In simplest terms, the investment policy statement (IPS) communicates a client's investment goals and the strategies that will serve as guideposts for managing the portfolio. There are, however, the good, the bad, and the ugly among them.
Good investment policy statements:
Provide appropriate guidance on portfolio construction and ongoing management
Help maintain focus on the client's mandate and assist in avoiding deviations due to changing market conditions
Serve as a critical tool in keeping clients focused on their stated objectives
Bad investment policy statements:
Are written to solely satisfy compliance or regulatory requirements
Are vague and fail to be integrated into the portfolio construction and management process
Provide no means of testing the success or effectiveness of the portfolio design to actual results, nor a way for the client to effectively reconcile the emotional definition of a conservative, self-professed mandate to the quantitative portfolio results
Ugly investment policy statements:
Are crafted in broad terms with the effect that similarly stated objectives can have drastically different interpretations from one client to another
Leave a client comparing portfolio performance to market and asset-class benchmarks that may or may not have relevance to the client's stated objective
Traditionally, an IPS is written with broad investment objectives and risk descriptions, such as "conservative growth" and "low risk." These factors would be translated into an asset allocation based on standard deviation, correlation and expected returns, thus attempting to translate qualitative interpretations of risk and return into statistical metrics.
How the IPS is used depends on whether or not one is working within a modern or post-modern portfolio context.
Within the "modern portfolio theory" construct, assessing portfolio strategy and portfolio results is often a highly subjective and intangible exercise between client and advisor. Much is left open to misinterpretation and misunderstanding, especially as it relates to reconciling client IPS objectives with actual portfolio results.
Ideally, an effective IPS incorporates two important and interrelated components: an outline of the client's quantitative and qualitative objectives and a set of metrics for the accurate evaluation of the portfolio's construct, including appropriate return and risk measures.
Integrating the IPS in a Post-Modern Portfolio Theory Environment
In a post-modern portfolio theory environment, the IPS serves as the cornerstone of a quantitative portfolio construction process:
- Multidimensional risk and performance factors are considered
- Specific quantitative ranges are set for up- and down-market scenarios
- Non-normality and illiquidity are considered
- Risk is emphasized, relative to drawdown loss
Perhaps most importantly, the client participates fully in this process, and has a full understanding of each aspect of it.
The IPS is also integrated into the portfolio monitoring and measurement process by coordinating risk and reward factors into simple, easy-to-understand metrics that define success and failure. These metrics should be measurable and not open to qualitative interpretation (i.e., composite construction, peer groups and statistical relevance).
Drawdown Analysis and Investment Capture
Where modern portfolio theory was largely focused on standard deviation, post-modern portfolio theory suggests that a drawdown-based analysis may best express the actual portfolio experience in up and down markets. It is tangible, measurable and considers illiquidity. Most importantly, it includes all four moments of a return distribution (mean return, standard deviation, skewness and kurtosis). The inclusion of kurtosis, also known as “tail risk," is important to the development of a more thorough understanding of risk, especially in multi-asset class portfolios that include allocations to less-efficient asset classes.
Investment capture seeks to set relative target return ranges during rising and falling market scenarios. It incorporates risk and return consequences for a portfolio within a single measurement. Ideally, the measurement period would encompass a full market cycle (defined by a peak to trough to peak, or vice versa) but a rolling 12-month period may suffice. Investment capture may be utilized to set target ranges for a manager, asset class or portfolio. It is composed of the up-market capture and down-market capture.
Implementation of the Investment Capture
Discussing the investment capture is an opportunity for the advisor to set realistic expectations with the client, while also enlisting them to take ownership of the risk they are seeking relative to their desired return. It is also an educational opportunity that may encourage an active dialogue around asset allocation, risk and capital markets, which in turn affords the advisor an opportunity to build credibility within a consultative interaction.
When discussing the investment capture, it is critical that the advisor engages the client to determine their risk tolerance (as defined by drawdown or loss tolerance) and sets the target return range. Equally important is testing whether the client's understanding of risk and reward is congruent with capital market reality (e.g., "I want 100% of the up market and 10% of the down market.").
The most common scenario would be a client reading headlines or speaking to friends about a smart manager or investment product that she would like to add to the portfolio. However, this idea may not be consistent with the up/down-market capture of the portfolio. Using the investment capture allows the advisor an opportunity to keep the portfolio focused while managing to the mandate, not to noise in the markets.
Up-market Capture: For every 10% return of the MSCI- All World Index, how much do you want your portfolio capture? 60 to 80% of it, that is 6 to 8% for every 10% rise of the broad equity index?
Down-market Capture: Inversely, for every 10% loss of the MSCI- All World Index, how much are you willing to accept? 50 to 70% of it, or a loss of 5 to 7% for every 10% loss of the broad equity index?
Once the investment is agreed upon and added to the IPS, it would be regressed and built into a formal asset allocation by the investment team and monitored to ensure that the desired range of returns is met over a market cycle.
The investment capture effectively builds an outcome-based investment strategy that can be measured and managed dynamically with a single measurement that can be easily understood by both a sophisticated investment committee and a novice investor. It compels the advisor and client to agree to a relative return capture range that is congruent with the risk the client is willing to accept. Risk as defined by what the client would actually experience (in a drawdown scenario) as opposed to a statistical measure that doesn't directly express portfolio loss.
The investment capture integrates the IPS into the portfolio. It is a key element and an easily utilized metric that ensures the integrity of the IPS is adhered to from a comprehensive risk and reward perspective. This attribute is what makes the IPS relevant: it is a tool for the client to use to advocate for their own goals, and it is a tool for the advisor to recognize if they are meeting client expectations.
Practicing outcome-based investing with an IPS built around a single metric that incorporates several aspects of risk, instead of a single aspect of risk, may afford clients the ability to more effectively advocate for themselves while also having a deeper understanding of the risk they may be taking on. The IPS should represent the clients' Bill of Rights, whereby they declare their independence from subjective interpretations of success and failure while better communicating their desired portfolio objectives.