Wealth of Knowledge — November 2011 — Do You Have an Investment Policy Statement?

November 01, 2011

By Tom Birrittella

As financial advisors, we are of the view that an Investment Policy Statement (IPS) is an invaluable tool for establishing a roadmap for an investor and advisor. The IPS is not only important as a stand-alone document, but provides the process for investment portfolio design, implementation, monitoring, and the entire investment process. An Investment Policy Statement is a written document, agreed upon between the investor and advisor, that records goals, expectations, and the management procedures of the investment relationship.

The first step in the investment process is gathering investor information and setting goals. It is necessary as an advisor to ask many questions to make sure no stone is left unturned. Some common factors for individual investors to consider in defining their goals include cash flow needs, retirement savings, age, time horizon, protection of principal, risk tolerance, and income tax situation. All of these factors should be taken into consideration when drafting an IPS. The first two pages of an IPS should clearly state a client’s financial goals and objectives, in order to provide both the investor and advisor with a common starting point.

As a step two, once an investor’s goals have been established, the advisor should build a strategic target asset allocation to meet those goals. A projected long term annualized model return can be established for the target allocation. It is important to analyze the investment model return both gross and net of all portfolio fees and taxes. For instance, if your retirement cash flow projection assumes your portfolio averages a 6% average rate of return and all portfolio fees (including advisory, custody, money managers and transaction costs) add up to 1.5%, your portfolio would need to generate a (pre-tax) 7.5% annual return. A primary goal should be to minimize portfolio costs in order to maximize return.

The target allocation is designed around the various asset classes’ projected risk, return, and correlation with each other. A well-diversified optimal target allocation is designed to generate the maximum amount of return for the given level of risk. An investor wants a target allocation’s volatility to be within the risk tolerance, yet generate the desired return (combined growth & income). The IPS will not only record the depicted target allocation for the selected asset classes, but affirm the lower and upper thresholds for those allocations. This important step allows the investor to know when to rebalance back to the original target. The rebalancing effort can help smooth portfolio returns over time by taking profits from asset classes when they have outperformed the broader market. Essentially, by harvesting gains an investor is avoiding excess risk taking by reducing exposure to an over-heating asset class before it experiences mean reversion. An example of mean reversion is if stocks have an average annual long term return of 10% a year, but over the last 3 years have returned 15%; as a consequence, there is a risk at some point they will revert back to their normalized long term trend of a 10% return. This reversion will occur by either having below average return, or negative return, in the period following the market expansion.

The third step in the investment process is to perform due diligence to select appropriate investment managers. In this regard, the IPS should have very specific manager selection guidelines. The IPS states the standards for choosing the appropriate money manager or mutual fund, considering multiple factors such as manager tenure, performance, and risk. A minimum track record of at least three years for the current manager’s tenure is essential, with an emphasis on the five-year track record. It is best to measure a manager over longer time periods so to capture their performance in both up and down periods of a full market cycle. Measuring overall performance against a respective peer group and benchmark over multiple time periods is important as well, also with an emphasis on longer time periods. A manager’s standard deviation, or measure of volatility, is another factor that is measured against the appropriate peer group and benchmark. Other factors including fund size, style drift, risk/return ratios, and management fees also need to be taken into consideration.

Once you have an IPS with goals and a target allocation and you’ve implemented your strategy, step four is to monitor the portfolio on an on-going basis. The IPS should include the benchmarks and peer groups to be used for monitoring each asset class, and how often the portfolio should be reviewed (typically four times per year). Guidelines and a process to determine when to replace a manager should be included in the event that a manager starts to fail key tests such as tenure, performance, style drift or risk. During the monitoring process, the portfolio should be rebalanced as needed in order to stay within the thresholds of the target allocation outlined by the IPS.

The Investment Policy Statement acts as the investor’s portfolio roadmap and is critical in every step of the investment process. The IPS ensures a meeting of the minds between investor and advisor. The guidelines for every step of the investment process are documented in the IPS. From time to time, there may be a material change in the investor’s goals, or strategic asset allocation. When this happens, the IPS should be redrafted. The IPS helps to remove emotions from the decision making process, whether it is replacing a manager or rebalancing between asset classes. Following the guidelines and procedures within one’s Investment Policy Statement can help ensure an investor achieves both their short and long term financial goals.

EisnerAmper’s A Wealth of Knowledge — November 2011: