The Handbook for Investment Committee Members

How to Make Prudent Investments for Your Organization

Russell L. Olson

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118161012
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Comprehensive coverage of what it takes to be a responsible member of an investment committee In a clear, organized, and easy-to-understand manner, this handbook explains the responsibilities and expectations of investment committee fiduciaries for pension funds, endowment funds, and foundations. Emphasizing all the do's and don'ts to follow for prudent investment management, this invaluable resource covers topics ranging from investment policy, asset allocation, and risk assessment to understanding information presented at committee meetings, asking meaningful and productive questions, and voting on recommendations knowledgeably. This book will empower readers with all the knowledge they need to feel confident in the investment decisions they make for their organizations

CHAPTER 1

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 upon appropriate 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.”1

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.2

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.”3

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.”4

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.”5

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 advise...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Acknowledgments
• Introduction: Organization of this Book
• Chapter 1: The Investment Committee
• Chapter 2: Risk, Return, and Correlation
• Chapter 3: Setting Investment Policies
• Chapter 4: Asset Allocation
• Chapter 5: Alternative Asset Classes
• Chapter 6: Selecting and Monitoring Investment Managers
• Chapter 7: The Custodian
• Chapter 8: Evaluating an Investment Fund’s Organization
• Chapter 9: Structure of an Endowment Fund
• Chapter 10: What’s Different about Pension Funds?
• Chapter 11: Once Again
• Glossary
• Bibliography
• Index
• About the Author