Long before takeoff, a pilot sets the course, tracking the intended path over the ground, adjusting for wind, avoiding traffic and managing fuel. In a similar fashion, an advisor sets a discrete investment policy statement, or IPS, for each portfolio, to meet a family’s financial goals. The plan, which is informed by a thorough financial planning analysis, provides structure, clarity and accountability along the way.
Here are some key components of a successful IPS.
Informed goal setting
Early discussions around financial planning should inform investment goals. For families and family offices, those discussions will cover lifestyle to legacy and everything in between. The goal is usually sustainable efficacy. There may be other desired outcomes, such as current income needs or just appreciation to provide for future generations. An IPS should include tax considerations and may reference outside holdings, privately held businesses, concentrated corporate stock positions and real estate that can influence the overall investment picture.
Clear investment objectives
The investment objective, or mission, is the foundation of disciplined long-term investing. It’s important to also look at the location of the assets. A multigenerational family may want an overall balanced approach, while establishing a different IPS for some or all of the individual portfolios. In some blended families, one side may have more funds or investment experience and would want to construct a portfolio IPS accordingly.
Considered risk tolerance
What is an acceptable level of risk? How much volatility is too much? What is the maximum tolerable drawdown limit? These answers will depend on the nature of the individuals involved, investment time horizons and liquidity needs. A financial plan and lifestyle analysis is critical in assessing the degree of risk for families. As with the other components, risk tolerance can change with time and evolving circumstances, so it’s important to keep the conversations going.
Investment guidelines
If the investment objectives are the “what,” the investment guidelines and the risk parameters expand on the “how.” They establish the types of portfolios – whether capital appreciation, balanced, or capital preservation – and the ranges for each asset class. Once the goals are established, appropriate benchmarks are set to measure success; any prohibited investments are defined (e.g., fossil fuels, armaments, and so on); and the appropriate use of leverage is determined.
Portfolio constraints
Are there additional requirements specific to the portfolio such as large future outlays? Is the portfolio held by a trust? Are there any regulatory or fiscal constraints? Perhaps the portfolio contains a stock concentration that needs to be managed. Perhaps it is designed to provide for a dependent with special needs who should also receive other benefits. There are as many possibilities as there are investors, so it’s important to address all relevant constraints.
Taxes
The IPS should identify the tax structure for the portfolio’s IPS. Individuals and trusts have different tax consequences. As a result of the different tax statuses of the portfolios, asset location should be identified and considered; for example, certain tax-inefficient assets should be placed in tax-deferred portfolios like retirement accounts or charitable remainder trusts.
Portfolio governance
Roles need to be defined. The governance section identifies who is responsible for the day-to-day management of the portfolio, how often the investors and managers will meet, and how the portfolio will be measured and rebalanced as necessary.
Flexibility
Although it sounds at odds with concept, a flexible IPS that is reviewed at every relationship meeting is stronger than a static document. The financial plan and, consequently, the IPS should be regularly reviewed and the IPS amended, if appropriate. For instance, if there is a period of low interest rates and the portfolio relies on dividends and interest for income, the IPS could change the asset allocation or could codify that assets could be sold to create income. An IPS is not going to improve performance directly, but it will create a process that will improve the chance of a positive outcome.
A well-drafted IPS, informed by a deep financial analysis and plan, enables both the investor and the manager to agree on a decision process – and to hold a steady course, no matter how choppy the markets. For families, as well as for foundations and endowments, an IPS enables those in charge to come to an agreement on the parameters of the management of the portfolio and offers guidance for new members who may join later.
Jonathan Bergner is a Partner and Portfolio Manager at Evercore Wealth Management. He can be contacted at [email protected].
