The Investment Policy Statement: kick-starting your investing journey
by Patrick Oberhaensli, on May 5, 2020 9:57:00 AM
Investing requires a wholesome understanding of the investor’s individual needs, determining this should be the first task on their to-do-list, independently from their age or experience as an investor. The compiled requirements will be formulated in a written document in what is a called an Investment Policy Statement (IPS): a single document, drafted by a portfolio manager and client, which is a framework that clarifies the “investment situation” (before investing). Therefore, finding the right online trading service who will provide sufficient advisory coverage is crucial.
In this article I will first provide an overview of the key components of the classic IPS and then further detail these components as necessary for a basic understanding. As a last discussion point, I will introduce possible advancements in the area of the Investment Policy to better reflect today’s possibilities.
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Risk vs. Return
The IPS process begins with specifying the adequate basis. This encompasses, among other variables, the expected future liabilities of the investor because not every amount can necessarily come from the investments.
The next question to address is the investor’s objectives. The investor should consider both risk and return and they must be consistent throughout the statement. The return target is deducted from meeting (the) liabilities while the risk tolerance results from the combination of two components: risk ability and risk willingness.
These objectives are associated with several constraints that need to be fulfilled. The first limitation is/are the time horizon(s). Each time horizon - matching a particular life-stage - corresponds with new objectives which leads to a separate analysis. The longer the time horizon, in most cases, the higher the risk ability. In some instances the time horizon isn’t considered as a constraint, but that doesn’t change the methodology as such.
Legal aspects, such as the laws, regulations and tax regime applied to the investor, are relevant dimensions to take into account in order to maximise the return. These aspects vary, for instance by type of investor and domicile, but in terms of returns it is only after-tax returns that are relevant. Additionally, there can be a number of restrictions and commitments to consider: from the type of instruments/products allowed (respectively not allowed) to the use of ESG (Environmental, Social and Governance) criteria in a more or less extensive capacity.
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Finally, shorter liquidity matters are also looked at separately: this concerns the regular needs for cash as well as the material non-recurring ones that will influence the beginning asset allocation. It should be noted that while another terminology can be used for the IPS, the core concept remains the same.
Although it seems as though I have outlined a process and therefore a specific sequence of tasks, when developing an IPS, objectives and constraints must be put into proper relation. In other words, it is a process that typically requires multiple iterations and the IPS needs to be updated at least once a year or when the investor’s circumstances change in a material way.