Investment Policy Statements

What is an Investment Policy Statement (IPS)?

Investment Policy Statements (IPS) are written directives provided by investors to their investment managers that defines the objectives, policies, and guidelines governing the management and oversight of their portfolio. An IPS serves as an essential tool in dictating how an investor’s portfolio should be managed. An IPS should state general guidelines for the investment manager to follow and should also state the investor’s specific investment objectives and risk tolerances.

When is an IPS Used?

Typically, investment managers use an IPS to document investment parameter guidelines. This document provides the investment manager with specific guidelines for investment decision-making and helps ensure that investments stay within investors’ preferences. An IPS also serves as an important corporate governance document for investors’ boards and auditors.

What Specific Information is Included in an IPS?

A fixed income investment policy statement typically includes specific information such as investors’ risk tolerances, desired concentration limits, maturity limits and liquidity requirements. These requirements will dictate how the investment manager may invest the investor’s cash, such as setting minimum credit ratings and maximum issuer concentration limits. A balanced IPS should allow enough flexibility for an investment manager to seek maximum income potential while also clearly defining the investor’s risk management objectives.

IPS From an Investor Perspective

From an investor perspective, an IPS is a protective guardrail that keeps investors and investment managers focused on long-term investment objectives. Specifically, the objectives of an IPS should include guidelines for the preservation of investors’ capital, the fulfillment of investors’ liquidity needs, and the maximization of investors’ risk-adjusted returns. An IPS should further establish monitoring and control procedures regarding the periodic review of the IPS, including the frequency of review and the subjects to be covered.

Risk Management Best Practices for Investors

An investment strategy that incorporates an IPS with broad investment goals while incorporating additional verbal guidelines preserves investors’ risk tolerances while providing the investment manager with a document to base their investment strategy. To protect investors’ risk management goals, investors may specify maximum maturity limits, a list of approved financial instruments, and concentration limits. Below are some of the risk management tools in greater detail.  

Setting Maximum Maturity Limits

In setting an appropriate maximum maturity limit, a variety of interest rate environments should be considered to avoid frequent investment policy revisions. During times of market volatility, staying true to the investment strategy is key to achieving the portfolio’s investment objectives.

Set of Approved Instruments

An IPS should include a list of eligible investments suitable for the investor’s risk tolerance. The most common eligible fixed income investment types include US Treasury bonds, US Agencies (including government-sponsored entities), corporate debt obligations (including commercial paper), bank debt obligations, SEC-registered money market funds, repurchase agreements, sovereign debt, asset-backed securities, and asset-backed commercial paper.

Establishing Minimum Credit Rating Thresholds

When establishing a minimum credit rating in an IPS, investors should look to national rating agencies’ grades. The letter grades indicate relative credit quality, and they separate investment grade bonds (i.e., BBB, A, AA, and AAA) from non-investment grade bonds. Most conservative cash investors prefer A-rated or higher securities to create a buffer between investment grade and non-investment grade bonds in the event of a security downgrade. In general, Treasury and Agency bonds are exempt from ratings requirements.

Deciding on Concentration Limits

Investors should also set concentration limits and include “at the time of purchase” language in their IPS to help avoid potential financial loss from overexposure to certain groups of borrowers, sectors, or geographic regions. Risk diversification should vary based on the size of the portfolio, as smaller portfolios may require higher concentration limits to reduce the risk of over-diversification. The limits should be specific to “at the time of purchase”, as portfolio balances change over time which could shift concentration levels in the portfolio. Treasury and Agency bonds generally are exempt from concentration limits set by the IPS.  

Conclusion

Investment policy statements provide cash investors and investment managers with a defined investment strategy and set of risk management objectives. An IPS helps create transparency and define investors’ expected results and restrictions to ensure a clear line of communication between investors and investment managers. In the business of investment management, an IPS is an important component of risk management to help investors preserve their assets.  At Capital Advisors Group, our portfolio managers are available to offer sample investment policies and provide guidance in the review and revision of existing policies.

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