TemplateDesign:DaltonMaag
RSVP'ingtheUnknown(It’sComingAnyway): The Role of Investment Policy Statements in Creating Better Long-Term Outcomes
Chris Magaña November 2015
www.imscapital.com
We make investing decisions based on how we feel rather than what we know
Source:CarlRichards,AuthorTheBehaviorGap
The worst time to try to make a prudent decision will be when these issues are on the front page of the Wall Street Journal.
Assume that when it comes to investing your board, finance committee and investment manager will behave irrationally
Take away
“Stockmarketso?enmoveinresponsetomanyfactorsunrelatedtotruevalue”ShlomoBenartziUCLAAndersonSchoolofManagement
“Theevidencethat
investor
emoJonsareinfluencin
gpricesof
securiJesisbecom
ingoverwhelming”
KentDaniels
GraduateSchoolof
Business,ColumbiaUnive
rsity
“Behavioralfinanceholdsthatinv
estors
tendtofallintopredictablepaPerns
ofdestrucJvebehavior.Inother
words,theymakethesamemistakes
repeatedly”LibraryofCongre
ss,BehavorialPaPernsandPiTall
sofUS
InvestorsResearcher:Seth
Elan
“Theinvestor’schiefproblem–evenhisworstenemy–islikelytobehimself.”BenjaminGrahamWarrenBuffe*’smentorandformerstudent
“Howcouldeconomicsnotbebehavioral?Ifitisn’tbehavioral,whatthehellisit?”CharlieMungerBillionaireinvestor,authorandphilanthropist
“Oursocietyglorifiesfreedomandfreewill,butwecarrymanyprimiJveimpulsesbeneaththethinveneerofcivilizaJon.Wewanttojoingroupsforsafetyandbeledbystrongleaders.Thegreatertheuncertainty,thestrongerourwishtojoinandtofollow.”AlexanderElderMedicalDoctorandProfessionalInvestor
ElementsofanIPS
InvestmentStrategy
Exhibits
ObjecIves
Acknowledgements
DefiniIonof
DuIes
Monitoring,EvaluaIng&
ReviewProcess
Purpose&Scope
SpendingPolicy&Liquidity
Nonprofits need to be more focused on finding the right level of spending in the face of lower expected future returns
Currently: US 10 Year Treasury yield 2.34%
ThecurrentyieldgivesyouadecentindicaJonofwhatyoumightearnoverJme.Since1926,henotes,theentryyieldonthe10-yearTreasuryexplains92%oftheannualizedreturnaninvestorwouldhaveearnedoverthesubsequentdecade
JohnC.Bogle FounderVanguardGroup
Source:WallStreetJournal“HowToPredictTheNextDecade’sBondReturns”March3,2014
Currently: Barclays US Agg Bond Index 2.37%
TheentryyieldontheBarclaysU.S.AggregateBondindexexplains90%ofits10-yearreturnsfortheyears1976to2012
TonyCrescenziPIMCOMarketStrategist
Source:WallStreetJournal“HowToPredictTheNextDecade’sBondReturns”March3,2014
Since 1926 US stocks have delivered a positive annual return about 75% of the time…if that relationship remains true will it be enough???
TemplateDesign:DaltonMaag
What do the tea leaves say about the future for stock prices?
7-YearAssetClassRealReturnForecastsUSLargestocks -1.1%USSmallstocks -1.2%InternaIonallarge0.8%Emergingstocks 4.2%GMO,LLCAugust31,2015
USEquity8-YearExpectedReturnBreakdown Core
USLargeCap 4.7%USMidCap 0.7%USSmallCap -3.7%Total(AllCap) 4.1%
WilliamBlairDynamicAllocaIonStrategiesTeam
October31,2015
SmoothedMovingAverageFormula:SpendingisbasedonastatedporIonoftheporeoliovalueattheendoftheprioryear.AsmoothingcalculaIonisthenappliedusingtheaverageendingporeoliobalancesoveranumberofpreviousyearsorquarter.Notes:SpendinghaslessvariabilityfromyeartoyearandgenerallymiIgatesmildebbsandflowsofthestockandbondmarkets.
BandedInflaJonFormula:StartwithadollaramountofspendingthatistypicallyexpressedasapercentageoftheiniIalporeolioinyearone.ThespendingamountforeachsubsequentyearisthendeterminedbymulIplyingtheprioryear’sspendingbyaninflaIonfactorsuchasCPI.Notes:Stablespendingyeartoyear,butmakesnoadjustmentfordecreasingspendinginanextendeddecliningstockorbondmarket.
HybridApproachFormula:ThelevelofannualspendingisdeterminedbycombiningafixedpercentageusingthebandedinflaIonmodelandafixedpercentageusingamovingaverageformulawith3or5yearsmoothing.Asaresult,aporIonofthespendingvariesbasedonthemarkets(inflaIonformula)andaporIonismorepredictable(movingaverage).Notes:ThisstrategyismostcommonlydeployedbyeducaIonrelatedorganizaIonsandprivatefoundaIons.Manysmallernonprofitsfindtheapproachtobeoverkillfortheirneedsandburdensomefortheamountofdedicatedresourcestheyhaveavailable.
SpendingRatesSurvey
Source:SEIReport“TheCurrentLandscapeofNonprofitSpending”2013
3% 4% 5%
Overall
Community
CulturalorArts
EducaJon
Faith-Based
Environmental
Sample:UCLAFoundaIonSpendingPolicy
TwelvequarteraveragewilltypicallydoagoodjobsmoothingoutmarketfluctuaJons
ForecasJngthenextsixquartersusingexpectedreturnscanbetricky,ifnotimpossibletodoconsistently.
Source:hips://www.uclafoundaIon.org/finances.aspx?content=investmentpolicy
Spending Policy Take Away
AprudentSpendingPolicyisthehardestandmostimportantstepsindevelopingtheIPS
ANonprofitmustdeterminewhichSpendingmethodologyisappropriatefortheirorganizaIon
TheSpendingPolicyshouldaiempttoachieveBOTHthecurrentandfuturespendinggoals
ThemethodologychosenshouldbeunderstoodbytheNonprofit’skeystakeholders
Themethodologyshouldnotbemorecomplicatedthatnecessary
Themethodologychosenshouldconsider:• Spendinggoals• Liquidityrequirements• VolaIlityinfunding
MyindustryrouInelydefinesriskasvolaIlityandorperformingpoorlyrelaIvetoabenchmark.WhatdothesedefiniIonsofrisktellusaboutanorganizaIonachievingit’sshortandlongtermspendinggoals? ANSWER: Very Little
Take Away: Find an investment manager that translates those definitions of risk into a discussion of your organization’s spending goals.
How would you evaluate an investment manager without using performance?
q Evidenceofcommitmenttotheinvestmentphilosophy
q Howthefirm’sdecision-makingprocessworks
q Philosophyonriskmanagementq Whatinternalcontrolsdoesthefirm
deployq Thequalityandpromptnessofits
reporIngsystem
q Thesizeofthefirmintermsofstaffandassetsundermanagement
q Howthefirmhaschargesclientsq Ancillaryservices(lending,planned
givingresourcesetc.)q Abilitytoentertainsponsorship
opportuniIesq Thefirm’sownershipstructure
www.imscapital.com
IPSChecklist
PoreolioRebalancing PrioriIzeRiskPerformanceMonitoring
SpendingPolicy AssetAllocaIonRoles&ExpectaIons
Case - Improving Due Diligence Scenario:Nonprofitclientreceivedafinancialwindfallof$20mandhired4investmentmanagerstooverseethefunds.IPS:TheclienthasathoroughlywriienIPSthatwasdraped10yearsago.TheIPSmateriallylimitsinternaIonalinvesIngandtheuseofhighyieldbonds.SpendPolicy:3%oftheaveragemarketvalueofthelast8quarters.ThestakeholdersconsistentlyhaveconcernstheorganizaIonisn’tspendingenoughtoachievethecurrentfinancialgoals.Also,thereissomeconcernregardingthevolaIlityintheannualspending,especiallyduringthe2008/09recession.InvestmentManagerDueDiligence:Theinvestmentcommiieemeetswitheachinvestmentteamquarterlyforonehour(backtoback).InvestmentManagers:TwolocalRIA,onelargebanktrustdepartmentandonelocaltrustcompany.All4managersdeploymostlyacIveinvesIngstrategies.
Case-DueDiligence(Issues)IPS:TheIPSisdatedandtheorganizaIonshouldreviewitandopenthediscussionuptotheinvestmentmanagerforcommentsorsuggesIons.It’sagoodpracIcetoreviewandpotenIallyrevisetheIPSevery5yearsorwhenmaterialcircumstanceshavechangedtheorganizaIonsspendingandinvestmentgoals.ThereconInuestobeinnovaIonintheinvestmentbusiness(notallforthegood)buttheIPSmaynotadequatelyaddresstheuseofETF,PrivateREITs,MLPasthesehavebecomemuchmorepopular.SpendPolicy:Thespendingpolicydoesn’tmatchtheorganizaIonsincomeneeds.Also,nooneinternallywantstodotherolling8quartercalculaIons.TheorganizaIonshouldconsidermodifyingthespendingrateto4%or5%whichwouldhelpthemachievetheircurrentspendinggoals.TheorganizaIonshouldalsoconsiderusingthe“smoothingmethod”over3or5yearstomaketheannualspendingamountmorepredictable.InvestmentManagerDueDiligence:TheInvestmentCommiieeisrelaIvelydisengagedbythefourthinvestmentmanagermeeIng.TheorganizaIonbudgetsonehourpermanageranddoesthembacktoback.SomeImesonlystoppingforashortbreakorlunch.Bythelastinvestmentmanagertheyhavealreadyheardseveralrecapsofthebigeconomic,poliIcalandinvestmentnewsmulIpleImes.It’smyopinionbythelastinvestmentmanagerortwothequalityofporeolioduediligenceisgreatlydiminished.InvestmentManagers:Using4acIveinvestmentmanagerstheorganizaIonisessenIally“blankeIng”thestockandbondmarkets.Theaggregateresultslookalmostlikeaverybroadstockandbondindexstrategy(minusmuchhigherfeesthanamorepureindexapproach).TheorganizaIonwouldbemuchbeieroffreducingtheirinvestmentmanagersto1or2.ReducingtheinvestmentmanagerswouldimprovetheiracIvemanagerbetsandmateriallyreducefees(astheorgwouldhavepricingpowerwiththeremaininginvestmentmanagers).ReporJng/MeeJngCycle:Meetlessfrequentlywitheachmanager,butdoamuchdeeperduediligencedive(meetonceortwiceperyearwitheachinvestmentmanager).TheinvestmentporeolioispermanentcapitalsomeeIngwithallforinvestmentmanagersquarterlyisoverkillandaninefficientuseoforganizaIonshumancapital.
Benchmarks
AbenchmarkcomprisedoftheexpectedinflaIonrateplusthespendingpolicyrate
Asimplebenchmark(apassivemixofstocksandbonds,suchas60%equity/40%fixedincome)
Arelevantpeeruniversebenchmark,suchasusingthedataprovidedbyHewiiConsulIngorRVKforperformanceofcomparableinsItuIons
TypicalInvestmentMeeJngAgenda• IntroducJonsandSmallTalk• Approveminutes• Reviewinvestmentperformancereport• Discussanymanager/assetclasschanges• Discuss“hottopics”intheeconomy/world
-WhenwilltheFedhikerates?-HowmuchwilltheChinaSlowdownimpactus?-What’sgoingtohappeninthenextelecJon?
• TelltheboardtoexpectvolaJlity(thereisalwaysvolaJlity)• CursoryreviewoftheSpendingPolicy,• CursoryreviewoftheIncomegeneraJonandanyunexpectedcash
flows• ClosethemeeJngwitha“Thankyouforyourbusiness”
KeyResponsibiliIesSpendingPolicyTheboardwithinputfromthefinance/investmentcommiiee
IPSoversightandtargetassetallocaJonThefinance/investmentcommiieeasauthorizedbytheboard
FrameworkforselecJng,sizing,andterminaJnginvestmentmanagersThefinance/investmentcommiieeasauthorizedbytheboard
InvestmentperformancemonitoringandreporJngandotherporTolioanalysisThefinance/investmentcommiiee
Odds and Ends
StockGips
Feeagreements
Stakeholdersfocusedonspendinggoals
AvoidBackTestedStrategies
ManagingRequestforProposals
SAMPLE:ConflictofInterestPolicyAnysituaIonwhichbringstomindthequesIonofapossibleconflictofinterestshouldbebroughttotheaienIonoftheInvestmentCommiiee;membersshouldbesensiIvetoeventheappearanceofimpropriety.Generally,aconflictofinterestexistswheneverliIgaIon,acontract,orotherrelaIonshipbeingenteredinto,reviewed,ormodifiedis:• BetweenABCandthemember,ortheemployer,businesspartner,orimmediatefamilyofthe
member;or
• BetweenABCandanorganizaIoninwhichthemember’semployer,businesspartner,orimmediatefamilyisdirector,officer,orlegalrepresentaIve,orhasamaterialfinancialinterest.
AconflictofinterestdoesnotarisesimplybecausedirectorsormembersoftheirfamiliesareincidentallybenefitedasmembersofaclassofpersonsenItledtobenefitfromatransacIon,policy,orprogramconsistentwithpurposesandaccomplishedingoodfaith.Forthesepurposes,“family”includesparents,siblings,children,grandchildren,andtheirspouses.ThispolicyisnotintendedtoprohibitinvesIngwithanyfirmsorinvestmentmanagerswithwhomaBoardMemberorCommiieeMemberisaffiliated;rathersuchrelaIonshipsmustbedisclosedandtheaffiliatedBoardorCommiieeMembershouldrecusehimselffromanydecisionspertainingtotheaffiliatedfirm.
Simplecanbeharderthancomplex:Youhavetoworkhardtogetyourthinkingcleantomakeitsimple.Butit'sworthitintheendbecauseonceyougetthere,youcanmovemountains
SteveJobs
ThankyouforyourImeandIwouldbehappytospeakwithyouaboutanyofthetopicswecoveredtoday.
Chris Magaña [email protected]
www.imscapital.com
AdvancedBonusCase-BenchmarkingShenanigans
Scenario:Nonprofitclienthasworkedwiththeinvestmentmanagerforovertenyears.Theporeoliosizeisover$1.5millioninassetswithmulIpleporIonsrestrictedandvariousannualpayouts(ranging2%-5%peryear).TheInvestmentmanagerusesanacIve(dynamic)benchmarkandreplacesabout20%ofthemanagersannual.TheInvestmentmanagertypicallyaddsand/orsubtractsabout1-2assetclassesperyearbasedonperformanceandtheinvestmentmanager’smacroeconomicforecast.TheinvestmentmanagerisrouInelya“preferred”($10k)sponsorattheNonprofit’sannualevent.InvestmentManager:Chargesaflat125bps(1.25%)annuallyforit’sinvestmentmanagementservices.DuJes:Theinvestmentmanagerisresponsibleforinvestmentduediligence,maintainingadequatecashreservesandreporIngtheinvestmentresultstotheNonprofit’sfinancecommiiee.TheNonprofithasnotputtheinvestmentmanagementrelaIonoutforanRFPsinceitstartedit’scurrentrelaIonshipwiththeinvestmentmanager.
CaseBenchmarking(Issues)Fees:Investmentmanagercharges1.25%annualwhichtranslatesinto$18,750peryear.Ifyoufactorinthe$10,000sponsorshiptheNonprofitonlypays$8,750peryearwhichtranslatesinto$8,750/1,500,000=.58%or58bps.Thatismuchmorereasonablegiventhefactthatthisisanonprofitclientwithasizeableporeolio.
Issues:q ConsiderincludingastaIcbenchmarkq UsetheacIve/dynamicbenchmarkforevaluaIngindividualassetclassmanagers.TheacIve/dynamicbenchmarksarenothelpfulfor
assessingtheinvestmentmanager’sassetallocaIonskills.Tofinishthestoryonthisissue.q Poreolioaveragedabout60%stockand40%bondsoverthelast10years.q AS&P500(60%)and(40%)BarclaysAggregatedindexstrategyoutperformedby2.5%peryearoverthepast10years.q The“strategicallocaIondecisions”haveshowntobelessthanstrategic(6out7trailedtheS&P500overtheImeperiodtheywere
held.q Theunderperformancecoststheclientabout$185Kover10years(That10KannualsponsorshipiscosJngtheorganizaJonmore
thantheyreallyknow).
BeforethisinformaIoncametolighteveryoneassumedthemanagerdidapreiygoodjobastheyshowedaposiIvereturnduringthelast10years(theS&P500wasup8%andbondsdidabout5%...it’stherisingIdelipsallboatsscenario).TheyalsoreallyliketheinvestmentmanagerandappreciatedthewhathadbecomeanannualcontribuIonof10KtoNonprofit’sannualevent.TheinvestmentmanagerwouldswitchequitybenchmarksfromImetoIme.ThesechangesviolatedtheNonprofit’sIPSbutthefinance/investmentcommiieedidnotchallengetheinvestmentmanageronthemaier.Ineveryinstancethebenchmarkchangeimprovedtheinvestmentmanager’sperformance.q TheinvestmentmanagerneedstobeheldaccountablefortheIPS.It’sagoodpracIcetoasktheinvestmentmanager(s)periodically
ifthecurrentIPSistoorestricIveinanyway.ThismakesforgooddiscussionsaboutpotenIalfuturerevisionsorhelpsgalvanizetheNonprofitontheir“core”investmentbeliefs.
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