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Set out the constraints that an investment policy statement records

CFA® Level I · Portfolio Management · Basics of Portfolio Planning and Construction · PM.3.c

The idea

Five constraints shape what a portfolio may do regardless of objectives. Liquidity covers anticipated cash needs and the reserve held against unanticipated ones. Time horizon may be single or multi-stage, and a long overall horizon does not excuse a near-term liability. Tax considerations affect asset location and turnover. Legal and regulatory constraints bind trusts, pensions and foundations in particular. Unique circumstances cover everything else a client specifies, from a concentrated holding that cannot be sold to an exclusion on ethical grounds.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of these is a constraint rather than an objective in an investment policy statement?

  1. Liquidity requirements — correct
  2. Required rate of returnWhy not: An objective, and the one that has to be reconciled with risk tolerance.
  3. Risk toleranceWhy not: The second objective, combining the investor's ability and willingness.

Constraints limit the feasible set; objectives state what is being aimed at within it. Liquidity, horizon, tax, legal and unique circumstances are the five constraints.

A harder one

An investor has a thirty-year horizon but must fund a house purchase in two years. How should the horizon constraint be described?

  1. Two years, since the nearest need governsWhy not: Lets a small near-term liability dictate the treatment of a thirty-year portfolio, forgoing decades of compounding.
  2. Thirty years, since the overall horizon governsWhy not: Leaves the deposit exposed to a drawdown it has no time to recover from.
  3. Multi-stage, with the near-term liability funded separately from the long-term portfolio — correct

Treating it as a single horizon either starves the long-term portfolio of risk or puts the house deposit in equities. Segmenting by liability handles both correctly.

The hardest tier

Why does a concentrated holding an executive is contractually barred from selling belong under unique circumstances rather than liquidity?

  1. Because concentrated holdings are always illiquidWhy not: Many concentrated positions are in highly liquid securities. Here the obstacle is contractual, not market depth.
  2. Because the holding cannot be sold at all — correct
  3. Because executives are exempt from liquidity requirementsWhy not: No such exemption exists. Executives have cash needs like anyone else.

It constrains the portfolio's construction rather than its cash availability. The rest of the portfolio must be built around an exposure that cannot be reduced, which is a structural constraint on asset allocation rather than a question of meeting cash needs.

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