Understanding Key Investment Policy and Asset Allocation Concepts

The Investment Policy Statement (IPS) is an important document in portfolio management, serving as a guideline for investment decisions. It outlines the investor’s risk tolerance, return goals, constraints, and investment strategy. Understanding the IPS and related asset allocation principles is crucial for making informed investment decisions.

Why a Written Investment Policy Statement (IPS) Matters

A well-structured IPS ensures that an investor’s financial goals are met in a planned way. While there are many reasons for having a written IPS, not all are equally important. The least important reason for having a written IPS is:

• Ensuring the client’s risk and return objectives can be achieved.

A written IPS mainly communicates an investment plan rather than guaranteeing success. It provides clear guidelines for both the investor and portfolio manager.

Features of an Effective IPS

A good IPS is created through a joint effort of the investor and the portfolio manager. Pre-made templates may ensure consistency, but they lack the personal touch needed to reflect an investor’s unique situation.

An IPS should include:

• Investment objectives (return expectations and risk tolerance)
• Investment guidelines (restrictions and exclusions on asset selection)
• Statement of duties and responsibilities (for both investor and portfolio manager)

Example: If an investor prefers socially responsible investing, the IPS may include guidelines that prohibit investments in industries such as tobacco, firearms, or fossil fuels.

While many details can be included in the appendices, the Statement of Duties and Responsibilities is usually part of the main IPS document rather than an appendix.

Understanding Investment Risk and Return Goals

Return goals in an IPS can be either absolute or relative.

• A goal to outperform an index (e.g., the FTSE 100 by 120 basis points) is a relative return objective because it is based on a benchmark.
• Risk assessment questionnaires help measure willingness to take risk, while financial conditions determine the ability to take risk.
• A relative risk objective would limit risk compared to a benchmark, such as not underperforming an index by more than a certain percentage.

Example: A retiree with limited savings and high living expenses might have a low ability to take risk, meaning their portfolio should focus on stable, income-generating investments like bonds rather than volatile stocks.

Client Risk Profile and Time Horizons

A client’s risk profile depends on both ability and willingness to take risk. Examples:

• A widow with young children, a stable job, and long-term financial goals (retirement, college savings) has a long-term time horizon.
• An individual with unstable income and high financial commitments may have a high willingness but low ability to take risk, requiring a cautious investment approach.
• A high-earning client with no dependents but low risk tolerance has high ability but low willingness to take risk, suggesting a conservative approach.

Example: A 30-year-old professional with a high salary, no debt, and no dependents might be encouraged to invest in growth-oriented assets like equities, while a 60-year-old retiree relying on savings for income might prefer a mix of bonds and dividend-paying stocks.

Strategic vs. Tactical Asset Allocation

Asset allocation is a key part of portfolio management. The two main types are:

• Strategic Asset Allocation (SAA): A long-term allocation strategy based on risk and return expectations.
• Tactical Asset Allocation (TAA): Short-term adjustments to take advantage of market trends.

Asset class correlations play a big role in diversification:

• Correlations within an asset class should be higher than those among asset classes.
• The asset class with the lowest correlation to US equities provides the most diversification benefits. In our case, Brazilian equities (correlation = 0.76) are most different from US equities.

Example: If an investor primarily holds U.S. stocks and wants to reduce risk, they might add investments in emerging markets, which tend to perform differently from U.S. markets.

Special Considerations for Certain Investors

Some investors, like corporate executives, face unique challenges:

• A company director subject to trading restrictions must have these rules included in the IPS.
• Insurance companies have different liquidity needs:
  • Property and casualty (P&C) insurers need more liquidity because claim payouts are unpredictable.
  • Life insurers have more predictable payouts, allowing for longer-term investments.

Example: A corporate executive who owns significant shares in their company might need to diversify their portfolio to reduce risk while complying with trading restrictions.

Conclusion

A strong understanding of the IPS and asset allocation helps in making better investment choices. Whether assessing risk tolerance, setting return goals, or building a diversified portfolio, these concepts are the foundation of smart investing. By tailoring the IPS to individual needs and market conditions, investors can create a roadmap to achieve their financial objectives.