The Handbook for Investment Committee Members: How to Make Prudent Investments for Your Organization
176
The Handbook for Investment Committee Members: How to Make Prudent Investments for Your Organization
176Hardcover
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Product Details
| ISBN-13: | 9780471719786 |
|---|---|
| Publisher: | Wiley |
| Publication date: | 03/24/2005 |
| Series: | Wiley Finance , #301 |
| Pages: | 176 |
| Product dimensions: | 6.20(w) x 9.30(h) x 0.68(d) |
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The Handbook for Investment Committee Members
By Russell L. Olson
John Wiley & Sons
ISBN: 0-471-71978-1Chapter One
The Investment Committee
Who is responsible for the investment of our investment fund? Ultimately, the board of directors of the fund's sponsor is responsible. But it is not practical for boards of directors to make investment decisions for the fund, so the board almost always appoints an investment committee to take on this responsibility.
STANDARDS TO MEET
Members of the investment committee are fiduciaries. What does this mean? State laws differ in the precise way they define the term. Many funds look to the federal law for private pension plans-ERISA (the Employees Retirement Income Security Act of 1974)-for guidance, even though the law does not in any way apply to public pension plans or endowment funds. Key standards of ERISA, as adapted for an endowment fund, would be:
1. All decisions should be made solely in the interest of the sponsoring organization.
2. The investment portfolio should be broadly diversified-"by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so."
3. "The risk level of an investment does not alone make the investment per se prudent or per se imprudent.... An investment reasonably designed-as part of the portfolio-to further the purposes of the plan, and that is made uponappropriate consideration of the surrounding facts and circumstances, should not be deemed to be imprudent merely because the investment, standing alone, would have ... a relatively high degree of risk."
Specifically, the prudence of any investment can be determined only by its place in the portfolio. This was a revolutionary concept, as the old common law held that each individual investment should be prudent of and by itself. There are a great many individual investments in investment funds today-such as start-up venture capital-that might not be prudent of and by themselves but, in combination with other portfolio investments, contribute valuable strength to the overall investment program.
4. The standard of prudence is defined as "the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims." This is often referred to as the "prudent expert" rule and strikes me as an appropriate standard. Everyone involved in decision making for the fund should be held to this standard. This does not mean that committee members should be experts. But they should be relying on experts.
That said, I fear that the words "fiduciary" and "prudence" have all too often been impediments to investment performance because of the scary emotional overtones those terms arouse. Such emotions lead to a mentality such as "It's okay to lose money on IBM stock but don't dare lose money on some little known stock." Neither should be more nor less okay than the other.
Prudence should be based on the soundness of the logic and process supporting the hiring and retention of an investment manager, and on an a priori basis-not on the basis of Monday morning quarterbacking. According to the Center for Fiduciary Studies, "Fiduciary liability is not determined by investment performance, but rather by whether prudent investment practices were followed."
Another aspect of my concern is that the terms "prudence" and "fiduciary" all too often motivate decision makers to look at what other funds are doing and strive to do likewise on the assumption that this must be the way to go. An underlying theme of this book is that this is not necessarily the way to go. As fiduciaries, we should do our own independent thinking and apply our own good sense of logic.
Everything comes down to facts and logic. Do we have all relevant facts we can reasonably obtain? Are the facts accurate? What are the underlying assumptions? We should ask questions, ad nauseam if necessary. Does a proposal make sense to us? If not, challenge it. And we should work hard to articulate our reasons.
COMMITTEE ORGANIZATION AND FUNCTIONS
Organization
Well, who should be on this all-important fiduciary committee? A committee may consist of outside investment professionals, as is often the case with some of the members of endowment committees of large universities, or the committee may be composed of a group of members of the sponsoring organization (perhaps including certain members of the board of directors), none of whom may have any special expertise in investing. All should meet the criteria listed on page xiv of the Introduction to this book.
What does the fiduciary committee do, and how should it function?
Initially, the committee may adopt a written Operating Policy that addresses such things as committee membership, meeting structure and attendance, and committee communications. As part of this Operating Policy, it should specify the adviser on whom the committee will rely, so selecting the adviser is the committee's first job. A sample Operating Policy is included at the end of this chapter as Appendix 1.
Then the committee should adopt a written statement of Investment Policies, such as those described in Chapter 3, including the fund's Policy Asset Allocation. These are clearly the committee's most important functions-ones that will have more impact on the fund's future performance than anything else the committee does. After that, the committee must decide whom to hire and retain as investment managers. All of these matters are a big responsibility, and the committee will need to rely heavily on its adviser for help.
Selecting an Adviser
The Uniform Prudent Investor Act empowers fiduciaries to "delegate investment and management functions that a prudent trustee of comparable skills could properly delegate under the circumstances." Jay Yoder, writing for the Association of Governing Boards of Universities and Colleges, adds that "because investing an endowment or any large pool of money is a complex and specialized task requiring full-time professional attention, I would argue that fiduciaries may even be required to delegate responsibilities."
Yoder argues forcefully for a strong investment office: "Endowments of $150 million and larger can and should create an investment office and hire a strong chief investment officer. ... Hiring a consultant is no substitute for employing a strong investment office." A first-rate internal staff "can be expected to produce a stronger, more advanced investment policy ... much better implementation of that policy; early adoption of new asset classes and strategies; greater due diligence and monitoring of managers; and, most important, better, more timely decision making."
Many investment funds are too small to afford a first-rate internal staff to recommend the asset classes in which they should invest and then select the best investment managers in those asset classes. Those funds therefore need to hire an outside consultant who understands the benefits of diversification and who specializes in trying to find the best managers in each asset class.
Such a consultant could be our local bank. Some banks have developed expertise in mutual funds, but most would rather guide us into investment programs managed by their own trust departments, very few of which rank among the better investment managers. And few banks have cutting-edge competence in asset allocation.
Many brokers and insurance company representatives offer mutual fund expertise. But can we expect totally unbiased advice from them when they are motivated to gravitate to the range of investment managers that compensate them? Many such consultants are paid through front-loaded mutual funds-those that charge an extra 3% to 8% "load" (read "selling commission")-or those that charge an annual 0.25% through a so-called 12(b)(1) deduction from assets (read "another form of selling commission")-or those that charge a back load when we sell the mutual fund, or get compensated in some other way.
A consultant's advice is more likely to be unbiased if the firm's only source of compensation is the fees that it charges its investor clients. Its direct fees will be higher, of course. But we will know fully what the consultant is costing us because none of its compensation will be coming through the back door.
If such a consultant recommends mutual funds to us, he will typically steer us toward no-load mutual funds that do not charge 12(b)(1) fees. Many world-class mutual funds fit this category. On occasion, the consultant might steer us toward a load fund or one with 12(b)(1) fees. If so, the consultant's only motivation should be that he believes future returns of that mutual fund, net of all fees, will still be the best in its particular asset class.
I suggest that an investment fund, in hiring a consultant, require the following:
1. The consultant should acknowledge in writing that it is a fiduciary of the pension plan (or the foundation or endowment fund).
2. The consultant should make a written representation annually that either:
a. It receives no income, either directly or indirectly, from investment management firms, or
b. If it does receive such income, the names of all investment managers from whom it has received such income during the prior 12 months, and in each case, the approximate amount of income and the services provided.
3. The consultant affirms it is prepared to provide to the fund all the services included in this book as expected from a fund's adviser.
It is easier to draw up the criteria for selecting such a consultant than to find and hire one. Some members of the committee may, in their regular businesses, have contact with investment consultants for whom they have high regard. But we shouldn't necessarily stop there. We can look in consulting directories, such as that provided by the A.S.A.P. Investment Consulting Directory, whose web site lists 74 consultants and whose volume titled Investment Consultant Directory lists 380 consultants.
How should we decide among alternative consultants? If we as committee members have first gained some perspective by reading a book such as this one, we will be better prepared to send prospective consultants a questionnaire, to place a consultant's response and presentation in perspective, and to ask meaningful questions.
Our selection should be based on the consultant's track record with other institutional funds, and on the predictive value we feel we can attribute to that track record when we evaluate all the subjective factors-including breadth of diversification in his approach, and continuity of staff.
Role of Committee Members
Once the committee decides on its adviser, the committee must expect to approve most of the adviser's recommendations. And if the committee has lost confidence in its adviser, it must make a change and get an adviser in whom it can place its confidence.
Does that mean that once the committee has an adviser in whom it has confidence, it should essentially turn all decisions over to him? No, decisions on investment objectives are not readily delegated. They should be developed in the context of the needs and financial circumstances of that particular plan sponsor. Authority to hire and fire investment managers may be delegated to an adviser who is registered with the SEC as an "investment adviser," but even then the committee has the responsibility to monitor results. The committee's written Operating Policies should specify which actions the adviser is authorized to take upon his own judgment, and which actions must first be approved by the committee.
What, then, should we as committee members do? We should ensure that the fund's objectives are consistent with the financial condition of the plan sponsor, and we should ensure that the fund's investment policies are consistent with the plan's objectives. Then we should review each of the adviser's recommendations from the following standpoints:
* First and foremost, is the recommendation consistent with the fund's objectives and policies? If not, should the committee consider modifying its objectives and policies, or is the recommendation therefore inappropriate?
* Is the recommendation consistent with the committee's Policy Asset Allocation? If not, should the committee consider modifying its Policy Asset Allocation?
* Is the recommendation internally consistent?
* Has the adviser researched all of the right questions relative to things such as:
- Character and integrity of the recommended investment manager,
- Assessment of the predictive value of the manager's track record,
- Nature of the asset class itself,
- Credentials of the manager's key decision makers,
- Depth of the manager's staff,
- The manager's decision-making processes and internal controls.
* What alternatives did the adviser consider?
* Have adequate constraints and controls been established, especially with respect to derivatives that a manager may be authorized to use?
* Does the fee structure seem appropriate?
* Is the recommendation consistent with all applicable law?
Does this sound like a heavy-duty demand on investment sophistication? Although investment sophistication helps, it's not among the criteria for committee members as I've listed them in the Introduction to this book.
Should a committee strive to include at least some investment professionals among its members? In many cases, investment professionals contribute valuable experience to the committee. They can sometimes suggest particular managers for the adviser to consider and perhaps open doors that might otherwise be closed.
But investment professionals should be conscious of any conflicts of interest. And if their experience is focused on particular investment areas, they may be less comfortable considering recommendations about other investment areas. Do they understand their limitations? To be successful committee members, they must become generalists, not specialists. Unless they can make this transition, their investment experience can actually be a drawback.
"What is the difference between competent and incompetent boards?" write Ambachtsheer and Ezra in their book Pension Fund Excellence. "Competent boards have a preponderance of people of character who are comfortable doing their organizational thinking in multiyear time frames. These people understand ambiguity and uncertainty, and are still prepared to go ahead and make the required judgments and decisions. They know what they don't know. They are prepared to hire a competent CEO and delegate management and operational authority, and are prepared to support a compensation philosophy that ties reward to results."
Committee procedures usually call for decisions to be decided by a majority vote. In practice, it is best if most decisions are arrived at by consensus. That doesn't mean that everyone must agree that a decision is the best possible, but everyone should ultimately agree that it is at least a good decision.
Number of Committee Members
How many members should compose the investment committee? This is not a committee that needs to be representative of the different constituencies that may compose the sponsor. This committee has a technical purpose, not an organizational policy purpose.
I favor a smaller committee of members who will take their responsibility seriously and will attend meetings regularly. A committee of five might be optimal for purposes of generating good discussion, giving each member a feeling he is important to the committee, and-not inconsequentially-the ease of assembling the committee for a meeting.
(Continues...)
Excerpted from The Handbook for Investment Committee Members by Russell L. Olson Excerpted by permission.
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Table of Contents
Acknowledgments.Introduction.
Organization of this Book.
CHAPTER 1: The Investment Committee.
Standards to Meet.
Committee Organization and Functions.
Interaction of Committee and Adviser.
Social Investing.
In Short.
APPENDIX 1: Example of an Investment Committee’s Operating Policies.
CHAPTER 2: Risk, Return, and Correlation.
Return.
Risk.
Correlation.
Risk-Adjusted Returns.
Derivatives—A Boon or a Different Four-Letter Word?
In Short.
CHAPTER 3: Setting Investment Policies.
Time Horizon, Risk, and Return.
Policy Asset Allocation.
Preparing a Statement of Investment Policies.
In Short.
CHAPTER 4: Asset Allocation.
Characteristics of an Asset Class.
Asset Classes.
Putting It All Together.
In Short.
CHAPTER 5: Alternative Asset Classes.
Liquid Alternative Assets.
Illiquid Investments.
Private Asset Classes.
In Short.
CHAPTER 6: Selecting and Monitoring Investment Managers.
Three Basic Approaches.
Criteria for Hiring and Retaining Managers.
Hiring Managers.
Retaining Managers.
In Short.
CHAPTER 7: The Custodian.
Custodial Reporting.
Management Information.
In Short.
CHAPTER 8: Evaluating an Investment Fund’s Organization.
Investment Objectives.
Asset Allocation.
The Fiduciary Committee.
The Adviser.
Investment Managers.
CHAPTER 9: Structure of an Endowment Fund.
The Total Return, or Imputed Income, Approach.
“Owners” of the Endowment Fund.
In Short.
APPENDIX 9: The Total Return or Imputed Income Method.
CHAPTER 10: What’s Different about Pension Funds?
Pension Plan Liabilities.
Investment Implications.
In Short.
CHAPTER 11: Once Again.
Glossary.
Bibliography.
Index.
About the Author.