Subject 4. The investment policy statement

Definition

The investment policy statement is a:

  • planning document that incorporates a client's needs, preferences, and circumstances to form an integrated statement of that client's objectives and constraints.
  • communication document that clarifies the understandings between manager and client.
  • governing document for all investment decision-making on behalf of the client.

Importance

The investment policy statement:

  • forms, with capital market expectations, the basis for critical investment strategies, most importantly the asset allocation decision.
  • provides a context for assessing the appropriateness of investment manager styles.
  • establishes the reference for monitoring and evaluating manager performance.
  • imposes long-term discipline on both client and manager.

An investment 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.

Contents

The investment policy 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-and-long-term needs, familiarity with capital market history, and investor expectations and constraints. A typical investment policy statement includes the following elements:

  • Brief client description.
  • Purpose regarding establishment of policies and guidelines regarding objectives, goals, restrictions, and responsibilities.
  • Identification of duties and investment responsibilities of parties involved, particularly regarding fiduciary duties, communication, operational efficiency, and accountability.
  • Statement of investment goals, objectives and constraints.
  • Schedule for review of investment performance and of the IPS itself.
  • Asset allocation considerations to be taken into account in developing strategic asset allocation.
  • Rebalancing guidelines for portfolio adjustments based on feedback.

Special Topic 1: Investment Strategy

An investment strategy is an approach to investment analysis and security selection. An investor needs to clearly formulate an investment strategy to impart organization and coherence to investment decisions and to guide those decisions toward the achievement of investment objectives.

  • In a passive investment approach, portfolio composition does not react to changes in expectations. Indexing and buy-and-hold strategy are types of passive investing.
  • In an active investment approach, portfolio managers hold securities that are different from a benchmark or comparison portfolio for the purpose of producing positive excess risk-adjusted returns or positive alpha as compared with the comparison portfolio.
  • A semi-active investment approach refers to an indexing approach with controlled use of weights different from the benchmark.

Special Topic 2: The Ethical Responsibilities of Portfolio Managers

Ethical conduct is the foundation requirement for managing investment portfolios. A portfolio manager is in a position of trust and his conduct affects the well-being of clients and many other people. He must meet the highest standards of ethical conduct to truly serve his clients. For CFA Institute members, this position of trust is reflected in the Code of Ethics and Standards of Professional Conduct.

Practice Question 1

Constructing a policy statement is mainly the responsibility of the ______.

I. financial planner
II. portfolio manager
III. investor
Correct Answer: II and III

There are two important reasons for constructing a policy statement: it helps the investor decide on realistic investment goals and it creates a standard by which the performance of the portfolio manager can be judged.

Practice Question 2

Which of the following issues does a policy statement not address?

A. Existing knowledge that the investor has in investments and capital markets.
B. Additional capital or income sources available to the investor.
C. Emotional reactions and risks to a positive financial outcome.
D. Any legal restrictions affecting the investment needs.
Correct Answer: C

The policy statement does not worry about the emotional reactions or risks related to exceptional or strong performance (the investor should be so lucky!).

Practice Question 3

Which of the following statements is NOT a characteristic of a policy statement in the portfolio management process?

I. It is a road map.
II. In it investors specify the types of risks they are willing to take and their investment goals and constraints.
III. Because investor needs change over time, it is periodically reviewed and updated.
Correct Answer: None of them

All of them are characteristics of a policy statement.

Practice Question 4

A policy statement is a process whereby investors:

A. outline either parts of or the overall investment strategy.
B. quantify the expected rate of return on investments.
C. articulate their realistic needs and goals and become familiar with financial markets and investing risks.
Correct Answer: C

Practice Question 5

Which of the following statements is the LEAST ACCURATE with respect to the reasons ethical conduct is a requirement for managing investment portfolios?

A. Most importantly, the role of portfolio manager is based on trust. The actions of a portfolio manager will have a profound impact on the financial well being of a client.
B. Ethical behavior is ultimately what allows an investment manager to stay in business.
C. The action of a few unscrupulous investment managers can easily taint the reputation of the profession.
Correct Answer: B

While having a reputation for ethical behavior is certainly a strong asset to have, it is by no means a tool meant to enlarge assets under management or to ensure that a manager stays in business. For example, even at the highest degree of ethical behavior, an investment manager may lose business or go out of business, if her style of investing remains out of favor for a prolonged period of time.

Practice Question 6

A policy statement:

I. helps set realistic investment goals.
II. creates the standards by which the portfolio manager is judged.
III. provides discipline to the investment process.
IV. allows monitoring of the portfolio in relation to prevailing economic conditions.

A. I, III & IV.
B. I, II & III.
C. II, III & IV.
Correct Answer: B

A policy statement is intended as a guide to the investment process, serving to identify and set realistic goals. This also creates the yardstick by which the portfolio manager can be judged when it comes to performance evaluation. Monitoring of the portfolio with respect to changing market conditions, however, is not a part of the policy statement.

Practice Question 7

A portfolio's performance should be measured against:

A. the goals in the policy statement and the specified benchmark.
B. the performance of other money managers.
C. a broadly diversified index or the overall market.
Correct Answer: A

The portfolio manager is constrained to operate within the guidelines provided by the policy statement. Indeed, part of the policy statement is the specification of standards by which the portfolio manager's performance would be judged. Hence, the use of an arbitrary market index or any other standard which is not pre-specified is inappropriate.