The 5 Investment Policy Statement (IPS) Constraints
How the CFA L3 Tests the IPS Constraints
As we've previously covered, risk and return form the two core pieces of the objectives section of the IPS. They are both heavily tested on the CFA L3 exam (for more on how the entire IPS study session is tested see this post).
After risk and return come the five constraints. They are T-T-L-L-U, which stands for:
- time horizon
In this post we're going to go through each of them in turn, but you should know that time horizon and liquidity tend to be the most tested constraints.
IPS Constraint 1: Time Horizon
The implications of more time are simple: the more time you have the greater your ability to take risk, all else equal.
That should be pretty intuitive.
Defining Time horizon
Time horizon is basically defined as one's remaining years of life. For the CFA Level 3 exam you're really determining if an investor has a long, short or medium-term time horizon. Short-term is usually less than three years, 15 plus years is long term, anything in between is medium. I wouldn't expect to see medium come up, so you're really dealing with short-term or long-term.
Outside of determining the relative length of an investor's time horizon, you will also need to identify if there is more than one stage for an investor. Many time horizons are often multistage vs. single stage, where a stage is determined by a life event.
A common example would be a client that has two years until retirement. Their first stage is that short-term 2 year window. Then let's say they have want to fund their grandchild's college tuition in 7 years. The second stage would be that five year window between retirement and the college fees. Their third stage would then be the rest of retirement (it is possible to have a fourth stage for bequests that extend past one's life but I wouldn't expect the L3 exam to bring up a multigenerational time horizon).
In summary: For a given investor again be able to identify the stages, talk about the length of each stage, the main objective of each stage, justify why it's short, long term, multistage, etc, AND be able to tie that back to their ability to take risk (average, above average, below average).
IPS Constraint 2: Taxes
Okay, taxes. This isn’t the in-depth section where we're calculating relative tax values etc. The IPS tax section is pretty straightforward. If it comes up on the exam just list any special tax considerations for the client.
This can include things like income and capital gains tax rates, wealth transfer issues, or a concentrated long-term holding that has appreciated in value to the point where selling it would generate a huge capital gains tax.
Two flags have come up repeatedly on old exams. The first is the presence of significant property tax or a long-term holding. The second thing to watch out for is whether an investor has multiple accounts that have different tax treatment--so a tax-free retirement account vs. a regular account etc.
The other place that taxes matter is in the return calculation itself. You especially need to be careful to make sure that any income that is being received you net of taxes before putting into that the payment line item. Otherwise your calculation of cash inflows and outflows will be wrong.
IPS Constraint 3: Liquidity
The third constraint is liquidity. Liquidity is generally defined as cash needs for ongoing expenses and one-time outflows (it can also be used to build an emergency reserve).
The more liquidity you need, the less risk you can take.
This should make sense. If you're going to you need cash, then you can't risk that cash in the short term.
If you are asked to list out liquidity concerns, you may want to break them into three categories. Immediate ongoing needs and then other one-off expenses. Ongoing needs could consist of things like a mortgage, living expenses, emergency reserves. Common one time events could include a child's tuition, a charitable donation, or a down payment on a house.
If you are asked to provide liquidity or talk about someone's liquidity needs on the CFA L3 exam this is almost always a calculation problem. This is especially true when talking about institutional investors. So don't be confused, and do include specific numbers in your answer.
Steps to solving for liquidity
The steps to solve for liquidity involve looking at all the incoming cash flow versus the outflow/spending needs. After you net that number, taking into account any other one off inflows or outflows are happening, you can determine how much liquidity from the portfolio an investor actually needs to cover expenses.
Just a final note, if you're asked to list any liquidity considerations, an investors' home is often a significant portion of their net worth and so if you're seeing a really, really expensive house in a passage that's a sign that you might list that as a liquidity concern and also in those calculations you're not including that as an investable asset in the present value line item.
Finally, remember that the higher the liquidity requirement the lower the ability to take risk, all else equal.
IPS Constraint 4: Legal
The Legal and regulatory constraint is pretty straightforward, at least in the context of the CFA Level 3 material (especially from the individual IPS level). The purpose here is not to be a legal expert, right? You're a trained financial advisor, so you just need to be able to point out that your client might have legal needs and refer them to a lawyer.
If there are no significant legal concerns then the prudent investor rule applies. Common things that might need to be flagged as a legal constraint include: tax related issues, trust or foundation questions, and potentially significant insider stock positions. Again, legal regulatory for the individual IPS is not a big thing and it won't be tested heavily. The most obvious place for this to come up is (1) with foundations or trusts where you just mention the prudent investor rule and the relevant (UMIFA) framework and (2) as a differentiator in risk tolerance between institutional investors that have legally binding liabilities (defined benefit pension plans vs. those that do not). We'll get into that more when we cover institutional investment policy statements.
IPS Constraint 5: Unique
Okay, the last constraint is the unique bucket. This is the catch-all constraint. There's a long list of what could fall into unique. One common one is a client imposed constraint on what to invest in--so a socially responsible portfolio, a prohibition against buying firearm or tobacco stocks etc. Unique can also include assets that are held outside of a given investment portfolio. This includes things like that huge house or the Monet hanging on the wall. A third category of unique considerations consists of any bequest that they want to give or perhaps if they're completely unreasonable in terms of desired objectives that's often something that you just dump into the "Hey this is unique" bucket.
So overall unique constraints are a pretty straightforward test of your ability to look at a passage and identify things that aren't immediately obvious anywhere else.
Summary: How IPS Constraints are tested on the CFA L3 exam
So just to recap, both the objectives (risk and return) and constraints (time, taxes, legal, liquidity, and unique) are super important and highly tested on the L3 exam. You should know all of them cold, you should familiarize yourself with the format of how they show up, and you should know their relationship to an investor's ability to take risk.