Investment Policy Statement
An investment policy statement (IPS) is a formalized document which serves as a strategic blueprint for the on-going management of your investment program. It is important to review this document to ensure that it properly reflects the future direction of your portfolio in order to meet your goals, objectives, and risk levels that you are comfortable with.
Key components of an IPS include:
- Portfolio Objectives: This outlines the key purposes of the portfolio. For example, the intent of the portfolio may be to provide for regular income to satisfy your lifestyle expenditures through retirement. Alternatively, the portfolio may be geared towards capital growth with longer term investment goals in mind.
- Risk Tolerance: This describes your general attitude towards risk. Risk tolerance can be described in terms of both your financial capacity and willingness to bear risk and will act as the key input in developing your return objectives and portfolio asset allocation.
- Return Objectives: You need to be clear on your long-term goals, this should be your true benchmark. For example, your objective may be to achieve an annualized return of 5%, net of expenses, through to your retirement date.
- Time Horizons: Specify the time horizons for each account. For example, your RRSP will more than likely have a longer time frame than your RESP, and the investment strategy should reflect this.
- Liquidity Needs: This outlines whether you will require lump sums of money from the account(s) in the future. Noting this will be a reminder to the advisor, and the investment strategy should reflect this anticipated need.
- Income Requirements: Specify your current income needs from the portfolio, and which accounts those will be drawn from. For example, you will draw $8,000 per month from the corporate account in Canadian dividends and capital gains.
- Taxes: Different investments have different tax implications, so your IPS should outline specific accounts and investment strategies that are best suited by each type of account. In addition, you may have legacy realized gains/losses which may impact future buying and selling decisions, so it should be noted here as well.
- Laws and Regulations: Identify any legal issues regarding the portfolio. Examples of this are insider trading restrictions or applicable legislation related to pension accounts.
- Unique Preferences and Circumstances: Outline any specific nuances which may impact your future investing. For example, you may be heavily exposed to a certain sector or stock, and wish to minimize or avoid such investments in the portfolio. You may also wish us to consider externally-held investments in the context of your overall program. Explicit ethical preferences should be outlined in this section as well.
- Asset Allocation: Specify the targeted asset allocation of various asset classes, acceptable deviations from the target, and any restrictions that may apply. For example, the overall portfolio will target an asset allocation of 40% equity and 60% fixed income allocation. Another might be that no one stock can represent more than 5% of the portfolio.
By discussing the above, you and your advisor will be better equipped to manage your investment portfolio with your needs and preferences in mind.
Once we have established clarity of your investment priorities, we are able to outline an asset allocation framework best suited to meet your objectives. The asset allocation of the portfolio is a key component of the IPS, and is a reflection of the risk/reward characteristics of the investor. In fact, a mismatch between the portfolio asset allocation and investment objectives poses perhaps the greatest risk to the success of your investment program.
From a high-level perspective, and for illustrative purposes, we will refer to two main categories of investments; fixed income and equities. For some, simply having a predetermined targeted allocation between these two categories and maintaining such an allocation would go a long way in improving their overall investing success.
For example, let’s say an investor determines that their ideal asset allocation would be 50% fixed income and 50% equities. Ten years ago, they allocate $2,000,000 in such a mix and then simply apply a buy and hold approach; investing $1,000,000 in equities and $1,000,000 in fixed income.
Figure 1: Buy and Hold Strategy.
Source: Blackrock, Morningstar
As you can see in Figure 1, with this buy and hold strategy over the last ten years, the investor’s portfolio had significant deviations from their targeted asset allocation. This puts their goals and preferences into jeopardy, which could have made negative periods of a particular asset class more discerning than if they were to stay true to their targeted allocation.
Figure 2: Annual Rebalance Strategy.
Source: Blackrock, Morningstar
In comparison, let’s say another investor with the exact same ideal asset allocation invests in the same asset mix; however, they realign their asset allocation every January 1st back to the original asset allocation. As you can see in Figure 2, the investor who incorporated an active annual rebalance of the portfolio experienced far less deviation from their targeted asset allocation. While in this example the rebalancing investor not only did a better job of maintaining the risk/reward integrity of the portfolio, they also achieved greater rates of return.
The main reason for adopting a rebalancing strategy is to ensure that the risk/reward integrity of the strategy is maintained. Rebalancing may not always provide better absolute returns.
The challenge many investors face is the discipline to adopt and apply a rebalancing strategy. This is true not only in times of market distress, but in times of market jubilance. They hesitate to sell the asset class which has done well in order to buy the asset class which has underperformed.
Rebalancing, however, can be achieved by selling and buying assets within the portfolio, by adding cash and purchasing assets to bring the allocation back on target, or by any combination of the two. You should also consider indirect implications such as tax consequences, transactional costs, and time and administration when rebalancing. These may impact the method of rebalancing as well as the range of acceptable deviations from the target.
One of the realities investors need to accept is that when it comes to investing, there are many things out of your control, however, there are many things that you can control. Having a well-defined investment policy statement and adhering to your asset allocation are aspects of investing which you can control, and have proven over time to have a meaningful impact on an investor’s results. If you would like to explore opportunities to improve your investment approach with respect to the principles outlined, please contact us for a private and confidential consultation.
Here is to wishing you a healthy and prosperous New Year!
To schedule a private and confidential consultation, contact us at (403) 234-0005 or [email protected].