Crafting IPS for Diverse Clients

Investment Policy Statement (IPS)

An IPS is a document that outlines the client’s unique investment objectives, risk tolerance, time horizon, and other constraints. It serves as a guiding framework for wealth managers to construct and manage investment portfolios tailored to meet the client’s goals. The IPS evolves over time based on the client’s changing circumstances and market conditions.

Benefits of an IPS

To Clients

• Encourages a disciplined approach to achieving financial goals.
• Promotes a clear understanding of long-term financial objectives, reducing the focus on short-term performance.
• Provides a framework for adapting to changes in personal circumstances or market conditions.

To Wealth Managers

• Clarifies the manager’s fiduciary responsibilities to the client.
• Establishes a mutual understanding of investment strategies and objectives.
• Acts as a reference document for decision-making and communicating with clients.

Key Components of an IPS

The IPS includes detailed information about the client’s investment objectives, asset base, and asset allocation, along with the wealth manager’s assumptions about capital markets. These components are essential for performing a capital sufficiency analysis, which evaluates whether the client’s resources can support their financial goals over time.

Capital Sufficiency Analysis

This analysis assesses whether a client’s assets, liabilities, income, and expenses are sufficient to meet their financial objectives. Key considerations include:

• Current and future capital resources.
• Expected cash inflows and outflows.
• Risk tolerance and investment time horizon.

If the analysis reveals insufficient resources, the wealth manager must work with the client to revise their objectives to ensure they are achievable.

Asset Allocation Strategies in an IPS

Strategic Asset Allocation

A long-term approach that establishes target allocations for asset classes based on the client’s objectives and risk tolerance. It uses historical data and expected returns to create a diversified portfolio. This strategy focuses on maintaining the balance between risk and reward over time.

Tactical Asset Allocation

A short-term, proactive approach that adjusts portfolio allocations to capitalize on temporary market opportunities or mitigate risks. This method requires active monitoring and higher skill levels but can potentially improve returns or manage risk more effectively. Key features include:

• Frequent adjustments based on economic or market conditions.
• Higher complexity and trading costs compared to strategic allocation.

Parts of IPS

Background

The background section includes critical details about the client, such as:

• Name, age, family details, and core values.
• Portfolio details, including market value and tax status.
• Significant external assets not managed by the wealth manager, such as private businesses or real estate.
• Tax jurisdictions and any relevant legal considerations.

Investment Objectives

The investment objectives section outlines the client’s goals and expectations for the portfolio:

Goals

Goals can include retirement planning, wealth preservation, income generation, or legacy creation. These should be specific and quantifiable where possible, such as funding a child’s education or achieving a specific lifestyle in retirement.

Conflicting Objectives

If goals conflict, such as balancing retirement needs with wealth transfer, the primary objective should be clearly identified.

Cash Flow Considerations

Cash inflows (e.g., contributions, inheritances) and outflows (e.g., living expenses, tax payments) must be accounted for in the investment objectives.

Investment Parameters

The IPS specifies preferences and constraints that shape the investment strategy:

Risk Tolerance

Assessment of the client’s ability and willingness to take on risk, often based on questionnaires and discussions.

Time Horizon

Details the time available to achieve investment objectives. For example, retirement goals may span 20+ years, while education funding might have a shorter horizon.

Asset Class Preferences

Identifies the asset classes suitable for the portfolio, such as equities, fixed income, or alternatives, based on the client’s needs and constraints.

Liquidity Preferences

Specifies cash needs, including maintaining a reserve for emergencies or short-term obligations.

Other Investment Preferences

• Legacy Holdings: Clients may prefer to retain specific investments, such as former employer equity, even against wealth manager advice.
• Portfolio Concentration Risk: Significant holdings in a single asset, like employer equity, can create risks that need managing.
• ESG Preferences: Clients may prioritize investments meeting ESG or SRI standards based on personal or ethical beliefs.
• Active vs. Passive Management: Preferences for actively or passively managed funds should be documented.
• Tax and Legal Considerations: Issues like dual citizenship or multi-country residency should be addressed for compliance and efficiency.

Constraints

This section outlines any restrictions that may affect the wealth manager’s ability to implement certain investments or strategies. Key considerations include:

• Clients may hold investments with large unrealized capital gains, which could trigger significant tax liabilities if sold. The IPS should clearly document the policy for managing such concentrations, which might include retaining or gradually liquidating the investment over time.
• Appropriate tax mitigation strategies, such as tax-loss harvesting or deferral mechanisms, should be included.
• For clients with specific preferences related to socially responsible investing (SRI), Environmental, Social, and Governance (ESG) factors, religious, or ethical standards, the constraints imposed by these preferences should be explicitly noted.
• The IPS should also document the process for obtaining client approval for any actions that fall within these constraints.

Portfolio Asset Allocation

This section specifies the target allocation or range for each asset class in the client’s portfolio. Key aspects include:

• Wealth managers employing a strategic asset allocation approach define specific target allocations for asset classes, along with upper and lower bounds to maintain portfolio alignment.
• For tactical asset allocation strategies, managers may provide target ranges rather than fixed percentages, allowing for flexibility to capitalize on short-term opportunities.

Portfolio Management

The portfolio management section of the IPS outlines the approaches and policies governing the management of a client’s portfolio. It includes details about discretionary authority, rebalancing policies, and tactical changes to ensure the portfolio remains aligned with the client’s goals and objectives.

Discretionary Authority

• Full Discretion: The wealth manager has the authority to make all portfolio adjustments, including rebalancing and manager replacements, without prior client approval.
• Limited Discretion: The wealth manager can perform specific actions, such as rebalancing, within predefined limits.
• Non-Discretionary Role: The wealth manager can only make recommendations, and all decisions require client consent.

Rebalancing Policies

Rebalancing ensures that the portfolio remains aligned with its target allocation by periodically adjusting the asset mix to account for changes in market values. The two primary rebalancing methods are:

Time-Based Rebalancing

Time-based rebalancing involves making adjustments to the portfolio at regular, predefined intervals, such as quarterly, semi-annually, or annually, irrespective of market conditions or asset class performance. Key details include:

• Advantages:
  • Maintains a disciplined approach to portfolio management by ensuring regular review and adjustments.
  • Prevents long-term drift from the strategic allocation caused by market fluctuations.
  • Simple to implement and easy for clients and managers to understand.
• Disadvantages:
  • May lead to unnecessary rebalancing when deviations from target allocations are minimal, resulting in higher transaction costs and potential tax liabilities.
  • Unresponsive to significant market changes, potentially exposing the portfolio to risks or missing opportunities between scheduled rebalancing periods.
  • Transactions are dictated by the calendar rather than prevailing market conditions, which could result in unfavorable trades.

Threshold-Based Rebalancing

Threshold-based rebalancing adjusts the portfolio when asset class weights deviate beyond a specified percentage from their target allocation. For example, rebalancing may occur if an asset class weight deviates by more than 5% from its target. Key details include:

• Advantages:
  • More responsive to market fluctuations and volatility, allowing for timely adjustments to maintain risk exposure within desired limits.
  • Minimizes unnecessary transactions by only rebalancing when significant deviations occur, reducing costs and tax impacts.
  • Better aligns with the client’s long-term objectives by avoiding overreaction to minor market movements.
• Disadvantages:
  • Requires continuous monitoring of portfolio weights, which can be resource-intensive and may necessitate advanced automation systems.
  • Can lead to inconsistent timing of adjustments, with periods of frequent rebalancing during volatile markets or long intervals without action in stable conditions.
  • May overreact to short-term market events, potentially deviating from long-term investment objectives.

Comparison of Time-Based and Threshold-Based Rebalancing

Both methods aim to align portfolios with strategic objectives, but they differ significantly in implementation:

• Predictability: Time-based rebalancing follows a fixed schedule, offering simplicity and consistency, while threshold-based rebalancing reacts to market conditions, making it more dynamic.
• Cost Implications: Time-based rebalancing may incur unnecessary costs during low volatility, whereas threshold-based rebalancing is more cost-efficient but requires monitoring systems.
• Risk Management: Threshold-based rebalancing is better at addressing sudden market changes, while time-based rebalancing ensures periodic adjustments regardless of market events.

Duties and Responsibilities

The IPS outlines the wealth manager’s responsibilities, including:

• Developing and implementing asset allocation strategies.
• Monitoring and rebalancing the portfolio.
• Reporting performance and maintaining the IPS.

Appendix

The appendix includes dynamic details, such as:

• Modeled portfolio behavior, showing potential performance outcomes.
• Capital market expectations, including expected returns and correlations.

An IPS serves as a vital framework for aligning a client’s financial goals with their investment strategy. By addressing the client’s unique circumstances, preferences, and constraints, the IPS promotes disciplined decision-making and increases the likelihood of achieving long-term financial success.

Practice Questions

Question 1: A wealth manager is preparing an Investment Policy Statement (IPS) for a new client. The client has expressed a desire for aggressive growth in their portfolio, but after conducting a capital sufficiency analysis, the wealth manager determines that the client’s current and future capital resources may not adequately support this objective. In this scenario, what should the wealth manager do next according to the principles of IPS and capital sufficiency analysis?

1. Proceed with the client’s desired aggressive growth strategy despite the results of the capital sufficiency analysis.
2. Ignore the results of the capital sufficiency analysis and focus on short-term performance.
3. Work with the client to revise the objectives and create those that are achievable based on the capital sufficiency analysis.

Answer: Choice C is correct.

According to the principles of Investment Policy Statement (IPS) and capital sufficiency analysis, the wealth manager should work with the client to revise the objectives and create those that are achievable based on the capital sufficiency analysis. The IPS is a document that outlines the client’s investment objectives, risk tolerance, time horizon, and other relevant information. It serves as a guide for the wealth manager in making investment decisions on behalf of the client. The capital sufficiency analysis, on the other hand, is a tool used to assess whether the client’s current and future capital resources are sufficient to meet their investment objectives. If the analysis shows that the client’s resources may not adequately support their desired aggressive growth strategy, it is the wealth manager’s responsibility to communicate this to the client and work with them to revise their objectives. This is to ensure that the client’s investment strategy is realistic and achievable, and that it aligns with their financial situation and risk tolerance.

Choice A is incorrect. Proceeding with the client’s desired aggressive growth strategy despite the results of the capital sufficiency analysis would be irresponsible and could potentially lead to financial losses for the client. It would also be a violation of the wealth manager’s fiduciary duty to act in the best interest of the client.

Choice B is incorrect. Ignoring the results of the capital sufficiency analysis and focusing on short-term performance is not a prudent approach to wealth management. While short-term performance is important, it should not be the sole focus of the investment strategy. The wealth manager should also consider the client’s long-term financial goals and risk tolerance, as well as the sustainability of their investment strategy. Ignoring the capital sufficiency analysis could lead to unrealistic investment objectives and potential financial losses for the client.

Question 2: A portfolio manager is looking for a proactive strategy that allows for frequent portfolio adjustments based on short-term market trends, economic conditions, or valuation changes. They are willing to bear higher trading costs and have the necessary skill and experience to consistently monitor market conditions and asset performance. Which asset management method specified in the Investment Policy Statement (IPS) would be most suitable for this portfolio manager?

1. Strategic Asset Allocation
2. Tactical Asset Allocation
3. A combination of Strategic and Tactical Asset Allocation

Answer: Choice B is correct.

Tactical Asset Allocation (TAA) is the most suitable asset management method for a portfolio manager who is looking for a proactive strategy that allows for frequent portfolio adjustments based on short-term market trends, economic conditions, or valuation changes. TAA is a dynamic investment strategy that actively adjusts a portfolio’s asset allocation based on short-term market forecasts. The goal of TAA is to improve the risk-adjusted returns of passive management investing. This strategy allows the manager to exploit market inefficiencies or exceptional opportunities through active management. It requires a high level of expertise and a commitment to ongoing market monitoring and analysis, as well as the willingness to incur higher trading costs associated with frequent adjustments.

Choice A is incorrect. Strategic Asset Allocation (SAA) is a portfolio strategy that involves setting target allocations for various asset classes and rebalancing periodically. The portfolio is rebalanced to the original allocations when they deviate significantly from the initial settings due to differing returns from various assets. SAA is based on long-term investment objectives, risk tolerance levels, and investment constraints, and does not involve frequent adjustments based on short-term market trends or economic conditions.

Choice C is incorrect. A combination of Strategic and Tactical Asset Allocation could be used in some cases, but it may not be the most suitable for a portfolio manager who is specifically looking for a proactive strategy that allows for frequent portfolio adjustments based on short-term market trends, economic conditions, or valuation changes. This approach would involve elements of both SAA and TAA, and while it could potentially offer some benefits of both strategies, it may not fully meet the manager’s needs for frequent, proactive adjustments.

Glossary

• Rebalancing: A method used by wealth managers to realign the portfolio to the target allocation.
• Threshold-based Rebalancing: A strategy that adjusts a portfolio based on significant deviations from its target allocation.
• Time-based Rebalancing: A strategy that adjusts a portfolio at regular intervals, regardless of the degree of deviation from the target allocation.
• Derivatives: Financial securities with values that are reliant on, or derived from, an underlying asset or group of assets.
• Repurchase Agreements (Repos): Short-term agreements to sell securities in order to buy them back at a slightly higher price.

LOS 4(e): discuss the differences between private and institutional clients and formulate an appropriate Investment Policy Statement for private clients