In addition to return and risk objectives, the IPS has to be cognizant of other investment constraints like liquidity requirements, the investment time horizon, tax concerns, legal and regulatory factors, and unique circumstances.
The IPS should detail the likely withdrawal of funds from the portfolio. For institutions, there could be rules around this, like spending requirements in the case of endowment funds. When a client has a known liquidity requirement, the portfolio manager should allocate a portion of the portfolio to cover this liability by ensuring the allocated assets can be quickly converted to cash at the point in time at which the obligation needs to be met. Allocating to a bond that has a maturity profile which matches the liability time horizon is an often-used strategy.
The IPS should state the time horizon over which the client is investing. Illiquid or risky assets may be unsuitable for an investor with a short time horizon as they may not have sufficient time to recover from investment losses.
Different investors will have a different tax status and the tax status should be stated in the IPS. Often, tax regimes will treat capital gains differently from income where capital gains may be subject to a lower tax rate and only payable when they are realized rather than when they are received. In this instance, there is a time value of money benefit to deferring tax. A taxable investor may wish to hold a portfolio which emphasizes capital gains over dividend income while a tax-exempt investor may be relatively indifferent between the two.
Legal and Regulatory Factors
The IPS should contain any legal or regulatory restrictions that are applicable. In some countries, pension funds are subject to restrictions on their portfolio composition. In the case of individuals, they may have access to non-public information on a particular listed company by virtue of directorship and as such are restricted from trading on that company ahead of the release of company financial results.
The IPS should also cover any unique circumstances that are applicable. A client may have religious or ethical objections to investing in particular stocks or sectors. These types of considerations are often referred to as ESG (environment, social, governance) factors and investing in accordance with ESG factors is referred to as SRI (socially responsible investing).
If a client is a director of a publicly listed pharmaceutical company and has stock options in the company which will vest over 10 years, which of the following best reflects where this should be noted in the constraints?
A. Liquidity and tax concerns
B. Unique circumstance and legal and regulatory factors
C. Time horizon and liquidity
The correct answer is B.
The IPS will need to contain detail on the legal and regulatory restrictions that apply to a director (who has access to non-public information) of public listed companies around dealing in shares of those companies.
Also, an over-exposure to a particular stock by virtue of stock options should be noted in the unique circumstances section as the portfolio construction may seek to downweight or avoid any additional exposure to this sector.
Reading 41 LOS 41e:
Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets