Investment Management & Concepts
Investment Policy Statement
An Investment Policy Statement (IPS) defines the investment goals and objectives of a family. It is a financial roadmap drawn in collaboration with a financial advisor.
An IPS forms the basis for a family’s portfolio construction by describing the strategies to be employed, and processes to measure their outcome.
Following is the outline of an IPS and the areas it should cover. Financial terms, such as asset allocation, risk and benchmarking, are explained in the next section of the handbook. The section also provides you thumb rules for drafting your family office’s IPS.
IPS and Governance
- Identification of investor type (individual or entity)
- Quantification of wealth under management
- Assignment of responsibilities towards different functions
Investment Function:
- Identifying key personnel involved in decision making process
- Outlining their responsibilities
- Laying out the organization structure.
Monitoring and Reporting Function:
- Identifying personnel involved in monitoring and reporting process
- Outlining periodicity of reporting.
- Review of IPS
Creation of process to review the IPS
Determination of periodicity of review.
- Asset allocation and external investment manager/advisor selection
- Establishment of asset allocation process and its alignment with financial objectives
- Devising criteria for selection and firing of external investment managers/advisors.
- Investment, Return and Risk
- Risk assessment
- Clear definition and documentation of risk tolerance
- Specification of risk criteria for sub-assets within the asset allocation, along with overall risk tolerance levels.
- Investment goals capture
- Statement of investment performance objectives in alignment with risk assessment
- Mapping them with funding needs
- Determination of spending assumptions
- Forecast of liquidity requirements based on short-, medium-, long-term needs
- Establishment of geographies in which assets will be invested and projecting currency requirements.
- Benchmark selection and review
- Selection of custom benchmark as per asset allocation criteria
- Selection may be made for sub-asset classes as well
- Review of selected benchmark to ensure suitability and cohesion with IPS.
- Performance evaluation and reporting
- Setting of evaluation horizon for investment performance review
- Determination of personnel involved in review process
- Outlining investment performance calculation criteria to ensure uniformity in performance calculation. This will enable harmonious interpretation and decision making among all stakeholders
- Designing the formats of reporting
- Self-reporting may be supplemented with independent third-party reporting to ensure transparency.
- Carrying out periodic portfolio rebalancing (explained later) to realign investments with the IPS
- Constraints
Identification and statement of constraints. These may be related to:
- Investment criteria (unwillingness to invest in certain assets)
- Legal limitations (cap on stock holding mandated by law)
- Tax considerations (tax on income that may render the investment uneconomical).
Appendix 8 contains the specimen of a commonly used Investment Policy Statement.
Investment Concepts
This section apprises family principals and family office professionals of basic investment terms and portfolio management techniques. This knowledge will help you manage your wealth better and engage in informed conversations with financial advisors.
“The only thing that money gives you is the freedom of not having to worry about money.” — Johnny Carson, American television host
The aim of investment is to sustain and grow wealth. This allows families to maintain their lifestyles with financial security, even post-retirement. Your investment returns will assure you of this freedom only if they beat inflation.
Inflation
Inflation affects financial planning monumentally. Despite saving and investing money diligently, the actual value of wealth is diluted by rising prices. Inflation cuts into returns, and, in some cases, even induces negative growth.
The effects of inflation and taxes mean real returns are far less than nominal returns:
Wealth management fails unless the post-tax returns come out higher than the inflation.
Fixed income asset classes provide liquidity for investment and generate stable income and cash flows. But, depending on a country’s nominal inflation rate, they rarely outrun inflation. Only certain asset classes, such as equity, have consistently proven this capability.
The following is an illustrative list of various asset classes. Knowledge of different investment avenues and their returns allows families and their family office professionals to oversee their investment portfolio.
Liquid assets are those which can be readily converted to cash. Whereas illiquid assets do not have regular buyers and sellers.
| Assets | Liquid | Publicly-Listed Equities | |
| Mutual Funds | Equity Mutual Funds | ||
| Debt Mutual Funds | |||
| Hybrid Mutual Funds | |||
| Exchange Traded Funds | |||
| Funds of Funds | |||
| Other Equity Investment Vehicles | Portfolio Management Schemes / Separately Managed Accounts | ||
| Alternative Investment Funds | |||
| Fixed Income Instruments | Corporate Bonds | ||
| Government Bonds | |||
| Fixed Deposits | |||
| Illiquid | Real Estate | ||
| Alternative Investments | Private Equity | ||
| Venture Capital | |||
| Hedge Funds | |||
| Commodities | |||
| Gold | |||
| Art/Antiques | |||
Wealth Trinity – Risk, Return and Time
This section will enable families and their family office professionals to gauge their risk tolerance, and measure returns from diverse investments. This will, in turn, help you draft an effective Investment Policy Statement.
Risk
Risk is the uncertainty in an expected outcome; it is also the possibility of losing some or all of your original investment. Rewards of an investment are tied to the risk associated with it. Higher risk justifies, but does not guarantee, higher returns.
Taking no risk at all does not give the returns required to sustain and grow wealth. Assuming too much risk threatens basic financial security.
The key is to take on calculated risks that promise returns with some degree of certainty. Informed risk-taking is distinct from an outright gamble.
Different kinds of risks, ways of measuring them, and methods for managing risk are:
I Standard deviation (δ)
Standard deviation is an estimation of the expected volatility in an investment’s returns. Volatility is the fluctuation in the returns from an asset over a given period of time.
Two stocks may give the same one-year return of 20%. But, if over those 12 months, returns from one stock rose and fell significantly, with those from the other staying more or less consistent, then the former is riskier than the latter.
Standard deviation measures how the returns from an investment vary with respect to its average returns during a given period. So, if a fund gives an average of 8% yearly returns with a standard deviation of 4%, you can expect returns to vary between 4% and 12%.
II Beta (β)
Beta measures the behavior of a stock with respect to the market as a whole. The market is represented by a leading stock market index, the beta of which is always 1.
| Beta of Security | Relationship with Market |
| =1 | Security’s risk is the same as overall market risk |
| <1 | Security is less volatile than the market |
| >1 | Security is more volatile than the market |
The higher the beta, the higher the risk. If a stock’s beta is 1.2, it is theoretically 20% more volatile than the market.
III Alpha (α)
Alpha measures the performance of a security on a risk-adjusted basis. It is the excess return of a security over its benchmark. If the market index returns 15% annually over a two-year period, and the investment generates 17% over the same period, the Alpha over the market index is 2% per year.
Risk tolerance differs from person to person and is tied to one’s income, lifestyle, goals and approach in life. This includes the ability to bear notional mark-to-market losses (temporary fluctuations in value) as well as real losses (a company in which you hold shares going defunct).
If you can identify and measure risk with different metrics, you can manage it.
Return
Akin to assessing risk, correctly measuring returns is also important.
Returns can be measured in various ways. Following are some basic return metrics:
I Absolute Return
Absolute return is an investment’s returns without accounting for the duration of investment.
| Investment Amount | Value After 6 Months | Absolute Return |
| USD 100 | USD 120 | USD 20 or 20% |
II Annualized Return
Annualized return is the absolute return adjusted for 12 months.
| Investment Amount | Value after 6 Months | Absolute Return | Annualized Return |
| USD 100 | USD 120 | USD 20 or 20% | 40% |
III Compounded Annual Growth Rate (CAGR)
CAGR is the measure of an investment’s annual growth rate over time, with the effect of compounding taken into account.
| Year | Investment Amount | Year-end Value @ 35.72%* |
| 1 | USD 100.00 | USD 135.72 |
| 2 | USD 135.72 | USD 184.20 |
| 3 | USD 184.2 | USD 250.00 |
35.72%* is the CAGR — a constant rate of growth — at which USD 100 would become USD 250 at the end of three years.
Wealthy families have complex portfolios spread across multiple asset classes and countries. Return metrics relevant to your investment holding are the following:
I Time Weighted Return (TWR)
TWR measures a fund’s compounded rate of growth over a specific time period. It does not consider the effects of cash inflows and outflows on the growth rate.
II Internal Rate of Return (IRR)
IRR measures the annualized implied discount rate calculated from a series of cash flows. It equates the cost of an investment with the present value of cash generated by that investment. Hence, unlike TWR, it factors in the timing and quantum of cash flows.
Where there are no intermediate cash flows in the life of an investment, TWR and IRR are the same. Here is an illustration:
A] With Cash Flows
| Return Type | IRR | TWR | |||
| Year | A
Portfolio Value at the beginning of the year |
B
Cash flows |
C
Absolute Gain |
D
Portfolio Value at the end of the year* |
Annual Return** |
| 2020 | — | + USD 1,000
(initial investment) |
— | USD 1,000 | — |
| 2021 | USD 1,000 | — | USD 100 | USD 1,100 | 10% |
| 2022 | USD 1,100 | – USD 650
(sales proceeds) |
USD 440 | USD 890 | 40% |
| 2023 | USD 890 | — | USD 445 | USD 1,335 | 50% |
| Total Gain = 100 + 440 + 445 = 985
IRR = 29.61% |
TWR = 32.19% | ||||
*Value at year end = A + B + C
**Return calculated on A to give C
B] Without Cash Flows
| Return Type | IRR | TWR | |||
| Year | A
Portfolio Value at the beginning of the year |
B
Cash flows |
C
Absolute Gain |
D
Portfolio Value at the end of the year* |
Annual Return** |
| 2020 | — | – USD 1,000
(initial investment) |
— | USD 1,000 | — |
| 2021 | USD 1,000 | — | USD 100 | USD 1,100 | 10% |
| 2022 | USD 1,100 | — | USD 440 | USD 1,540 | 40% |
| 2023 | USD 1,540 | — | USD 770 | USD 2,310 | 50% |
| Total Gain = 100 + 440 + 770 = 1310
IRR = 32.19% |
TWR = 32.19% | ||||
*Value at year end = A + B + C
**Return calculated on A to give C
The TWR remains unaffected by the timing of cash flows. This is because it measures returns from the beginning to the end as if there were no cash flows. It considers only the absolute annual return. Hence, in both the illustrations above, the TWR was the same.
The purpose and way to use these metrics is given in the portfolio review section.
Time
Often overlooked, time is the most crucial factor when it comes to optimizing the returns from investment, and forecasting cash flows.
Optimizing Returns
Time in the market (the amount of time for which an investment is held) is much more important than timing in the market (the time at which you buy or sell an investment).
The longer you hold an investment, the lower the probability of a negative return. The caveat is that the investment should be fundamentally sound.
Historically, some of the worst short-term market losses have given way to substantial market recovery. It is essential to not panic and sell holdings during a volatile period.
Forecasting Cash Flows
Before making an investment, determine the time horizon i.e. the number of years before you start using your returns. This prevents the need to sell investments at less than optimum prices, or at a loss, to fulfill liquidity needs.
Divide the time horizon into:
- Short-term time horizon (Less than 2 years to invest): Low risk investments, such as fixed income instruments
- Medium-term time horizon (3 to 5 years to invest): A mix of equities and fixed income based on your risk appetite
- Long-term time horizon (More than 5 years): Considerably higher proportion of equities.
The earlier you start investing, the greater the odds of generating more wealth.
Asset Allocation, Portfolio Rebalancing and Portfolio Review
This section gives guidance on determining asset allocation strategies. It then cites metrics to periodically review overall portfolio and individual asset class performances through benchmarking. This will further enable families to evaluate financial advisors’ output.
Asset Allocation
“90% of your portfolio’s risk-adjusted return is connected to your asset allocation” – Findings of a landmark research paper by Brinson, Hood and Beebower, published in 1986
Investments are multi-layered instruments with varying degrees of risks and returns. It is up to families to find the right combination for themselves as per their financial objectives and risk appetite. This includes considering future cash flow requirements.
Determining the asset allocation is more important than the individual investments to be bought. Asset allocation is putting money in a well-thought-out mix that can ride out market volatilities and steadily grow wealth in the long run.
A good mix of assets consists of uncorrelated investments. To have a combination of uncorrelated investments is to possess a well-diversified portfolio. This means not putting all eggs in one basket.
Correlation is the degree to which two securities move in relation to each other. Correlated assets are tied to the same market risks, say, direct equity stock and equity mutual funds. They will rise and fall at the same time and in the same proportion.
Since different investment categories are affected by different types of market conditions, diversifying the portfolio decreases the risk from fluctuations in market returns. Thus diversification protects against losses. If one asset loses value, the others make up for the loss. And, in aggregate, all of them appreciate and beat inflation in the long term.
Diversification helps to balance risk and return.
Portfolio Rebalancing
Rebalancing a portfolio is to bring it back to the original asset allocation proportion. Some investments end up growing faster than others. Over time, this gap in growth rates misaligns the investments from the family’s financial goals.
For example, a boom in the equity market might change your original asset allocation of 70% equity and 30% fixed income to 90% and 10% respectively.
| Year | Equity Investment | Fixed Income Investment | Portfolio Value | Equity Investment Allocation | Fixed Income Investment Allocation |
| 1 | USD 70 | USD 30 | USD 100 | 70% | 30% |
| 2 | USD 135 | USD 15 | USD 150 | 90% | 10% |
This means the risk profile of your portfolio has increased. It is beyond the risk tolerance set during the original asset allocation.
You should now either sell some of your equity investments or buy more of the under-weighted fixed income categories, to restore the asset allocation balance.
By rebalancing your portfolio in this manner, you will be adhering to Warren Buffet’s mantra by default – ‘sell high, buy low’.
Portfolio Review
A quarterly review of the holdings is equally important. This applies even to long-term investments. Investments lagging in performance should be replaced with a suitable alternative to earn the best possible returns. The power of compounding means even a 0.1% lesser return can result in a massive lost financial opportunity.
The investment portfolio should be reviewed by benchmarking the returns against those available in the public and private marketplace. This is done using either TWR% or IRR%.
These two metrics should not be compared for the same investment. Their purpose and usage differs from investment to investment.
- Time Weighted Return% (TWR):
- Also called the ‘portfolio manager’s way’ of calculating return
- Is used to calculate performance of assets where the family has little control over cash flows (say dividend re-investing mutual funds)
- Can be used to measure return only from frequently traded assets like public stocks. The returns so calculated are compared with appropriate benchmark indices
- Helps to evaluate a portfolio manager’s performance.
- Internal Rate of Return% (IRR):
- Also called the ‘investor’s way’ of calculating return
- Is used to calculate performance of private investments where there is control over cash flows (say direct investment by the family in private equity)
- Can be used for assets that are not frequently traded like real estate. Such assets do not have readily available and real-time market information for benchmarking
- Helps to evaluate the overall portfolio performance.
This is why you need to deploy best practices in creating a responsive and flexible investment grouping while setting up your family investment entities in the performance reporting and general ledger platform.
The investment position grouping, which is distinct from the COA, should enable the family separate their private and public investments. Consolidated groupings where TWR and IRR are presented against the same line items may produce misleading results.
Analyzing the portfolio as a whole gives us a general picture of the overall investments.
Asset performance of individual classes, too, needs to be measured using applicable metrics. For example, private equity is a long-term investment. Its full return potential may not be realized until the end of the investment life. Interim performance is measured using the following ratios:
- Capital Account Value (CAV):
Measures the current value of the investment.
- Distributed Value to Paid-In (DV/PI):
Measures how much of the invested capital is recovered as cash flow till date. A ratio less than 1 means the investment has not returned the capital yet. A ratio greater than 1 means the investment has generated more cash back than the invested amount.
- Total Value to Paid-In (TV/PI):
Measures the total return from cash flows generated as well as the amount still invested in the fund.
Harness Technology
Designing an accounting system integrated with liquid and illiquid investment performance tracking ability can be a daunting task. Even if a family manages to combine these functions by putting manual processes in place and using a tool like Excel, their results are sub-optimal at best. It is also difficult to access information that enables performance measurement by benchmarking with the larger market. Harnessing technology simplifies these activities for families.
The ideal software platform, replete with a document vault, marries a general ledger, applicable accounting standards and investment management and real time market updates. This allows the investors to identify market trends affecting their portfolio and project cash flows so that they can have a better handle on underlying risk and exposure.
Asset Vantage, one of the leading family office software solutions, possesses all of these capabilities. Appendix 9 illustrates a host of its detailed and nuanced investment reporting and accounting prowess.
Key Takeaways
- Your Investment Policy Statement (IPS) is the roadmap to your financial goals and well-being
- Your post-tax returns must be higher than inflation for true financial growth
- Return measurement criteria varies as per asset and purpose. Understand those criteria to accurately measure your portfolio performance
- 90% of your portfolio’s risk-adjusted return is connected to your asset allocation. A good mix of uncorrelated investments can survive market volatilities and steadily grow wealth in the long run
- Periodically rebalance your portfolio to realign it with the IPS.
