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- Dealings With Qualified Clients and Accredited Investors Depending upon an RIAs business model and investment strategies, it may be important to identify “qualified clients” and “accredited investors.” The Dodd-Frank Act authorized the SEC to change which clients are defined by those terms.
I am currently involved with managing a very large endowment. For its first three years, we worked vigorously to develop an investment policy statement (IPS). Our challenge in the beginning was developing a formal process of working with an outside investment advisor and developing the periodic procedures of reviewing, monitoring, and following our IPS. Once we accomplished that, our confidence improved, our portfolio performance was better, and we understood the risks and rewards inherent in our portfolio. Most of all, we made more intelligent decisions based on objective standards. Getting there was not easy, but the process was very instructive.
Looking back, this exercise was the best thing that could have happened. The board has always been composed of individuals with a great deal of experience in the investment business, all with strong opinions honed over many years. Can you imagine a bunch of investment people all trying to manage a large pool of money without a formal policy or process to follow? We tried to be objective, but our biases came through every time. Normally, the stronger committee members got their way by wearing everyone else down. One of the members was a very outspoken individual who was pro-indexing. We had another strong member who was anti-indexing; the conflict was terrible. First the pro-index guy would win, and then the anti-index guy would jump in and win a round. We had one member with a strong bias against real estate, so there was pressure on us to get out of that asset class and we complied. Guess when? At the absolute bottom! Of course, real estate has doubled since we moved out.
Before we adopted our IPS, it seemed like we were always out of sync in our decision-making process. Even though we had retained an outside investment advisor, we were unable to suppress our biases and emotions. After all, we were experienced professionals. It wasn't until we began to listen to our outside advisor and follow the IPS religiously that everything shifted for the better. Our advisor helped us develop tight investment policy guidelines and provided information about what we needed to do. After a few months, our investment results began to improve. But even more important, our confidence skyrocketed. Because of the combination of the outside investment advisor and the IPS, the advice we relied upon changed from being subjective--where everyone had a strong opinion--to objective.
My experience with the foundation is totally applicable to your work as advisors. Writing and implementing an investment policy statement is crucial to ensuring that you and your clients are in compliance with various investment practices and procedures, as well as to protecting you from personal liability in the event a client becomes dissatisfied with your investment performance. The IPS is there to help you understand how much risk your client is willing to assume. It also helps you manage clients' emotions and expectations as risk is actually experienced. But the IPS can also be a method of setting up a positive experience for your clients to differentiate the services you offer. If you become knowledgeable in writing and implementing an investment policy statement, you can not only leapfrog your competition but also enhance your image and reputation in the marketplace.
Writing an IPS can be thought of either as a burden or as the best safeguard for demonstrating prudence and compliance with procedural mandates of ERISA or the responsibilities attendant with being a fiduciary advisor. It can also establish your value as an advisor. You are able to prove your practical value by having an investment process in place and documenting that process, while also alleviating many of the concerns your clients have about risk. The challenge is really one of developing and documenting a formal investment process. This is easy to say, but, frankly, more difficult to accomplish.
It is important to implement an investment policy statement not only for all of your fiduciary clients, but all your high-net-worth clients. All should be treated as if they were an institution rather than an individual. This will produce results similar to those of institutional portfolios and can do more to raise your perceived value as a financial advisor than just about any other strategy. I can tell you from my personal experience as a plan fiduciary that when you start relying on a written IPS, your confidence rises to a new level. This has made my job not only more enjoyable and less stressful, but also easier. It has also improved the quality of relationship with our investment advisor. There is no doubt that having an IPS in place greatly improves the odds of meeting defined financial and investment objectives.
Where to Start?
To begin the process, first educate yourself and your clients about the role of fiduciaries and the provision of investment advice. If you are rendering investment advice for a fee or have any discretionary authority or responsibility over investment assets, you are a fiduciary. You must assume that your investment decisions will be examined in detail at some time in the future.
There should never be a problem as long as you can provide evidence linking every investment-related decision to an individual's financial or investment plan and your proper exercise of fiduciary responsibility. If you are an advisor to a qualified plan regulated under ERISA, remember that you may also be responsible for the negative results of any capricious or arbitrary decisions on your part not supported by an IPS. According to ERISA Sections 402(b)(1) and 404(A)(1)(D), any qualified plan must have a well-articulated written description of procedures for investment selection and ongoing investment evaluation. This document is generally recognized as the investment policy statement.
When you write a clear investment process and methodology for selecting and monitoring a client's assets, this document serves as a risk management tool. It is also the first line of defense against potential fiduciary liability from disgruntled clients should they involve you in a lawsuit, and it offers protection should you become the subject of a U.S. Department of Labor inquiry, specifically in the case of ERISA plans, or an SEC or NASD audit. In any event, the IPS is generally one of the first documents reviewed in an audit.
Following are some simple guidelines excerpted from How to Write an Investment Policy Statement (Marketplace Books, 2004), by my colleague, Jack Gardner, managing director at Thornburg Investment Management. The guidelines can help you formalize a prudent investment management process for your clients.
1. The Objective
The overall objective of the IPS is to provide sufficient detail so that a third party will be able to implement the investment strategy in a complex and dynamic financial environment. Understanding any idiosyncrasies is key to meeting the needs of the client without requiring constant modifications and updates.
For qualified plans, trusts, endowments, and foundations, you begin by gathering and thoroughly analyzing all relevant documents that pertain to your client's situation. These may include plan documents and amendments, a summary plan description, written minutes of committee meetings, any agreements for outside services, investment performance reports, enrollment activity reports, participant education material, loan activity reports and procedure manuals, IRS Form 5500 and schedules, and any independent audit reports. This will help you identify trustees and named fiduciaries, whether any investment decisions have been delegated, whether any asset classes are restricted or prohibited, and what supporting documentation you should keep on file.
2. General Description
The details of your findings are the basis for the first section of the IPS. This contains an "Executive Summary" describing the client's plan, the purpose, and the outline of the duties and responsibilities of the various parties. This section is a concise description of pertinent data, including the client's attitudes, expectations, and investment objectives. Within a 401(k) qualified plan context, you write out as a stated purpose the intent to comply with ERISA Section 404(c) by describing processes and providing instructions that will ensure continuity of compliance and aid the clear communication of the investment policy to participants. This can also apply to high-net-worth individuals within a family wealth management context.
Next, you detail the specific mandates of the investment process, identify the parties involved and their specific roles, including the retirement plan committee, if applicable, as well as the investment consultant, investment manager, and custodian. This also supports the continuity of the investment process if there is a change in fiduciaries, helps prevent misunderstandings between parties, and helps prevent omission of critical fiduciary functions. For non-qualified plans, or high-net-worth individuals, the roles of the client, the advisor, and anyone else associated with the assets are also identified. Fiduciary functions are also defined under this section.
Today's investment strategy is not about the avoidance of risk, but the prudent management of risk, taking into account all hazards that may follow, including inflation, volatility of price and yield, and lack of liquidity. Risk management requires that as much careful attention be given to the particular client's risk profile as to volatility attributes of the investments themselves.
3. Statement of Current Situation and Mandates of IPS
A secondary purpose of the IPS is to initiate a discussion about risk with your clients and to help educate them. Those discussions might include considerations of how inflation over the past quarter of a century has become an important and seemingly permanent feature of the economic landscape, or how global events affect domestic results, or how Federal Reserve policy affects the economic environment. It's also important to discuss the historical performance of various asset classes to enable your clients to understand those classes' ranges of volatility with the goal of matching investments with your client's risk tolerance along with the client's investment time horizon.
This formation process of the IPS provides a platform for a discussion about how to analyze and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the trusts or accounts under administration or management. It is all about educating your clients (whether trustees or fiduciaries or high-net-worth individuals) on how to effectively use an IPS.
The primary objective of this second step is to determine and describe the client's assets and liabilities, current asset allocation, goals and objectives, philanthropic and estate planning desires, and tax status. Because the IPS is a written document that serves as the business plan and communication device for directing the activities of the investment program, one of the most important components of the IPS includes a description of the duties and responsibilities of all parties involved in the management of the portfolio. Diversification and rebalancing guidelines, the due diligence process for selecting and monitoring investment options and service vendors, as well as the policy for accounting investment expenses are all described.
4. Diversifying and Allocating the Portfolio
The primary objective here is to determine the acceptable risk level of the portfolio, the modeled return needed to realize the stated goals and objectives of the client, and the general asset classes that will be used to construct the portfolio. Asset allocation decisions are a fundamental aspect of the investment strategy and the starting point in formulating a plan of diversification. Therefore, investment fiduciaries must not only consider the purposes, terms, distribution requirements, and other circumstances of the client. They must also consider the risk tolerance and risk attributes for each asset. Specific goals should be established in terms of investment performance with appropriate benchmarks identified to monitor results.
5. Implementing the Policy
Once the desired asset allocation is finalized, a determination is made as to which aspects of the investment plan will be implemented and who will be responsible. By adhering to what has been documented in the IPS, the fiduciary can ensure proper and competent implementation of the investment plan. In this part of the process, the decisions are made as to the specific investment options to be used and the amount of money to be placed into the appropriate asset classes.
6. Identifying Specific Investment Alternatives
Now you're ready to identify the asset class guidelines. You need to lay out clear guidelines for choosing which asset classes to be included, and identify the appropriate index and peer group for each asset class being offered. Basic asset classifications might include cash equivalents, bonds, asset-backed securities, real estate, and corporate stock. Both debt and equity categories are further divided by risk-reward or income-growth characteristics, and by domestic, foreign, tax-exempt status, or other characteristics of the issuers.
It is not uncommon to characterize equity investments by capitalization ranges, or by management attributes such as "value" or "growth." Debt securities likewise can be characterized by attributes such as "length of maturity" and quality ratings. In order to assist in diversification and in controlling costs, the modern investment fiduciary may consider mutual funds as a vehicle for diversification.
An example of investment options might consist of six core equity options: large-cap growth, large-cap value, small-cap growth, small-cap blend, mid-cap blend, and large-cap blend. There may also be a money market fund, several bond funds covering various portfolio maturity ranges, a laddered bond strategy including governments and corporate bonds, an international equity fund, or a real estate or REIT fund to allow further diversification alternatives to participants.
This section is also where you outline the guidelines to be employed in the investment manager selection, the number of investment managers, and which asset classes each manager will manage. (By delegating investment management responsibility you enable fiduciaries to shift or apportion responsibilities and associated future potential liabilities to investment professionals.) You also should define accounting and investment expenses and establish procedures for the fiduciaries that fulfill the general obligation to manage investment decisions with the requisite level of care, skill, and prudence, while also satisfying the specific obligation of the fiduciary to incur only reasonable and necessary expenses. As a fiduciary, the responsibility for determining if the expenses are reasonable for the services being provided can only be met with appropriate benchmarking against industry standards.
7. Monitoring and Reviewing
The last section of the IPS details the manner in which the fiduciary will exercise diligence in overseeing the client's investments and demonstrate prudence and legal compliance; monitoring, reporting, and rebalancing. Monitoring and reviews, held at least quarterly, are generally mandated by the IPS to ensure that appropriate progress is being made. Reports should be maintained to determine quarter-to-date, year-to-date, and inception-to-date performance so that the entire portfolio can be reviewed against overall portfolio goals and objectives. Service providers are also evaluated to ensure they are performing in accordance with written agreements. This includes an evaluation of the providers' fees.
In this section, you will lay out the process and timing of investment monitoring, define specific performance criteria, and list the objectives to be accomplished during the review process. A decision that is typically more difficult to make than selecting a manager or asset class fund is determining when the time has come to replace the manager or fund. If you decide performance criteria in advance, this decision is easier to manage and to implement since the IPS eliminates emotions and biases as reasons to terminate an investment manager. Here you should also identify appropriate benchmarks for evaluating money managers, with outlined comparative time periods such as a three- to five-year time horizon. The investment managers should provide reports concerning their strategy, outlook, performance, and holdings so presentation of information to the committee becomes an important procedural step. Independent of the manager's performance comparisons are comparison reports relative to the appropriate manager or fund peer group. At a minimum, you should require an annual review that determines whether there have been any material changes to the goals and objectives, or to the risk/return profile, or to the criteria for manager selection. Lastly, you must state when and how you will rebalance the portfolio or adjust the allocations you've chosen. The time frame for reviewing the allocations as well as the ranges of acceptable variance will also be described, thereby providing objective standards for reallocation without those aforementioned emotional considerations.
Your overall objective as an advisor is to provide sufficient guidance and advice to help your clients document in writing that they have a defined investment process. The investment policy statement outlines the considerations and guidelines fiduciaries must follow in the selection and monitoring of investment managers, including all plan expenses. Where circumstances or allocations vary, the IPS provides the methods and processes for making necessary adjustments and rebalancing. A well-drafted and properly implemented IPS assists investment advisors in meeting their responsibility to their clients. Just as important, the IPS enables clients to make investment decisions rationally, which is always the greatest challenge in attaining investment success.
Ken Ziesenheim is the author of Understanding ERISA: A Compact Guide to the Landmark Act (Marketplace Books, 2002. He is president of Thornburg Securities and a managing director of Thornburg Asset Management in Santa Fe. He can be reached at firstname.lastname@example.org.