The Investment Policy Statement

“Te Kaitiaki Tãhua Penihana Kaumatua õ Aotearoa.” —The New Zealand Super Fund, in Mãori

The final strategy Te Kaitiaki Tãhua Penihana Kaumatua õ Aotearoa follows (at least for purposes of this series of blog posts) is to create and follow religiously an investment policy statement (IPS).

The Super Fund—switching back into English—calls its IPS a “Statement of Investment Policies, Standards and Procedures,” and the behemoth is 27 pages long and refers to a series of 14 policy statements that, when aggregated with the main IPS, make the overall IPS hundreds of pages long. (The policy on risk management is itself 61 pages long.)

Which is exactly what an IPS for a family should not be. In the first place, hardly anyone in the family would understand it, and in the second place no one in the family would ever look at it.

Still, since the Fund follows its policy statement conscientiously, and has done extraordinarily well, there are probably some things we could learn from it. Some or all of the following 10 points might be lifted from the Fund’s statement and inserted in your family’s IPS (you do have an IPS, don’t you?)

1. Purpose. Most IPS’s begin by stating what the purpose of the policy statement is. Here, foreshortened, is how the Super Fund puts it: “This [IPS] establishes the framework…for the governance and investment of the [Super Fund] by providing a clear [sic] statement of the policies, standards and procedures that must be adhered to in investing the Fund.” A family IPS might add that the IPS is intended to allow any family member or advisor to read it and understand in all essential detail how the family’s capital is to be managed.

2. Review and amendment. Typically, an IPS should be reviewed at least annually and any changes must be approved via the family’s governance structure. The Super Fund, via its enabling legislation, is required to “review [its IPS] for the Fund at least annually,” and so should you.

3. Version control. The Super Fund does something quite interesting that I haven’t seen before: it keeps track of every modification the IPS has gone through. Since the first IPS was approved for the Fund in 2003, its IPS has been modified 24 times, i.e., once every 18 months. The beauty of version control is that a family can look back and see how its IPS has evolved over the years (and decades). This can be profoundly educational, as it allows the family to see how its investment strategy has evolved over time, which changes worked out and which didn’t, and so on.

Here is a an excerpt (redacted) from the Super Fund’s Version Control page:

Version 5, approved 5.2.06: Revised strategic asset allocation
Version 10, approved 5.31.08: Revised strategic asset allocation
Version 14, approved 6.23.09: Introduction of cash as an asset class
Version 15, approved 7.7.10: Revised throughout for Reference Portfolio concept

4. Governance and decision making. When a family first sells its business and becomes wealthy in a liquid sense, investment decisions are typically made by a member or members of the senior generation—the patriarch, matriarch, or both. But as the generations expand, decision making can become a serious issue. This issue is typically resolved by creating an investment committee consisting of both family members and close advisors. That committee might have final say over decisions or it might be advisory, with a family board having final say.

5. Asset classes. As noted in an earlier post, the Super Fund has decided that it will invest in seven equity markets, six fixed income markets, eight currency markets, and one real estate market and that it will do so via long-only investments, long/short investments, public equities, and private equities. Families should also decide in advance which asset classes will be included in their portfolios—including whether hedge and private equity will be in the portfolio—although of course these decisions can evolve over time.

6. Investment constraints. “Constraints” refers to such issues as how far the actual portfolio can stray from the Reference Portfolio, typically indicated by maximum and minimum allocations to each asset class. Another constraint might relate to what percentage of the portfolio can be invested with any one manager (which would presumably differ depending on the risk presented by a particular manager).

7. Performance reporting/benchmarks. Except for extremely large family offices, most families will get their performance reporting from whichever advisor they are working with. Still, the frequency of the reporting and the quality of the presentation of results are very important issues both to the decision makers on the portfolio and to other family stakeholders. Regarding benchmarks, the performance of the actual portfolio should be compared to the performance of Reference Portfolio, preferably on a risk-adjusted basis. The performance of each manager should be compared to appropriate indices.

8. Investing responsibly. If the portfolio is going to invest using Environmental, Social and Governance Investing (ESG) criteria the IPS should specify why the family believes that traditionally non-investment criteria are to be included, how ESG considerations are to be implemented, whether the ESG investments are to be measured against ESG indices or traditional indices (or both), and how the impact of the ESG investments is to be assessed.

9. Balancing risk and return. An IPS should explicitly state how much risk the family is willing to take, and that risk level will dictate the likely magnitude of the returns the family can expect to achieve. Typically, risk will be defined in terms of portfolio volatility, but most families will also want to state explicitly that they will not knowingly invest in an asset whose value could go to zero.

10. Derivatives policy. A derivative is an instrument the value of which derives from (or is linked to) some underlying asset, which might be a stock, bond, index, or an interest or exchange rate. The Super Fund is expected to use derivatives “judiciously,” and so should you. The Fund’s derivatives policy drones on for 24 pages. But most families will simply want to limit derivatives to those designed to reduce risk, rather than leverage returns. There would be exceptions for derivatives employed by specific managers.