IPS Investment Constraints
An investment policy statement (IPS) is a formal document that is used when managing an investor’s portfolio. An IPS will list the investment constraints. Investment constraints are those factors that restrict or limit the universe of available investment choices. Constraints can be generated either internally (those determined by the investor) or externally (those determined by some outside entity, such as a governmental agency.
On this page, we discuss the five main classes of IPS investment constraints. These relate to liquidity, time horizon, legal and regulatory concerns, tax considerations, and unique circumstances.
Liquidity constraints are related to expected cash outflows that will be needed at some specified time and are in excess of available income. In addition, it is generally prudent to set aside some amount (e.g., three months of living expenses) to meet unexpected cash needs. Often, liquidity is required over multiple time periods. A down payment for a home, funding for children’s education, and providing for special needs during retirement are all liquidity concerns.
The reason liquidity constraints are important to consider is that, depending on liquidity, certain assets may generate only a portion of their fair value if they must be sold quickly. Special attention must be paid to an asset’s ability to be turned into cash without significant impact on portfolio value or asset allocation.
Time horizon constraints
Time horizon constraints are associated with the time horizon(s) over which a portfolio is expected to generate returns to meet specific future needs (e.g., paying for retirement or children’s college education).
Tax constraints depend on how, when, and if portfolio returns of various types are taxed. Some institutional investors (e.g. mutual funds, pension funds, and endowments) have a tax-exempt status. However, income and realized gains generated by personal portfolios are taxable and attention must be paid to the taxing environment when formulating the IPS.
Often, differential tax treatments are applied to investment income and capital gains, which may be taxed at a lower rate. On the other hand, returns on certain types of retirement accounts are tax deferred until withdrawals are made.
Legal and regulatory factors
Legal and regulatory factors are externally generated constraints that typically only affect institutional investors. These constraints are usually associated with specifying which investment classes are not allowed or dictating any limitations placed on allocations to particular investment classes. Trust portfolios for individual investors may also be subject to substantial legal and regulatory oversight, which must be considered when establishing the IPS. Otherwise, this constraint does not usually affect individual investors.
Unique circumstances are internally generated and represent special concerns of the investor. University endowments and philanthropic organizations, for example, might not allow investments in companies selling tobacco, alcohol, or defense products.
Individuals might wish to have their portfolios fund specific activities or they might be unfamiliar or inexperienced with certain investments. These, as well as any special investor circumstances restricting investment activities must be considered in the formulation of the IPS.
We discussed five IPS investment constraints that are typically addressed in an investment policy statement (IPS).