Articulating Investment Objectives
As a new athletic season starts, coaches map out drills, practices, and notes about opponents with the ultimate goal—to win the championship—in mind.
When it comes to asset allocation, it's the same thought process: mapping out a plan to achieve the ultimate goal. Put another way, what are you trying to achieve?
Yes!
It's all about the investor's own objectives because those establish the purpose of investing in the first place. So understanding and articulating the long- and short-term objectives for the investor is crucial.
For example, a defined-benefit pension plan's goal might be to ensure that plan assets are able to meet current and future liabilities. For an endowment fund, the objective may be to earn a rate of return required to fund real ongoing distributions. And when it comes to individual investors, the goal could be to provide for retirement at the investor's desired retirement age, family needs, and bequests.
Not exactly.
There's more to the ultimate goal than return.
Not quite.
That's not going to achieve the ultimate goal.
Clearly, the investment objective will vary depending on the client, but you can see a familiar theme among all three examples. What's the primary focus of the investment objective?
No.
Though liquidity needs are important, they don't drive the investment objective decision.
That's not it.
Constraints like taxation are considered, but that's not the primary focus.
Exactly!
The rate of return is the primary focus of the investment objective statement because it's the main goal of investing the assets. But even though it's so important, there are additional factors that also play a role in a comprehensive investment objective. So you'll need to include any obligations that should be funded, the nature of cash flows, and the investor's willingness to take risk.
For example, contributions to an investment fund will vary significantly between various clients. Pension funds can be receiving assets consistently from employees or frozen so there are no additional inflows. Endowments can have highly fluctuating cash flows, as contributions can come irregularly.
For this reason, understanding cash flows is crucial in developing achievable investment objectives because cash flows can impact risk. If cash inflows are highly consistent over time, all else equal, how do you think that will impact risk tolerance?
That's right!
Risk tolerance will increase if there are continual inflows into the investment account. So cash flows are critical in developing a proper investment objective. But inflows aren't the only risk tolerance factor. There's also liquidity risk, volatility, risk of loss, and risk of making a decision at the wrong time. So risk tolerance has multiple inputs.
Not so.
Risk tolerance doesn't decrease due to continuous inflows.
No.
Additional investment funds that are consistent can help you allocate assets better.
Liquidity is also a factor for the investment objective, especially when it comes to funding specific spending needs or payouts. For example, retired individuals may rely on consistent outflows, so taking excess risk that puts the individual's retirement in jeopardy is out-of-bounds. Likewise, excess risk for pension funds can be really dangerous, as the contractual liabilities make catching back up to liabilities difficult.
So overall, investment clients have unique retirement requirements and investment objectives that factor in various issues.
These issues, along with the investment objectives, are captured in the investment policy statement, which you can think of as the overall investment game plan. Put another way, it's the guidelines for ongoing fund management, and it assures investors that the investment program is managed with the appropriate care and diligence.
There are several key elements of a successful IPS, beginning with a descriptive introduction that provides the purpose and scope of the document, along with information about the asset owner. Here, the link between goals and objectives of the client and the execution of the investment program should be made clear. So what's another description you would expect to find in the IPS introduction?
No.
That doesn't have to do with purpose and scope of the document or the asset owner.
Not quite.
That's not going to be included in the description of the asset owner or the document.
That's right!
The introduction to the IPS details the purpose and scope of the document, which will include the fundamental beliefs about the investment program. That's because if another analyst picked up the IPS, that analyst needs to know the basis for why decisions—such as active versus passive management, for example—are being made.
This introductory section should also include the current business environment, sources and uses of assets, and any relevant laws and regulations.
In reality, the introduction is crucial in setting up the rest of the IPS because it naturally flows into the rest of the document.
Another element the IPS should contain that might stem from the introduction is a statement of investment objectives, which details the client's philosophy for generating investment returns and the client's ability to endure volatility to achieve these returns. Put another way, what's so important about this part of the IPS?
Way to go!
If you're talking about volatility, then that's going to relate to the client's risk tolerance. So this part of the IPS will include a discussion about what risks the client is willing and/or able to take. It's a two-part process here.
Next comes a section discussing the investment constraints that impact the investment program. This section will include liquidity requirements, time horizons, tax concerns, legal and regulatory factors, and unique circumstances.
Not quite.
That's a constraint, not volatility.
No.
That type of information would be in a feedback step.
From here comes a statement of duties and responsibilities outlining the allocation of decision-making and responsibilities of the investment committee, investment staff, and any third-party services.
There's also an explanation of the investment guidelines for implementing the investment program, including asset restrictions, and a section specifying the frequency and nature of reporting to the investment committee and board.
Together, these elements work to ensure that the client's overall objectives are satisfied, so the IPS is a changing and moving document that can be revised over time.
To sum it up:
[[summary]]
The highest after-tax return
The objectives of the investor
A level of income to meet spending requirements
Liquidity
Taxation
Rate of return
It will increase
It will decrease
There's no impact on risk tolerance
Frequency of reviews and audits
Rights and responsibilities of decision-makers
Fundamental beliefs about the investment program
It details the client's risk tolerance
It states the client's liquidity goals
It informs the asset manager of the necessary benchmarks
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