The Investment Policy Statement

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Agenda • The elements of an investment policy statement • The process involved in creating an investment policy statement for an individual investor.

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Investment Policy Statement (IPS) • A formally written document providing guidelines for portfolio investment decision making • The IPS does the following: – Provides guidance for current and possibly subsequent investment advisor decisions – Promotes long-term discipline in investment decision making – Insures against short-term shifts in strategy when either market conditions or portfolio performance cause panic or overconfidence 3

Several elements to a suitable IPS • A description of the client’s situation • The purpose of the IPS with respect to policies, objectives, goals, restrictions, and portfolio limitations • Identification of responsibilities of parties involved • The formal statements of objectives and constraints • A calendar schedule for both portfolio performance and IPS review • Asset allocation ranges and statements regarding flexibility and rigidity when formulating or modifying the strategic asset allocation • Guidance for portfolio adjustments and rebalancing 4

Investment Policy Statement • Benefits to the Client – Objectives and constraints are considered in formulating investment decisions that benefit the client in an optimal way – The process is dynamic and allow changes in circumstances to be incorporated into overall investment decisions – A well-written IPS represents the long-term objectives of the investor – Even if there are changes in conditions or investment advisers, subsequent managers should be able to implement decisions congruent with the individual’s goals and objectives

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Investment Policy Statement (Cont’) • Benefits to the Adviser – If questions arise regarding specific investment decisions, the IPS can be consulted for clarification – The document should indicate, or at least provide direction for dispute resolution

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Creating an IPS • Determine and evaluate the investor’s risk and return objectives. Planning return expectations should take place concurrently with risk tolerance discussions • Determine portfolio constraints • Define the appropriate investment strategy upon an analysis of objectives and constraints and market expectations • Determine the proper asset allocation appropriate to meet the investor’s objectives and constraints • Execute portfolio decisions in a timely fashion, and , after an agreed upon time period, evaluate performance • Make modifications or adjustments 7

Investment Objectives • Relate to what the investor wants to accomplish with the portfolio • Objectives relate to determining risk and return relationships • Are mainly concerned with: – risk consideration – return considerations

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Return Objectives • Desired Return – The level of return stated by the client indicating how much the investor wishes to receive from the portfolio – are associated with non-primary goals and objectives.

• Required Return – Some level of return that must be achieved by the portfolio, at least on an average basis to meet the target financial obligations – are those necessary to meet an investor’s major long-term financial objectives.

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Differentiating between real and nominal returns Distinguishing pretax and after-tax returns Should be considered from a total return perspective Return requirements will usually be dictated by spending and growth objectives • Discrepancies between return and risk may be resolved by carefully evaluating desired return levels

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Risk Objective • can be divided into ability and willingness to take risk. – Ability to take risk is determined by the time horizon of the investment and the portfolio size in relation to goals. – Willingness to take risk is much more subjective, and related to the psychological profile of the client

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Risk Objectives (Cont’) • Risk tolerance – combining willingness and ability to accept risk • Two measurements:– Absolute risk objectives – use Standard deviation – Relative risk objectives – use tracking risk

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Ability to take risk • The investor’s short- and long-term goals – Determined by time horizon and size of his portfolio

• The importance of the investor goals – Goals related to financial security, maintaining current lifestyle and providing for loved ones are usually classified as critical

• The amount of volatility the portfolio can bear before its ability to meet major goals is jeopardized – If the expected return on the portfolio must be increased to the point that the portfolio is just too risky, the goals must be re-evaluated 12

Investment Constraints • Factors restricting or limiting the universe of available investment choices • Constraints can be generated either internally or externally • Five main classes of constraints:– Liquidity – Time horizon – Legal and regulatory concerns – Tax considerations – Unique circumstances 13

Five major constraints exist for the individual: • Time horizon (e.g. pre-retirement, and post-retirement) • Taxes, which can reduce the final value of the portfolio by the amount of tax or, if paid in the interim, affect the portfolio through a reduction in compounding benefits • Liquidity, which consists of normal expenses, surplus reserves, and major planned events • Legal and regulatory, which are mainly concerned with taxes and transfer of personal property, guided by the prudent investor rule • Unique circumstances are out of the ordinary expenditures, inconsistencies, and exclusion from portfolio planning, which may affect the client 14

Time Horizon • Time period during which a portfolio is expected to generate returns to meet major life events (eg: paying for children’s college education, retirement) • May involve multiple period • Attention to near-term, intermediate-term, longer-term and in some situations, time-period beyond an investor’s life expectancy (during gifting) • Longer time period  greater ability to take risk even if willingness is not evident 15

Tax Concerns • Differential tax treatments are applied to investment income and capital gains

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Liquidity Constraint • Either expected or unexpected cash outflows that will be needed a some specified time • Required multiple time periods • Eg: down payment for a home, children’s education, special needs during retirement • Security: marketability  immediate conversion to cash • Higher liquidity requirements  low tolerance for risk taking 17

Legal and Regulatory Factors • Mainly impact institutional investors • Associated with specifying which investment classes are not allowed • Or dictating any limitations placed on allocations to particular investment classes

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Unique Circumstances • Internally generated and represent special concerns of the investor • Special investor circumstance restricting investment activities • Eg. University endowments may not allow investments in companies selling tobacco and alcohol

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The Role of Capital Market Expectations • Forming capital market expectations generates forecasts of risk-return characteristics for asset classes and assists in connecting investment alternatives to the investor’s objectives and constraints • Continuous attention paid to capital market expectations  allows flexibility in rebalancing of the portfolio 20

Current Market Expectations • Historical returns can be used to generate capital market expectations. – Some limitations are the an assumption is made that the past indicates the future, estimation of mean behaviour is problematic (mean blur), and the time period used can have dramatic affects on the forecasted expectations

• Current market information can be used to generate expectations that may better incorporate market beliefs than historical data 21