No Surprise - CFA L3 IPS Exam Questions Follow a Typical Format
The IPS gets tested in essentially the same way every year, so year in and year out. It's a codified process. You're going to know what to expect. That's not to say CFA L3 IPS problems are easy, but it does mean you can prepare extremely well. In this post we'll cover what an IPS is, how to create one, how it relates to the entire Level 3 curriculum, and most importantly, how EXACTLY it has been tested for 10+ years.
What is an Investment Policy Statement?
The IPS is a living document that defines the client/advisor relationship and sets clear objectives and constraints on the portfolio in order to develop a strategic asset allocation (SAA) that is unique to each investor. The goal of an IPS is to understand the investor's life situation, their behavioral profile, their assets, etc. and then develop an asset allocation plan that takes into account their objectives and their constraints as well as capital market expectations and then builds upon that so that the advisor and the client have a really clear understanding of what they're doing and how.
The IPS is the foundational document that sets the groundwork for working with clients (and since Level 3 is about a portfolio manager perspective that means it's pretty important).
The 7 Steps of Creating an IPS
The construction of an IPS itself has seven major steps.
You start by determining the investor's objectives and this has two parts: The return requirements and understanding the risk tolerance. For our purposes this is an identification game, where we decide if an investor is above, below or average in terms of their ability and willingness to take risks. A
Once we've determined their objectives, then we look at their constraints.
What assets are they bringing to the table? Do they have liquidity needs like a mortgage or pay for their kids' college, etc.? Are they young? Do they have a long investment time horizon or not? And then any unique considerations that they're facing etc. taxes, of course, always important as well.
The objectives and constraints really form the heart of how the individual policy statement is tested on the CFA Level 3 morning constructed-response section (see our post on calculating required return). We unpack these constraints in great detail in other posts, but for now there's an acronym here to know them. It's R-R-T-T-L-L-U.
Once you've determined their objectives and identified their constraints then you're actually going to start translating that into what an appropriate asset allocation plan might look like. In other words, you're forming the investment strategy that falls in line with those objectives and constraints and is realistic given the market.
From there you're actually carrying out the plan and then over time evaluating the performance. One caveat on performance evaluation: this is the performance of the portfolio certainly but it's also useful/suggested that you revisit the IPS itself. Again, it's a living breathing document. The guideline for reviewing says annually or if the client or investor has any major changes to their life situation.
Why the IPS is So Important to the CFA Level 3 Exam
The sections of the IPS really form the outline of the Level 3 curriculum and that should make sense right? Level 3 is all about portfolio management, being an investment advisor, and the real-world application of all this theoretical knowledge that we've been learning over the last two levels.
The IPS defines Level 3 because it defines portfolio management process and the outline of the readings follows this (we explore this in more depth here). Knowing this basic framework is helpful as you read the curriculum because it lets you sort of tie it together back into this document.
It's also a clear sign that this is going to be tested extensively.
How CFA L3 Tests the IPS
Let's talk about how the investment policy statement is actually going to be tested.
In practice, it's going to be a major standalone problem in the morning section. It'll be heavily weighted at least 20 points, at 20 minutes of your time with 360 points for the exam, that's significant, right?
And it's not going to really be about rote memorization of anything. You're certainly not going to be regurgitating the 7 steps of the IPS. What you're going to need to do though is read this long passage and look at and solve for clients' expected return. You're also going to look at their unique situation and identify their risk tolerance both ability and willingness. And then you're going to look through and identify any constraints that they're facing based on the details of that passage and one thing to take away right, is that this is a codified process, so you're going to have a long passage.
You're going to have to solve for an investor's required return. You're going to have to talk about their risk tolerance--is it above average, average, or below average. Why? We dive into how to identify that in this post.
You probably going to have something in there about their constraints.
Again, if you look back at all these past CFA morning exams that have been released, you'll see that these IPS questions are fairly consistent. Always a little different of course, but there shouldn't be too many surprises if you really spend your time preparing and going through these practice problems (and that's one of the things we do in our custom course for Level 3 candidates with grading and feedback etc.) However you approach it, there's no excuse for coming in unprepared.
Types of IPS Questions for the morning exam
There's really a few different types of questions that are asked within these passages.
Starting from the top...
First is situational profiling which is really looking at the person's life circumstances and thinking about their risk and ability to take a risk.
Second is determining if they have any behavioral biases that are at play here. This should make sense as the IPS is tying together a lot of material we just covered in the last three behavioral finance readings and actually translating knowledge of an individual investor into an actionable asset allocation plan for them. We might actually have to classify investors into a type, so this is building on the Barnwell, Pompeii and BB&K models of the Reading 7 within the CFA L3 curriculum.
And then there is I call the advanced stuff.
One is the calculations and statements of their risk and their return, another is really diving deep into the constraints and pulling out the details that justify what those constraints are and then last but not the least it's based on all these details you might actually have to pick a suitable portfolio from basically a table of portfolios for the investor (somewhat related to corner portfolios).
Hopefully this has served as a high level overvew of how the CFA L3 exam introduces the IPS and how it frames exam problems around the material. If you sign up for our free newsletter we'll send you much more in-depth material including the 35 slides on how to attack individual IPS problems.