IPS constraints: liquidity, time horizon, taxes, legal and unique circumstances

What are the IPS constraints?

The objectives say what the client wants. The constraints say what limits the client in getting it. There are five, and every fact in a client vignette belongs to one of them. Constraints come in two kinds, internal and external constraints : internal ones are set by the client, external ones by law or regulation. The investment policy statement (IPS) records all of them in the same place.

Investment constraintswhat limits the assets a client can hold

• Liquidity requirements Memorize cash the client will need
  • Expected needs tuition, a house deposit, a tax bill, benefit payments
  • Unexpected needs emergencies, insurance claims
• Time horizon Memorize when the money is needed
  • Single stage one goal, one date
  • Multistage working years, then retirement
• Tax concerns Memorize how returns are taxed
  • Taxable investor judge returns after tax; favor gains over income
  • Tax-exempt investor indifferent to the form of return
• Legal and regulatory factors Memorize rules that apply to the investor
  • Portfolio limits caps on equities, foreign assets, self-investment
  • Trading restrictions insiders and material nonpublic information
• Unique circumstances Memorize anything else particular to the client
  • Beliefs and values faith, environmental, social and governance (ESG) and ethical exclusions
  • Concentrations employer shares, income tied to one industry

Sort each fact into its constraint before you read on. In a vignette, sort first, then answer.

Liquidity: when will cash be needed?

Memorize

Liquidity requirements are the expected and unexpected withdrawals from the portfolio. For an individual: healthcare, tuition, a house deposit, a tax bill. For institutions: spending rules at an endowment, claims at a property and casualty insurer, benefit payments at a pension plan or life insurer.

When a requirement exists, set aside part of the portfolio to cover it, in assets that are easy to turn into cash and low in risk when the need arises. A bond that matures the month the tuition falls due is ideal, because its value is known with reasonable certainty. Illiquid assets such as private equity or real estate are unsuitable for money needed soon.

Time horizon: how long until circumstances change?

Memorize

The time horizon is the period over which the investor is investing: the accumulation period before assets are withdrawn, or the period until the client’s circumstances change. A 52-year-old who plans to retire at 64 has a 12-year horizon, even though the portfolio is not liquidated at 64. Its structure may need to change as the client starts drawing income.

A multistage time horizon has several phases with different needs: for example 20 working years of saving, then 25 years of retirement spending. Plan each stage.

A longer horizon allows more risk and more illiquidity, because there is time to recover from losses. A short horizon makes risky or illiquid assets unsuitable.

Taxes: what does the client keep?

Use it

Tax concerns depend on the investor’s status. Some investors, such as many pension funds, are exempt. Others face different rates on income (interest and dividends) and capital gains. Typically income is taxed more heavily than gains, and gains are taxed only when realized, so deferral has a time-value benefit.

A taxable investor therefore judges returns after tax and may favor assets that produce gains rather than income, and tax-advantaged instruments (for example, municipal bonds in the United States, whose interest is exempt from tax). A tax-exempt investor is relatively indifferent to the form of return.

$$r_{AT} = r\,(1 - t)$$

Legal and regulatory factors: what do the rules say?

Memorize

Legal and regulatory factors are restrictions on how the portfolio may be invested. Some countries limit institutional investors’ portfolios, for example a cap on the share of equities, real estate or overseas assets in a pension fund. Pension funds also often face self-investment limits on securities issued by the plan sponsor.

An individual can be restricted too. A company director who has material nonpublic information, or who must avoid trading before results are published, cannot trade the company’s shares. The IPS should record the restriction so that the manager does not trade by accident.

Unique circumstances: what else is particular to this client?

Memorize

Unique circumstances cover everything else that materially affects the portfolio, including beliefs and values.

• Faith and ethics. An investor following Shari’a avoids interest-bearing debt and gambling. Others avoid weapons, tobacco or businesses with poor labor or environmental records. Exclusions apply to the investable universe and to the client’s benchmark.
• Concentration. An employee with shares and options in the employer is already exposed to it and should not add more. A shipbroker, whose commissions rise and fall with freight rates, should hold little in shipping shares.
• Other wealth. A portfolio may be only part of the client’s wealth. Whatever is outside the manager’s control still affects what the portfolio should hold.

Investing in line with such preferences is often called socially responsible investing. The final lesson of this module covers the environmental, social and governance (ESG) approaches in detail.

Exam tip Three look-alikes: a dated outflow is liquidity; life stages are time horizon; a client’s own values are unique circumstances.

Go deeper Emergency reserves for individuals

Individuals usually set aside an emergency fund in cash before taking risk with the rest. It is a liquidity cushion for unexpected events such as a health bill or a job loss. The size depends on income stability and obligations. It also raises the client’s ability to bear risk on the invested portfolio, because a market fall will not force a sale.

Go deeper Why institutions face the heaviest regulation

Banks, insurers and pension funds hold other people’s money and promise to pay it back. Regulators therefore set rules on asset mix, concentration and capital. Insurers and pension funds also have liabilities that drive liquidity needs, so their IPS constraints read very differently from an individual’s. The investor types are compared in the lesson on types of investors earlier in this topic.

Go deeper A concentrated holding with a low cost basis

A client who owns a large block of one stock bought long ago has two linked problems. Diversification says sell some of it; tax says a sale triggers a large capital gains bill because the cost basis is low. The IPS records both the concentration (unique circumstances) and the tax effect (tax concerns), and the manager weighs the tax cost against the risk of staying concentrated.