With no sign that the volatility in today’s marketplace is going to change any time soon, organizations need to focus on long-term investment goals and objectives to avoid making imprudent decisions based on short-term fluctuations.
An Investment Policy Statement (IPS) can keep an organization on track, serving as a roadmap for the organization and its investment manager(s). An effective IPS outlines the responsibilities of the parties involved and defines the investment strategy based on the objectives and constraints of the organization.
“Having a well-structured Investment Policy Statement in place provides direction from an investment strategy perspective and can add a lot of value in volatile times,” says John E. Comello, CFA, senior vice president and chief investment officer for First Commonwealth Advisors. “It is a living, breathing document that should be reviewed at least annually to ensure that the investment strategy remains appropriate given the potential changing needs of the organization. Markets evolve, as do client circumstances, so this document should adjust to changes that may impact the organization and its investment strategy.”
Smart Business spoke with Comello about the components of an effective IPS and how to get the process started.
How can an IPS benefit an organization?
If structured properly, an IPS provides a systematic approach to documenting the investment objectives and constraints of an organization. An IPS is customized and should articulate the investment goals of the organization and formalize an investment strategy to achieve those goals. This document is especially important today, as volatile markets can result in rash investment decisions. An IPS can help refocus an organization on its long-term investment goals. It can also help an organization administer the portfolio through the departure of key personnel or board members. An IPS spells out the responsibilities of the parties involved and provides all parties with a mechanism to understand what the investment strategy is, and why it is in place.
What key components should an IPS include?
There are six key elements, starting with clear identification of the assets that will be governed, as well as specific language addressing the roles and responsibilities of all parties involved. This might include defining the role of a board-assigned finance committee, a CFO or an investment committee.
Second, the IPS should identify the primary investment goal(s) of the organization. Third, it should document investment constraints that would influence the investment strategy of the portfolio. For example, understanding how long the assets are to be invested, if there are liquidity needs, understanding tax, legal or regulatory issues tied to the assets and understanding any unique circumstances or preferences that the organization would like taken into consideration are critical.
After outlining investment constraints, an IPS should define the institution’s overall risk and return objectives. With return objectives, institutional investors tend to have specific obligations or spending policies that help determine the required rate of return. Factors such as the expected rate of inflation or estimated fees tied to the management of the assets should also be taken into consideration.
Regarding the identification of risk tolerance, acknowledgment that the portfolio will be exposed to risk is prudent. The IPS should address both the organization’s ability and willingness to take risk. A review of the goal(s), constraints and return objectives of the portfolio can provide a basis for determining the ability of the organization to take risk.
However, conversations with representatives from the organization are needed to determine the willingness to take risk and to identify potential disconnects between the risk/return profile of the organization. If it is requiring a high rate of return but is not willing to assume a comparable level of risk, that needs to be rectified prior to moving forward.
Fifth, the IPS should define the asset allocation policy, defining the portfolio’s broad asset allocation targets and ranges, as well as the targets and ranges of eligible sub-asset classes. This should support the goals, constraints and risk and return objectives documented in the IPS. Finally, it should address accountability and risk management issues, identify the frequency of the portfolio review process and establish consistent and reliable benchmarks to help evaluate the investment performance of its manager(s). The organization may also specify risk metrics to review. For example, the IPS may require that, during a review, the hired manager provide a review of the allocation mix of the portfolio to ensure compliance with the stated asset allocation policy, or inclusion of manager attribution information.
Who should be involved in creating an IPS?
The organization needs to clearly define the individual or committee/board responsible for overseeing development. If the responsible person does not have the experience or expertise to create an IPS in house, seek out assistance from a financial institution that can help construct the document. Also, because there may be legal considerations tied to an IPS, it could be prudent to include legal counsel.
The hired investment professional will need a thorough understanding of the organization’s circumstances, which will most likely require time and an open dialogue with representatives of the organization to ensure the appropriate language is embedded into the IPS.
What review measures should be in place to ensure the IPS stays relevant?
An IPS should evolve if the objectives and constraints of the organization change over time. Review document no less than annually to ensure relevancy. During reviews, any changes in the organization’s circumstances should be noted and discussed to determine what, if any, adjustments are needed.
Ultimately, the investment strategy identified in the IPS needs to address the changing circumstances of the organization and accommodate its investment goals.
John E. Comello, CFA, is senior vice president and chief investment officer of First Commonwealth Advisors. Reach him at (412) 690-4596 or firstname.lastname@example.org.