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From Planipedia

Thanks to PlanPlus and WEA for sharing their material for this Best Practices Guide.

In the past, as a result of a focus on financial products rather than service, many clients looked upon financial advisors as someone with a kit bag of investments and insurance policies and the facilities to implement them. The good news is that the professionalism demonstrated by today’s top advisors has manifested itself as an evolution in approach from a “transaction” orientation to a “problem solving” one. Nowhere is that more evident than in the attention being given to the necessity for having a written Investment Policy Statement (IPS) that clearly articulates what it is that each client hopes to accomplish with respect to their investment portfolio and how they anticipate meeting those objectives.

As has been stated in previous sections of this Handbook, “best practices” dictates that advice on all fronts is given only after a thorough understanding of the client’s needs. In particular, when it comes to the investment management function, it is essential that recommendations be built on a solid foundation of knowledge about the client ¾ both their personal attitudes as well as their financial objectives. For while an insurance policy can be tucked away in a drawer for several years without too much concern, the news media ensures that clients live with their investment decisions every day. And although it is tempting (and often more fun and psychologically appealing) for example, to try to outguess the stock market in the short run, professional advisors must guard clients against leaping forward to specific investment “tactics” or securities before they have adequately established a solid basis for an appropriate long-term strategy.

From the advisor’s best practices perspective, a "qualitative and quantitative statement" developed with the client, will provide a clear idea of how to construct their portfolio to insure it addresses both current needs and long-term objectives. In addition, it will become the "guiding light" by providing a frame of reference for future investment recommendations and for keeping the client “on track”. Whenever something new comes along ¾ a new project, a new investment proposal – the advisor and the client will be able to evaluate it together within the context of the goals that have been jointly set. If the new opportunity complements what has been planned, then it should be explored further. If, on the other hand, it distorts or detracts from the plan, it can be quickly rejected.

A well-written Investment Policy Statement is extremely useful for all these reasons. Clients and their advisors can refer to it, from time to time, to provide an ongoing point of reference for decision-making. While it cannot provide guarantees of performance or success, the IPS can become a sort of ‘contract’, so to speak, that spells the client’s and advisor’s respective responsibilities as well as their mutual expectations about investment philosophy, objectives, targeted returns, portfolio structure and security selection. Using Engagement Agreements mean you can remove some of these aspects from the IPS. Because the IPS can be such a valuable tool, time taken to ensure that it does, in fact, reflect the way the client really feels about the entire investment process will be rewarded for years to come with greater peace of mind for all concerned.

To ensure the greatest likelihood of clients meeting their lifetime financial goals, top professional advisors have learned that they must, in this order: 1. Understand how the client thinks, feels and behaves as an investor 2. Help clients visualize and verbalize what it is they are trying to accomplish 3. Structure the client’s portfolio to most efficiently and effectively manage the relationship between their goals and their risk tolerance 4. Choose investments that have the best possible chance of meeting their needs and expectations.

Again to emphasize, order is important. There is no point, for example, in having clients get excited about a particular stock or mutual fund (Step 4 above) if its historical or projected performance is outside their ‘comfort zone’ in terms of volatility or risk (Step 3 above). Advisors have to ground every decision by the ones made earlier in the process.

Why a Formal Written Investment Policy Statement?

The Investment Policy Statement makes decision-making efficient and effective. Thus, we can think of an IPS as a “Letter of Understanding” between the investor and their advisor and, as such, is fundamental to a “best practices” approach to the client relationship. To summarize, its benefits are that it:

• Provides a written description of the investment decision-making process from objective setting through implementation and ongoing monitoring of progress towards the goal;
• Is a model against which to measure performance;
• Provides a framework for evaluating new investment opportunities as they come along;
• Serves as the non-emotional tether that investors (and advisors) can use to ground themselves when markets are misbehaving and the temptation to act impulsively or irrationally is high;
• Provides a basis for return and volatility projections for retirement and other long-term planning, thereby creating reasonable expectations that can be supported should they ever be questioned at a later date;
• Helps bring all, or at least more of the client’s investment assets under one advisor to improve efficiency and effectiveness. The integration of all a client’s assets into the IPS means that the proper weighting is achieved through recognition of all holdings, which is not as easily accomplished if only a portion of the client assets are being dealt with;
• Can be made part of the financial or estate plan. This will be particularly important to older investors who have built sizeable portfolios. When the investor dies, the executors won’t have to second-guess the intended investment strategy of the portfolio. It can be left intact for the heirs for many years if that was the deceased’s wish. This might be desirable where the heirs are minors or have spendthrift habits; and
• Facilitates the implementation by incorporating an “Action Plan”.

Contents of an Investment Policy Statement

The sample IPS shown here should not be considered in any way to be “perfect” or “all-encompassing”. For purposes of clarity, much of the “boilerplate” text that is part of many Investment Policy Statements has been omitted to focus on the relevant points. Most firms that provide professional money management services have their own format based on their philosophies and anticipated client needs and preferences. This sample IPS should be viewed as just that – a sample. Advisors who are not associated with a firm that already produces a detailed IPS for its clients may find the sample useful as a guide to creating one. Typical contents would be as follows.

1. Purpose

• Why the IPS was written – by whom, for whom, when. Many IPS documents will begin with a brief recount of the clients’ background, why they are interested in the IPS process and how they came to meet the advisor. The advisor’s professional credentials are also frequently listed.
• Who has responsibility for what? The creation of an effective investment policy is a joint responsibility of the client and the advisor. The advisor’s role is normally familiar ¾ to gather information, analyze it, make recommendations, and assist in the implementation and follow-up to track progress, making adjustments as required. The client’s responsibilities not only includes the provision of accurate information about their personal affairs, but also extends to their willingness to seriously consider the resulting recommendations and act on them, if they are appropriate.

2. Objectives

• Projected financial needs – how much and when. A capital needs and income analysis is essential to determine the target rate of return needed to meet the client’s objectives
• Present asset allocation – where is the client today? The impact of any recommendations can only be projected and subsequently measured if the starting point is known. Additionally, the client’s existing asset allocation will reveal the expected results if they “do nothing”, which frequently illustrates that inaction means falling short of their goals.
• Risk tolerance and time horizon of the client – Strategies and tactics can vary between short and long-term objectives and depend on the willingness and ability of the client to manage fluctuations in returns and occasional declines in their portfolio value.
• Risk profile and investment time horizon of the portfolio – Illustrating the range of likely returns (from highest to lowest) both short and long-term periods illustrates that volatility decreases over time and reinforces the importance of maintaining the agreed upon strategy through short-term market ups and downs.

Note also that a well-written IPS will often contain several ‘qualitative’ statements such as:

• To be "reasonable and prudent"
• To seek returns commensurate with the investors risk tolerance
• To control costs of managing the portfolio
• To minimize taxes

3. Investment Policy

• The “rules” by which the investment strategy will be implemented – Outlining details of such issues as permitted and non-permitted strategies, leverage, timing, reinvestment of profits, fees and such ensures both client and advisor agree on how the portfolio is to be managed.
• Acknowledgement of the uncertainties of investing – Historical performance is no guarantee of future results so it is imperative that the client acknowledges the likelihood of variable returns and portfolio losses.
• Investor preferences for asset classes or securities – The universe of investment options is vast and familiarity often spells comfort for investors. Having the client describe their likes and dislikes enables advisors to narrow the choices to those the client is most likely to maintain under varying market conditions.
• Desired rate of return – As a result of the income and capital needs analysis, the rate of return required to meet the client’s needs, can be calculated. This can then be compared to the return that can realistically be expected as a result of the implemented investment strategy. Inflation, taxes and fees should be considered in arriving at the required rate of return.
• When and how to rebalance – The initial asset allocation will inevitably change due to market forces as asset classes perform at varying rates. It is essential to periodically rebalance the portfolio to preserve its risk/reward profile. The conditions under which that rebalancing will take place should be spelled out, including a consideration of transaction costs and potential taxes.

4. Security Selection

• Criteria for choosing securities – As in 3(c) above, investor comfort with the chosen investments will likely result in better adherence to a long-term strategy
• List of types of securities not to be included in portfolio. Some clients may wish to restrict or prohibit investment in certain securities, for example, tobacco and alcohol stocks, real estate, etc.
• List of types of transactions not permitted. Some investors may be uncomfortable with more specialized strategies such as currency trading, arbitrage, options, commodities, etc.

5. Manager Selection

• Results – As stated, while past performance may not be indicative of future results, evaluating the cumulative and year-by-year results of the chosen manager or sector is useful as a point of reference for setting realistic expectations
• Risk – A comparison of historical volatility and returns will reveal the “efficiency” of the portfolio. Calculation of the Sharpe Ratio, for example, illustrates the improvement in return for each incremental unit of risk.
• Rank – When choosing the services of an investment manager, it is important to evaluate them within their peer group. For example, Canadian equity mutual fund managers should be compared to other Canadian equity fund managers to see how they performed relative to the others.
• Resources – Portfolio managers can change and it is useful to know if the same people who achieved the success that made them attractive in the first place are still part of the management firm. Many firms operate with an investment committee structure that minimizes the risk of a change in performance when an individual manager leaves; however, it is always prudent to be aware of who is making the investment decisions.

6. Monitoring

• Monthly - Current holdings, market value and transactions should be updated regularly and the schedule outlined in the IPS
• Quarterly - How is the portfolio doing against the benchmark? How is the manager doing against his or her peers? Is the asset allocation being followed?
• Annually – Review the investor’s risk tolerance, desired rate of return, asset class preference and time horizon to major disbursements to determine if any changes in strategy or tactics are required. Analyze expenses and fees paid to ensure they are reasonable and in line with expectations.

Summary

If the Investment Policy is well written, almost anyone reviewing the portfolio should be able to follow what was done. Guidelines should be specific enough to make it clear what was intended, yet give whomever is charged with implementing the strategy authority to actively (but prudently) manage the portfolio. The thoughtful drafting of a comprehensive IPS ensures that all responsibilities, assumptions and measurements are spelled out. However, the creation of an IPS is not a do-it-once and-forget-it exercise because the investment markets and client attitudes towards them change, along with their objectives and needs. In the “best practices” framework of wealth management, however, it can be a most valuable tool for both investors and their professional advisors.

Following are two sample Investment Policy Statements. The first is completely textual and might be considered a little more formal. The second was generated using IPS creation software, demonstrating that the production of an IPS need not be difficult or laborious. In fact, the information required to produce the second report should be part of every advisor – client discussion, that is:

• Know Your Client data
• Risk tolerance
• Current asset allocation