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Effective Endowment Management. CAIS / NYSAIS Business Affairs Conference May 4-6, 2005. Topic 1: Writing a strong, effective investment policy. Why? Fiduciary responsibility demands it Written guidelines protect your endowment from market-driven departures from sound long-term policy
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Effective Endowment Management CAIS / NYSAIS Business Affairs Conference May 4-6, 2005
Topic 1: Writing a strong, effective investment policy • Why? • Fiduciary responsibility demands it • Written guidelines protect your endowment from market-driven departures from sound long-term policy • It serves to educate and inform all parties involved
Characteristics of a well-written policy • Detailed and specific • Includes sound rationales in the form of explicit answers to “Why?” questions • Individual components are logically consistent
Seven necessary components • Return objectives • Relevant risks • Asset allocation guidelines • Asset class rationales • Rebalancing • Benchmarks • Indexing
Return objectives • Financial • The overall financial goal of the endowment is to maintain its inflation-adjusted market value while contributing approximately 5% per year to the college’s operating budget (i.e. CPI + 5%) • Investment • Earn a total return matching or exceeding the portfolio’s composite benchmark • Earn a total return matching or exceeding your peer group
Relevant risks • Volatility • Decline in real value of endowment • Peer risk • Headline risk • Inflation • Deflation • Failing to achieve your policy objectives
Rebalancing • Importance • Failure to do so increases risk and reduces return • Difficult to implement • Counterintuitive • Doesn’t work until trend reverses • Conclusions • An automatic rebalancing rule is extremely important • The method of rebalancing is less important than enshrining the decision in the investment policy and implementing it rigorously
Benchmarks • Definition: The standard or index against which performance is measured • Examples at the portfolio level: • CPI + 5% • Composite benchmark (sum of asset class benchmarks x policy weights) • Peer performance • Extremely important because: • Poor benchmarking leads to poor (i.e. misleading) analysis • Poor analysis leads to poor decision-making
Facts about indexing • Logic dictates that the average manager underperforms • Historical evidence proves that the average manager underperforms • History shows that past performance does not predict future performance • No one benefits from indexing—except the investor!
Past performance is not predictive Where did most top quartile managers come from? Where did most top quartile managers go? 1996-99 2000-03 1996-99 2000-03 Top Quartile Second Quartile Third Quartile Bottom Quartile Source: Frank Russell Company
Views on indexing • How will you beat the odds? • Smart people? • Contrarian decision-making? • A policy on indexing is crucial to avoid jumping back and forth between active management and indexing
Is your investment policy strong and effective? A quick test. • Does your policy meet fiduciary standards by addressing all the issues a prudent expert would address? • Has the policy achieved its goals in the past? If new, is it likely to do so in the future (based on reasonable assumptions)? • Is the policy specific enough and clear enough that a stranger could properly manage your endowment based solely on the policy document?
Topic 2: Good governance and policy implementation • Roles & responsibilities • Board, investment committee, staff, & consultant • Committee structure • Size, tenure, & composition • Policy implementation • Solutions • Conflicts of interest • Frequency of meetings • Reporting
Committee structure & role Traditional Best Practices
Problems with traditional structure… • Lack of expertise, experience, resources, education and/or time • Diffusion of responsibility • Group decision-making …lead to common mistakes
Common mistakes… • Favoring asset classes, strategies, and managers that have enjoyed recent success • Substituting one’s own (shorter) time horizon for that of the perpetual time horizon of endowment • Overconfidence in the ability to market-time and select managers that will outperform in the future • Selecting managers for all the wrong reasons …lead to poor implementation and value lost
Policy implementation • Two components • Manager selection • Market-timing (all departures from policy) • Determine success of policy implementation by calculating the value-added or lost—in dollar terms over a long period of time. • Present results to the Board and the Committee
XXXXX College endowmentHistorical performance Effect on Market Value • Expected endowment market value: $1.01 billion • Value lost through market timing: $6 million • Value lost through manager selection: $100 million • Actual endowment market value: $907 million
Solutions to poor policy implementation • Revise governance structure • How? If endowment exceeds $100 million: • Institute or revise written guidelines that impose best practices on committee structure (size, tenure, composition) • Hire an experienced CIO and create a strong investment office • Delegate significant authority to the CIO • Employ specialized consultants or advisors
Solutions to poor policy implementation • If endowment is less than $100 million: • Create a strong investment policy • Resist all attempts to improve or tweak this new policy for several years • Institute or revise written guidelines that impose best practices on committee structure (size, tenure, composition) • Delegate policy implementation to an individual • Index large percentage of traditional asset classes
Consultant roles • Proper (because they usually succeed): • Assisting Board, Committee, and CIO in performing their respective tasks • Serving as an independent voice • Functioning as an extension of staff • Improper (because they often fail): • Choosing managers • Substituting for a strong CIO
Conflicts of interest • Disclose • Recuse • Address in formal written policy • Require full disclosure of any conflicts, potential conflicts, or appearance of conflicts • No investing in firms related to committee members • May invest with firms represented by board members, but board members may not promote firm to staff or committee members
Frequency of committee meetings • Four times a year is most typical • Twice a year is enough if the committee is properly focused on major policy issues • Monthly is probably necessary if committee insists on filling CIO role
Reporting • Traditional: 50 pages of detail that provide very little useful or actionable information • Best practices: • Where do we stand? (Asset allocation) • How have we done? (Performance) • vs. financial objective (CPI + 5%) • vs. policy (composite benchmark) • vs. peers
Topic 3:Alternative Investments What are they? • Informal definition: • Any investment or asset class that is unusual, unfamiliar, or causes discomfort among those responsible for investing. • Formal definition: • Investments with unique risk and return properties that are not generally obtainable from traditional asset classes.
Alternative investments —marketable or liquid • Hedge funds • Distressed debt • Long/short • Market neutral • Managed futures • Arbitrage strategies • Convertible • Fixed income • Merger • Capital structure
Alternative investments —non-marketable or illiquid • Real Assets • Energy • Real Estate • Timber • Commodities • Private equity • Venture capital • Buyouts
Rationale for alternatives • Higher returns • Greater diversification • Non-correlated returns • Reduced volatility • Can fulfill certain policy objectives better than traditional investments
Challenges of alternative investments • Require greater expertise • Lack of transparency • Benchmarking • Too much money chasing too few good managers • Expensive
Risks • Low correlation – and stock market soars • Committee panics and retreats at exactly the wrong time • Manager risk • Career or headline risk
Manager risk Ten-year Performance Data Through 2002 Top Bottom Quartile Quartile Difference U.S. Bonds 7.9 % 7.1 % 0.8 % U.S. Stocks 12.5 % 8.8 % 3.7 % Int’l Stocks 7.8 % 4.7 % 3.1 % Hedge Funds 14.3 % 8.5 % 5.8 % Buyouts 38.3 % 12.9 % 25.4 % Venture Cap 39.0 % 10.6 % 28.4 %
Risk mitigators • Ensure that all decisions are driven by sound policy • Perform strong due diligence • Use a fund-of-funds
Key investment policy questions: • Does your investment policy address the seven key components? • What types of risk are most relevant to your endowment? • Are these risks codified and reflected in the policy? • Does rebalancing regularly and automatically take place? • Are all benchmarks appropriate and effective ones? • Has your institution added value by selecting active managers? • Has your institution added value by market timing? • Does your policy pass the three-part test from the prior slide?
Key governance/policy implementation questions: • Has your policy implementation—market timing and manager selection—added to or detracted from endowment returns? • What has been the resulting impact to the market value of your endowment? • Is your investment committee focused largely on broad policy and strategic issues? • Do you have written guidelines governing the structure of your committee? • If your endowment exceeds $100 million, do you have a strong CIO to whom you have delegated significant authority? • If your endowment is less than $100 million, have you considered the five steps to success?
Key questions on alternative investments: • Can your endowment benefit from alternatives? • Why are you interested in alternatives? • Are you willing to make a significant, long-term, policy-driven commitment to alternatives? • Are you willing to incur the challenges and risks of alternative investments? • How will you access the expertise necessary to invest in alternatives?
Helpful Resources for the Business Officer • Pioneering Portfolio Management, by David Swensen • Winning the Loser’s Game, by Charles Ellis • Endowment Management: A Practical Guide, by Jay Yoder (available from www.agb.org)