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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 - PowerPoint PPT Presentation
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Effective Endowment Management
CAIS / NYSAIS
Business Affairs Conference
May 4-6, 2005
2Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
3Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
4Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Seven necessary components
Return objectives Relevant risks Asset allocation guidelines Asset class rationales Rebalancing Benchmarks Indexing
5Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
6Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Relevant risks
Volatility Decline in real value of endowment Peer risk Headline risk Inflation Deflation Failing to achieve your policy objectives
7Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
8Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
9Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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!
10Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Past performance is not predictive
2 51
1
12
36
51 2
4
9
36
1996-99 2000-03 1996-99 2000-03
Source: Frank Russell Company
Top Quartile
Second Quartile
Third Quartile
Bottom Quartile
Where did most top quartile managers come from?
Where did most top quartile managers go?
11Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
12Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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?
13Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
14Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Roles and responsibilities
Fiduciary Level
PolicyReturn objectives
Define risk
Asset allocation
Strategy
Sub-asset classes
Manager structure
ManagementPolicy
implementation Manager hiring &
firing
Execution
Security selection
ControlReviews results vs. guidelines
& objectives
Board of Trustees
Formally approves Oversees
Reviews committee decisions
Investment Committee
Determines Formally approves Oversees Reviews CIO decisions
Chief Investment Officer
Recommends Determines Determines Oversees Reviews money managers
Money Managers Determines
Complies with guidelines
15Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Committee structure & role
Size of Investment Committee
10-15 members 5-7 members
Committee Role
Makes all final decisions.
Very hands-on.
Delegates much. Focused largely on big-picture/policy
issues.
CIO Role
Filled by committee/consultant
/treasurer
Strong role, filled by individual with authority to
implement policy.
Roles, Committee tenure, composition, & conflicts of
interestUndefined Well-defined
Traditional Best Practices
16Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Problems with traditional structure…
Lack of expertise, experience, resources, education and/or time
Diffusion of responsibility
Group decision-making
…lead to common mistakes
17Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
18Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
19Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
XXXXX College endowmentHistorical performance
-5% 0% 5% 10% 15%
ActualPerformance
Manager Selection
Departure fromPolicy Asset Alloc
Policy Portfolio
11 Years ending June 30, xxxx
Annualized Return
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
Effect on Market Value
20Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
21Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
22Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
23Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
24Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
25Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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
26Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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.
27Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Alternative investments —marketable or liquid
Hedge funds
• Distressed debt
• Long/short
• Market neutral
• Managed futures
• Arbitrage strategies
• Convertible
• Fixed income
• Merger
• Capital structure
28Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Alternative investments —non-marketable or illiquid
Real Assets
• Energy
• Real Estate
• Timber
• Commodities
Private equity
• Venture capital
• Buyouts
29Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Rationale for alternatives
Higher returns Greater diversification Non-correlated returns Reduced volatility Can fulfill certain policy objectives better than
traditional investments
30Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Challenges of alternative investments
Require greater expertise Lack of transparency Benchmarking Too much money chasing too few good
managers Expensive
31Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Risks
Low correlation – and stock market soars Committee panics and retreats at exactly the
wrong time Manager risk Career or headline risk
32Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Manager risk
Ten-year Performance DataThrough 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 %
33Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
Risk mitigators
Ensure that all decisions are driven by sound policy
Perform strong due diligence
Use a fund-of-funds
34Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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?
35Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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?
36Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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?
37Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ [email protected]
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)