Explore how an IPS serves as the foundational blueprint for managing portfolios by defining objectives, constraints, benchmarks, and responsibilities.
Imagine you’re meeting a new client—maybe it’s an institution, maybe it’s a busy professional—and they lay out all their hopes, dreams, and concerns for how money should be managed. The conversation might go every which way, but at some point, you and the client (or the investment committee) need something concrete—a guiding document that captures the essence of what must be done. That’s where an Investment Policy Statement (IPS) enters the scene. It’s not just a bureaucratic requirement. Honestly, I’ve found it’s almost like the “relationship contract” that keeps everything on the rails. If markets go haywire, or if we suddenly discover a need for cash, the IPS is there in black and white, showing exactly how to respond.
An IPS helps ensure that the portfolio aligns with the investor’s long-term objectives and constraints, acting as a guardrail when emotions might tempt us to yank everything out of the market at the worst possible time. In some ways, it’s the bedrock of prudent investing.
At its core, an IPS is a formal, written document that provides structure and guidance. A couple of your friends might say, “It’s for compliance,” or “It’s just stuffy paperwork,” but if you ask me, it’s so much more. Specifically, an IPS:
This approach is also deeply linked to ethics—some practitioners cite the CFA Institute’s standards requiring clarity, disclosure, and a structured approach. Indeed, it’s not just a best practice: it’s integral to professional conduct.
Below are several fundamental purposes, each of which ties back to creating a more transparent and disciplined investment process.
You might wonder: “How do we avoid surprises?” The IPS addresses that right away. By defining the roles and responsibilities of each party, it instantly sheds light on who does what. For example:
The IPS effectively acts as the shared reference point.
Risk tolerance refers to the amount of volatility or potential loss you’re willing (and able) to endure. Meanwhile, return objectives outline what you intend to achieve—maybe it’s beating an index, or maybe it’s achieving a certain absolute performance target like 6% annualized.
Mathematically, you might capture an expected return as:
where \(w_i\) is the weight of each asset in the portfolio, and \(E(R_i)\) is the expected return for that asset. While the IPS might not detail every formula, understanding how target returns align with constraints is essential. For instance, if a client wants a 10% return but can’t stomach a drawdown of more than 5%, well, that’s a conflict that the IPS must highlight and reconcile.
Constraints vary widely. Sometimes we have legal restrictions, sometimes we have tax considerations, and sometimes there’s a philanthropic objective—like ensuring a certain fraction of the portfolio aligns with socially responsible investing (ESG). If the client invests on behalf of a pension plan, liability management might be at the forefront. In other words, the IPS enumerates each factor:
When the IPS spells these out, it keeps everyone from drifting into areas that are off-limits.
The IPS can’t flourish without a benchmark—it’s like playing a sport without keeping score. Just as a runner might compare their sprint time against a record, a portfolio manager should compare returns (and risk) against a relevant market index or a composite measure.
The IPS enumerates which index or combination of indices will be used to judge performance. That ensures everyone, from the client to the manager, can quickly see if we’re meeting or lagging behind the goals.
The explicit guidelines in an IPS make it easier to see whether a manager’s decisions remain consistent with the client’s objectives. If the client is extremely conservative and the manager invests aggressively, the IPS highlights that mismatch. Likewise, if the manager is overly timid and the client expects higher returns, the manager’s performance shortfall is evident.
Markets can be, um, pretty rocky. If you recall periods like the 2008 financial crisis or extreme market volatility in recent years, you’ll know that fear and greed can push investors to wild decisions. The IPS is there like a calm friend reminding you: “Hey, we agreed to stay in this for the long haul. Are you sure you want to exit now?” By formalizing a plan, you reduce the chance of drastic moves triggered by panic.
An effective IPS generally includes the following sections:
A concise statement of what the portfolio is supposed to do. Is it capital preservation? Growth? Generating income? Often we see something like, “Achieve long-term total returns in excess of 5% annually while maintaining a moderate level of volatility.”
A clear articulation of risk preferences—both willingness (psychological comfort) and ability (financial capacity). Institutions might have different thresholds, such as “annual drawdown must not exceed 15%,” or “volatility must stay within a band around the benchmark.”
Broadly indicates the permitted asset classes (e.g., domestic equities, international equities, government bonds, corporate bonds, alternatives). It also addresses approximate target weightings and permissible ranges (e.g., 45–55% in equities if the neutral blend is 50%).
This part details constraints around liquidity, time horizon, taxes, legal factors, and unique circumstances. For instance, an endowment might have a perpetual horizon, but also an annual spending requirement. Or a retiree might have a very short horizon and need a stable capital base.
Specifies relevant indices or blended benchmarks for each asset class. Alternatively, it might define a custom benchmark to match the targets defined in the asset allocation plan.
Often the IPS spells out who does what: The portfolio manager’s role, the client’s role, the investment committee’s role, and even the consultant’s role, if applicable.
Indicates how often the portfolio is rebalanced and under what conditions. Some IPSs direct rebalancing only if assets deviate more than, say, 5% from their targets. Others prefer a calendar-based approach (quarterly, semi-annually, or annually).
Describes the frequency and format of reports the client will receive—maybe monthly statements, quarterly performance summaries, and an in-person annual review.
Clarifies how often the IPS is revisited, who can revise it, and under what circumstances.
To get a bird’s-eye view, here’s a simple (and hopefully helpful) diagram illustrating how the IPS process generally fits into portfolio management:
flowchart LR
A["Client <br/> Objectives"] --> B["Define <br/> Risk Tolerance"]
B --> C["Identify <br/> Constraints"]
C --> D["Draft <br/> IPS"]
D --> E["Implement <br/> Portfolio"]
E --> F["Monitor & <br/> Review"]
F --> D
The process loops back as we reassess objectives, constraints, and real-world changes.
I once encountered an investor who felt an IPS was a “waste of time.” They just wanted to invest quickly in “whatever was hot.” When the market swerved, they panicked, sold at a steep loss, and re-entered at a higher level later, compounding the damage. In that conversation afterward, they admitted: “Maybe I should’ve had a stronger plan.” An IPS can’t guarantee profits, but it can reduce the odds of making haphazard decisions.
Clients’ circumstances evolve—someone might get married, start a business, or experience changes in health. Market conditions evolve too—interest rates, inflation, regulatory frameworks. So, the IPS isn’t a set-it-and-forget-it deal. You revisit it periodically, typically at least annually or after any material life event or market shock. This ensures the portfolio remains aligned with the investor’s real needs.
At the risk of overstating the obvious, the IPS is also about dialogue. Both the advisor and the client need to understand exactly what the instructions (and their rationale) are. You might hold formal quarterly or annual meetings. Or, if the client’s preference is frequent check-ins, you might have shorter monthly calls. In all these interactions, the IPS serves as your mutual point of reference.
While we’re focusing right now on “4.1 The Investment Policy Statement (IPS),” remember that an IPS forms the launchpad for many other chapters in this book:
The synergy between these chapters ensures that by the time you finish Volume 9, you’ll see how everything—risk, return, constraints, and governance—ties together in building robust portfolios.
Investment managers and advisors should keep in mind a few best practices and watch out for familiar stumbling points:
Best Practices:
Common Pitfalls:
A university endowment typically has a long horizon (maybe even perpetuity) and a moderate risk tolerance because it needs stable returns to fund scholarships but also aims for growth. It might specify a 5% spending rate each year, so liquidity needs are relatively predictable. The IPS for such an institution might emphasize preserving capital in real terms (inflation-adjusted) over the long term.
Contrast that with an individual retiree who might need monthly withdrawals to pay living expenses, likely has a shorter time horizon than an endowment, and might be more averse to losses. Their IPS might emphasize lower-volatility instruments, a strong focus on capital preservation, and a clearly defined rebalancing strategy to ensure no single equity sector grows too large.
An IPS is the foundation on which portfolio construction rests—both in practice and in your CFA studies. For the exam, be prepared to:
When tackling exam questions, watch for the subtle interplay between willingness and ability to take risk—if a question scenario highlights high net worth but a risk-averse temperament, the IPS must reflect that discrepancy. Also, be ready to critique an IPS that lacks clarity on benchmarks or rebalancing rules.
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