When considering outsourcing your investment management—whether for your personal finances your business or a nonprofit board you serve on, having a mutually agreed upon statement for how your investments will be managed is key to building a healthy, goal-focused relationship with your chosen investment manager. This statement is often referred to as an Investment Policy Statement (IPS).
Investment Policy Statements should be standard operating procedure for any investment management firm. If an IPS doesn’t come up as part of initial conversations with your financial advisor or wealth manager, that should raise a red flag.
In this article, we’ll unpack the IPS, including an overview of what it is, the purposes it serves, and the key components a solid IPS should include before a client agrees to sign on the dotted line.
Investment Policy Statement Definition
An Investment Policy Statement (IPS) is a formal document drafted between an investment portfolio manager or financial advisor and their client. It outlines the client’s general investment goals and objectives and details the strategies that the manager plans to utilize to meet those goals.
A complete and thorough IPS will:
- Establish reasonable expectations, objectives, and guidelines for the investment of the client’s asset
- Set forth an investment structure that details the targeted allocation among permitted asset classes
- Encourage effective communication between advisor and client
- Create the framework for a well-diversified asset allocation designed to generate long-run returns commensurate with the client’s stated risk tolerance
The Purpose of the Investment Policy Statement
In short, the statement exists to allow your investment manager to maintain your portfolio over time without pestering you every time they want to make a minor trade, rebalance, or any other adjustment. A well-crafted Investment Policy Statement establishes a clear understanding between the client and investment manager as to objectives and risk tolerance applicable to the client’s accounts.
Beyond setting expectations for the client regarding the management of their portfolio over time, they also outline the investing philosophy that will be followed. An easy way to end up unhappy and firing your investment manager is not asking enough questions about their investment philosophy up front. Be sure to have a thorough understanding before investing dollar one.
Key Components of an Investment Policy Statement
Purpose
The first section of the IPS is the Purpose, which is outlined above. The Purpose will set guidelines on how the money will be invested, and how the advisor and client will communicate regarding portfolio management.
Current Portfolio Overview
This section will typically list an overview of what is currently in the portfolio, namely a list of accounts that the investment manager is taking over, along with the approximate values at the start of the relationship.
Naturally, deposits and withdrawals will be made along the way, as well as growth and losses realized during the life of the investment, so this overview just covers the starting point.
Asset Allocation
One of the heftier sections of the IPS is the Asset Allocation, which explains the majority of variability in returns, roughly 90% according to historical analysis.
For example, if the client has a large allocation to stocks, they will expect to have higher returns, but also greater volatility in returns compared to a portfolio with a lower stock allocation.
The Asset Allocation section will likely include a pie chart, or similar visual, to demonstrate the client’s broad asset class exposure, i.e. domestic vs. International, real estate, fixed income, cash, etc.
The asset allocation serves as the primary guide for managing the client’s portfolio and are controlled by agreed upon rebalancing thresholds. This means market movements and shifts can be made within an agreed upon range of your desired asset allocation (in our case within 5%) without needing to amend the IPS.
While these permissions are allowed within the IPS, a good advisor will always communicate with the client ahead of making changes so they are kept aware and up to date on what’s going on within their accounts. Don’t take this as a sign your investment manager can simply do whatever they want, it just bakes in some flexibility for them to make tweaks and rebalance without the hassle.
Rebalancing
The next section will focus on how the investment manager will rebalance the client’s portfolio to maintain the desired asset allocation and risk tolerance.
It will cover frequency of rebalancing, as well as their specific approach that may consider relative asset class volatility, taxes, liquidity needs, trading costs, and portfolio objectives.
Model Results & Risk
The IPS will then cover model portfolios along with their historical returns and historical volatility.
This section gives the client the opportunity to understand the portfolios they will be investing in, and what the returns and volatility could look like based on historical data.
It’s a great place for a gut check: are you as the client pleased with the historical returns? Does the volatility data for the worst year of the portfolios cause you to question the investment philosophy as a whole?
The Model Results & Risk section can provide an abundance of clarity for you on how your investment manager’s philosophy fits into your overall goals.
Portfolio Considerations
This section covers key factors like investment horizon, liquidity needs, and specific preferences or considerations taken into account for managing your portfolio. Maybe you have separately managed assets that should be taken into account for your overall diversification needs or perhaps you have a unique need to generate cash at a certain point to cover a life event. Those factors would be covered here.
Investment Strategy
Portions of your investment strategy not covered in asset allocation or other sections should be covered somewhere in your IPS. This is where you can learn a lot about if your investment manager plans to favor certain asset classes or if they emphasize growth or value when investing in equities. You might see this labeled broadly as active or passive investing, but be sure to dig in on what that specifically means with your advisor.
Duties & Responsibilities
This section is self-explanatory but could be very helpful if you haven’t had someone manage your investments for you. It will outline your role, responsibilities, and what you must approve as compared to what the investment firm will manage on your behalf to avoid any surprises. This section should establish a clear way that the investment manager will monitor and report compliance with your IPS.
Advisor’s Fiduciary Duty
Many people see the term fiduciary and tune out, but here’s why you should lean in and always ask whether your advisor will put their fiduciary duty in writing. The simple definition of fiduciary is someone who is legally obligated to act in your best interest.
Dual-registration has made this more difficult to pin down over the years, but we strongly believe being free of conflicts of interest is core to giving advice you can trust. For more on this, check out our blog on how to tell if your advisor is a true fiduciary.
At Plancorp we’re proud to say we are subject to annual fiduciary audits to maintain our CEFEX certification, a special designation that a third-party has verified that we uphold our fiduciary standard with clients.
Adoption & Updates
Your IPS should conclude with information on when it goes into effect, that you have read and understand it’s components, and have a place for you and your advisor to sign. This will ensure both parties are committed to the established plan.
But don’t think your IPS is infinitely binding. Your IPS can (and at times should) be updated if you make major life changes. For example, your risk tolerance may shift as you approach retirement, you may come into a large sum of money from an asset sale or inheritance, and the market may change with new offerings. All of these may be big enough shifts to warrant signing a new IPS with your advisor so they can uphold your wishes.
Closing Thoughts
If you’re reading this article, you’re likely in the process of evaluating signing up with an investment manager or more comprehensive financial advisor. We applaud you on taking that important step toward crafting a financial plan that works for you.
We put together a free worksheet with the top questions you should ask while interviewing a financial advisor to make sure you’re a good fit. Asking for a sample IPS is a great way to get to the bottom of key questions like their investing philosophy and stance on the fiduciary standard.
Earlier in your search for an advisor? Take our 2-minute financial analysis to get instant access to a report on where your plan could be improved.
