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Set out the constraints that an investment policy statement records

CFA® Level I · Portfolio Construction · Basics of Portfolio Planning and Construction · PM.3.c

The idea

Five constraints shape what a portfolio may do regardless of objectives. Liquidity covers anticipated cash needs and the reserve held against unanticipated ones. Time horizon may be single or multi-stage, and a long overall horizon does not excuse a near-term liability. Tax considerations affect asset location and turnover. Legal and regulatory constraints bind trusts, pensions and foundations in particular. Unique circumstances cover everything else a client specifies, from a concentrated holding that cannot be sold to an exclusion on ethical grounds.

A practice question

From the question bank, with the reason each wrong option is wrong.

The trustees of the Delmar Municipal Employees Pension Plan are completing the plan's investment policy statement. Pension law that applies to the plan caps holdings in the securities of any single issuer at 10% of plan assets and requires the trustees to diversify prudently. The trustees want to record this restriction in the IPS. Under which constraint does it belong?

  1. Unique circumstancesWhy not: Unique circumstances covers restrictions that the client or trustees choose for themselves, such as an ethical exclusion. This cap is imposed by law rather than chosen, so it is a legal and regulatory constraint.
  2. Tax considerationsWhy not: Pension rules are sometimes lumped in with tax rules, but this cap governs what the plan may hold and has nothing to do with the after-tax return, so tax considerations is the wrong heading.
  3. Legal and regulatory - correct

A policy statement records five constraints: liquidity, time horizon, tax, legal and regulatory, and unique circumstances. The test is where the restriction comes from. A cap on single-issuer holdings is imposed by law whatever the trustees prefer, so it belongs under legal and regulatory. Unique circumstances is for restrictions the client chooses, such as an ethical exclusion. Tax considerations affect after-tax returns, not which securities may be held.

A harder one

An investor has a thirty-year horizon but must fund a house purchase in two years. How should the horizon constraint be described?

  1. Short, because the nearest liability governs the whole portfolioWhy not: Lets a small near-term liability dictate the treatment of a thirty-year portfolio.
  2. Long, because the thirty-year goal governs the whole portfolioWhy not: Leaves the deposit exposed to a drawdown it has no time to recover from.
  3. Multi-stage, with the two-year need funded separately from the rest - correct

Time horizon is how long until the money is needed. This investor has two needs at different times. The house deposit is needed in two years, so it should be kept in safe assets that will not fall much. The rest is not needed for thirty years, so it can take more risk to grow. Using one horizon fails either way: two years starves the long-term money of growth, thirty years puts the deposit at risk. The answer is a multi-stage horizon, with each need funded separately.

The hardest tier

An adviser has drafted the constraints section of the investment policy statement for the Harrow Family Trust, which makes constant annual distributions to its beneficiaries until it ends in 12 years. The draft records: liquidity, annual distributions of $300,000 plus a $500,000 reserve for unexpected medical costs of beneficiaries; time horizon, a single stage of 12 years; unique circumstances, a target return of 5.5% a year. The trustees ask for one correction. Which should it be?

  1. Move the medical reserve to unique circumstancesWhy not: The reserve held against unanticipated needs is part of the liquidity constraint, alongside anticipated cash needs such as the distributions. It is already correctly placed, so moving it would introduce an error.
  2. Move the 5.5% target out of the constraints section - correct
  3. Record the time horizon as multi-stageWhy not: A multi-stage horizon applies when needs change over time, such as a near-term liability inside a longer horizon. Here the distributions are constant until a single end date, so one stage is correct as drafted.

Check each entry. Liquidity covers expected cash needs (the 300,000 distributions) and a reserve for unexpected ones (the 500,000 medical reserve), so that entry is right. The horizon is one stage because the distributions are constant until the trust ends in 12 years, so that is right too. The 5.5% a year is a return objective, meaning what the portfolio should aim to earn. Constraints are limits on what it may do. So the correction is to move the 5.5% target out of the constraints and into the objectives section.

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