Investment Constraints | CFA Level 1 - AnalystPrep (2024)

In addition to return and risk objectives, the IPS has to be cognizant of other investment constraints, such as liquidity requirements, the investment time horizon, tax concerns, legal and regulatory factors, and unique circ*mstances.

Liquidity

The IPS should detail the likely withdrawal of funds from the portfolio. For institutions, there could be rules around this, like spending requirements in the case of endowment funds. When a client has a known liquidity requirement, the portfolio manager should allocate a portion of the portfolio to cover this liability by ensuring that the allocated assets can quickly be converted to cash whenever the obligation needs to be met. Allocating to a bond that has a maturity profile that matches the liability time horizon is an often-used strategy.

Time Horizon

The IPS should state the time horizon over which the client is investing. Illiquid or risky assets may be unsuitable for an investor with a short time horizon since they may not have sufficient time to recover from investment losses.

Tax Concerns

Different investors will have different tax status. The tax status should be stated in the IPS. Often, tax regimes will treat capital gains and income differently. Capital gains may be subject to a lower tax rate payable only when they are realized rather than when they are received. In this instance, there is a time value of money benefit to deferring tax. A taxable investor may, for example, wish to hold a portfolio that emphasizes capital gains over dividend income. A tax-exempt investor, on the other hand, may be relatively indifferent to the two.

Legal and Regulatory Factors

The IPS should outline any applicable legal or regulatory restrictions. In some countries, pension funds are subject to restrictions on their portfolio composition. In the case of individuals, they may have access to privileged information on a particular listed company by virtue of directorship and, as such, are restricted from trading on that company ahead of the release of company financial results.

Unique Circ*mstances

The IPS should also cover any unique circ*mstances that are applicable. A client may have religious or ethical objections to investing in particular stocks or sectors. These types of considerations are often referred to as ESG (environment, social, governance) factors, and investing in accordance with ESG factors is referred to as SRI (socially responsible investing).

Question

A client is a director of a publicly listed pharmaceutical company and has stock options in the company that will vest over 10 years. Which of the following best reflects where this should be noted in the constraints?

A. Liquidity and tax concerns.

B. Unique circ*mstance and legal and regulatory factors.

C. Time horizon and liquidity.

Solution

The correct answer is B.

The IPS will needs to contain detail on the legal and regulatory restrictions that apply to directors (who have access to privileged information) of publicly listed companies in reference to dealing in shares of those companies.

Also, an over-exposure to a particular stock by virtue of stock options should be noted in the unique circ*mstances section as the portfolio construction may seek to down weight or avoid any additional exposure to this sector.

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