Investment advisors should have a policy whereby they obtain (and maintain) sufficient information regarding the client's circumstances so as to demonstrate that the firm managed the client's assets consistent with that client's designated investment objectives and any corresponding restrictions. How does the firm accomplish this? Is the answer an investment policy statement?
No! At least not in the manner that most advisors think of an investment policy statement (IPS), which all too often is: much too long; much too complicated; and a much too clumsy dissertation of various investment-related information and historical data that serves more to confuse than to enlighten the client.
Such a comprehensive formal process is also most likely very time consuming, and a major reason why too many advisors do not properly document client investment suitability parameters, either initially or on an ongoing basis.
Moreover, such documents are too-often forgotten relative to acknowledging amendments to the document resulting from changes in the client's financial situation or investment objectives subsequent to the commencement of the investment management process.
Yes, But . . .
Some type of investment policy statement should be obtained and maintained by an investment advisor. However, longer does not mean better!
Too many times, especially when defending advisory firms in litigation or arbitration proceedings, we see advisors falling victim to their own sloppy documents (a "canned" questionnaire or ambiguous form that is a minefield for conflicting responses). If the client indicates on page 2 of the IPS that his objective is a 10% annual return, but on page 5 (which is clearly, in my opinion, already too long a document) that he can only tolerate a principal loss of 5%, we have a conflict, such that the advisor, as a "fiduciary," should not begin the investment management process until the client's objectives and risk parameters are consistent, and written confirmation thereof has been obtained.
Moreover, a new client's response on a canned questionnaire in 2005 that she could only withstand a 10% decline was long forgotten during the 2008 plunge when her account plunged by a multiple of that number! Why even have such questions on a questionnaire!
The Trouble With Language
Also, be very careful not to label investment suitability or strategies in terms of "conservative," "moderate," "aggressive," "balanced," "growth," or some other nondescript terms, without defining what you mean by them: Ambiguities will most likely be construed by a court or arbitration panel against the advisor. Most important, be clear to define the risks associated with such strategies (i.e., principal risk and fluctuation), portfolio composition (i.e., equities, fixed income, a combination of the two, etc.) and the minimum anticipated time horizon associated with such a strategy.
Our general recommendation (and the corresponding documents we provide to our clients) is to keep the client "intake" process simple.
o First, use a new-client information document that requires the client to indicate, in his own handwriting, his risk parameters and investment objectives, and, most important, any reasonable restrictions that the client desires to impose on your investment management services.
o Second, have the client complete and execute the document, including a written indication if he wants to impose any reasonable restrictions: if none have the client, in his own handwriting, indicate "None."
o Thereafter, prior to commencing the investment management process, confirm the information obtained in a written investment objectives or policy statement, either to be executed by the client, or, in the alternative, advising the client to notify you immediately, in writing, if his/her understanding is contrary to that stated.
o In addition, the confirming document should advise the client to immediately notify you if there has been a change in her financial situation or investment objectives, or if she desires to impose, add, or modify any reasonable restrictions to the management of her accounts.
o Finally, the advisor should send an annual letter to the client confirming that you continue to manage the accounts in accordance with their previously designated investment objectives, and that it remains her responsibility to advise you if there has been a change in her financial situation or investment objectives, or if she desires to impose, add, or modify any reasonable restrictions to the management of her accounts.
Thomas D. Giachetti is chairman of the Securities Practice Group of Stark & Stark, a law firm with offices in Princeton, New York, and Philadelphia that represents investment advisors, financial planners, broker/dealers, CPA firms, registered reps, and investment companies, and a regular contributor to Investment Advisor. He can be reached at firstname.lastname@example.org.