How to Build an Investment Policy Statement That Will Stand the Test of Time

Whether an individual investor, a family office, an endowment, or any other sort of institutional investor, one of the most critical initial steps to be taken in formulating an investment strategy is to create an Investment Policy Statement (IPS). The IPS serves as the guiding beacon of the investment strategy, dictating the overall investment objectives and setting parameters around what is allowed, how decisions are made, and how performance is ultimately measured.  

More practically, the IPS serves as a powerful tool to foster alignment between an asset owner and an investment manager. It forces discussion about what success really looks like in an investment context and provides guardrails as to how that success can be achieved.  

Although Investment Policy Statement structures and content will differ based on parameters such as the type of institution or individual stakeholders, the relationship between the asset owner and the asset manager, the overarching goals of the investor, the relevant constraints, and other external factors, this overview is intended to provide a general structure that can be adopted and expanded upon for a variety of investors. It is important to remember that this structure is simply the output of what should be a wide-ranging process that considers both the objective realities and subjective factors that every investor will have. 

Lastly, in line with current best practices, we recommend updating this document at least annually to account for any relevant changes to investor objectives, parameters, or changes to the asset owner and investment manager relationship. While the intricacies of daily investment strategies may or may not be made readily transparent, the IPS should be made freely available to all stakeholders who wish to review it.  

Introduction 

The first section of an IPS, the Introduction, should serve to define the investor and structure of the investment entity. This section of the IPS broadly serves to organize thoughts and push the asset owner to define things such as their purpose, mission, values, and potentially provide context relevant to the formation of the management of these assets.  

The content of the introduction should be based on wide-ranging discussions with the asset owner around what is important to them as an individual or as an organization. While this output is based less on analytical rigor than the other sections of the IPS, the Introduction serves as the foundation for defining measurable objectives and constraints in the remainder of the document. 

Governance 

Governance structures vary widely between the different types of investment entities. For an individual investor who serves as the sole decision-making authority in all regards, this section may be unnecessary. For an institutional investor with wide-ranging oversight responsibilities, this will be one of the most critical pieces of the IPS. It serves to foster alignment between asset owners and investment managers and lays out the appropriate channels of accountability for investment performance. 

The Governance section of the IPS should, at a minimum: 

• Define the composition of each committee, board, investment advisor, staff, or other stakeholders with a formal responsibility to the success of the investment strategy.  

• Define the roles and responsibilities of each party. 

• Define a standard of care that the investment manager and relevant parties will be subject to. Many (but not all) investment managers are held to a fiduciary standard, meaning that they are required to always act in the best interest of their clients and avoid conflicts of interest.  

• Set reporting guidelines, outputs, cadences, and responsibilities for the different parties.  

• Detail the process and responsibilities for how (and how frequently) the Investment Policy Statement should be updated.  

Investment Parameters 

The Investment Parameters section should be thought of as the “how” to the Introduction’s “why.” This section asks: now that the overarching purpose of the asset base has been defined, how can this purpose be best achieved through tangible investment goals and objectives?  

The Investment Parameters section of the IPS should, at a minimum: 

• Define the overall investment objective. 

• Set an investment time horizon. 

• Set a return requirement. 

• Define anticipated or required liquidity needs and cadence. 

• Define the tax policy or regime to which the asset pool will be subject. 

• Describe any other considerations relevant to the investment strategy. 

• Define a policy portfolio or benchmark against which the investment performance will be measured under a defined asset allocation framework. 

Risk Management 

If the Investment Parameters framework dictates how the investment objectives can be achieved, the Risk Management policy serves as the counterweight to set the guidelines and constraints under which the investment manager should operate. Through a combination of the rules laid out in this section with the oversight responsibilities laid out in the Governance section, it should be clear as to what the investment manager can and cannot do and what party is responsible for maintaining oversight of compliance with these stipulations. 

The Risk Management section of the IPS should, at a minimum: 

• Define the risk tolerance of the investor. 

• Set risk limits on various aspects of the investment pool, such as concentration limitations on position sizing, geographic exposures, and sector exposures. 

• Set a policy around the use of leverage (either at the fund or investment level) to achieve investment objectives or as a risk management tool. 

• Set any limitations around the types of investments that are allowed to be made. 

• Describe a formal rebalancing policy that describes which portfolio rebalancing method should be used and how the asset allocation will be monitored.  

Appendix 

Finally, an optional Appendix can include relevant exhibits, examples to illustrate calculations in practice, and other relevant information that expands upon the information included in the Introduction, Governance, Investment Parameters, and Risk Management sections.  

While much of this information included in this section is optional and simply further illustrates concepts from the IPS, it is recommended that an Appendix at least includes Version Control and an illustration of the Benchmark Portfolio.  

Version Control should detail the history of every approved version of the IPS over time. This record should be updated whenever changes are made and approved by the appropriate governance entity and include a summary of the key changes, along with a link to a saved copy of the prior version. 

The Benchmark Portfolio chart should illustrate the benchmark index composition, along with any tactical deviation allowances. This illustration should be updated over time to show periodic performance figures compared against the benchmark portfolio to determine the value added by the chosen investment strategies in an objective way. 

In conclusion, an IPS is a critical tool for aligning investment objectives, fostering accountability, and establishing clear guidelines for success. By incorporating governance, defined investment parameters, and comprehensive risk management, the IPS ensures a disciplined approach to achieving long-term goals. Regular updates further solidify its role as a framework for navigating evolving investment landscapes.