How the Individual IPS Gets Tested on CFA Level 3

The Individual Policy Statement, or IPS, is a document that identifies the needs, goals, and risk tolerance of an investor as well as any constraints under which the portfolio must operate. It's a vital document. In fact our first goal as portfolio managers is to build an investment policy statement along with our clients in order to clarify their financial goals, set expectations, and provide a framework for our future interactions with them.

Basically, the end goal as an investment manager is to build an IPS that is consistent with a client’s beliefs, attitude, and life stage.

How the IPS Fits into the Exam

We wrote an entire blog post about How the CFA Level 3 Exam IS the IPS StatementTo summarize:

You can think of the IPS as the document/plan unifying traditional finance’s prescriptive approach to asset allocation with the fact that an investor has individual quirks and unique situations that we need to account for as a portfolio manager (i.e. its a logical progression from the behavioral finance sections that precede it).

Once we've specified those conditions we can then determine a strategic asset allocation (SAA) that meets an investor's required return while staying within the risk and constraint parameters of a given investor. Conveniently, the particulars of how to pick those assets and benchmark our performance is what the bulk of the subsequent Level 3 curriculum readings cover.

How Level 3 Tests the Individual Policy Statement

In practice, the L3 exam wil test your understanding of the individual IPS with a major stand-alone question in the morning section of the exam (usually the first problem, accounting for 18+ points). Rather than knowing the steps or constraints by rote you will be asked to:

  • Solve for a client’s expected return
  • Identify their ability and/or willingness to take risk (on a scale from low to very high)
  • Pick out their key constraints from a long passage 

While the original CFA Institute readings present the IPS in the context of a long, choppy case study the best way to really see how this material is tested is via the practice problems found in the morning CFAI practice exams.

Each exam has at least 1 lengthy problem on managing an individual’s portfolio. If you do 8-9 of them in preparation you are virtually guaranteed to do well on this pivotal and often feared morning section (and hopefully get faster at it too).

It is shocking how many Candidates wait until the last month to look at past morning exams. Don’t make this rookie mistake.

So what does the IPS document consist of?

The Formal IPS Process

  1. Determine the Investor’s Objectives
    1. Return Requirements (return objective, and required return to meet those objectives)
    2. Risk Tolerance
  2. Determine the Investor’s Constraints
    1. Time Horizon
    2. Taxes
    3. Liquidity needs
    4. Legal/Regulatory
    5. Unique considerations
  3. ID the appropriate investment strategy (SAA)
    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 (i.e. is realistic)
  4. Carry out the Asset Allocation process
  5. Execute portfolio trades
  6. Evaluate portfolio performance at regular intervals
  7. Rebalance the portfolio as needed

For the morning exam question this boils back down to understanding RR-TTLLU.

Risk, Return and the five constraints -- Time, taxes, liquidity, legal, and unique.