The CFA L3 Exam IS the Investment Policy Statement

The CFA L3 Exam IS the Investment Policy Statement

IPS questions for both individual investors and institutional investors are GUARANTEED to be on the CFA Exam. Together they may make up to 10-15% of the overall points. But this post is NOT about tackling the IPS questions themselves (for more on that see this post).

Instead what we're talking about here is how the actual literal framework of an investment policy statement informs the Level 3 curriculum and the structure of the exam itself. This should make some sense. After all, Level 3 is all about what you need to know as a portfolio manager managing other people's money, and the IPS is the living, breathing document that captures this process.

Ultimately, if you go through each step of building and executing an IPS you will touch on all of the concepts in the entire L3 curriculum.

The Actual Formal IPS Process

Determine the Investor’s Objectives

1. Return Requirements
2. Risk Tolerance

Determine the Investor’s Constraints

1. Time Horizon
2. Taxes
3. Liquidity needs
4. Legal/Regulatory
5. Unique considerations

ID the appropriate investment strategy

1. Must meet the investor’s objectives
2. Must fall within the investor’s constraints
3. Is appropriate given the manager’s capital market expectations (is realistic)

• Carry out the Asset Allocation process
• Execute portfolio trades
• Evaluate portfolio performance at regular intervals
• Rebalance the portfolio as needed

Relating the IPS to the L3 Curriculum

Completing each step of the IPS requires an understanding of some facet of asset management--whether understanding a client's circumstances and mental frameworks, thinking about asset allocation and correlation across assets, or finding investments, executing trades, and monitoring performance. Given that, let's spend some time linking each IPS step to the L3 curriculum itself.

1. Determine the Investor's Objectives

Clearly this requires an understanding of the client's assets, their needs, and the general return profile of different investments. This includes the behavioral finance and individual/institutional wealth management readings . This is also where you will revisit TVM calculations and the underlying asset, cash flow, and return considerations that entails.

Together with Step 2, the IPS risk/return section is all about combining a client's real world realities with the more traditional financial knowledge we've build in L1 and L2.

2. Constraints

These are mostly straightforward, however, the unique bucket also ties into behavioral finance.

IDing the Appropriate Investment Strategy

This involves strategic asset allocation (using capital market expectations and core concepts regarding asset allocation, risk management, understanding fixed income/equity portfolio management, and thinking about alternatives and derivatives for modifying portfolio exposures and hedging risk.

4. Carrying out the Asset Allocation Process

OK, so this one is mostly contained in other steps...

5. Execute Portfolio Trades

Concepts involving market structure (liquidity, international investing), trading costs, and currency are featured here.

6. Evaluate Portfolio Performance at Regular Intervals

You guessed it--this ties to monitoring and rebalancing which includes benchmarking (IDing appropriate benchmarks, calculating risk relative to the benchmark) and evaluating individual manager performance

7. Rebalance the portfolio as needed

Asset allocation and the application of risk management techniques using derivatives are key as is Tactical Asset Allocation.

The steps of the IPS = The Keys of the CFA L3 curriculum. It's what lets you zoom in and out of the curriculum so you can put the micro aspects of what you're learning into the macro exam picture. Happy Studying!