Portfolio Management II
Reading 54. Basics of Portfolio Planning and Construction
Learning Outcome Statements
a. describe the reasons for a written investment policy statement (IPS);
b. describe the major components of an IPS;
CFA Curriculum, 2020, Volume 4
Subject 1. The Investment Policy Statement and its Major Components
The first step of the portfolio management process is to develop a policy statement. The statement covers the types of risks the investor is willing to assume along with the investment goals and constraints. It should focus on the investor's short-term and long-term needs, familiarity with capital market history, and expectations and constraints. Periodically the investor will need to review, update, and change the policy statement.
A policy statement should incorporate an investor's objectives (risk and return) and constraints. It should address the following issues:
- What are the risks of an adverse financial outcome?
- What are the emotional reactions to an adverse financial outcome?
- How knowledgeable is the investor about investments and markets?
- What other capital or income sources does the investor have? How important is the portfolio to the overall financial position?
- What legal restrictions may affect investment needs?
- What unanticipated consequences of interim fluctuations in portfolio value may affect investment policy?
Moreover, the policy statement should attempt to answer the following questions:
- Does the policy statement meet the specific needs and objectives of this investor?
- Does the policy statement enable a competent stranger to manage the portfolio in compliance with the client's needs?
- Does the client understand the investment risks and the need for a disciplined approach to the investment process?
- Does the portfolio manager have the discipline and flexibility to maintain the policy during an adverse market?
- Does the policy statement, if implemented, meet the client's needs and objectives?
A policy statement is like a road map: it forces investors to understand their own needs and constraints and to articulate them within the construct of realistic goals. It not only helps investors understand the risks and costs of investing, but also guides the actions of portfolio managers.
Performance cannot be judged without an objective standard. The policy statement should state the performance standards by which the portfolio's performance will be judged and specify the specific benchmark which represents the investor's risk preferences. The portfolio should be measured against the stated benchmark rather than the portfolio's overall performance.
Major components of an IPS include an introduction, statement of purpose, duties and responsibilities, procedures, investment objectives, constraints and guidelines, evaluation and review, and appendices.