By Roy Larsen, CFP®, AAMS®
In some cases, investors choose to authorize a money manager to make the actual investing decisions for their portfolio rather than simply make recommendations. In such cases, it can be valuable to have a mechanism for making sure in advance that investor and manager are on the same page.
An investment policy statement (IPS) is designed to ensure that both sides understand the scope of the manager's decision-making authority and the guidelines on which investment decisions will be based. The portfolio's owner can take comfort in knowing that the investment manager has a clear sense of what's expected, while the manager can employ his or her best judgment and experience in following the IPS guidelines.
An investment policy statement also can be used by an investment committee--for example, officials responsible for managing the assets of a nonprofit organization, pension fund, or university endowment--to spell out the policies underlying the committee's investment decisions. Such a statement can increase transparency and improve consistency in case of turnover in committee membership.
Though an investment policy statement can be as simple or as complex as the parties involved want it to be, here are a few elements that are likely to appear.
Roles and responsibilities
An IPS generally spells out which accounts are covered by the policy statement and establishes procedures to be followed--for example, how subsequent modifications to the IPS itself will be handled. It also may set forth a process for ongoing monitoring of the portfolio, such as how often the investment manager will report on performance. In the case of an institutional investor, the IPS may specify who will be responsible for reviewing those reports and communicating with the investment manager, and which party is responsible for documenting compliance with any regulatory requirements.
Investment objectives and/or philosophy
An IPS generally will spell out the portfolio owner's goals and objectives. For example, it might state that the portfolio's primary goal is providing a certain level of income annually, or pursuing maximum growth; it also might specify how much volatility the owner is comfortable with. Such guidelines will affect the portfolio's asset allocation and the manager's selection of individual investments, though there obviously is no guarantee that a portfolio might not occasionally exceed the agreed-upon volatility guidelines or fail to achieve the desired goal.
Asset allocation and criteria for investment selection
Based on the above factors, an IPS may specify asset classes that are or are not appropriate for the portfolio. For example, it might allow investments in both individual bonds and bond funds, but exclude investments in the sovereign bonds of emerging markets. As a general rule, an IPS does not name specific securities for either inclusion or exclusion, permitting the manager to select individual securities within the approved asset classes. However, there may be exceptions--for example, when an investor already has a concentrated stock position. An investor who holds a large number of shares accumulated by exercising stock options granted as part of an employee compensation program might want to ensure that those holdings are not increased.
An IPS may or may not spell out a general asset allocation for a portfolio or set targeted ranges for each permitted asset class; for example, it might permit a portfolio's allocation to equities to range from 50% to 70%. It also may specify how often or under what circumstances the portfolio will be rebalanced to maintain a targeted asset allocation; set liquidity and marketability requirements; outline any specific cash reserves needed; and encourage or prohibit tax management strategies.
Criteria for gauging performance
A portfolio that doesn't produce the return necessary to meet its owner's financial and legal obligations--for example, pension payments owed by a pension fund--has even bigger problems than a portfolio that falls short of providing the return hoped for by an individual owner. That's why an IPS will often include expected performance criteria, such as a targeted percentage return or a requirement that the portfolio's assets match or exceed the performance of one or more appropriate benchmark indices.
As you can see, an IPS can be as detailed or as general as the parties involved feel is appropriate. Your financial professional can help you explore whether an IPS is appropriate for your individual situation.
Roy Larsen, CFP®, AAMS® is a Fee Only Certified Financial Planner practitioner and acknowledged fiduciary. He works with clients in the Gainesville, GA. area outside of Atlanta and throughout the United States. Larsen Wealth Management specialized in the distribution phase of retirement or your version of chapter two. Roy has been quoted in the Wall Street Journal as well as the New York Times and has won the 5-Star Professional award for 6 consecutive years as one of the top Wealth Managers in Atlanta. Roy can be reached at 678-696-8755 or roylarsen @investinretirement.net.
The opinions voiced in this material are for general information purposed only and are not intended to provide specific advice or recommendations for any individuals(s). To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Roy Larsen is a Certified Financial Planner™ practitioner and Fee Only Wealth Manager who resides outside of Atlanta, Georgia.
Roy's Financial Blog contains articles on the multiple and complex issues of living successfully in Retirement. There are additional resources on our educational website, www.successfulretirementinstitute.com.