) is a customized, client-centric document for planning and managing investor’s portfolio of investments. The IPS provides protection to both investor and the investment advisor, and it sets accountability standards for various entities involved in the investment portfolio management. This document determines parameters for investment planning, asset allocation, investment policy implementation, monitoring, risk management and reporting investment results. The elements of the IPS are unique for every investor and, hence, do not apply in all situations.
A document of investment objectives and constraints
More than two-thirds of the IPS is based on investment objectives and constraints, however, before setting the objectives and constraints, it is often useful to discuss the scope and governance parameters of the investment program. The IPS should highlight the sources of wealth for implementing investment strategy, the investor and the assets that are subject to IPS mandate. The IPS should specify the key responsibilities of the investment advisor, their role in planning, implementing and evaluation of portfolio assets, their fiduciary standards as custodians of investor assets, and other related legal matters in the portfolio management process.
Risk/Return objectives
Almost all of the investment decisions are based on risk and return objectives. The IPS must clearly define the risk and return objectives after carefully analyzing qualitative and quantitative features. There are two types of investment returns that investors are concerned with: desired return and required return. It is the responsibility of the investment advisors to consider both when determining the investor’s required return. Investor’s short-term and long-term goals, annual spending needs and retirement savings goals are the determinants of return objectives. Advisors should carefully identify the investor’s investment goals and then determine the after-tax return that is required to fulfill those goals. The investment decisions are based on total return methodology and the return objectives must be consistent with investor’s risk tolerance.
The opposite side of the coin is the risk objectives. There is a trade-off between risk and return: the higher the risk, the higher the return and vice versa. Investors must recognize that some level of risk must be assumed in realizing return objectives. Both willingness to take risk and ability to take risk are considered in determining the risk objectives, but the investment decision must be based on the ability to take the risk. Some of the factors that determine willingness and ability to take risk are the type of the investor (risk-averse versus risk-taker), financial needs, investment goals, etc. It is the investment advisor’s responsibility to carefully analyze the profile of the investor, his investment experience, financial position, stage of life, short-term goals and long-term goals before determining his willingness and ability to take the risk.
Constraints
Investors do not have a free hand to invest when and where they want to. Rather they have to face a number of constraints that limit their ability to play with their capital as they would wish. The IPS of the investor contains some of the constraints that are unique to that investor. Remember, IPS is a customized document and these constraints do not apply to every investor. The following are five types of investment constraints:
Time Horizon:Â Every investor has its unique time period to put their capital into earning assets. There is not a single definition to explain what a time horizon means. However, it is the industry norm to consider less than three-year periods as short-term and more than three years as a long-term time horizon. Investments require a long-term perspective, but not every investor can invest for the long term. Therefore, it limits the investor’s ability to invest for long-term assets if there is an opportunity to earn higher risk-adjusted returns but the investor has a short-term time horizon.
Liquidity:Â Liquidity is defined as the investment portfolio’s ability to meet investor’s anticipated and unanticipated cash flow needs. However, in the times of high market volatility, as is the current situation, and the high transaction costs, liquidity becomes a serious concern for many investors.
Tax considerations: Taxes are also a limitation on investment decision making that keeps tax-sensitive investors away from the investment arena because investors have to pay taxes on dividends and capital gains.
Legal constraints:Ă‚ These issues vary from one country to another and are concerned with taxation and transfer of assets. To deal with legal constraints, investors should consult with legal advisors who understand these issues well. Investment advisors must be very careful when advising investors that have legal constraints in their investment portfolio.
Unique circumstances:Ă‚ These constraints are very specific and unique to every investor. Some investors do not like to use leverage in their portfolio, others are concerned with foreign investment securities and some may be social investing concerned. Investment advisors should completely understand the investor philosophy while drafting his IPS.
Risk management/operational guidelines
Risk management is very crucial for an investment management business. There must be some reliable and objective mechanisms for portfolio risk management as well as investment performance evaluation. An adequate level of portfolio diversification is one of the most widely used risk management techniques in the investment world. The portfolios that control risk by implementing effective risk management metrics outperform the portfolios that lack such mechanisms. Inappropriate risk metrics should be avoided. The IPS should clearly define such risk management and performance evaluation metrics and their effectiveness should be monitored over time to achieve desired goals.
Asset allocation is a major concern in making portfolio management strategy. The IPS should define a mechanism for rebalancing the assets to target asset allocation. The actual allocation may deviate from target allocation in the short run, but in the long run, they must follow the target allocation strategy. Performance analysis must be based on relative performance of the benchmark.
Final remarks
An investment policy statement is a client-specific, customized document that provides guidelines and standards to manage the investment portfolio of the investor. It enlists the investment objectives (risk and return objectives), investment constraints (liquidity, time horizon, taxes, legal concerns and investor’s unique circumstances) and some other factors that are important in the management of a client’s assets. It provides the investment manager a mandate to make investment decisions on behalf of the investor. This document is reviewed and updated on a periodic basis to incorporate any changes in the investor circumstances since the last reviewed period.
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