Level 1 CFA® Exam:
Investment Policy Statement in Detail
In this lesson, we are going to talk about the basics of portfolio construction. First, we are going to discuss the purpose and significance of an investment policy statement (IPS) and its main components. We are also going to present the main objectives and constraints which you may face when planning a portfolio. We are going to show you the differences between willingness and ability to take the risk. Finally, we are going to show you how to allocate assets when constructing a portfolio.
Each investment should be preceded by portfolio planning. Regardless of whether you make all the decisions and manage your own portfolio by yourself, or you do it with more or less the help of your manager. Good planning is essential for an investor to achieve his or her objectives. A document that governs an investment plan is called an investment policy statement, or simply an IPS.
Investment policy statement (IPS) is a document that governs the client’s investment plan.
Investment success is impossible without developing a clear plan that will set goals concerning the risk taken and the expected return. These goals should be set jointly by the client and the manager of the portfolio who must understand the client’s situation, including any restrictions concerning investment opportunities. In other words, investment success, or meeting the IPS objectives, is possible only thanks to good cooperation and mutual understanding.
Very often investors demand a high return but at the same time are very risk-averse. Unfortunately, high returns and low risk are mutually exclusive. And so the role of a professional portfolio manager is to explain in detail the mechanisms governing the financial markets, especially the risk-return relationship. The portfolio should be compatible with the risk that the investor may and wants to take. Risk rather than return should be the primary consideration.
An IPS can take many forms, but typically such a document looks this way:
- The Introduction describes the investor’s situation.
- Then comes a Statement of Purpose, which defines the purpose of the IPS.
- The next section is a Statement of Duties and Responsibilities, which details the duties and responsibilities of both the client and the investment manager.
- A section called Procedures describes how to develop or change the IPS, with particular emphasis on emergencies.
- Another section is Investment Objectives, which thoroughly explains the client's investment objectives.
- Investment Constraints is a section that presents constraints that need to be considered when formulating objectives as well as constructing and monitoring the portfolio.
- Then comes Investment Guidelines, which explain how the investment plan should be executed. It includes any limits on the division of the portfolio into asset classes and defines specific types of assets excluded from investment. It provides information on the proper use of leverage.
- Evaluation and Review is next and discusses the investment performance together with the reasons and guidelines for the future to allow for more efficient management of the portfolio.
- The final section is Appendices – it usually consists of two parts. The first determines strategic asset allocation in the portfolio. The second part describes the rebalancing policy which defines actions in case of changes in the portfolio structure resulting from changing prices.
An IPS is not always composed of the sections we’ve just discussed. It should at least include a description of the investor’s situation, objectives, and constraints and it should explain the way of assessing the manager’s performance.
It is important to determine the level of risk. Risk can be defined in an IPS in many ways. First of all, we distinguish:
- absolute risk objectives and
- relative risk objectives.
What is also extremely important in terms of management is to determine the level of risk that will fit the situation and the personality of the client. There’s something you need to be aware of! You need to distinguish between the WILLINGNESS to take the risk and the ABILITY to take the risk.
Willingness to bear risk is a subjective factor. It depends on an investor’s perceptions of investing and a possible rate of return. A portfolio manager often examines the willingness to take a risk using a short questionnaire prepared for the client.
Understanding your client’s subjective perception of risk is relevant when it comes to the ability to take the risk. It is determined by the current situation of the investor, his investment horizon, current liabilities and expenses, investment objectives, and generally speaking, the financial situation. The manager gathers information about the client's situation to properly adjust the level of risk that the given investor might accept.
Often there is a conflict between the willingness and the ability to take the risk. A good portfolio manager should first take into account objective factors, that is, the client's ability to take risk. She should also explain the difference between those two aspects of risk to ensure an appropriate level of client’s investment security and well-being.
On the other hand, however, clients with high ability and low willingness to bear risk should be encouraged to take more risk to effectively use their assets. The manager has to remember that the level of risk has to be adjusted to the client’s expectations.
The rate of return can be described as:
- absolute return objectives, or
- relative return objectives.
Both the rate of return and the risk are, as we already mentioned, the most important features of investment. But, when constructing a portfolio you have to take into consideration several other important factors that are a kind of investment constraints:
- time horizon,
- tax concerns,
- legal and regulatory factors,
- unique circumstances.
Liquidity is associated with the ability to convert investments into cash. High liquidity means that this conversion can be done relatively easily and at a low cost. Investment liquidity is a very important feature of every investment. For example, if an investor has a loan that he repays regularly, then he will be interested in highly liquid investments.
If the investment is liquid, he will be able to quickly convert this investment into cash and use it to repay the loan. Low liquidity is often associated with a higher expected rate of return. In the case of low investment liquidity, the investor accepts the fact that when he needs money he may not be able to obtain it easily. Examples of non-liquid investments may be investing in works of art and rare spirits.
A time horizon is related to the length of the client’s potential investment. In general, we can say that the longer the investment horizon, the more risk can be taken by the investor, and the less liquid investments can be accepted. The shorter the horizon, the greater the required liquidity and the lower the risk that an investor can bear (when you have less and less time until the end of the investment, you have fewer and fewer opportunities to make up for any loss associated with high risk).
Strategic Asset Allocation, Tactical Asset Allocation, Security Selection, & Rebalancing Policystar content check off when done
Strategic asset allocation (SAA) is designed to determine the share of long-term assets in the portfolio. SAA is determined by a long-term perspective for various asset classes. In one of our previous lessons, we presented the main characteristics of each asset class. Now, just to remind you, return and risk allow us to identify major asset classes, which include: cash, equities, bonds, real estate, commodities, hedge funds, private equity, etc.
SAA is created based on clearly defined investment objectives which we have discussed and restrictions or limitations that an investor must face. Analysis of historical data shows certain relationships between the risk and return which are used to build a portfolio that meets clients’ requirements. In the context of a portfolio’s performance, it is also important to focus on the correlation between the assets in a portfolio. Each fund must be considered individually, taking into account not only return, risk and correlation but also, as we discussed earlier, liquidity or the investor’s individual situation.
The process of establishing strategic asset allocation consists of long-term capital market expectations and objectives and investment restrictions (resulting from the IPS). Later, optimization and simulation are introduced to help to determine the appropriate portfolio structure.
There are two approaches to investing:
- active investment, and
- passive investment.
Active investment management uses, among other things, tactical asset allocation (TAA) which allows for some deviation from the established structure of the portfolio (SAA), increasing the weight of assets whose short-term perspectives are more favorable.
- A document that governs an investment plan is called an investment policy statement (IPS).
- The role of a professional portfolio manager is to explain to an investor in detail the mechanisms governing the financial markets, especially the risk-return relationship.
- An objective defined by absolute risk concerns the likelihood of losing a portion of the total investment or shows the amount of the loss.
- Relative risk identification is about referring to values other than the sum of investment.
- Willingness to bear risk is a subjective factor. It depends on an investor’s perceptions of investing and a possible rate of return.
- The client's ability to take risk is an objective factor.
- When considering absolute return objectives, we refer to nominal or real values.
- Relative return objectives refer to the benchmark.
- Investment constraints include: liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances.
- Liquidity is associated with the ability to convert investments into cash.
- A time horizon is related to the length of the client’s potential investment.
- Tax concerns must be considered individually for each client.
- Legal and regulatory factors affect all investors in a given country or region.
- Unique circumstances are associated with a client’s individual characteristics.
- Strategic asset allocation (SAA) is designed to determine the share of long-term assets in the portfolio.
- Tactical asset allocation (TAA) which allows for some deviation from the established structure of the portfolio, increasing the weight of assets whose short-term perspectives are more favorable.
- Portfolio rebalancing is designed to restore a portfolio structure compatible with the SAA.