An investment policy statement (IPS) can be one of the most important documents for individual and institutional investors. However, not all IPS are of the same quality.
Which of these statements best describes your IPS?
A. IPS is the backbone of our successful investment program.
B. I know there’s an IPS around here somewhere.
If you answered B, you are not alone. But you are probably losing the benefits that a well-researched IPS can create for your investment program.
If you put your IPS to a stress test, would it be strong enough to withstand the pressure?
Four considerations can help determine the robustness of an IPS. The dominant theme among them is rigour: Rigor around the functions of governance, oversight, investment management and monitoring/evaluation of the investment program.
But before we get to these four considerations, we need to upgrade the current IPS landscape.
Simply put, there are more “bad” investment policy statements than “good” ones. The IPS can be the most important governance and oversight document for an investment program and as such should cover all details relevant to the governance, execution and monitoring of the program and his wallets. In our view, the key difference between a “good” IPS and a “bad” IPS is implicit: again, thoroughness.
Common IPS Sections
A complete IPS should contain as many of the sections listed above as are relevant to the given investment program. For example, a nonprofit organization can use an investment program to support its mission. The IPS should document how this investment program will be constructed to support the mission and tie into the overall purpose of the assets, whether supporting distribution, budget, specific investment projects , etc.
The six key sections identified in the preceding table cover a wide range of responsibilities for governance, portfolio execution, and monitoring and oversight. These are relevant for board or investment committee members acting in a fiduciary capacity.
In our experience, this is where organizations with “bad” IPS fail. In some cases they omit sections, in others they include them but not with enough specificity to drive the intended behavior, processes and results. These gaps tend to fall into one of our four areas of consideration.
1. Definition of responsibilities
It may seem obvious, but the IPS needs to identify who is doing what. For example, for board or investment committee members serving as trustees for an institutional investor, there should be no ambiguity as to who is responsible for the various tasks associated with the investment program. The following assignments must be made:
- Who is responsible for the governance, oversight and maintenance of the IPS?
- Who will set the fund’s investment and distribution objectives?
- Who will make asset allocation, manager selection and other portfolio management decisions?
- Who will assess the extent to which the investment program achieves its objectives?
These and other responsibilities should be identified and assigned to specific owners, in writing, so expectations are clear. These primary owners may include asset owners, board members, trustees, and investment committee members, in addition to financial service providers such as investment advisers, custodians, etc. Done well, it clarifies the responsibilities of each party, especially those who have fiduciary duties and accountability around performing those tasks.
2. Objectives and constraints
When creating an investment portfolio, you should consider return objectives, risk tolerance, time horizon, taxes, liquidity, legal/regulatory requirements, investment responsible and unique circumstances.
State these factors, define them and share them with the managers of the investment program. When reviewing these key goals and constraints, ask yourself the following questions:
- Return goal: What are these funds used for? If the objective is to make a distribution while preserving purchasing power, does the return objective take this into account?
- Risk tolerance: What is the appropriate level of risk for the portfolio?
- Temporary horizon: How long will these assets be invested? In perpetuity or for a fixed term?
- Taxes: Are there any tax impacts or implications that should be considered with respect to the investment portfolio?
- Liquidity: What are the cash requirements of the portfolio (for example, to fund distributions)?
- Legal or regulatory requirements: Are there applicable federal or state regulations? What about other considerations?
- Responsible investment: Does the construction and management of the portfolio require the integration of responsible investment factors?
- Unique circumstances: Are there any specific policies, such as special rules regarding the approval of alternative investments, that need to be incorporated into portfolio management?
An investment program must be built on these factors and must be designed to adapt as they change.
3. Comparative analysis of the plan
Measuring progress is critical to the success of an investment program strategy. Specifically, evaluating the performance of the investment program against set benchmarks can help determine if it is on track to meet its objectives or if strategy adjustments might be needed. Two steps are integral to this process:
- Define “success” in specific terms, through a relative or absolute benchmark.
- Periodically measure the performance of the investment program against the definition of success.
A relative benchmark applies an index or a combination of indices to compare the performance of the investment program. For example, a relative benchmark might compare an investment portfolio to that of a 60%/40% blend of the S&P 500 and the Bloomberg Barclays Aggregate Bond Index.
An absolute benchmark, or hurdle rate, is an actual percentage return. For example, if the objective is to conserve the capital and purchasing power of the portfolio against an annual distribution of 4%, inflation of 2% and fees of 0.5%, a calculation at the bottom of the envelope requires a yield of 6.5%. Investment returns below this benchmark suggest that the program is not achieving its objective. Higher returns imply that the goal has been achieved.
The second critical aspect of benchmarking is ensuring that benchmarks are actually used. Specifically, the performance of the investment program against established benchmarks should be calculated on a regular basis.
We recommend that benchmarks be reviewed annually and in response to significant changes in the investment portfolio or investment program objectives. This can help determine if they remain suitable for the purpose of the investment program.
Over time, the circumstances, decision makers and financial service providers associated with a policy may change. When the team responsible for long-term goals is in turnover, how do you keep the investment program on track? An effective IPS can help.
With this in mind, will anyone be able to grasp the IPS and understand the investment program without any further guidance? Here are some key factors to consider when answering this question:
- Does the IPS include the common sections mentioned above?
- Have you defined the responsibilities of key decision makers?
- Have you defined the objectives and constraints?
- Have you defined what success looks like (i.e. established benchmarking guidelines)?
- Have you defined how you will monitor the portfolio and how often?
If the answer is “yes” to these questions, your SPI may be able to overcome the uncertainties inherent in investing.
A solid IPS can provide a solid foundation for an investment program and give investors the discipline they need to persevere in difficult investment environments.
With these considerations in mind, we recommend that you work with your clients, policy makers, legal services firm and investment managers to ensure that your investment policy statements meet the stringency threshold.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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