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Investment Policy Statement: An Essential Governing Document for Institutional Investors
A well-constructed investment policy statement (IPS) is an essential governing document that can significantly improve the oversight of your institutional investment funds. Unfortunately, the IPS is often overlooked and under-appreciated by financial professionals.
Overlooked and unappreciatedAbout 40 percent of the investment policy statements we encounter appear well-written and thorough, but are nevertheless missing key information.
Only about 10 percent of investment policy statements we review are properly written and complete. We believe this should be particularly troubling to most institutional investors because they are generally required to operate as fiduciaries towards these funds. The definitions, guidance, and benchmarks set down in the IPS help institutional investors meet the highest standard of duty to the beneficiaries of the funds.
Fill-in-the-blank is not enough
Other than your investment advisor or consultant, there are not many places to get specific advice about how to write and manage your IPS. If you search the internet for an IPS template you will typically find generic, one-size-fits-all solutions. That may not be surprising considering that the most useful IPS is a highly customized document.
The CFA Institute, a global leader in promoting ethics and education for investment professionals, defines the IPS as a strategic guide that:
- Anticipates issues related to governance
- Plans for the appropriate asset allocation, internal and/or external investment managers, monitoring and reporting results, and risk management
- Establishes accountability
- Offers an objective course of action during periods of market disruption
The definition goes on to call the IPS “… a highly customized document, uniquely tailored to the preferences, attitudes, and situation of each investor.” Clearly, an off-the-shelf solution will not even begin to address the unique needs and specific issues facing your institutional investment funds.
Why so many IPSs fall short
We believe the dearth of specific IPS advice is the root cause of why nearly half of the IPSs we review are significantly deficient (i.e., need immediate attention). For example, many documents are not signed and dated. Others haven’t been reviewed, affirmed, or updated in years, even though the fund is more mature, economic and market conditions have changed dramatically, and the needs of the beneficiaries have evolved. Still others are missing multiple key elements, such as specifying an appropriate “risk budget” and/or return objective. Some have unacceptably wide target ranges in their asset allocation (i.e., equities 30 to 70 percent).
About 40 percent of the investment policy statements we encounter appear well-written and thorough, but are nevertheless missing key information. They may not address the need for periodic estimation, review, and affirmation of investment management fees and expenses. Or, they may not adequately describe the potential sources and uses of funds that should be considered before adopting any specific asset allocation.
At its heart, an IPS is an agreed-upon framework that defines roles and sets boundaries and expectations for investible assets that is established by the governing body of an organization on behalf of the fund’s beneficiaries. Like the organization it serves, an IPS should be specific in its content yet flexible and open to change. Best practices dictate that the document should be reviewed at least annually and then either affirmed by the governing body or updated and then affirmed.
Eleven key topics to address
At a minimum, your organization’s IPS should address the following 11 topics:
- History and purpose of the fund — How long has the fund been in existence? Who is the governing body? What are the fund’s primary sources and uses of funds?
- Standard of care — What is the legal jurisdiction (i.e., “prudent investor rule,” ERISA, UPMIFA, state law)?
- Annual review/update affirmation — Who should participate in this review? How often should it take place?
- Definition of duties — What authority has the governing body delegated and to whom? How are conflicts of interest resolved?
- Investment objectives — What is the target return (i.e., absolute, relative to inflation, actuarial) and what is an appropriate risk budget (i.e., standard deviation of returns)?
- Asset allocation — What is the target asset allocation and what are the minimum and maximum percentages for each asset class?
- Rebalancing — Who is responsible for monitoring the actual asset allocation relative to the target? Who is responsible for initiating and executing the trades needed to rebalance the account back to target?
- Benchmarks — What are the appropriate benchmarks to monitor fund performance?
- Manager guidelines and restrictions — What criteria do we use to hold the investment managers accountable?
- Prohibited securities and transactions — What types of investments are prohibited?
- Brokerage/“soft dollar” use — When buying/selling securities, this section addresses the need for “best execution” and what are acceptable uses of brokerage commissions.
- Securities lending — Is this practice allowed or not?
How we can help
Every IPS will be different based on your organization’s mission, funding sources, fixed costs, income requirements, risk budget, and stage of organizational development. Whether you are beginning an investment relationship or revisiting one that is already established, our institutional investing professionals can help you give this foundational governing document the significance attention it demands and deserves.