What is a written Investment Policy Statement?

A written investment policy statement (IPS) creates a framework for the prudent implementation and ongoing administration of the trust’s asset portfolio. It sets forth written and objective guidelines for the acquisition of assets, for their reasonable and appropriate review, and for the monitoring of their performance. According to the restated Prudent Investor Rule:

The trustee is under a duty…to invest and manage the funds of the trust as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances of the trust. This standard requires the exercise of reasonable care, skill, and caution, and is to be applied to investments not in isolation but in the context of the trust portfolio and as a part of an overall investment strategy, which would incorporate risk and return objectives reasonably suitable to the trust.

The IPS, therefore, concerns itself with the ‘overall investment strategy’ of the aggregate portfolio. It provides the context that makes possible critical evaluation of how well or how poorly individual investments contribute to the objectives of the trust. It is the ‘blueprint’ for how to build a portfolio at the risk and reward level most appropriate to the requirements and circumstances of the trust.

What is the need for a written Investment Policy Statement?

In the words of Charles Ellis (Investment Policy):

‘The principal reason for articulating long-term investment policy explicitly and in writing is to…protect the portfolio from ad hoc revisions of sound long-term policy, and to…hold to long-term policy when short-term exigencies are most distressing and the policy is most in doubt. History teaches that both investment managers and clients need help if they are to hold successfully to the discipline of long-term commitments. This means restraining themselves from reacting inappropriately to disconcerting short-term data and keeping themselves from taking those unwise actions that seem so ‘obvious’ and urgent to optimists at market highs and to pessimists at market lows. The best shield for long-term policies against the outrageous attacks of acute short-term data and distress are knowledge and understanding committed to writing. All too often, investment policy is both vague and implicit, left to be “resolved” only in haste, when unusually distressing market conditions are putting the pressure on and when it is all too easy to make the wrong decision at the wrong time for the wrong reasons.’

What are the benefits of a written Investment Policy Statement?

The evaluation criteria commonly used to judge the merits of investments in isolation are generally inadequate to explain how investments interact with each other in diversified portfolios. Take, for example, the commonly used criteria of investment return. Because of the mathematics of compounding, it is often the case that combining two investments with relatively low average returns produces greater ending wealth than putting all funds with a single investment with a high average return. This seemingly paradoxical result arises from the fact that investments with differing return patterns mitigate large losses; and, therefore, create a more favorable outcome for the investor. A loss of 10% requires an approximately 11% gain to break even; however, a loss of 20% requires a 25% gain to break even. The IPS models risk and return from the portfolio level as opposed to the individual investment level; and, therefore, enables the investor to combine individual investments in optimal combinations.

Conventional investment wisdom assumes portfolio return is determined by two factors:

1. the ability to select good stocks/bonds; and,
2. the ability to time the market.

Academic evidence tells us that return is a function of three factors:

1. the ratio of stocks to fixed-income investments (i.e. the asset allocation decision);
2. the degree to which the investment portfolio is well diversified—i.e., returns based on market performance vs. returns from a series of company or industry sector bets; and,
3. the consistency to which the investor adheres to the asset allocation decision through up and down markets—i.e., investment policy.

Procedural Prudence

A written IPS indicates that the fiduciary made conscious decisions regarding the overall risk and reward profile appropriate for the trust. It documents the care, skill and caution used to select and retain specific investments; and, most importantly, provides a set of objective guidelines that indicate that decisions were well conceived rather than ad hoc. Potential disputes are changed into matters of fact and circumstance rather than matters of mere opinion.

Ultimately, the fiduciary has a choice. He or she can rely on their ability to identify and select securities that generate favorable outcomes. In this case, the fiduciary must rely on the future (and, unknown) results of investment decisions in order to demonstrate the prudence of their stewardship. Alternately, the fiduciary can document the procedural prudence of the decision making process. In this case, there is little or no likelihood that the fiduciary will be held liable for unforeseen future outcomes.