How an Investment Advisor Can Craft an Investment Policy Statement

1.5 How an Investment Advisor Can Craft an Investment Policy Statement

It’s not every day that an advisor sits down to write an Investment Policy Statement (IPS). But, honestly, an IPS is like the compass on a long road trip: it points you in the right direction and helps you get to where you want to go without losing sight of your ultimate destination (and hopefully without getting lost, too). In my earliest days working with clients, I remember feeling slightly overwhelmed drafting these documents. I’d ask myself, “Am I missing something important? Does this reflect the client’s real needs?” Over time, I discovered that building a great IPS involves both the art of understanding clients’ personal ambitions and the science of aligning those ambitions with risk, constraints, and real-world markets.

Below, we’ll delve into how you, as an advisor, can systematically put the puzzle pieces together. We’ll explore core components, practical illustrations, and even a few little anecdotes on what not to do. Let’s roll up our sleeves.

Introduction

Think of an IPS as a contract between you and your client that states, “This is what we’re doing, how we’re doing it, and—most importantly—why we’re doing it.” In financial terms, it defines the guidelines for managing a portfolio, addressing everything from target asset allocation ranges, to performance goals, to risk tolerance, and more. It also establishes the “rules of engagement” that get used to measure whether the portfolio is working in line with the client’s objectives, or if it’s time to pivot.

Remember: once upon a time, Canada’s financial regulatory environment was overseen by organizations known as the Mutual Fund Dealers Association of Canada (MFDA) and the Investment Industry Regulatory Organization of Canada (IIROC). However, on January 1, 2023, those merged into the Canadian Investment Regulatory Organization (CIRO). Today, CIRO is the single self-regulatory body for investment dealers, mutual fund dealers, and marketplace integrity in Canada. CIRO encourages the use of a well-structured IPS—and, you know, so do I. A well-crafted IPS not only meets regulatory expectations but helps your client sleep better at night.

The Role of the IPS

An IPS is the foundation of the advisor-client relationship. It’s more than just an administrative to-do. I like to say it’s the anchor (or maybe the guardrails) that keep everyone from veering off track when markets get rocky or when an exciting new investment trend emerges (like some unbelievably “hot” initial public offering or a new digital asset token that’s taking the world by storm). It helps clarify:

• How the portfolio is built.
• The permissible types of investments.
• The metrics for measuring success (performance benchmarks).
• Any constraints or unique preferences your client holds.

If the client suddenly wants to pile half their portfolio into a high-risk start-up they saw on the news, the IPS is there to guide the conversation about whether that move is consistent with the originally agreed-upon plan.

Key Components

Client Profile Summary

Every journey begins by knowing who’s taking it. So, an IPS typically starts with a concise summary of your client’s background: their age, profession, family situation, net worth, and of course—risk tolerance and risk capacity. Sometimes, you’ll see an expanded section listing financial goals, like “saving for retirement in 20 years” or “funding a child’s education in 10 years.” This summary ensures that anyone glancing at the IPS can see, at a high level, who the client is and what they care about, right away.

When building the client profile summary:

• Gather essential personal details (age, employment, family structure).
• Outline financial details (annual income, total net worth, liquidity needs).
• Record risk tolerance: is the client conservative, balanced, growth-oriented, or perhaps more speculative?
• Note the investment horizon (how long the client anticipates remaining invested) and major life events that might shape future cash flow.

In my own experience, I once had a client who seemed super excited about investing in high-tech companies because he was an engineer himself and “totally got the technology.” But he was also heading to retirement in just a few years and wanted steady income. Explaining how a short time horizon and desire for stable income might conflict with high-volatility, high-tech stocks was where the IPS process came in handy. We documented it all so we didn’t forget those details six months later, even if the markets started looking extra rosy (or extra stormy).

Objectives & Constraints

Next up, you need to articulate the “what” and “why” behind the investment plan:

• Objectives: Are we aiming for capital preservation, steady income, or aggressive growth? Precisely stating these goals is crucial. Sometimes, your client might have a multi-layered objective: preserve capital for liquidity in the short term and, in the long run, grow assets for retirement.
• Constraints: This is where you lay out the specifics of time horizon, liquidity requirements (monthly or annual withdrawals?), and tax considerations (Canadian vs. U.S. citizens have different constraints, for instance).
• Keep an eye on any personal preferences, like ethical concerns, or prohibitions against certain industries (some folks absolutely want no tobacco or arms manufacturing in their portfolio).

So, if a client wants consistent monthly income to fund living expenses but also wants to plan for a future real estate purchase, that’s a constraint to highlight: a chunk of the portfolio must remain easily accessible. This can shape whether you position them heavily into short-term Government of Canada bonds or perhaps keep a portion in well-managed money-market instruments.

Asset Allocation Guidelines

Asset allocation determines how the portfolio is split among different classes—equities, fixed income, real estate, cash, alternatives, and so on. By establishing minimum and maximum exposure levels, you ensure the portfolio remains balanced with the client’s risk threshold. For instance, you might set:

• Equities: 40–60%
• Fixed Income: 30–50%
• Alternatives & Real Assets: up to 15%
• Cash: 0–10%

These ranges map back to the client’s goals, risk tolerance, and time horizon. If the equity component drops below 40% because markets slid, you might rebalance to stay within the minimum. Or if equities shoot up to 65% and breach the upper limit, you’ll have a conversation about trimming equity exposures to maintain discipline.

By the way, let’s look at a quick visual overview of how the IPS creation process flows (including the asset allocation step). Sometimes seeing a simple diagram is easier than reading a wall of text:

    flowchart LR
	    A["Gather <br/>Client Information"] --> B["Identify <br/>Objectives & Constraints"]
	    B --> C["Define <br/>Asset Allocation"]
	    C --> D["Draft <br/>IPS"]
	    D --> E["Review & <br/>Revise as Needed"]

This flow helps you imagine the steps from that initial client conversation to finalizing the statement.

Permitted & Prohibited Investments

We all have that moment: the client calls and says, “Hey, my neighbor told me about these new penny stocks. I want in!” or “I heard about short-selling, can we do that?” This is where the IPS spells out exactly what’s allowed, what’s discouraged, and what’s outright off the table. Some key examples:

• Permitted: Canadian or U.S. equities, high-quality bonds, certain index funds, select alternative strategies, etc.
• Prohibited: Possibly short-selling, options (if the client is risk-averse), or restricted industries (e.g., no tobacco, cannabis, or gambling).

It’s perfectly okay if the client allows you a broad universe of permissible investments—just make sure it’s recorded. The last thing you want is a misunderstanding over whether an ultra-high-risk derivative strategy was “agreed upon.”

Performance Benchmarks

With the IPS, you’re basically promoting accountability (or at least I hope you are). You want to establish how success will be measured. That’s where performance benchmarks come in. Common benchmarks might include:

• S&P/TSX Composite Index for Canadian equities.
• S&P 500 for U.S. equities.
• FTSE Canada Universe Bond Index for fixed-income holdings.
• Customized or blended benchmarks if your allocation spans multiple sectors.

Benchmarks should closely resemble the underlying risk/return profile of the assets in the portfolio. If the portfolio is 60% equities and 40% bonds, a 60/40 composite of, say, the S&P 500 (or S&P/TSX) and FTSE Canada Universe Bond Index could be used to gauge performance. Some advisors use more granular benchmarks, blending small- and large-cap or global exposures. The key is to choose something relevant and fair.

Review and Revision Schedule

An IPS is not a “set-it-and-forget-it” document; it’s a living piece of guidance. It should be revisited at least annually—sometimes more frequently if there are material changes in the client’s life or shifts in the market that significantly impact portfolio objectives.

A typical revision schedule might say: “The IPS will be reviewed every 12 months or sooner if there is a major life event (birth, death, marriage, job change, retirement) or if the portfolio experiences an unusually large fluctuation in value.” The goal is to keep it up to date with whatever new circumstances come your client’s way.

Practical Approach and Examples

To illustrate each point, let’s run through a short hypothetical. Suppose you have a client, Sarah, a 45-year-old marketing executive:

• Profile & Risk: She’s got a moderate risk profile, a 15-year horizon to retirement, and a fairly robust annual bonus (though it’s inconsistent).
• Objectives & Constraints: She wants balanced growth plus some liquidity for a second home purchase in about five years.
• Asset Allocation Guidelines: 50% in equities, 40% in fixed income, 10% in alternatives, with a permitted range of ±5% for equities and fixed income.
• Permitted and Prohibited Investments: Allowed: Canadian and U.S. equities, high credit-quality bonds, REITs for real estate exposure. Prohibited: leveraged derivatives, short-selling, micro-cap stocks.
• Performance Benchmarks: 50% S&P/TSX Composite and 50% FTSE Canada Universe Bond Index.
• Review: Semiannual check-ins with an annual in-depth portfolio analysis, plus ad-hoc if there’s a major life change (like a job transition).

This example clarifies for both Sarah and you, her advisor, exactly how the portfolio will be managed and measured. If next month she says, “I’d like to invest in a hedge fund that does 300% leverage,” you’d respectfully remind her of the “prohibited investments” section and have a discussion about whether updating the IPS might or might not be in her best interest.

Pitfalls to Avoid

Crafting the IPS can be surprisingly tricky—especially if you don’t keep a few specific pitfalls in mind:

• Using overly vague language. You want clarity, like exact ranges for assets. “Invest mostly in equities with some bonds” is too ambiguous.
• Ignoring client psychology. Just because a client says they want “high risk” doesn’t mean they have the emotional fortitude to handle a big drawdown. The IPS must reflect genuine tolerance, not idealized illusions.
• Failing to update. People’s lives and markets change. If you keep the same old dusty IPS from five years ago, it may no longer reflect your client’s best interests.
• Overcomplicating. I recall a brand-new advisor who created a 30-page IPS that read like a PhD dissertation on advanced derivatives. The client was totally confused. Keep it comprehensive but readable.

Glossary

Benchmark
A standard—often in the form of a market index—used to measure a portfolio’s performance. Examples: S&P 500, S&P/TSX Composite Index, FTSE Canada Universe Bond Index.

Minimum/Maximum Allocations
The lower or upper thresholds for portfolio allocations in a given asset class. If the equity portion falls below the minimum or goes above the maximum, it’s time to rebalance the portfolio or at least have a conversation.

Prohibited Investments
Those securities or strategies that the client and advisor have agreed not to pursue—whether for ethical, personal, or regulatory reasons. Examples: short-selling, penny stocks, certain derivatives.

Additional References

Because the financial world never sits still, you’ll want to keep an eye on resources that help you stay consistent with the latest industry standards and regulatory guidelines:

• CIRO (https://www.ciro.ca): Canada’s single self-regulatory organization for investment dealers, mutual fund dealers, and marketplaces. Check for guidelines and bulletins on best practices for disclosures and documentation.
• CIPF (https://www.cipf.ca): The Canadian Investor Protection Fund is the sole protection fund as of 2023, offering coverage if a member firm fails.
• Standards of Practice Handbook, CFA Institute: Includes sections on professional integrity in drafting IPS documents.
• Microsoft Word and Excel Templates: Helpful skeleton structures for IPS creation. Plenty of free templates exist online.
• Robo-Advisor Platforms: Many have integrated IPS generation wizards that produce basic draft statements for client review.
• Sample IPS Frameworks: Leading Canadian financial institutions often provide free glimpses of sample policy statements and recommended benchmarks.

A few interesting books and courses:

• “The Handbook of Portfolio Mathematics” by Ralph Vince (for those who want to get more into risk management).
• “Winning the Loser’s Game” by Charles D. Ellis (a classic on long-term investment approaches).
• Various online courses offered by the CFA Institute and major Canadian universities on portfolio management.

At the end of the day, you’ll find that a well-crafted IPS is a powerful tool—a blueprint that ensures your client relationship is built on clarity, trust, and discipline. There’s nothing more satisfying than looking back at a well-written IPS months or years later and realizing it’s still capturing the essence of your client’s goals (and hopefully still guiding them toward better outcomes).

Test Your Knowledge: Crafting an Effective IPS