The investment objectives and investment constraints are arguably the key components of the IPS which set out the risk and return objectives. Return objectives and expectations must be consistent with the risk objectives and constraintsthat apply to the portfolio.

The IPS should clearly state the risk tolerance of the client. The risk objectives are the specifications for portfolio risk and can be stated as absolute or relativemeasures using quantitative metrics. Absolute metrics may be around the probability ofloss of portfolio capital over a particular time frame whereas a relative risk objectives would key off a particular benchmark like the S&P 500 or LIBOR to measure risk. For institutional clients, the benchmark may be linked to some kind of liability the institution has, for example, a pension plan must be able to meet their payment obligationswhen they become due. When a policy portfolio has been specified, the risk objective may be for the portfolio to remain within a certain bandwidth around that policy allocation.

A clients overall risk tolerance is a function of their ability to bear risk and their risk attitude or willingness to take onrisk.When there is consistency between risk willingness and ability, the investment task is made easier. Where the two are in conflict, the advisor should seek to explain the conflict and its implications but should not aim to try and change the clients willingness to take on risk that is not as a result of misperception. The prudent approach is to reach a conclusion about risk tolerance that is the lower of the two factors ability and willingness.

The return objectives may be stated on an absolute or relative basis. An absolute return objective may state the desired returns in nominal or real terms while a relative return objectivecould be outperformance relative to an index or even peer group. However, a good benchmark should be investable which can make return objectives relative to peers or other managers and institutions less appropriate.

The return objective should be clearly stated as either before or after fees and pre or post-tax. The return objective must be consistent with the clients risk objective and also appropriate with respect to the market and economic environment.

Which of the following best demonstrates an absolute risk objective and a relative return objective?

A. Target a maximum annual portfolio volatility of 1.5x the S&P 500 and returns of4% of the S&P 500 annual return

B. Target a maximum portfolio drawdown of 10% with 95% confidence and annual returns of 12%

C. Target a maximum portfolio loss of $100 000 with 95% confidence and annual returns within 2% of the MSCI World Index

An absolute objective does not key off a benchmark or index whereas a relative objective is with respect to a benchmark, index or peer group.

Describe risk and return objectives and how they may be developed for a client

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