The IPS is the document that governs how an investor’s portfolio is managed.
- Designing an IPS is a critical part of the Planning phase of the portfolio management process.
- The IPS will bring together an investor’s objectives and constraints (see below) to create a logical investment strategy.
- The investment objectives of an IPS are specific and quantified statements regarding risk and return for the portfolio’s investment time horizon.
- Risk Objective
- The Risk Objective is commonly quantified by standard deviation of returns and this value is based on both the investor’s willingness and ability to bear risk.
- Even though a client may be very willing to assume risk, he/she may be unable to bear risk.
- Risk factors include: spending needs to be funded by the portfolio, the client’s level of wealth, and the client’s overall financial situation.
- Return Objective
- A relationship exists between risk and return, so the Return Objective is a realistic goal for returns based on the degree of risk that a client is willing and able to absorb.
- It will be important for a portfolio manager to consider: current spending in relation to long term wealth accumulation needs; the inflation impacts on spending needs; and whether or not the expected return is sufficient based on the client’s needs.
- The Investment Constraints of an IPS outline any client specified (internal) or external constraints or considerations for the portfolio.
- The 5 Types of Investment Constraints
- Investment Time Horizon
- Liquidity Needs
- Legal and Regulatory Constraints
- Investor Unique Circumstances
Importance of Capital Market Expectations
- Formulating capital market expectations is a critical component of the Planning Phase.
- The portfolio manager will forecast expected returns and standard deviations for the asset classes and the correlations between asset classes.
- Capital markets expectation data will help inform the strategic asset allocation and will be considered within the context of the objectives and constraints of the portfolio.
Investment Time Horizon
- The time horizon is the period over which the portfolio objectives are to be achieved.
- An investor’s time horizon can consist of multiple periods.
- While there are exceptions, a longer time period typically increases the investor’s ability to absorb risk.
- Directionally, less than three years could be considered a short time horizon and greater than ten years could be considered a long-term time horizon.