John Wiley amp Sons Inc
The PracticalGuide to Managing NonprofitAssets
William A Schneider
Robert A DiMeo
Michael S Benoit ampAssociates
00 schneider fm 22405 714 PM Page iii
00 schneider fm 22405 714 PM Page ii
The PracticalGuide to Managing NonprofitAssets
00 schneider fm 22405 714 PM Page i
00 schneider fm 22405 714 PM Page ii
John Wiley amp Sons Inc
The PracticalGuide to Managing NonprofitAssets
William A Schneider
Robert A DiMeo
Michael S Benoit ampAssociates
00 schneider fm 22405 714 PM Page iii
This book is printed on acid-free paper
Copyright copy 2005 by John Wiley amp Sons Inc All rights reserved
Published by John Wiley amp Sons Inc Hoboken New JerseyPublished simultaneously in Canada
No part of this publication may be reproduced stored in a retrieval system or transmitted in any form or by anymeans electronic mechanical photocopying recording scanning or otherwise except as permitted under Section107 or 108 of the 1976 United States Copyright Act without either the prior written permission of the Publisheror authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center Inc 222Rosewood Drive Danvers MA 01923 978-750-8400 fax 978-646-8600 or on the web at wwwcopyrightcomRequests to the Publisher for permission should be addressed to the Permissions Department John Wiley amp SonsInc 111 River Street Hoboken NJ 07030 201-748-6011 fax 201-748-6008 or online athttpwwwwileycomgopermission
Limit of LiabilityDisclaimer of WarrantyWhile the publisher and author have used their best efforts in preparingthis book they make no representations or warranties with respect to the accuracy or completeness of the contentsof this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purposeNo warranty may be created or extended by sales representatives or written sales materials The advice andstrategies contained herein may not be suitable for your situation You should consult with a professional whereappropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercialdamages including but not limited to special incidental consequential or other damages
For general information on our other products and services or technical support please contact our CustomerCare Department within the United States at 800-762-2974 outside the United States at 317-572-3993 or fax317-572-4002
Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not beavailable in electronic books
For more information about Wiley products visit our web site at wwwwileycom
Library of Congress Cataloging-in-Publication Data
ISBN-13 978-0-471-69233-1ISBN-10 0-471-69233-6
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
infin
00 schneider fm 22405 714 PM Page iv
To my wife Caren and children Erik Laura Chris Katie and Jamie for their love andsupport
William A Schneider
To my wife Adriane and sons Chris and Danny for providing enormous joy in my life andto my partners and associates for being truly great teammates in building a wonderful firm
Bob DiMeo
To my wife Mary Alice and family for their encouragement and patience in putting up with me while working on this bookAlso thanks to my associates Julie and Katie for their help in deciphering and organizing many of my cryptic notes
Mike Benoit
To my wife Jeannie for her ever lasting love devotion and supportAlso to my beautiful daughters Mira and Petrea who bring way too much joy to my life Lastly to my loving mother Sandy and to my late fathermdashI miss you Lee
Doug Balsam
To my wife Kristin my inspiration whose love and support has meant everythingAlso to my parents Carrie and Jay for their guidance and encouragement
Matt Porter
I would like to thank my wife and partner Jennifer for her endless patience and under-standing during all the evenings and weekends spent at the local coffee shop working onthis book
Matt Rice
I would like to thank my husband Jeff Rondini for his constant encouragement confi-dence and support in all of my endeavors
Jackie Rondini
To my wife Kelli whose constant support and encouragement is so very appreciatedAlso to my parents Polly and Frank for their friendship and guidance through the years
Steve Spencer
To my husbandTodd who patiently listened to the countless readings of my drafts and offered well-timed words of encouragement Also to my dogs Bobby and Max who eagerly participated on long walks through the streets of Chicago to clear my writerrsquos block
Trina Sweet
00 schneider fm 22405 714 PM Page v
00 schneider fm 22405 714 PM Page vi
About the Authors
William A Schneider CIMA is a Managing Director of DiMeo Schneider ampAssociates LLC a Chicago-based firm that provides advisory services to spon-sors and financial institutions He currently advises several hospitals universityendowments and private foundations as well as not-for-profit organizations cor-porate plans several leading Midwest law firms and Fortune 500 companies Heholds the title Certified Investment Management Analyst awarded through theInvestment Management Consultants Association (IMCA) accreditation programat the Wharton School of Business He is the coauthor of Asset Management forEndowments amp Foundations (McGraw-Hill) and Designing a 401(k) Plan (Probus)
Robert A DiMeoCIMACFP is a Managing Director of DiMeo Schneider ampAssociates LLC Bob is an Advisory Board member for Catholic Charities ofChicago on the Governance Board for Notre Dame High School and a formermember of the Board of Directors for the IMCA He is the coauthor of AssetManagement for Endowments amp Foundations (McGraw-Hill) and Designing a 401(k)Plan (Probus)
Michael SBenoitCIMACFP is Managing DirectorPrivate Client Services atDiMeo Schneider amp Associates LLC He is a cofounder of the firm As aCertified Financial Planner he provides investment counseling services to corpo-rate executives family trusts and private foundations He has addressed nationalconferences on subjects including professional money management financialplanning and estate planning Mike is a member of the Financial PlanningAssociationHe received his bachelorrsquos degree from Bradley University in PeoriaIL and has completed the College for Financial Planningrsquos CFP ProfessionalEducation Program Mike is a Certified Investment Management Analyst
Douglas M Balsam CIMAAIFA is a Principal and Director of InstitutionalConsulting at DiMeo Schneider amp Associates LLC Prior to joining the firm
VII
00 schneider fm 22405 714 PM Page vii
he was a CommunicationsEducation Consultant at Scudder Stevens amp ClarkHe earned his bachelorrsquos degree at Miami University in Ohio and his MBAwithhonors from Loyola University in Chicago He is a Certified InvestmentManagement Analyst and Accredited Investment Fiduciary Auditor
Mathew P Porter CIMA is a Principal at DiMeo Schneider amp AssociatesLLC Matt chairs the firmrsquos investment committee Prior to joining the firm hewas a Trust OfficerWealth Management Trust Administrator at the NorthernTrust Company He is currently a member of the Investment ManagementConsultants Association (IMCA) Matt received a Bachelor of Science degree inFinance from the University of Illinois in Urbana-Champaign IL He obtainedthe title Certified Investment Management Analyst (CIMA) from IMCArsquos ac-creditation program at the Wharton School of Business
Mathew R Rice CFA CIMA CIMC is a Senior Consultant at DiMeoSchneider amp Associates LLC and member of the firmrsquos investment committeePrior to joining the firmhe was a Trust Officer Institutional Investment Servicesat Old Kent Bank Matt has performed extensive research in the areas of asset al-locationportfolio optimizationbest-practice portfolio rebalancing methods andalternative investment strategies Matt earned his Bachelor of Arts degree inEconomics from Northwestern University where he was Co-Defensive MostValuable Player on their 1996 Rose Bowl Team He is a Chartered FinancialAnalyst Certified Investment Management Analyst and Certified InvestmentManagement Consultant
Jacqueline A Rondini CFP CMFC is a Senior Investment Analyst at DiMeoSchneider amp Associates LLC and member of the firmrsquos investment committeePrior to joining the firm she was the Managed Accounts Coordinator atRodman amp Renshaw Inc She earned her Bachelor of Business Administrationdegree from Iowa State University in Ames IA She is a Certified FinancialPlanner and a Chartered Mutual Fund Counselor
Stephen W Spencer CIMC is a Senior Consultant at DiMeo Schneider ampAssociates LLC and a member of the firmrsquos investment committee Prior tojoining the firm he was a Financial Representative at Scudder KemperInvestments Steve earned his Bachelor of Arts degree in Economics from theUniversity of New Hampshire Steve is a Certified Investment ManagementConsultant and a member of the Investment Management ConsultantsAssociation (IMCA)
VIII about the authors
00 schneider fm 22405 714 PM Page viii
Trina M Sweet is Director of Investment Research at DiMeo Schneider ampAssociates LLC and a founding member of the firm She previously worked atFranklin Mutual Fund Company Securities Counselors of Iowa and KidderPeabody amp Company Trina has advanced training in performance monitoringShe received her bachelorrsquos degree from Northeast Missouri State
about the contributors
Joseph SAdams is a partner in the international law firm of McDermott Willamp Emery LLP based in the Firmrsquos Chicago officeAs a member of the EmployeeBenefits Department Joe concentrates his practice on employee benefits and ex-ecutive compensation matters for private public and tax-exempt organizationsA frequent speaker and writer on employee benefits and executive compensationissues Joe currently serves as the contributing editor for the Pension Plan Fix-ItHandbook and for Executive Compensation StrategisHe has previously served as thecontibuting editor for the Guide to Assigning and Loaning Benefit Plan Money andco-authored the first and second editions of Domestic Partner Benefits AnEmployerrsquos Guide Joe received his law degree cum laude from Cornell Law Schoolwhere he served as an editor for the Cornell Law Review Joe received his under-graduate degree from the University of Chicagorsquos Honors Economics Program
Richard S Gallagher is a partner in the Milwaukee office of Foley amp LardnerAs chair of the firmrsquos Tax and Individual Planning Department and a member ofthe Taxation Practice Group his practice focuses on business and tax matters forfamily-owned companies corporate planning and reorganizations trust and es-tate administration the qualification of tax-exempt organizationsunrelated busi-ness income and private inurement matters and tax estate and gift planning forphilanthropists foundations and charitable trusts
Mr Gallagher is the former chairman of the Exempt Organizations Commit-tee of the American Bar Association (ABA) Section on Taxation the past chair-man of the Committee on Administration of Estates and Trusts of the RealProperty Probate and Trust Law Section of the ABA and a fellow of theAmerican Law Institute the American College of Tax Counsel the AmericanCollege of Trust and Estate Counsel and the Milwaukee Bar AssociationFoundation over which he presided as president from 1977 until 1983 He islisted in The Best Lawyers in America under Tax Law and Trusts and Estates
MrGallagher graduated from Harvard University Law School (JD1967) andfrom Northwestern University (BS in business administration with distinction1964) He was admitted to the Wisconsin Bar in 1967
about the contributors IX
00 schneider fm 22405 714 PM Page ix
00 schneider fm 22405 714 PM Page x
XI
Contents
chapter 1 Introduction 1A Crying Need 1Shocks to the System 2Finances 3Contributors 4The Pension Problem 4Environment of Mistrust 4The Good News 5The Fund-Raising Challenge 6Gifting Strategies 6Investment Strategies 6Expect to Find 7How to Use this Book 8Who Should Use this Book 9
chapter 2 Special Issues 11HospitalsmdashThe Retirement Plan Mess 11Underfunded Pensions 11403(B) versus 401(K) 12Annuities 13Mutual Funds 15Education and Communication 16Endowment and Operating Funds 18Contributions 18Considerations for Religious Institutions 19Summary 20
chapter 3 The Total Return Approach 21Early History 21The Modern Era 22The Legal Challenge 23The Barker Report 23UMIFA ERISA UPIA and the Prudent Investor Standard 24The Case for the Total Return Approach 25Potential Negatives 26Summary 26
00 schneider fm 22405 714 PM Page xi
XII contents
chapter 4 The Prudent Steward 29Build a House Build an Investment Program 29Set Goals The Blueprint 29Allocate Assets 30Manager Selection Hire the Subcontractors 30Rebalance 30Monitor Performance 31
chapter 5 Set Goals 33Introduction 33Define the Mission 34Determine a Spending Policy 34Establish the Required Return 40Understand Your Risk Tolerance 41Designate the Time Horizon 42Summary 44
chapter 6 Investment Policy 45Overview 45Why Is It Important 45Content 46Sample Investment Policy Statement 46Implementation and Maintenance 48Specific Investment Guidelines 48Investment Benchmarks 49Summary 49
chapter 7 Asset Allocation 51The Efficient Frontier 51Capital Market Assumptions The Building Blocks
of Portfolio Construction 53Developing Expected Return Assumptions 54Modern Portfolio Theory 60Shortcoming of Traditional Mean Variance Optimization 62The Long Run 64Probabilistic Optimization Models 65Summary 67
chapter 8 New Asset Classes 69Real Estate Investment Trusts 69The Statistical Properties of Historical REIT Returns 71High-Yield Bonds 73International Bonds 78Mutual Fund or Separate Account 86Experience Counts 87Summary 87Inflation Indexed Bonds 87Risk Factors 92Conclusion 92
00 schneider fm 22405 714 PM Page xii
chapter 9 Investment Style 93Academic Research 93Ancillary Uses 97The Current State 98Summary 98
chapter 10 Manager Selection 99Overview 100Herd Mentality 100Avoiding the Star System 101Where to Begin 102Manager Selection 104Passive versus Active Management 111Databases 112Administrative Compatibility 113Trade Execution 113Social Investing 113The Commonfund 114Proxy Voting 115Account Types 115Negotiate Fees 116
chapter 11 Alternative Investments 119Hedge Funds (Absolute Return Strategies) 120Funds of Funds 121Risks 122Benefits 124Fund-of-Funds Search 125Real Estate 126Timberland 127Private Equity 131Structured Equity 134Managed Futures 136An Investment Strategy 136Benefits of Diversification 137Risks 137Conclusion 139
chapter 12 Portfolio Rebalancing 141Traditional Rebalancing Methods 141A New Approach 143Building Your Own Model 147Conclusion 150
chapter 13 Performance Measurement and Evalaution 151Performance Calculations 152Benchmarks 153Market Indexes 155Style 155
contents XIII
00 schneider fm 22405 714 PM Page xiii
Picking the Right Index 156Multiple Benchmarks 157Presenting the Data 157Universe Comparisons 157Portfolio Analysis 160Style Analysis 160Risk Analysis 162Recent Developments 164Performance Reporting 166Terminating a Manager 166
chapter 14 Socially Responsible Investing 169History 169Socially Responsible Investing Strategies 170Separate Accounts versus Mutual Funds 175Performance Impact of Socially Responsible Investing 176Incorporating Socially Responsible Investing
into Investment Policy 178
chapter 15 Selecting Other Vendors 179Step One 179Step Two 180Step Three 182Step Four 184Record Keepers 186Narrow the Field 188Final Steps 190Defined Benefit Plans 190Gift Annuities 191Brokers 194
chapter 16 Hiring an Investment Management Consultant 195Identifying the Need A Tale of the Typical
Nonprofit Organization 195The General ContractormdashAKA The Investment Consultant 196Effective Use of a Consultant 204Summary 205
chapter 17 Behavioral Finance 207Trying to Break Even 208Snake Bitten 208Biased Expectations and Overconfidence 208Herd Mentality 209Asset Segregation or Mental Accounting 209Cognitive Dissonance 210Anchors 210Fear of Regret and Seeking Pride 211Representatives 211Familiarity 211Investor Personality Types 211
XIV contents
00 schneider fm 22405 714 PM Page xiv
Risk-Seeking Behavior 212Naturally Occurring Ponzi Schemes and Market Bubbles 212Conclusion 213
chapter 18 Legal Aspects of Investing Charitable Endowment Restricted and Other Donor Funds 215Overview 215The Nature of Endowment or Restricted Funds 216Endowments Created by the Board 216Donor-Created Endowment Funds 217Donor-Created Restricted Gifts or Funds 217General Statement About Investing Endowment
and Other Funds 217The Prudent Man Rule 218The Prudent Investor Act 218Uniform Management of Institutional Funds Act 220Private Foundation Rules 222Summary 223
chapter 19 Fiduciary IssuesmdashRetirement Funds 225ERISA 225Who Is a Fiduciary 227Fiduciary Requirements 229Penalties for Fiduciary Breaches 231Prudent Procedures to Limit Fiduciary Liability 233Department of Labor Tips to Help Fiduciaries
Understand Their Responsibilities 236
chapter 20 Final Thoughts 239Summary 239The Prudent Steward 240Take Aways 240Conclusion 241
appendix a Sample Investment Policy Statement 243Introduction 243Purpose 243Spending Policy 244Investment Policy 244Investment Objectives 244Asset Allocation 245Cash FlowsRebalancing 245Transaction Guidelines 246Selection of Investment FundsManagers 246Performance Monitoring 246Termination of Managers 247Proxy Voting Policy 247Responsibilties of the Investment Consultant 247Meeting Schedule 248ABC Hospital Fund 248
contents XV
00 schneider fm 22405 714 PM Page xv
General Guidelines for All Managers 248Specific Guidelines 249Investment Manager Objectives Evaluation
Benchmarks of Selected Managers 249
appendix b Investment Manager Questionnaire 251
appendix c Sample Search Investment Analysis 259Definition of Key Statistics 259Large Company Value Search The Screening Process 261Large Company Value Investment Analysis 262Large-Cap Value Equity Analysis 264
appendix d zzz eVestment Alliance LLCeA US Equity Sample Product 271
appendix e Request for Proposal for Hedge Fund-of-Funds Management 293
appendix f Request for Proposal Record-Keeping ServicesFirm Background 305
Plan Sponsor Services 307AdministrationRecord Keeping 308Participant Services 309Communication and Education Services 311Investments 312Trustee Services 313Mutual Fund Trading Practices 313Fees 314Conversions 316
appendix g Resources 319Data 319Analytical Software 320Other Resources 323
Glossary 325
Index 333
XVI contents
00 schneider fm 22405 714 PM Page xvi
chapter 1
Introduction
a crying need
ldquoIt was the best of times it was the worst of timesrdquoThatrsquos how Charles Dickensbegan A Tale of Two Cities a novel about another turbulent era Our own is morechallenging Information can travel around the globe at the speed of an electriccurrent but the ancient scourges of ignorance disease poverty and hatred are farfrom banishedAn optimist can find cause for gratitude new advances in agri-culture allow fewer and fewer farmers to feed the world Biotechnology haschanged the face of medicineThe fall of Communism has already freed millionsof workers and is beginning to create more vibrant economies around the globeBut change creates turmoil Some lives improve others get worse
Not-for-profit institutions (charitieshospitals schools and religious organiza-tions) face a growing need for their services Simultaneously governments in theUnited States and around the world have been forced to cut back some of theirtraditional supportThe money simply is not there
Demographics have changed and will continue to change dramaticallyMedical science makes it possible to live longer but at a cost An aging popula-tion taxes the infrastructure Promised entitlements such as Social Security andMedicare will ultimately be cut backWho will pick up the slack
The extended family structure that served mankind for centuries has brokendown Millions of children are now raised by single parents Even in the ldquotradi-tionalrdquo family if both parents need to work the odds are the kids will be shippedoff to a day-care center rather than to loving relatives Many grandparents nowlive halfway across the country rather than around the corner Incapacitated
1
01 schneider 22405 715 PM Page 1
grandparents themselves face the prospect of ending up in a nursing home or assisted-care facility rather than in a spare room at their sonrsquos or daughterrsquos home
Increased globalization also creates serious challenges On the one hand soci-ety profits from free trade Goods and services become more affordable and ulti-mately more jobs are created as entrepreneurs find ways to profit from the neweconomyThink of all the people employed in importing distributing and retail-ing a portable compact disc player made in China And since the player is socheap almost every teenager has oneThe teens in turn become voracious con-sumers of compact discs thus employing musicians singers artists producers salespeople and so forthOn the other hand try explaining all that to an unemployedfactory worker whose assembly line job will never return to the United States
Our educational system has produced uneven outputAlthough our collegesand universities train the best and the brightest as future doctors and scientists analarming percentage of high school students fall through the cracks Math andreading scores have fallen and drop-out rates have increased over the past 30years In the mid-20th century those failing students could still join the work-force as unskilled laborers or find a job on an assembly linemdashboring jobs to besure But itrsquos exactly those boring or repetitious jobs that are being lost to au-tomation or exported to countries with cheap labor
shocks to the system
Other disturbing trends are afoot around the globeFirst and foremost the spreadof AIDS may overwhelm all other forces Sub-Saharan Africa provides an exam-ple Just as the great plague threw Europe into the Dark AgesAIDS has alreadydestroyed the fabric of society in certain areasTens of thousands of orphans havebeen left to raise themselvesWith no parents to teach them how to farm eventhe basics of food production lie in jeopardy
The world has become more polarized The rise of Islamic fundamentalismhas led to new levels of intolerance and barbarismWe live in a time when someparents and ldquoreligious leadersrdquo train their own children to become suicidebombers Even in the United States politicians seek to exploit class warfare andpartisanship for their own political ends
Billions of dollars worth of illegal drugs and alcohol are consumed each yearBy some estimates the underground drug trade may be the third or fourth largestsector of the economy The social challenges are enormous Government at-tempts to stamp out the drug trade have been a spectacular failureWe havehow-ever succeeded in creating the largest prison population of all time
In short there is a crying need for all of the services provided by not-for-profit
2 chapter 1 introduction
01 schneider 22405 715 PM Page 2
organizations It does not matter whether your mission is extremely broad orquite narrow the challenges are enormous
finances
Although the challenges are abundant money is notThe 21st century beganwith a three-year bear market in stocksThis downturn (the worst in 100 years)devastated many nonprofit organizations Even a strong market recovery in 2003and 2004 hasnrsquot restored financial health
In the 1980s and 1990s fund fiduciaries became accustomed to equity returnsof over 15 per year and double-digit bond returns as wellNonprofit investmentcommittees debated whether to spend part of the ldquoextrardquo return they had earnedSometimes they did Many universities issued bonds to finance new stadiums orother facilities counting on return from the portfolio to help pay the debt By2003 some of the loan covenants were in jeopardy
To put the magnitude of the equity decline into perspective if returns on theStandard amp Poorrsquos (SampP) 500 index average 15 per year from 2004 through2009 then the average annual return for the entire decade will be just 69 Andmost experts doubt that the SampP 500 will return anywhere near 15 per year forthat period
There are only three possible components of stock return dividend yield plusearnings growth plus (or minus) multiple expansion (or contraction)The divi-dend yield of the SampP 500 is currently under 2Assuming that analysts are notwildly optimistic nominal earnings growth might be in the 5 to 6 rangeThisproduces a 67 to 78 returnmdash unless you expect multiples to rise
Earnings multiples (the price-earnings ratio or PE) reflect the price investorsare willing to pay to acquire a dollarrsquos worth of earningsThe SampP 500rsquos currentmultiple is around 21 times earningsUnfortunately that number is near the highend of its historic rangeThe long-term PE ratio average for the index is 16times earningsBearish investors argue that PE ratios are more likely to contractthan to expand Non-US stocks seem more reasonably priced but one canrsquotbuild a portfolio of only foreign equities
Bonds donrsquot seem to be a compelling bargain eitherWith interest rates near a45-year low and the threat of inflation increasing rates may continue to rise Thatis a problem for bond investors Bond prices of course move in the opposite di-rection from interest rates like the opposite ends of a teeter-totterWhen rates goup bond prices fall and vice versa
Wersquove heard the argument that ldquoif we hold the bonds until maturity wersquoll getall our money backrdquoThat may be true but prior to maturity one would not be
finances 3
01 schneider 22405 715 PM Page 3
able to sell without realizing a substantial lossThis means the investor would belocked into lower-yielding bonds and unable to replace them with higher yieldsavailable in the marketplaceThis is still an opportunity cost Investors who usebond funds rather than directly owning the bonds themselves do not even havethis option Bond funds never mature
contributions
One additional component of this ldquoperfect stormrdquofor nonprofit organizations hasbeen the effect on givingThere used to be a substantial incentive for wealthydonors to gift appreciated stock to charities Not only did the donors avoid paying capital gains tax on the stock but they also received a tax deduction forthe full amount donated After the bear market highly appreciated stock may bein short supply Additionally the tax code now provides more favorable capitalgains treatment than it did a few years ago In any case donations have droppedconsiderably
the pension problem
Some not-for-profit organizations face an additional challenge Organizationsthat offer a defined benefit (DB) pension plan to employees may find their re-sources squeezed even further Because of the way pension liabilities are calcu-latedDB plans face a double whammy The lower interest rates act as a multiplierfor pension obligations while lower asset values mean that there is less money topay for those liabilitiesThis has forced some institutions to make required pen-sion contributions instead of funding important programs
environment of mistrust
Fund fiduciaries are also uneasy about their financial vendorsCorporate Americais sporting a black eye It now seems that a number of companies were cook-ing the books so that insiders could reap huge profits in the form of rising prices on their stock options In some cases auditors who were supposed to safeguard the public were in on the scamAndersen one of the oldest and most respected accounting firms was driven out of business for its role in the Enronscandal
Wall Street analysts in many cases were shown to be nothing more than shillsfor the investment bankersE-mails revealed that certain analysts privately labeled
4 chapter 1 introduction
01 schneider 22405 715 PM Page 4
stocks ldquodogsrdquo that they publicly touted as strong buys Several of the largest bro-kerage firms were forced to pay huge fines
Even mutual funds long considered to be the champion of the small investorwere tainted by the probes A significant number of fund companies allowed cer-tain hedge funds to trade in ways that harmed the rest of their investorsldquoLatetradingrdquo and ldquomarket timingrdquo abuses led to hundreds of millions of dollars infines Some fund CEOrsquos lost their jobs and in one case the founder of the fundcompany was forced to resign
In this environment board members of not-for-profit organizations feel theadded pressure of scrutiny themselvesThe Senate Finance Committee has beenreviewing the financial practices of public charities Not-for-profit funds are cat-egorically different from most other investment pools (In most cases there are noldquobeneficiariesrdquo who have a claim on the fundsmdashhence less chance of litigation)However in some cases dissatisfied donors have demanded refundsMaybe boardmembers are just feeling less confident then they did in the late 1990s In anycase there is a clear increase in fiduciariesrsquo desire for prudence See Chapters 18and 19 for more information on regulatory requirements
the good news
The bleeding stopped at least temporarily in 2003 and 2004Virtually all of thecapital markets performed well Stocks and bonds both domestic and interna-tional turned in solid years Furthermore even the substyles (large-cap mid-capand small-capmdashboth growth and value) did well In addition Congress has pro-vided some legislative relief on pension funding requirements
Perhaps the most important developments have come in the form of advancesin investment theory These should lead to improved risk-adjusted (and absolute)returnThese advances will be presented later in the bookTo take profit fromthese new techniques fund fiduciaries will need greater knowledge and analyti-cal capabilitiesBut the payoff from new investment strategies and asset classes willbe substantial
One outgrowth of the Wall Street scandal is that investment organizations aremuch more concerned with complianceThe treatment of investors should be-come much more even-handedMutual funds in particularwill be working hardto avoid any hint of future scandal Nothing focuses attention on governance is-sues more than a few highly public firings
Finally costs are coming down Some of the mutual fund settlements have in-volved fee reductionsAlso the Securities and Exchange Commission (SEC) andother regulators are focusing on expenses 12b-1 fees and trading costs will likely
the good news 5
01 schneider 22405 715 PM Page 5
shrink dramatically The use of ldquosoft dollarrdquo payments is coming to a screechinghaltSoft dollars are commissions (usually above market rate) awarded to compen-sate brokerdealers for other services such as research and marketing
the fund-raising challenge
Entire books are written on the subject of fund-raising and it has become an in-dustry unto itself Here rather than present fund-raising ideas we wish to brieflyaddress the important role that investment strategy and structure has in aiding thefund-raising effort for nonprofit organizations
All fund-raisingmdashwhether a significant capital campaign or a single request foran individual giftmdashwill have a better chance of success if you can articulate well-conceived gifting strategies and investment policies Sure potential donors wantto know ldquowhat their donation will buyrdquo however they also need to understand
1 What gifting options or strategies are available to them and
2 How the money will be managed (investment policy)
gifting strategies
Nonprofit organizations that expand the ways in which donors can make gifts receive more contributionsSuccessful institutions move beyond year-end check-book campaigns to offer donors true value-added gifting strategies
To increase your raise be flexible in how yoursquoll accept gifts Create mecha-nisms that allow you to accommodate and even encourage nontraditional gifting
Noncash Gifts Make it simple for individuals to donate appreciated securitiesreal estate or other assets It is important to have policies in place regarding thedisposition of such assets Also and this is critical be sure that appropriate ac-knowledgement and appreciation procedures are in place There is perhaps noth-ing that will harm your fund-raising efforts more than not thanking donors on atimely basis Too many nonprofit organizations tolerate sloppy proceduresWeeksor even months pass between the day a donor ships securities to the broker ofrecord and when the charity is notified of the gift (Exhibit 11) Obviously thelack of a prompt ldquothank yourdquo discourages future gifts
investment strategy
The more that donors and potential donors know about your investment pro-gram the better Donors gain confidence when they see a well-conceived strat-egy that is clearly articulatedAs a result they are likely to give more
6 chapter 1 introduction
01 schneider 22405 715 PM Page 6
Consider the University of Notre Dame EndowmentAt over $3 billion it isamong the 20 largest educational funds in the United States A visit to the in-vestment office link at wwwndedu reveals a nonprofit organization that is seri-ous about communicating investment strategy
The site is flush with general information on the purpose of the fund but forthose interested they provide specific details on topics including
bull Basic Objectives of the Fund Specific rate-of-return targets
bull Investment Policy Long-term asset allocation targets by asset class
bull Investment Management Strategy Selection criteria for hiring and evaluatingmanagers
bull Performance Results Historical results compared to key benchmarks
bull Spending Policies and Trends
In attempting to raise money nonprofit organizations must use every availableresource This book can help an institution create an outstanding investmentstructure The key is to be sure to communicate this structure to donors and po-tential donors
expect to find
In this book the authors will
bull Examine fund-raising challenges
bull Explore special issues facing hospitals colleges and religious orders
expect to find 7
exhibit 11 keys to world-class donor service
bull Be committed
bull Be properly resourced
bull Be consistent
bull Be quick
bull Be personal
bull Be known
bull Be meticulous
bull Be there
bull Be honest
Source CharityVillagecomKen Burnett author of Relationship Fund Raising-Based Approachto the Business of Raising Money
01 schneider 22405 715 PM Page 7
bull Examine spending policy and its impact on the health of the organization
bull Explore investment theory including some of the new insights of behavioralfinance
bull Discuss fiduciary issues including the evolving state of the various uniforminvestment acts as well as the impact of the Employee Retirement IncomeSecurity Act (ERISA)
bull Provide a framework for evaluating and selecting consultants brokers ven-dors record keepers and other resources for the fund
Most importantlywe will outline a systematic approach for the prudent stew-ard The coming chapters explore in depth each of these important steps
bull Goal setting
bull Asset allocation
bull Developing a written investment policy statement
bull Selecting managers
bull Portfolio rebalancing
bull Performance evaluation
bull Cost control
how to use this book
Of course one could read the book from beginning to end But the book is de-signed to be modularThat is each section is self-contained So if for exampleyour immediate concern is manager selection you could turn to that sectionOne important note to create the optimal systematic approach you need to fol-low all the steps listed above If you skip any of them you will do your fund andyourself a great disservice
We have attempted to make this resource as user friendly as possibleWhereverpossible we have included checklists forms sample documents and worksheetsWe also list sources for information software and servicesThese lists while notexhaustive should provide helpful direction
We examine the roles and responsibilities of various providers and vendors tothe fund Fiduciaries are often confused about the function of consultants versusmoney managers versus brokers versus custodiansWe explain what you shouldand should not expect from eachWe also provide a framework to help you selectproviders in each area
8 chapter 1 introduction
01 schneider 22405 715 PM Page 8
who should use this book
This book is written first and foremost as a practical guide for fiduciaries of non-profit fundsmdashboard members and internal business managersWe hope to con-vey the best practices of the marketplace as well as current academic researchWetry to keep this as readable as possible so that it can be a pragmatic guideWherever possible we attempt to tell you ldquowhat time it isrdquo rather than ldquohow thewatch is maderdquoSome technical explanations are necessary from time to timebutwe will stick to plain English as much as possible
A second group that may find this book useful are the various advisers to non-profit organizationsThis group includes accountants attorneys and even con-sultants Hopefully this book will enable professionals and their client (thenot-for-profit organization) to better communicate It should also provide toolsthat can help add even more value for your client In some cases it may provideammunition to persuade your client to take needed action
Money managers brokers custodians and other vendors will find this bookuseful It may give you an enhanced sense of how your service fits into the clientrsquosworld-view It may even be a sales tool to help clients understand how your serv-ices benefit them
Finally anyone who is interested in the oversight of nonprofit funds shouldgain new insightThis group includes legislators teachers students communityactivists reporters and others
who should use this book 9
01 schneider 22405 715 PM Page 9
01 schneider 22405 715 PM Page 10
chapter 2
Special Issues
hospitalsmdashthe retirement plan mess
Regardless of how large or small a hospital might be retirement plans are a bigissuePension plans cover a growing number of retirees and defined contributionplans have almost become a requirement for attracting and retaining quality em-ployees In this chapterwe discuss several topics including underfunded pensionplans 403(b) 401(k) plans and capital campaigns
underfunded pensions
During much of the 1980s and 1990s pension funding was an afterthoughtConsistent double-digit returns from the equity markets kept the coffers full formost plans Plan sponsors were not as interested in true asset allocation strategiesas they were in just being ldquoin the marketrdquoAs wersquove noted the bear market of theearly 2000s changed all of that Steep declines in the equity markets coupled withlow interest rates helped create the current mess but ill-conceived investmentpolicies compounded the problemsFor the first time in nearly two decadespen-sion plan committees are looking at hefty funding requirements Hospital ad-ministrators face a serious challenge in dealing with underfunded pension plans
Because government regulations require pension plan balances to stay withina certain percentage of outstanding liabilities (the amount owed to current andfuture retirees) organizations must ratchet up contributions to their plans if theratio slips Corporations face similar problems but the cost of pension plan lia-bilities shows up in lower corporate earningsWhen hospitals or other not-for-profit organizations are forced to make extra contributions to pension plans
11
02 schneider 22405 715 PM Page 11
important organizational goals may be jeopardized If budgets are tight a contri-bution to a pension plan may take the place of a new piece of much-neededmedical equipment
The pension quandary forces you to make sure that you have a full and real un-derstanding of your pension planWhat does the demographic profile of the planlook like Has an assetliability study been done recently Is there too much riskembedded in the planrsquos asset allocation Too little Do you properly monitor theinvestment managers Although these questions are extremely important for all pension plans they are crucial for not-for-profit organizations that may rely on donations or special funding for their success In addition to pension problemsnot-for-profit organizations face challenges with their other retirementvehicles
403(b) versus 401(k)
Since its inception in 1958 the 403(b) has been the primary retirement savingsplan available to not-for-profit organizations Historically most 403(b) vendorshave been insurance companies Some have been top-notch vendors but manyare secondary or tertiary players Mutual fund companies have traditionallyavoided this market even though their record keeping investment prowess andeducational materials make them the dominant providers in the 401(k) arena
401(k) plans had their inception in 1981They quickly grew to become thedominant retirement plan typeCompeting vendorsmostly mutual fund compa-nies engaged in a kind of ldquoarms racerdquo of service offerings seeking to increasetheir share of this exploding market Daily valuation on-line account access 24-hour call centers robust educational capabilities and almost complete investment flexibility became hallmarks of the 401(k) arenaVendors commit millions of dol-lars each year for hardware software systems and people to enhance their abilityto service participant-directed plans Simultaneously competition has drivenprices down
Superficially 401(k) and 403(b) plans look very similar Both are sponsored bythe participantsrsquo employer Both allow participants to save their own money on atax-deferred basis Both allow for investment choice However there were smallbut significant differences in testing record-keeping and eligibility requirementsMaybemore importantly assets in 401(k) plans were showing enormous growthwhile 403(b) plan assets were not Part of the problem for 403(b) plans has beenthat they have been just different enough that the mutual fund companies aban-doned the field to the insurers
With the passage of legislation in 1996 nonprofit organizations (including
12 chapter 2 special issues
02 schneider 22405 715 PM Page 12
hospitals) now have more options Some of the ldquoone-off rdquo reporting and record-keeping requirements were modified to make 401(k) and 403(b) plans more sim-ilar Not-for-profit organizations are able to offer 401(k) plans in lieu of oralongside 403(b) plans Plan sponsors can look outside the insurance industry forprovidersThe ability to access 401(k) plans and vendors has been a significant up-grade for both not-for-profit plan sponsors and participants
Traditional 403(b) plans have several inherent problemsTwo of the biggest arethe issues of ldquoretailrdquo (as opposed to institutional) pricing and the lack of adequateparticipant education Historically each 403(b) participant has been treated as anindividual investor rather than as part of a sizable retirement plan Competingvendors often set up tables in the cafeteria and tried to sell individual participantstheir product Any ldquoeducationrdquo was typically a thinly disguised sales pitch Ofcourse this inefficient delivery system required sizable commissions to incent thesales force Commissions as high as 5 to 7 of invested assets are common Inaddition there are often trailers ongoing commissions paid as long as the policyis in force
annuities
The overwhelming majority of investment options in 403(b) plans are variable orfixed annuities Exhibit 21 shows the breakdown of assets within the 403(b) marketplace
As an investment vehicle annuities are qualitatively different from mutualfundsAn annuity is a contract with an insurance companyAnnuities can be ei-ther variable or fixed Variable annuities do not pay a stated rate of return but rathera variable rate depending on the market returns for the underlying investmentsIn essence they are mutual funds within the umbrella of an annuity contractFixed annuities operate in a similar fashion to a certificate of deposit (CD) pay-ing a stated rate of return
There are typically added layers of expense attached to the variable contractssometimes this added layer is called a wrap fee (because it wraps around the usualmutual fund expenses)The wrap fee is used to pay administrative fees mortality(these are insurance contracts) and commissionsAn additional expense often as-sociated with both types of annuity contracts is the surrender charge or deferredsales chargeThis is a fee that is paid out of the fund balance if the investment issold within a defined period after the contractrsquos purchaseThe surrender chargeschedule may extend as long as 10 years with charges declining each year untilthe surrender period is over Excessive fees and onerous contracts are the biggestproblems with annuity investments In response to competitive pressure some in-
annuities 13
02 schneider 22405 715 PM Page 13
14
ex
hib
it 2
14
03
(b)
pla
n a
ss
ets
an
d s
ha
re
of
to
ta
l 4
03
(b)
pla
n a
ss
ets
by
ins
tit
utio
n
19
96
ndash20
03
Life
Insu
ranc
eVa
riab
le A
nnui
tyN
onndashV
aria
ble
Annu
ity
Com
pani
esM
utua
lFun
dsM
utua
lFun
ds
Asse
tsS
hare
As
sets
Sha
re
Asse
tsS
hare
As
sets
(bill
ions
)(p
erce
nt)
(bill
ions
)(p
erce
nt)
(bill
ions
)(p
erce
nt)
(bill
ion)
1996
208
5810
329
4513
356
1997
238
5612
930
5914
425
1998
205
4715
836
7517
437
199
92
364
519
136
98
1952
52
00
02
524
917
434
90
1751
62
00
12
05
46
150
348
82
04
432
00
22
3554
120
28
7918
435
20
03
26
950
158
3010
52
053
2
Per
cent
age
ofto
tal4
03(b
) pla
n as
sets
So
urce
Inv
estm
entC
ompa
nyIn
stitu
te
02 schneider 22405 715 PM Page 14
surers have upgraded their offerings to bring them in line with current best prac-tices But far too many are still sold the old-fashioned way
Why is the annuity still so prevalent in the 403(b) marketplace Until 1974they were the only approved investment for 403(b) plans Over many years theybecame entrenched and until recently were thought of as an appropriate invest-ment vehicle for participantsAs mentioned traditional 403(b) plan investmentsare sold directly to employeesA large commission-based sales force has focusedon these plans for decadesOf course they have a strong incentive to defend theirmarket share
403(b) plans that make no employer contributions are not subject to theEmployers Retirement Income Security Act (ERISA) Such plans do not facediscrimination testing requirements and do not have to file a form 5500Thisflexibility will likely keep certain sponsors in the 403(b) fold Plans that do makea match have either already moved or are considering a switch to 401(k)Howevermany of the major 401(k) vendors are now beginning to service 403(b)plans as well
mutual funds
Why should a plan sponsor consider mutual funds instead of annuities There areseveral reasons starting with fees Mutual funds in 401(k) and ldquoupdatedrdquo 403(b)plans are available with no front-end or back-end loads to participantsTheiroverall expense ratio will generally be low as well (if the plan sponsor is prudentin the selection process)A retirement plan has an enormous advantage over anindividual investor hellip sheer size Defined contribution (DC) plans have access to institutionally priced funds that are unavailable to individual investorsTheseinstitutional funds often have expense ratios that may be half of those in retailshare classes
Access to superior money management is the second major advantage of mu-tual fundsWith the number of mutual funds nearing 9000 there is an abundanceof quality money management firms from which to choose In the mutual fundworld if a fund underperforms significantly investors leaveAs you can imaginecompetition for top talent is fierce and money managers who succeed are re-warded handsomelyThere are few back-end loads or contracts to keep investorsin place Fund companies recognize this and go to great lengths to maintain acompetitive performance record
A final advantage of mutual funds is name recognition It comforts participantsand may raise their level of interest in the plan Name brand mutual funds aremore likely to generate water cooler conversation about investing
Because of these advantages a number of insurers have begun to offer well-
mutual funds 15
02 schneider 22405 715 PM Page 15
known mutual funds either as subadvisers to their annuities or as stand-alone of-ferings within the plan
education and communication
Average participation rates in 403(b) plans are near 60whereas the average par-ticipation in 401(k) plans is 70 (Exhibit 22)
Why is there such a significant difference particularly among the nonndashhighlycompensated group One major reason is the lack of access to effective partici-pant educationWith investment options often scattered across several insurancevendors and a lack of a central record keeper providing statements it is exceed-ingly difficult to communicate a consistent message to employeesAnd a consis-tent message is crucial With multiple vendors and multiple statementsparticipants may become victims of information overload and simply quit tryingto understand it allTo exacerbate the problem when it comes to the number ofinvestment choices 403(b) plans have operated under the assumption that ldquomoreis betterrdquo Recent research shows that as the number of plan investment optionsincreasesparticipation rates actually declineExhibit 23 details the number of in-vestment options that hospitals offer by plan type
Academic research shows that asset allocation is the prime determinant of in-vestment success In other words a participant needs to be able to effectively di-versify among several asset classes (see Chapter 7) But with roughly half ofhospital-sponsored 403(b) plans offering in excess of 20 investment options par-ticipants are overwhelmed It is tough enough to help participants understand the
16 chapter 2 special issues
exhibit 22 participation and deferral rates byplan type
403(b) 401(k)
Rates of participation
Median for all employees 60 70Median for HCE 95 100Median for NHCE 55 66
Employee deferral rates
Median for all employees 5 5Median for HCE 7 7Median for NHCE 4 5
HCE highly compensated employees NHCE nonndashhighly compensated employeesSource American Hospital Association Diversified Investment Advisors Retirement Plan Trends in TodaysHealthcare Market 2003
02 schneider 22405 715 PM Page 16
difference between large-cap and small-cap stocks or value and growth styles It istoo much to expect them to sift through a list of 30 choices several of whichoverlap Ill-informed participants either invest in something they have heard oforthey are frightened of making a bad decision so they invest in the safest optionKeeping it simple is the most effective way to communicate Participants need tolearn why they should save for retirement why the plan is the best place to saveand how to invest
Participants in defined contribution plans all have the same needs and con-cernsThe goal of a plan sponsor should be to put them in the best position tosucceed A 403(b) plan or a 401(k) plan is by far the best tool to help them savefor retirement A quality DC plan should offer low-cost high-quality invest-ments state-of-the art services such as Web access and call centers high-qualitycommunication materials and in-person employee educationOften the best wayto have these benefits is to move away from the traditional 403(b) model (multi-ple annuity investments from multiple vendors) to a consolidated environment
education and communication 17
exhibit 23 number of investment options offeredby plan type (hospitals only)
403(b) 401(k)
1ndash5 8 46ndash10 12 2711ndash15 21 2416ndash20 13 22More than 20 47 24includes multiple provider situations
Source American Hospital AssociationDiversified Investment Advisors
812
21
13
47
4
2724
2224 403(b)
401(k)
50403020100
1ndash5 6ndash10 11ndash15 16ndash20 More than 20
case study
A Midwest-based hospital sponsored a traditional 403(b) plan a smaller401(k) plan and several nonqualified plans There were three 403(b) vendorseach offering its own investments each with its own contact people and eachproviding individual statements to participants The client wanted to consoli-date both qualified plans but was unsure of how to proceed Our firm drafted arequest for proposal The goals were to consolidate the investments find aprovider who excelled in communication and education and to offer state-of-the-art technology and participant services
One major obstacle arose There was a huge deferred sales charge (back-end load) attached to the annuity investments This multi-million dollar liabil-
02 schneider 22405 715 PM Page 17
ity would be owed by participants The hospital was very sensitive to the im-pact that a move away from these annuities would have on their employeesrsquobalances The vendor who was ultimately selected agreed to buy out thesesales charges and allow participant balances to transfer to the new platformwithout shrinkage The vendor did not do this for free (a large up-front hitmakes it tough to have a profitable relationship) but they did allow partici-pants to ldquopay backrdquo the sales charges over a period of three years in the form of a slightly higher expense ratio until the liability was erased That ex-pense was netted from performance Of course our firm made certain that thefees were reduced after the three years So there are creative ways to exit a dif-ficult situation
When the process was completed the new vendor administered their403(b) 401(k) 457(f) and 457(b) plans as well as their COBRA (ConsolidatedOmnibus Budget Reconciliation Act) and HIPAA (Health Insurance Portabilityand Accountability Act) plans All the plans were structured to use the exactsame investment line-up Communication materials and education campaignswere uniformly presented to all participants regardless of which plans theyparticipated in Participants could now check their funds in the newspaper andcould see all of their balances on one statement Both participation and satis-faction rates increased Simply put the move created a much better environ-ment for participants and the hospital
endowment and operating funds
Pension and 401(k) plans are governed by ERISAmdashbut what are the guidelinesfor running non-ERISA funds Section 404 of ERISA sets a standard often re-ferred to as the prudent expert rule Plan fiduciaries must act in the manner of ldquoa prudent person familiar with such mattersrdquo It only makes sense to apply thesame standard of prudence to the oversight of endowments and operating fundsWhat does this mean If your board is not expert in these areas hire someonewho is Setting goals writing an investment policy statement asset allocationmanager selection and performance monitoring and evaluation are crucial com-ponents in the oversight of your fundThis book will explore each of those areasin coming chapters In addition fund-raising is likely to take on greater andgreater importance
contributions
As most board members and trustees knowcontributions are the lifeblood of anysuccessful endowment Just how important might contributions be in the coming
18 chapter 2 special issues
02 schneider 22405 715 PM Page 18
years Credit rating agency Standard amp Poorrsquos (SampP) on June 10 2004 wrote ldquoavariety of emerging or intensifying factors threaten the future performance andcredit quality of the nationrsquos not-for-profit health care systemrdquo In a new reporton the midyear outlook for the US not-for-profit health-care sector the agencysaid ldquogrowing concerns include unquenchable demand for health care servicesand related growth in new health care technology and health care costs the sus-tainability of managed care rate increases the slow erosion of employer-basedhealth insurance reductions in Medicaid eligibility and reimbursement thegrowing burden of rising bad debt and charity care the governmentrsquos long-termability to adequately fund Medicare without future reductions and the availabil-ity of an adequate and affordable labor supplyrdquoThe question for many providerssays SampP is how well they can respond to ldquoan environment that is expected toenter a period of more rapid change and mounting pressurerdquo It added that theemerging pressure will be hardest on providers that are already struggling finan-cially If one of the most prominent credit rating agencies sees further financialdifficulties on the horizon then maybe hospitals should plan to aggressively cam-paign for new contributions
considerations for religiousinstitutions
Although religious institutions may have larger portfolio balances then 40 or 50years ago they face several real challenges
As an example think of the typical Catholic religious order in the 1950sTherewere an abundance of young men and woman choosing religious life as a voca-tion Churches in the United States were well staffed by priests and nuns andclergy were often sent overseas on foreign missions
Rev Michael Renninger who oversees priest vocations for the RichmondDiocesedescribes the abundance of priests years agoldquoWe were one of the coun-tries sending surplusmission priests to places like AfricaCentral America and thePhilippinesrdquo
Not anymore In 1965 there were nearly 1000 priests ordained in the UnitedStatesToday that number has fallen to less than 500 Other religious institutionshave experienced similar declines Several special challenges that religious non-profit organizations face today are identified below
Doing More with Money Less with People
Given the dramatic reduction in clergy some catholic institutions now achievemore by writing checks instead of committing clergy to various missionsThe
considerations for religious institutions 19
02 schneider 22405 715 PM Page 19
shortage of nuns and priests also has a significant impact on Catholic schools andhospitals Full-salary laypeople have essentially replaced clergy in most positions
Aging Institutions
You simply need to read the popular press to appreciate how shaky our SocialSecurity system isThe number of workers supporting each retiree has plum-meted over the years Once at 10 workers to every retiree we have fallen to 3 to1 now and will be at 2 to 1 in a few years However compared with the precari-ous state of many religious orders the social security picture appears almost rosy
The decline in the number of young people choosing religion as a vocationplaces great strain on the institution Some orders will choose to merge or evenclose In any event religious institutions are forced to think outside the box in theway they manage their money
Lots of Real Estate No Money
Some religious institutions own vast amounts of real estate yet lack sufficient re-turn and liquidity from their investment portfoliosWhen an institution is ldquohouserichrdquo and cash poor they must consider alternatives that might include
bull Outright Property Sales With fewer clergy andor a change in mission cer-tain properties may no longer serve a useful purpose In this scenario realestate can be liquidated and proceeds invested in a more traditional portfo-lio that generates sufficient liquidity earnings and cash flow
bull Sale and Leaseback If the institution is cash strapped and the property con-tinues to play an important role a sale and leaseback can be consideredHere real estate is soldmdashtypically to an institutional investormdashand a long-term lease is simultaneously put in placeThe religious institution essentiallyshifts from being a landlord to a tenantA large amount of cash is generatedand the use of the property continues
summary
Religious institutions must incorporate many factors into how they structure aninvestment portfolio Demographics time horizon liquidity requirements andother issues specific to the institution all play a role in developing an effective in-vestment policy
20 chapter 2 special issues
02 schneider 22405 715 PM Page 20
chapter 3
The Total Return Approach
Your nonprofit organization has a missionWhatever that mission you willultimately need to spend to achieve your goals Spending policy is discussed ingreat detail in Chapter 5 but at this point we want to explore a basic fork in theroad Although most not-for-profit organizations have adopted a total returnspending policy a few still are structured to spend ldquoincomerdquo (dividends and in-terest) and preserve ldquoprincipalrdquo (everything else)We would like to examine theramifications of that distinction
early history
The Oxford English Dictionary states that the word ldquoendowmentrdquodates from the15th or 16th century In fact as early as the 12th century land was donated as aperpetual support for ecclesiastical organizations According to Ennis andWilliamson this land-based funding source is important in explaining the tradi-tional approach to spending policy Land generates rental income for the en-dowed institution But both land values and income tend to rise over timeenabling the institutions to ldquocope not only with rising costs but with expandedactivities as wellrdquo In this context it made sense to spend ldquoincomerdquo but preserveldquoprincipalrdquoBy the 1800s the Church of England had accumulated so much en-dowed wealth that the British Parliament legislated spending restrictions on thechurch1
However by the late 19th century most institutions were endowed not withland but with bonds and mortgagesmdashldquofixed return investmentsrdquo The built-in
21
1Richard M Ennis and J Peter Williamson Spending Policy For Educational Endowments (Westport CTThe Common Fund January 1976) 6
03 schneider 22405 715 PM Page 21
inflation hedge of the land endowment had vanished According to Ennis andWilliamson ldquopreservation of capital meant preservation of lsquobook valuersquo notpreservation of purchasing power or real valuerdquo2
The first foray into equities had not gone well In 1719 the British Parliamentapproved the purchase of shares in the South Sea Company by English trusteesUnfortunately the company folded a year later causing huge losses Parliamentresponded by issuing a list of ldquosaferdquo trust investments (mostly government bonds)Equities were not to be added again for 140 years3
The above prejudice passed into American law in 1830 Judge Samuel Putmanpresided in the case of Harvard College v Amory (see Chapter 18)To clarifywhat it meant to be prudent courts and state legislators created lists of acceptableinvestments On these ldquolegal listsrdquo bonds were deemed prudent and stocks wereconsidered speculative Other types of investments were classified according tothe belief system of those doing the classifyingThe point is that each investmentwas considered on its own meritThere was no attempt to integrate investmentsinto a coherent portfolio4
the modern era
In 1952 a young graduate student named Harry Markowitz published his doc-toral thesis on the diversification of portfolios In his thesis and in his 1959 bookPortfolio Selection Efficient Diversification of Investments he outlined what came tobe known as Modern Portfolio Theory (MPT) Using the first computers to an-alyze daily transaction records going back to 1926 researchers had made a startling discovery Market returns were normally distributed (actuallylog-normal distributions)This meant that robust statistical tools could be appliedThis was a watershed eventMarkowitzrsquomathematical model became the bedrockof financial management In 1990 he shared the Nobel Prize in economics forthat work
MPT is based on several assumptions First that risk and return are linkedmore volatile investments tend to produce higher return over time Second ra-tional investors seek to maximize return at each given risk levelThird the riskand return of a single investment are immaterialWhat counts is the impact thateach investment has on the total portfolio (its correlation coefficient) By com-bining investments with low correlation with each otherone could create a port-
22 chapter 3 the total return approach
2Ennis and Williamson Spending Policy For Educational Endowments 73Kevin CoventonldquoPrudent InvestorsNew Rules for Centuries-Old ProblemrdquoNon Profit Times (2001)4Coventon Non Profit Times
03 schneider 22405 715 PM Page 22
folio that was less risky than any of its components Finally central to MPT is theidea that a dollar of income is equal to a dollar of growthmdashthe total return con-cept In fact it is impossible to optimize for anything other than total return (seeChapter 7)
the legal challenge
By 1969 it had become widely recognized that traditional approaches to themanagement of endowed funds (eg spending ldquoincomerdquoonly) were less than op-timalHowever trustees wouldnrsquot veer from those suboptimal practices for fear ofexposing themselves to litigation under existing trust lawSo in that year the FordFoundation commissioned two reportsThe first report by law professor WilliamL Cary and Craig B Bright Esq argued that trust law (the prudent man rule)did not apply to endowed funds
Under traditional trust law there are typically two parties with conflicting in-terests (1) the income recipient who would prefer to maximize current incomeat the expense of future growth and (2) the remainderman who receives theproceeds of the trust upon the death of the income recipientThe remainder-manrsquos interest of course would be to maximize future growth rather than cur-rent income Trust law existed to protect the interest of both parties ldquoSpendincome preserve principalrdquo
However in the case of a typical endowed fund there is only one partyThefund fiduciaries must balance the current spending needs with the requirementfor future spending taking into account the loss of purchasing power caused byinflation Cary and Bright argued that the more applicable law was that whichgoverns corporations Under corporate law realized gains are clearly part of theincome of the corporation5
the barker report
The second Ford Foundation report Managing Educational Endowments alsoknown as the Barker Report (after the chairman of the committee Robert RBarker)was even more compellingThe advisory committee analyzed the invest-ment results of 15 large educational endowments and compared their perform-ance to that of 21 randomly selected balanced funds 10 large growth funds and
the barker report 23
5William L Cary Craig B Bright The Law and Lore of Endowment Funds (New York The FordFoundation 1969)
03 schneider 22405 715 PM Page 23
the endowment of the University of Rochester the results were dismal Exhibit31 summarizes their findings
The authors wroteldquoWhat is the explanation for so striking a contrast We be-lieve the fundamental reason is that trustees of most educational institutions be-cause of their semi-public character have applied a special standard of prudenceto endowment management that places primary emphasis on avoiding losses andmaximizing present incomeThus the possibility that other goals might be rea-sonablemdashand perhaps even preferablemdashhas hardly been considered rdquo TheBarker report went on to recommend that educational endowments adopt thetotal return approach that a ldquosmall portion of realized gains may be used to sup-plement interest and dividends for operating purposes rdquoFurthermore the advi-sory board recommended that the management of those funds be delegated toprofessional money managers6 Following this report most large university en-dowment began to adopt the total return approach
umifa erisa upia and the prudentinvestor standard
In 1972 the National Conference of Commissioners on Uniform State Laws rec-ommended the adoption of the Uniform Management of Institutional Funds Act(UMIFA)This act sought to codify the findings of the two Ford Foundation re-ports Since then the other important pieces of legislation listed above have allsought to bring uniform fiduciary practices in line with the discoveries of MPT(see Chapters 18 and 19)
Although most state laws have now been brought in line with MPT somefund fiduciaries may still feel that spending ldquoincomerdquo and preserving ldquoprincipalrdquois more conservativeWe think otherwise
24 chapter 3 the total return approach
6Ford Foundation Advisory Committee on Endowment Management Managing EducationalEndowments (New YorkThe Ford Foundation 1969)
exhibit 31 1959ndash1968 total return
Cumulative Annual Average
15 educational institutionsmdashaverage 134 8721 balanced fundsmdashaverage 143 92University of Rochester 283 14410 large general growth fundsmdashaverage 295 146
03 schneider 22405 715 PM Page 24
the case for the total return approach
There are several compelling reasons that the thrust of academic theory federallaw and state law has been a movement toward a total return spending policy
bull A rational investor would choose to maximize return and minimize riskThe artificial distinction between income (dividends and interest) and prin-cipal forces an ldquoincome onlyrdquo investor into inefficient portfolios (lower ex-pected return at the same risk level)For example the need to spend incomeforces one toward a larger and larger percentage of income-producing se-curities while the purchasing power of that income shrinks due to inflation(see Chapter 7)
bull The artificial distinction further forces fiduciaries into short-term decisionsthat may be contrary to the long-term goodThat ismaximizing current in-come is often antithetical to the real goal of creating an ever-increasing in-come stream and principal valueTo accomplish that objective there must besufficient growth in the portfoliomdashand a mechanism to harvest thatgrowth
bull Asset allocation should drive spending rather than the reverseThe ldquoincomeonlyrdquo approach often leads to reduced spending in real termsmdashexactly theopposite effect from that intended
bull Another unintended consequence of the ldquoincome onlyrdquo approach is that itforces yield-hungry investors toward riskier investmentsTheyrsquoll invest inbonds with longer duration (which suffer worse declines in a rising interestrate environment) lower credit qualityor high prepayment risk (mortgage-backed securities)
bull The total return approach can smooth spending during times when avail-able yields in the marketplace become low Such a policy avoids undue andunnecessary hardship for the beneficiaries of the trust For example a fundwith an expected 8 return might adopt a policy of spending 4 of thethree-year average year-end balance Half the time returns would likely beabove the 8 target and half the time returns might be below the targetButover long periods of time the fund would be expected to grow 4 abovethe spending rate In other wordsover long periods of time spending wouldgrow by 4
bull Furthermore the three-year averaging would smooth the effect of tempo-rary market declinesAdditionally the fund could be more broadly diversi-fied once it was freed from the constraints imposed by the pursuit ofldquoincomerdquoBroader diversification generally has led to smoother total return
the case for the total return approach 25
03 schneider 22405 715 PM Page 25
26 chapter 3 the total return approach
experience although as the disclaimer reads past performance is no guar-antee of future results
bull The total return approach facilitates rebalancing efforts Such an approachmakes it possible to profit from inevitable cycles in the capital marketsSometimes stocks outperform sometimes bonds sometimes small stocksand so forth If you can freely rebalance you can harvest the gains from thewinning asset class and rebalance to the underperformers (which turn intothe winners in the next phase) By using such rebalancing methods an in-vestor not only keeps the risk profile of the portfolio constant but also isable to add excess return
potential negatives
bull Fund fiduciaries need to be cautious in the asset allocation processTheportfolio must be optimized to control risk not merely to seek the highestexpected return
bull During periods of strong market performance trustees must avoid thetemptation to spend the ldquoextrardquo returnMarkets are mean-reverting above-target returns must be banked for the inevitable below-target period thatwill follow
bull Once the focus is shifted to total return there is a natural human tendencyto change strategy at inopportune timesThat is most people want to ldquoselloutrdquoat market bottoms and ldquobuy inrdquoat peaks (that is what creates peaks andbottoms) Therefore you need to adopt a well-reasoned investment andspending policy and avoid reactive decisions
summary
Based on academic research and current best practices most large funds haveadopted a total return approach to the prudent investment of trust assetsWe concur Exhibit 32 summarizes important landmarks leading to that recommendation
03 schneider 22405 715 PM Page 26
summary 27
Exhibit 32 landmarks to the total return approach recommendation
Year Landmark Event Spending Policy
Early history
12th Century First land endowments Spend ldquoincome onlyrdquo
1720 First ldquolegal listsrdquomdashGreat Britain Spend ldquoincome onlyrdquo
1830 Prudent Man Rule Spend ldquoincome onlyrdquo
Late 19th throughearly 20th centuries ldquoLegal listsrdquo of acceptable investments Spend ldquoincome onlyrdquo
Modern era
1952 First academic researchBeginning of Modern Portfolio Theory Total return
1969 First Ford Foundation Report challenges thelegal basis for applicability of trust law toendowed funds Total return
1969 The Barker Report analyzes performance and espouses a move toward a total return spendinginvestment policy Total return
1972 The Uniform Management of InstitutionalFunds Act codified the Ford Foundation Reports and since has been adopted bymost states Total return
1974 The Employee Retirement Income Security Act(ERISA) was passed by Congress to establish a higher standard for retirement plan fiduciaries Total return
1994 The Uniform Prudent Investor Act of 1994 shifted the focus from the ldquoprudent manrdquo to the ldquoprudent investorrdquo Total return
1997 The Uniform Principal and Interest Act of 1997 was designed to permit trustees to make investment decisions on a total return basis Total return
03 schneider 22405 715 PM Page 27
03 schneider 22405 715 PM Page 28
chapter 4
The Prudent Steward
In the 1990s when stocks and bonds experienced tremendous performanceinvestment committee members had it relatively easyEven if they lacked a well-conceived strategy the bull market of the 1990s generated outsized returns andcommittee members often basked in their perceived success Not anymore
With the start of a new millennium the stock market declined for threestraight years for the first time in roughly 70 years Various financial scandals andthe jail sentences that followed made board and committee members very con-cerned about personal liability
Suddenly volunteering to oversee a nonprofit organizationrsquos investment pro-gram is no longer a simple thingCommittee members have to work hard to seekadequate returns and at the same time avoid personal liability Prudent steward-ship is being redefined
build a house build an investmentprogram
Just as there is a tried and true method to constructing a home there is a system-atic way to build an investment portfolioAlthough some committees considerhiring investment managers to be the most important task this is far from thetruthA successful construction project begins with a plan and so too should theconstruction of your investment program
set goals the blueprint
Prior to hiring or even evaluating investment managers committees should cre-ate their own version of a blueprintThe process begins with an effective goal-setting exerciseYou need to raise and answer important questions
29
04 schneider 22505 901 AM Page 29
bull What is the purpose of this investment fund
bull Who should oversee the fund
bull What are our spending goals and limitations
bull What socially responsible investment screens should be used if any
bull What is our time horizon
bull What asset classes or investment types are we willing to consider
allocate assets
The last question on asset classes is extremely important because it begins to ad-dress your most important decisionasset allocation Virtually every academic studyshows that asset allocation is the main contributor to investment returns It is alsothe prime mechanism used to quantify and control risk
Once your committee has a sense of its return targets spending objectives risktolerance and asset class preferences you can begin to determine the most ap-propriate or optimal asset allocation for your nonprofit organizationrsquos uniqueneedsTo get back to our construction analogy the investment policy statementbecomes your programThis investment policy should be reduced to writing andmodified as circumstances merit
manager selection hire thesubcontractors
Armed with the investment policy committee members are in a position to hirespecialists for each of the areas of investment management called for in your assetallocation Chapter 8 addresses this topic in great detail but suffice it to say thatbeginning the hiring process without first establishing an investment policy ismore than a waste of time It can be detrimental to your investment performance
rebalance
Even when performance on all fronts is goodmarket movements cause a portfo-liorsquos weightings to differ from target allocationsA systematic rebalancing programis absolutely necessarymdashotherwise your asset allocation strategy wonrsquot workChapter 9 presents a logical and effective way to answer the question of when torebalance
30 chapter 4 the prudent steward
04 schneider 22505 901 AM Page 30
monitor performance
Creating a plan and hiring specialists to help implement it goes a long way to-ward achieving success but a committee memberrsquos job is never donePerformance must be evaluated to ensure that individual managers as well as theentire fund are comparing favorably to established and meaningful benchmarksWhen underperformance occurs an effort must be made to determine if prob-lems are likely to persistAt times difficult decisions must be made
In summary volatile financial markets and increased fiduciary responsibilitiesmake for greater challengesThe strategies described in this book can help you inyour quest to act as a prudent steward
monitor performance 31
04 schneider 22505 901 AM Page 31
04 schneider 22505 901 AM Page 32
chapter 5
Set Goals
introduction
ldquoThe crew looked back to shore not knowing where the winds would pushthem rdquoThis sounds like the start of a novel about a perilous voyageWill theboat arrive safely What is the destination Will the crew encounter dangerousstorms How long will their supplies last However if the story begins ldquoThecrew set sail for their four-day journey to the shores of Spain with maps in handand rdquo the reader has a greater sense of certaintyThere may be risks but thecrew appears more prepared for the task
To chart a successful journey for your fund you need to determine the desti-nation and have the right toolsYou need a clear vision of your time horizon andgoals in order to create a sense of purpose for members staff and donors
You will face several challenges in this important step Can the committeereach a consensus How will you balance short-term needs and long-term ob-jectives How will members employees and donors react The following stepsmay provide a useful framework
1 Define the mission
2 Determine a spending policy
3 Establish the required return
4 Understand your risk tolerance
5 Designate the time horizon
33
05 schneider 22505 902 AM Page 33
define the mission
As a first step the board should compose a clear mission statementAddress thefollowing questions
bull What is the organizationrsquos purpose
bull Who or what will benefit from the funds
bull What do members staff and donors need to understand
An organization may have several objectives but itrsquos helpful if you can boil themission down to a single well-defined statement For example the Society ofThoracic Surgeonsrsquo Web site clearly articulates their mission to ldquoHelp Cardio-thoracic Surgeons Serve Patients BetterrdquoThe By-Laws of the Society list severalobjectives that support this mission
determine a spending policy
Once you articulate the mission and objectives for the funds the next step is toformulate a spending policy This critical step requires balancing short-termneeds and long-term objectivesAn effective spending policy facilitates currentinitiatives but also preserves principal for longer-term expendituresA spendingpolicyhoweverdoes not exist in a vacuum It must incorporate investment fund-ing and cost expectationsThere may also be legal requirements notably the 5spending requirement for private foundations
In a perfect world your fundrsquos purchasing power would consistently growthrough a combination of strong market returns a high level of donor supportand low inflation Such an environment existed during most of the 1980s and1990s In such boom times organizations can spend without appearing to drainprincipal In fact itrsquos easy to overspend For example in 1999 many funds foundthemselves with 2 inflation a 5 spending policy and 20 fund returnsThetendency was to regard some of the ldquoexcessrdquo return as found moneyThe prob-lem is that market returns are lumpy That ismoney made in good years must bepreserved to tide your fund through the inevitable downturns In short there wasno excess return
So what should a nonprofit organizationrsquos board expect for returns A reviewof long-term market results by decade may be helpful Over the past 78 years(1926ndash2003) stocks have averaged returns of 104 and long-term governmentbonds 54A look at performance by decade paints a different picture
34 chapter 5 set goals
05 schneider 22505 902 AM Page 34
Bonds
Over the full 78-year period long-term bonds have averaged 12 above infla-tion However a majority of this return has come in the past few decades Bondyields rose steadily from the 1940s up until their peak in 1981 From there yieldshave fallen faster and farther than any time in history creating the greatest bullmarket the asset class has seen (When interest rates go downbond prices go up)Not only were absolute returns high real returns (above inflation) in the 1980s1990s and 2000s were enormousmdash7559 and 72 above inflation respec-tivelyThis period accounts for almost the entire premium above inflation longtermReal returns in the 1940s (ndash22)1950s (ndash23)1960s (ndash11) and 1970s(ndash19) paint a much bleaker picture
With bond yields below 5 by 200 there is little room for further declinesThe great tail wind of falling rates is gone In fact the current low interest rateand low inflation environment looks more like the 1950s and 1960sThe like-lihood of absolute returns above 5 (to meet the typical spending target) seemssmallMore importantly the likelihood of real returns above inflation seems evenmore remote
Stocks
Even with the recent negative experiencestocksrsquo long-term average of 102 looksmuch more attractiveHowevera closer look at annual returns over the past 77 yearsshows that only three years actually fell in the 10 to 11 rangeMost of the returnfor large-cap stocks came during four bull markets the late 1920s 1941ndash19611982ndash1987and 1991ndash1999If the presentpost-1990s environment is more like thepost-1950s stock returns may be well below average Returns in the 1960s were78 and the 1970s were worse at 59 (actually a negative real return)1
Assuming 3 inflation and adding a 62 premium for stocks and 12 forbonds produces targets of 92 and 42 respectivelyAssuming some reversionto the mean suggests potentially lower average returnsAchieving a spending tar-get of 5 above inflation may be quite difficult
determine a spending policy 35
1Calculated by DiMeo Schneider amp Associates LLC using data presented in Stocks Bonds Bills andInflationreg 2004 Yearbookcopy 2004 Ibbotson Associates IncBased on copyrighted works by Ibbotson andSinquefieldAll rights reserved Used with permission
05 schneider 22505 902 AM Page 35
The Perfect Storm
The beginning of the 21st century ushered in a ldquoperfect stormrdquo for not-for-profitorganizations Shrinking government and donor support an economic down-turn and a three-year bear market quickly turned excessive spending into re-duced spending Nonprofit organizations continue to struggle with rising costsincreased demand and reduced ability to meet funding requirementsThe goldendecade of the 1990s is likely the exception rather than the rule
Looking forward it may be hard to generate double-digit returns on assets re-sulting in continued pressure on spending policy Exhibit 51 illustrates how var-ious spending policies impact the ability to preserve real (inflation-adjusted)dollars In this example the portfoliorsquos expected annual return is 73 with an-nual inflation of 25The 4 spending policy is the only approach that preservesprincipal in real termsThe other spending rates all result in decreased wealthAnd note this analysis shows median expected resultsHalf the time results mightbe worse and half the time they might be betterThe possibility of higher infla-tion only exacerbates the problem
Traditional Spending Methods
Many funds spend a percentage of assets However a variety of other approachesexistOne possibility is to designate a fixed dollar amountWhen returns are highthis method will build principal however you may eat into principal when re-turns are low Alternately withdrawals may be based on a percentage of return
36 chapter 5 set goals
exhibit 51 the impact of spending policy
$11000
$10000
$9000
$8000
$7000
$60000 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10
4 Spending Policy (median) 5 Spending Policy (median)6 Spending Policy (median) 7 Spending Policy (median)
Source DiMeo Schneider amp Associates LLC
05 schneider 22505 902 AM Page 36
for example ldquo75 of last yearrsquos gainrdquo This method ensures that you will not invade principal but will result in years in which there is no spending This is an unacceptable outcome for most funds
As we said the most common method is a fixed percentage of assets for ex-ampleldquo5 of three-year average year end balancesrdquo The three-year average pro-vides a smoothing effect Of course you must set spending policy below theexpected return on your assets
The bear market of 2000ndash2002 revealed the flaw in all these approachesSpending a fixed percentage of assets when fund balances declined resulted infewer dollars to meet rising costsThe smoothing techniques resulted in rising av-erage balances even though the actual fund balances had decreased Converselyduring periods of high returns like the 1990s these policies result in higherspending Unfortunately once you increase spending it is difficult to lower itagain People rapidly come to depend on those funds
New Approaches
A number of institutions are exploring alternative spending policies One suchmethod is to choose a nominal dollar amount of spending and then adjust it up-ward by the inflation rate For example an initial dollar amount equal to 4 ofcurrent asset value is adjusted annually for inflationThe underlying principle is totie spending to cost increases rather than investment returnsAn inflation bandsuch as 3 to 6 ensures a minimum and maximum annual expenditure(Exhibit 52) Research suggests that this approach helps smooth spendingamounts and increases the likelihood of principal growth over time Some or-ganizations take the inflation-based method a step further by using a more rele-vant price index than the consumer price index (CPI) For example collegesmight use the higher education price index (HEPI)
Another very simple approach is to use the current nominal level of spendingas a fixed targetThe finance committee can then readjust the target every fewyears based on the circumstances If fund returns are generally positive this sim-plistic spending approach should allow the pool to grow although in real termsspending will actually decline
Defining spending policy requires critical self-examination of short-termspending needs long-term capital objectives fund-raising initiatives and invest-ment strategy Once the spending methodology is identified an organization will undoubtedly face challenges and even resistance in adopting the new ap-proach However todayrsquos spending decisions translate into tomorrowrsquos financialhealth
establish the required return 37
05 schneider 22505 902 AM Page 37
38
ex
hib
it 5
2e
xa
mp
le
of
an
in
fla
tio
n b
an
d
Infl
atio
n In
dexe
d (N
o Co
ntri
buti
on)
HEP
I4
Spen
ding
rate
Sim
ulat
ion
Tria
lsPo
rtfo
lio v
alue
Year
1Ye
ar 5
Year
10
Year
15
Year
20
10th
Per
cent
ile
$55
043
376
$
759
143
12
$10
570
89
52
$14
293
262
4 $
194
526
448
25
th P
erce
ntile
$
516
514
64
$64
966
168
$
834
769
04
$10
568
524
8
$13
28
949
04
50th
Per
cent
ile
$48
109
864
$5
448
776
4 $
637
365
52
$73
554
08
0
$8
245
140
8
75th
Per
cent
ile
$44
810
616
$
460
244
16
$48
240
160
$
490
344
08
$
471
071
00
90
th P
erce
ntile
$
420
80
784
$39
20
693
2 $
371
352
52
$32
760
294
$
236
025
18
Spen
ding
ban
ds(b
ased
on
sim
ulat
ion
tria
ls)
Perc
enti
leB
and
Year
1Ye
ar 5
Year
10
Year
15
Year
20
10th
Per
cent
ile
30
0
($1
651
301)
($2
277
429)
($3
171
269)
($4
287
979)
($5
835
793)
Fixe
d flo
w($
185
90
00
)($
217
50
00
)($
264
60
00
)($
321
90
00
)($
391
70
00
)10
th P
erce
ntile
6
00
($
330
260
3)($
455
48
59)
($6
342
537)
($8
575
957
)($
116
715
87)
25th
Per
cent
ile
30
0
($1
549
544)
($1
948
98
5)($
250
430
7)($
317
055
7)($
398
68
47)
Fixe
d flo
w($
185
90
00
)($
217
50
00
)($
264
60
00
)($
321
90
00
)($
391
70
00
)25
th P
erce
ntile
6
00
($
309
90
88
)($
38
979
70)
($5
00
86
14)
($6
341
115)
($7
973
694)
50th
Per
cent
ile
30
0
($1
443
296)
($1
634
633)
($1
912
097)
($2
206
622)
($2
473
542)
Fixe
d flo
w($
185
90
00
)($
217
50
00
)($
264
60
00
)($
321
90
00
)($
391
70
00
)50
th P
erce
ntile
6
00
($
28
86
592)
($3
269
266)
($3
824
193
)($
441
324
5)($
494
70
84)
75th
Per
cent
ile
30
0
($1
344
318
)($
138
073
2)($
144
720
5)($
147
103
2)($
141
321
3)Fi
xed
flow
($1
859
00
0)
($2
175
00
0)
($2
646
00
0)
($3
219
00
0)
($3
917
00
0)
75th
Per
cent
ile
60
0
($2
688
637
)($
276
146
5)($
28
944
10)
($2
942
064
)($
28
264
26)
90th
Per
cent
ile
30
0
($1
262
424)
($1
176
208
)($
111
40
58)
($98
28
09)
($70
80
76)
Fixe
d flo
w($
185
90
00
)($
217
50
00
)($
264
60
00
)($
321
90
00
)($
391
70
00
)9
0th
Per
cen
tile
6
00
($
25
24
84
7)($
23
524
16)
($2
22
81
15)
($1
96
56
18)
($1
416
151
)
Fixe
d flo
w a
nd 9
0th
per
cent
ile a
re th
e ac
tual
spen
ding
dol
lar a
mou
nts
Hig
hlig
htin
g re
pres
ents
thos
e tr
ials
in w
hich
the
spen
ding
ban
dsar
e vi
olat
ed
05 schneider 22505 902 AM Page 38
39
ex
hib
it 5
2(c
on
tin
ue
d)
Mar
ketV
alue
(No
Cont
ribu
tion
)CP
I4
Spen
ding
rate
Sim
ulat
ion
Tria
lsPo
rtfo
lio v
alue
Year
1Ye
ar 5
Year
10
Year
15
Year
20
10th
Per
cent
ile
$54
444
524
$
721
504
16
$95
372
760
$
121
436
80
0
$15
324
00
00
25
th P
erce
ntile
$
512
211
32
$63
032
772
$
786
114
00
$
958
489
92
$11
538
994
4 50
th P
erce
ntile
$
479
88
536
$
538
782
16
$62
861
432
$
737
662
32
$8
48
82
688
75
th P
erce
ntile
$
448
284
04
$46
295
60
0
$50
68
196
8
$56
538
10
8
$62
634
620
90
th P
erce
ntile
$
420
352
16
$40
624
80
0
$41
887
968
$
441
567
68
$47
546
516
Spen
ding
ban
ds(b
ased
on
sim
ulat
ion
tria
ls)
Perc
enti
leB
and
Year
1Ye
ar 5
Year
10
Year
15
Year
20
10th
Per
cent
ile
30
0
($1
633
336)
($2
164
512)
($2
861
183
)($
364
310
4)($
459
720
0)
10th
Per
cent
ile
($2
268
522
)($
30
06
267)
($3
973
865
)($
505
98
67)
($6
385
001)
10th
Per
cent
ile
60
0
($3
266
671)
($4
329
025)
($5
722
366)
($7
286
208
)($
919
440
0)
25th
Per
cent
ile
30
0
($1
536
634)
($1
890
983
)($
235
83
42)
($2
875
470
)($
346
169
8)
25th
Per
cent
ile
($2
134
214)
($2
626
366)
($3
275
475)
($3
993
708
)($
48
079
15)
25th
Per
cent
ile
60
0
($3
073
268
)($
378
196
6)($
471
668
4)($
575
094
0)
($6
923
397)
50th
Per
cent
ile
30
0
($1
439
656)
($1
616
346)
($1
88
58
43)
($2
212
987)
($2
546
481)
50th
Per
cent
ile
($1
999
522)
($2
244
926)
($2
619
226)
($3
073
593)
($3
536
779)
50th
Per
cent
ile
60
0
($2
879
312)
($3
232
693)
($3
771
686)
($4
425
974)
($5
092
961)
75th
Per
cent
ile
30
0
($1
344
852
)($
138
88
68)
($1
520
459)
($1
696
143)
($1
879
039)
75th
Per
cent
ile
($1
867
850
)($
192
89
83)
($2
111
749)
($2
355
755)
($2
609
776)
75th
Per
cent
ile
60
0
($2
689
704)
($2
777
736)
($3
040
918
)($
339
228
6)($
375
80
77)
90th
Per
cent
ile
30
0
($1
261
056
)($
121
87
44)
($1
256
639)
($1
324
703)
($1
426
395)
90th
Per
cent
ile
($1
751
467)
($1
692
700
)($
174
533
2)($
183
98
65)
($1
981
105)
90th
Per
cent
ile
60
0
($2
522
113)
($2
437
488
)($
251
327
8)
($2
649
406)
($2
852
791
)
05 schneider 22505 902 AM Page 39
establish the required return
The decades of the 1980s and 1990s were unprecedented in capital market his-tory Bond and stocks rallied as interest rates declined inflation decreased andproductivity grew Never before had there been back-to-back decades with an-nualized stock returns above 17 Exhibit 53 compares long-term market re-turns to the abnormal gains during those decadesThe market bust of the early2000s erased some of those gainsLooking forwarduncertainties surround inter-est rates inflation terrorism and global economic growth Future return expec-tations may be dramatically lower
Defining required return goes hand in hand with spending policy formulationIs it possible to set a 5 spending rate if real return expectations are below thatlevel Should you pursue higher returns or ratchet down spending needs Areyou prepared to invest in riskier asset classes Your required return is one thatmeets your short-term spending needspreserves principal and grows capital overtimeThe required return and assumed risk represent critical inputs in determin-ing your investment approach
Although stocks generated high double-digit returns in the 1980s and 1990shistorical evidence suggests more moderate returns in the future Unreasonablereturn expectations are a precursor to failureBut lower return expectations makeit more difficult to achieve your required return Investment committees will beforced to revamp their asset allocations and incorporate new investmentsFinancecommittees may have to lower the target spending rateFund-raising will becomemore importantNonprofit organizations must face these challenges if they are tooperate effectively or even survive It goes without saying that not-for-profit
40 chapter 5 set goals
2500
2000
1500
1000
500
0001926ndash2003 1980s 1990s
Source Ibbotson Associates and Johnston Investment Counsel Calculated by DiMeo Schneider amp Asso-ciates LLC using data presented in Stocks Bonds Bills and Inflationreg 2004 Yearbook copy 2004 IbbotsonAssociates Inc Based on copyrighted works by Ibbotson and Sinquefield All rights reserved
Bonds
Stocks
exhibit 53 average annual returns over variousmarket periods
58o
10301190
17501820
720
05 schneider 22505 902 AM Page 40
2 Inflation $9056807921
35 Inflation $14033968520
5 Inflation $21609711870
$0 $50000000 $100000000 $150000000 $200000000 $250000000 $300000000
Source DiMeo Schneider amp Associates LLC
funds should adopt a total return approachThe combination of interest incomeand capital gains increases the likelihood of generating the required return andmeeting spending needs
Inflation and Goal Setting
Like a vampire inflation sucks away the purchasing power of your dollars In re-cent years inflation has been relatively benignbut it has not gone away In an en-vironment where costs increased at barely 2 annually even modest investmentreturns increased real purchasing power Higher inflation rates diminish invest-ment returnsYou must factor in inflation expectations as you formulate yourspending policy
For example imagine a university endowment with a 5 spending policyRequired real return for the next 20 years is 6 and inflation is expected to trackits long-term average of 31This equates to a required target return of 91If actual long-term inflation rates fall below 31 and the fund achieves its tar-get return the university maintains purchasing power It can continue to providethe same level of financial support 20 years from now as it does today Howeverif inflation increases at a rate higher than 31 more dollars will be needed(Exhibit 54)
understand your risk tolerance
ldquoNo pain no gainmdashno risk no rewardrdquo Perceptions of risk vary greatly amongindividuals Climbing a ladder may feel risky to one person while another wants
understand your risk tolerance 41
exhibit 54 the effects of inflation how much youneed in 30 years to equal$50000000 in todayrsquos dollars
05 schneider 22505 902 AM Page 41
to climb Mount Everest How is this relevant to setting goals Your required re-turn inevitably requires you to assume some level of riskThe recent bear marketreminded investors that risk is more than a theoretical constructTodayldquoHowmuch can I loserdquo is often the first question posed by investors
For example in late 1998 a university investment committee hired us to pro-vide investment consulting servicesAt the time they had a single manager whoallocated assets between domestic stocks and bondsThey sought our assistancefor two primary reasons to further diversify assets and to generate higher returnsOur first step with any client is to understand their goals current perceptions andrisk tolerance Exhibit 55 is a sample committee input questionnaire we use togather information and start the dialogue In this case the committeersquos responseswere inconsistentTheir consensus return objective was over 10 most commit-tee members were comfortable with a 100 stock allocation the majority feltthey had a high risk tolerance yet most agreed they would change strategies ifthey experienced a 5 loss on assetsClearly they did not understand that a 100equity allocation had the potential to fall significantly more than 5 As you mayrecall by the end of 1998 the SampP 500 index had generated four consecutiveyears of double-digit returns and last experienced a down year in 1990ldquoThe riskis being out of stocksrdquo was the mantra during the late 1990s Nowadays capitalmarket risks are all too apparentVolatility or the risk of incurring negative re-turns now concerns investors However there are other risks to consider such asnot beating inflation or not achieving long-term goalsThe committee needs toset their goals in light of all these trade-offs
designate the time horizon
Your time horizon plays a critical role in your investment decisions Does yourfund have a long- or short-term period for investing Different funds have dif-ferent time horizonsMany funds are expected to last into perpetuityothers existto achieve a specific goal Is there uncertainty about your time horizon The an-swers to these questions dramatically impact asset allocation An organizationhaving uncertain or imminent spending demands might be forced to maintain ahigh cash or fixed-income position Most organizations have a long-term if notinfinite time horizonThey can take more short-term risk and seek greater re-turns from higher equity allocations Sometimes itrsquos necessary to segregate fundswith varying time horizons into investment pools each with a customized assetallocationWhatever your circumstance defining your time horizon is critical tothe investment planning process
42 chapter 5 set goals
05 schneider 22505 902 AM Page 42
exhibit 55 sample committee questionnaire
Introduction
This questionnaire will help us gain a better understanding of your thoughts regarding our fundrsquos risk and re-turn objectives time horizon and investment approach The collective responses will help establish a start-ing point for our asset allocation analysis We appreciate your responses
I General Thoughts1 What do you feel is the primary objective(s) for the funds
Capital preservation Maximize current income Maximize total return through income and capital growth Maximize capital growth with little consideration for income
2 What do you feel are the most critical issues facing the fund in short-term (less than 3 years)3 What do you feel are the most critical issues facing the fund longer-term (over 10 years)4 Please specify any other issues concerns or obstacles you feel may impact the fundrsquos effectiveness
II Risk and Return Objectives1 I define investment risk as (check one)
Losing principal Not matching inflation Not having enough money to meet fund goals
2 Starting with $10000000 I would change strategies if the fund had a one-year loss of (check one) ndash2 or $200000 ndash5 or $500000 ndash10 or $1000000 ndash15 or $1500000 ndash25 or $2500000Other _____________
3 How concerned are you with fluctuations in market value Very concerned with market value fluctuation Somewhat concerned but more focused with the long-term growth Not concerned because funds are invested for the long-term
4 Circle the one portfolio (AndashE) with which you are most comfortable
Annual Return A B C D EOptimistic 172 206 248 295 344 Expected 61 67 73 79 84 Pessimistic ndash50 ndash72 ndash103 ndash138 ndash175
The pessimistic scenario represents the potential downside likely to occur in any given year There isa small (25) probability of achieving either the pessimistic or optimistic results There is a high proba-bility (50+) of achieving the expected results There is a very high probability (95) of falling betweenthe optimistic and pessimistic scenarios
III Investment Structure1 Indicate which investment categories you feel should be excluded from your asset allocation (in gen-
eral the more asset classes included the better the diversification effect)_____ Money Market _____ Small US Stocks _____ Inflation Linked Bonds_____ International Stocks _____ High Yield Bonds _____ Emerging Markets Stocks_____ Investment Grade Bonds _____ Real Estate _____ Large US Stocks_____ Hedge Funds Other____________________
2 I am most comfortable with stock exposure of 0 to 20 20 to 40 40 to 60 60 to 80 80 to 100
3 Please outline any specific investment management restrictions you feel should apply________________________________________________________________________________________________________________________________________________________________________
designate the time horizon 43
05 schneider 22505 902 AM Page 43
44 chapter 5 set goals
summary
ldquoThose who fail to plan plan to failrdquo Proper goal setting leads to a better invest-ment processThe five steps outlined in this chapter should guide committeemembers in setting short- and long-term objectives In Chapter 7we describe indetail how these steps become inputs in the asset allocation process
1 Define the mission
2 Determine a spending policy
3 Establish the required return
4 Understand your risk tolerance
5 Designate the time horizon
By working through these steps you will build a solid foundation for the workthat will come Your committee can better respond to questions raised by donorsemployeesor the public about the investment process Yoursquoll avoid the panic thatoften clouds investor thinking during periods of market unrestMost importantlyyoursquoll demonstrate that you have a solid well-conceived investment program fo-cused on achieving your organizationrsquos goals
The next chapter shows you how to formalize your process into a written in-vestment policy statementThis important document is the ldquoblueprintrdquo to build-ing success for your fund
05 schneider 22505 902 AM Page 44
chapter 6
Investment Policy
overview
An architectrsquos blueprint provides direction to a builder plumber electrician andother contractorsMost importantly it gives the home owner a clear vision of theproject and the ability to monitor its progressThe blueprint designates responsi-bilities and goals for the involved parties Can you imagine building a home oreven adding a deck without a blueprint
How could anyone hope to oversee a multi-million dollar fund without writ-ten guidelines It is imperative that you formalize your goals and investmentstrategy in writingThe written policy should be clear concise and specificAwell-written investment policy statement (IPS) outlines your investment philosophyand defines the investment management oversight and long-term objectives ofyour organization
why is it important
The IPS is critical to the ongoing oversight of your investment process It memo-rializes your vision It sets the parameters by which you will monitor responsibil-ities and track the progress of associated parties It also outlines your proceduresfor fund oversightA written IPS also provides for continuity in the supervisionof your fund Itrsquos not uncommon for members to serve limited terms sometimesas short as one or two years A constant rotation in members presents challenges
New committee members may want to make their markUnfamiliar with theinitial goal-setting process outlined in the previous chapter they may question
45
06 schneider 22505 902 AM Page 45
the existing investment approach and objectivesThey may have preconceivednotions about the use of certain asset classes or overall asset allocationThey mayeven have a basic misunderstanding of investing or diversification principlesAwell-written investment policy educates new members It acts as an ldquoemployeemanualrdquo to provide new and existing members with a clear concise descriptionof your fundrsquos purpose standards and objectives
Inevitably your committee will face periods of market turmoil Committeemembers may question existing strategy and consider reacting to short-termevents At such times the IPS acts as an anchor to steady the ship in rough seas Itprevents knee-jerk reactions that may impede the fundrsquos long-term objectives
content
The policy consists of several sections addressing critical areas of oversightTypically these should include
bull Purpose
bull Spending policy
bull Investment policy
bull Liquidity needs
bull Asset allocation
bull Rebalancing
bull Manager selection
bull Performance evaluation
bull Manager termination procedures
bull Proxy voting
bull Responsibilities of all parties
Organization is the key to drafting your policy The IPS should provide a clear road map for committee members Specifically it must provide policy di-rection and procedural guidelinesAn IPS checklist can be a good starting point(Exhibit 61)
sample investment policy statement
A sample IPS may be helpfulHowever itrsquos important to customize the documentto address your organizationrsquos specific needsTo get started please see the samplepolicy provided in Appendix A
46 chapter 6 investment policy
06 schneider 22505 902 AM Page 46
sample investment policy statement 47
exhibit 61 investment policy statement checklist
Investment Policy Statement Sections radic Comments
I Purpose
Identifies the organization and fund
Outlines the mission of the organization and fund
Establishes the specific short-term and long-term objectives for thefund
II Spending policy
Sets the specific spending requirements for the funds
Designates who has authority in establishing spending policy
Establish liquidity needs
III Investment policy
Enumerates total return targets on a nominal and inflation-adjusted basis
Sets risk parameters for overall fund
IV Asset allocation
Establishes commitment to diversify across a broad range of asset classes
Defines specific asset classes and target asset allocation
Prescribes authority and process for reviewing and adjusting asset allocation
V Cash flowsrebalancing
Establishes process for handling contributions and disbursements
States purpose for rebalancing
Designates authority process and timing for portfolio rebalancing
VI Investment manager selection
Designates criteria for investment manager selection
VII Performance monitoring
Specifies timing for manager reviews
Outlines investment manager reporting responsibilities
VIII Investment manager termination
Designates performance expectations for investment managers
Outlines issues other than performance that may result in manager termination
IX Proxy voting policy
Designates responsibilities and procedures for voting proxies
X Responsibilities of investment consultant
Outlines role and responsibilities of investment consultant
06 schneider 22505 902 AM Page 47
implementation and maintenance
Itrsquos a good idea to have all committee members review a draft IPS Once the IPSis amended all committee members should acknowledge their review and ac-ceptance of its termsWe recommend an annual redistribution and review of theIPS Of course any interim changes in investment managers allocations orspending policy may require revisions to the policy statement
specific investment guidelines
The degree of specificity in your investment guidelines depends on the type ofinvestment vehicles you useThere are various procedures and considerations thatare appropriate for different investment vehicles
bull Mutual Funds A mutual fund pools assets of multiple investorsAs a resultan individual investor cannot establish specific investment managementguidelinesThe mutual fundrsquos prospectus informs investors about the fundrsquosstrategy investment restrictions risks performance expenses and adminis-trative guidelinesYour IPS language should therefore focus on the role ofthe mutual fund and your standards for fund review not on guidelines forthe fund manager (who wonrsquot take your direction anyway)
bull Commingled Funds A commingled fund pools together assets from multipleinvestors but usually requires a higher minimum initial investmentCommingled accounts are usually sponsored by a bank or trust companyUnlike a mutual fund commingled accounts are exempt from registrationunder the Investment Company Act and do not have a prospectus How-ever an individual investor still cannot establish specific investment man-agement guidelines Commingled account investment guidelines are setforth by the investment management firmYour IPS language for commin-gled funds should be similar to language used for mutual funds
bull Separate Accounts A separate account portfolio is managed exclusively forone person or institutionThis allows you to establish specific investmentguidelines and restrictions For example you may wish to prohibit certaintypes of securities such as alcohol or tobacco stocks Because itrsquos a cus-tomized portfolio an investor needs to establish specific investment guide-lines for the manager The investment management guidelines shouldprovide specific direction on investment objectives restrictions risk param-eters performance measurement and reporting responsibilities
48 chapter 6 investment policy
06 schneider 22505 902 AM Page 48
investment benchmarks
Itrsquos important that you establish specific investment benchmarks for mutual fundsand investment managersThe investment benchmarks guide the committeersquos re-view of investment manager performanceWe recommend a multidimensionalapproachYou should compare the returns of the fund as a whole and each man-ager to an appropriate index and a style-specific peer group or universeYou shouldalso designate a way to measure risk and incorporate the fund or managerrsquos risk-adjusted performanceSee Appendix A for an example of designated benchmarksfor fixed income domestic equity and international managers
In Chapter 13 we discuss in greater detail performance evaluation designat-ing specific benchmarks and instituting an effective oversight process
summary
Your IPS is a summation of your goals philosophy and processAs such it re-quires careful thought and execution Our sample policy may provide a startingpoint but an effective IPS should be customized to fit your goals and objectivesOnce finalized and approved it serves as a blueprint for your investment programThe IPS designates the procedures and guidelines critical to the ongoing over-sight of your fund
There is little doubt your investment committee will face questions and evencriticism from time to timeThe IPS can be an anchor to windward during tur-bulent timesThe IPS can provide well-documented rationale to avoid the latestinvestment craze short-term market events or individual investment biases
summary 49
06 schneider 22505 902 AM Page 49
06 schneider 22505 902 AM Page 50
chapter 7
Asset Allocation
Asset allocation the strategic diversification of your portfolio is the mostimportant determinant of return Academic studies support the conclusiondrawn by Brinson Hood and Beebower that asset allocation accounts for over94 of investment return1 Security selection and market timing together con-tribute less than 4 to investment results In other words the key question is notin which stock or bond to invest but rather ldquoWhat percentage should I allocateto stocks bonds or other asset classesrdquo (Exhibit 71)
While individual security selection decisions are usually delegated to special-ists asset allocation is your responsibility Once you have determined the assetmix there are literally hundreds of money managers who can handle the imple-mentation However only you can decide how much volatility or risk the fundshould assume
the efficient frontier
In the 1950sDrHarry Markowitz developed a theoretical framework to managethe asset allocation decision In 1992 he was awarded the Nobel Prize for thiswork Dr Markowitz postulated an ldquoefficient frontierrdquo the line describing thehighest expected return at each risk levelToday commercial software programscalled mean variance optimizers incorporate Markowitzrsquos algorithm If you plugin the appropriate input assumptions described below the optimizer will gener-ate an efficient frontier defining the ldquooptimalrdquo portfolio mix at each risk levelldquoOptimalrdquo means having the highest return at that risk
51
1Gary P Brinson L Randolph Hood and Gilbert L BeebowerldquoDeterminants of Portfolio ReturnsrdquoFinancial Analysis Journal (JulyAugust 1986)
07 schneider 22505 925 AM Page 51
For example if your portfolio consisted of Mix A in Exhibit 72you would nodoubt prefer either Mix B (equal risk but higher expected returns) or Mix C(equal expected return but lower risk) Mixes B and C are on the efficient fron-tier Mix A is inefficient
So how should you go about determining the asset allocation for your not-for-profit organizationrsquos fund Nowadays there are numerous commercial soft-ware programs that incorporate Markowitzrsquos algorithm But be careful Theoutput of these programs is heavily input sensitive The programmerrsquos adageldquoGarbage in = garbage outrdquo applies
52 chapter 7 asset allocation
exhibit 72 efficient frontier
8
6
4
2
00 2 4 6 8 10 12 14 16
Risk (Std Dev)
Real
Retu
rn
MIX C MIX A
MIX B
exhibit 71 what determines success
Market Timing2
Asset Allocation94
Security Selection4
Components of Investment Return
Source Brinson Hood Beebower 1986
07 schneider 22505 925 AM Page 52
capital market assumptions the buildingblocks of portfolio construction
The first stage in the portfolio optimization process is to develop three key inputs
bull Expected return of each asset class
bull Expected standard deviation of the returns
bull Expected correlation among different asset class returns
The problem of course is that the inputs are forecasts and as Yogi Berra isquotedldquoForecasting is tough especially if it involves the futurerdquo Letrsquos examineeach of these inputs
Expected Return
The expected return of any asset class should be viewed in a probabilistic ratherthan deterministic sense In other words not as an exact number but rather as themidpoint estimate of possible and likely future outcomes Even those of us whofancy ourselves as esteemed forecasters need to admit that whatever forecast wemake will likely be wrong In a probabilistic sense the litmus test for our assump-tion should be that we believe our return forecast has an equal chance of beingtoo high or too lowWersquoll discuss estimation methods shortly
Standard Deviation
Investment professionals use the standard deviation of returns as the most commonmeasure of risk It is a statistic that measures the variability of returns around theaverageThe higher the annual standard deviation the more uncertain the out-come In a normal distribution about 68 of returns fall within (plus or minus)one standard deviation of the mean For example assume that your portfolio hasan expected annual return of 10 and a 10 standard deviationThe annual re-turn should fall between 0 and 20 two thirds of the time (10 plus or minus10) About 95 of annual returns fall within two standard deviations of themean (in our example between ndash10 and +30)About 99 of annual returnsfall within three standard deviations from the mean (or ndash20 to +40)
Correlation
The correlation coefficient measures the degree to which two asset classes move to-gether Statisticians use the Greek letter rho (ρ) to signify this statisticThe value
capital market assumptions 53
07 schneider 22505 925 AM Page 53
of the correlation coefficient ranges from ndash1 to +1 Assets that have a ρ of ndash1 areperfectly negatively correlatedEvery time one goes up in value the other declinesAssets that have a correlation coefficient of +1 are perfectly positively correlatedvalues always move in the same direction at the same time ρ = 0 indicates thereis no relationship at all In reality most assets have some positive correlation al-though it may be small
developing expected return assumptions
The above three inputs are forecast numbers And if the inputs are substantiallywrong the output will be wrong Consultants jokingly call optimizers ldquoerrormaximizersrdquo So how do you develop these crucial inputs
Well you could guessmdashprobably not a great idea Or you could take long-term historical averages as your input assumptions For reasons wersquoll discussshortly using this method alone is also not a very good idea
Following are various methods to generate the expected return for each assetclass Each method has strengths and weaknesses
The Capi ta l Asset Pr ic ing ModelNobel Prize winner William Sharpe developed the Capital Asset Pricing Model(CAPM) The CAPM is a single factor economic model You regress an assetrsquos re-turn against that of a market portfolio (the index) to calculate a beta (β) orslope coefficient Beta measures the sensitivity of an assetrsquos price to the mar-ket portfolio Beta in combination with the risk-free rate (eg Treasury bills)and the expected market portfolio return determine the expected return of theinvestment Sharpersquos formula is
E(R) = Rf + β(RM ndash Rf)
Where E(R)= Expected return of the asset
RM = Return of the market Index (broad market index containing all risky assets)
Rf = Risk-free rate
Exhibit 73 shows a regression analysis to calculate the β of the Russell2000 small-cap index compared with the Wilshire 5000 index as a proxy for theldquomarket portfoliordquo
We can apply the β calculated by the regression analysis
Expected return (small-cap) = risk-free rate + β times (expected return of market portfolio ndash risk-free rate)
β = 110
54 chapter 7 asset allocation
case study the capital asset pricing model
07 schneider 22505 925 AM Page 54
55
y =
11
0x
- 0
00
R2 =
07
7
-20
-15
-10
-5
0
5
10
15
20
-20
-1
5
-10
-5
0
5
1
0
15
Wils
hir
e 50
00
ex
hib
it 7
3c
ap
m r
eg
re
ss
ion
an
alys
is (
19
79
ndash20
04
)
Russell2000
07 schneider 22505 925 AM Page 55
Expected return of market portfolio = 90
Risk-free rate = 30
Expected return (small-cap) = 3 + 110 times (90 ndash 30) = 96
Because the CAPM requires the use of regression analysis it is inherently ahistorical measure Also it describes return in terms of a single factor system-atic risk or risk sensitivity to the overall market portfolio Another seriousdrawback to using the CAPM is that the market portfolio can be difficult tospecify Often a proxy for the market portfolio is used (eg Standard amp Poorrsquos[SampP] 500 index Wilshire 5000 index etc) Of course you still have the prob-lem of developing an estimate for the return of the market portfolio But someof the methods described in the following sections can be helpful in coming upwith that starting number
Beta can be misleading when an asset class has low correlation with theproxy A general rule of thumb is that when the correlation of an investment rel-ative to the proxy market portfolio is less than 070 or the R-squared (anotherstatistic that measures dispersion) is less than 049 the CAPM is not an effec-tive forecasting tool for the asset class For example real estate investmenttrusts (REITs) and commodities have historically exhibited low correlation (andsensitivity) to the proxy market portfolio giving the asset classes a low βmeasure This low β leads to artificially low expected return numbers when ap-plying the CAPM (Exhibits 74 and 75)
Arbitrage Pricing TheoryUnlike the CAPM which is a single-factor model the Arbitrage Pricing Theory(APT) is a multifactor model that describes investment return and risk as acombination of factors (eg gross domestic product [GDP] consumer priceindex [CPI] interest rate changes etc) However the specifications of the APTare quite difficult to estimate (and are quite possibly limitless) and the inde-pendent variables (eg GDP CPI interest rate changes etc) are often at leastas difficult to forecast as the dependent variable (the asset classrsquos expected re-turn) itself The APT is an interesting academic exercise but generally is notvery practical for developing capital market assumptions The APT formula is
E(R) = Rf + β1 times (GDP) ndash β2 times (CPI) ndash β3 times (INT)
Risk Premium The risk premium method is a sort of ldquobuilding blockrdquo method The expectedreturn of an asset equals the risk-free rate plus a risk premium (a return abovethe risk-free rate or other referenced asset) If markets are efficient investorsshould demand a higher expected return for asset classes with higher riskTheoretically markets would be self-regulating If investors donrsquot expect thehigher-risk asset to lead to higher returns they would sell it The price of thehigher-risk asset would then decline until its future expected return becamehigher than that of the lower-risk asset class The risk premium of an invest-ment can be described in absolute terms (vs the risk-free rate) or relative
56 chapter 7 asset allocation
07 schneider 22505 925 AM Page 56
57
y =
0
48
x
R2
=
0
27
-20
-15
-10
-50
5
10
15
20
-20
-1
5
-10
-5
0
5
10
15
20
Samp
P
50
0
ex
hib
it 7
4c
ap
m r
eg
re
ss
ion
an
alys
is (
19
78
ndash20
04
)
Wilshire REITIndex
07 schneider 22505 925 AM Page 57
58
ex
hib
it 7
5c
ap
m r
eg
re
ss
ion
an
alys
is (
19
79
ndash20
04
)
y =
-0
07
x
R2
=
0
02
-15
-10
-50
5
10
15
-15
-10
-5
0
5
10
15
Samp
P
50
0
MLM CommodityFuturesIndex
Samp
P50
0
07 schneider 22505 925 AM Page 58
terms (vs a reference risky investment) The following equations are examplesof absolute and relative risk premium calculations
Absolute Expected large-cap equity return = [10-year treasury yield] + [large-cap equity risk premium]
Relative Expected small-cap equity return = [large-cap equity return] + [small-cap equity risk premium]
The small-cap equity risk premium is defined as the excess return investorsdemand from holding riskier small-cap stocks The risk premium method isboth practical and easy for most people to conceptualize making it an effec-tive method for developing capital market assumptions We also have anabundance of data on historical risk premiums This method is useful for as-sets like real estate that have low correlation and low betas to the proxy marketportfolio
Historical AnalysisHistory is not destiny but it can provide valuable insights into the expected re-turns risks and correlations of assets Historical analysis is particularly help-ful for statistics like standard deviation and correlation coefficients becausethey tend to be less end point sensitive than return numbers
An unbiased estimate of expected long-term returns should not vary toomuch from long-term historical data What is too much One way to answerthat question is to calculate a time horizon standard deviation That measurecan be estimated by dividing the annual standard deviation by the square rootof the time horizon For example if large-cap stocks have a 16 annual stan-dard deviation you can approximate the 10-year standard deviation by divid-ing 16 by the square root of 10 (3162) The result is a 10-year standarddeviation of about 5 Thus if your time horizon is 10 years and the long-termreturn is 10 an unbiased estimate of a 10-year return should lie between 5and 15 (10 plus or minus 5)
However beware of the human tendency to extrapolate the recent pastDuring the bull market of the late 1990s many investors became overly opti-mistic and extrapolated 10 or 20 years of historical data to come up with farhigher return estimates than were warranted See Chapter 16 for a discussionof behavioral finance
Returns Decomposition The returns decomposition method requires the investor to break the total re-turn down into its various components For example bond returns can be bro-ken down into (1) the yield (2) price changes caused by interest ratefluctuations (3) yield spread changes and (4) default losses For investment-grade bonds the default component is very small It is extremely difficult topredict interest rate movements (and the accompanying effects of pricechanges) over a 5- or 10-year time horizon Thus the current yield should bethe largest component of expected returns for investment grade bonds (inter-est rates canrsquot increase or decrease forever)
developing expected return assumptions 59
07 schneider 22505 925 AM Page 59
On the other hand equity returns are composed of (1) dividend yield (2) re-turn on reinvested earnings (3) inflation and (4) price-earnings (PE) ratio ex-pansion or contraction
Long-term equity returns = [(1 + DIV) times (1 + PE) times (1 + GDP times ERR) times (1 + CPI)] ndash 1
Where DIV = dividend yield
PE = PE ratio expansion or contraction
GDP = GDP growth
ERR = earnings retention ratio = (1 ndash dividend payout ratio)
CPI = consumer price index (inflation)
The current dividend yield and earnings retention ratio figures can be usedalong with forecasts of GDP CPI and PE expansion or contraction to arrive atour long-term expected equity return The one drawback of the returns decom-position method is that GDP growth future trends in CPI rates and PE multi-ple expansion or contraction can be difficult to estimate although GDP and CPIinflation have historically moved in narrower ranges than returns
modern portfolio theory
As mentionedwith his article ldquoPortfolio Selectionrdquowhich appeared in the 1952Journal of Finance Harry Markowitz introduced Modern Portfolio Theory(MPT)MPT provides a context for understanding the interactions of systematicrisk and rewardMarkowitzrsquomodel has profoundly shaped the management of in-stitutional portfolios Because asset class investment returns are (approximately)normally distributed Markowitz was able to apply statistical techniques to opti-mize portfolios (iemaximize return at every risk level)Today virtually all fidu-ciaries rely on MPT to some extent when overseeing the investment ofinstitutional assets
MPT and mean variance optimization (MVO) have been generally beneficialto the investment processOver the past 50 years there was a paradigm shiftEachinvestment was no longer judged solely on its individual merit but rather by howit affected the portfolio as a whole MPT allowed fiduciaries to understand thatadding additional ldquoriskyrdquo investments (with low correlation) to a portfolio couldactually reduce the volatility of the entire portfolioExhibit 76 demonstrates howallocating 13 to a riskier asset class (eg stocks) in an all-bond portfolio can ac-tually reduce the risk of the entire portfolio (and increase expected returns)Thedriver of its risk reduction is the relatively low correlation between stocks andbonds One asset often ldquozigsrdquo when the other ldquozagsrdquo The offsetting fluctuationsdecrease overall portfolio volatilityThe expected return (geometric) of a two-
60 chapter 7 asset allocation
07 schneider 22505 925 AM Page 60
61
ex
hib
it 7
6tw
o-a
ss
et e
ff
icie
nt f
ro
ntie
r
456789
10
38
13
1
8
Ex
pe
cte
d
Ris
k
Eff
icie
nt
Fro
nti
er
10
0
Bo
nd
s
10
0
Sto
cks
87
B
on
ds
13
S
tock
s
Expected Return
07 schneider 22505 925 AM Page 61
asset portfolio is the weighted average expected return (arithmetic) of the two as-sets minus half the varianceWhen two assets are less than perfectly correlated thestandard deviation of the portfolio is less than the weighted average standard de-viations of the asset classesThis diversification benefit is one of the few quantifi-able free lunches offered by the financial markets
shortcoming of traditional meanvariance optimization
The Markowitz algorithm (mean variance optimization or MVO) is very ele-gant It has precise mathematical calculations and draws unambiguous conclu-sions This output gives fiduciaries a sense of security and confidence and iscertainly better than other seat-of-the-pants asset allocation methodologiesHowever humans tend to overestimate the precision and importance of infor-mation including the Markowitz modelWhile the mathematical application ofthe model is ldquopreciserdquo the basic inputs (return risk and correlation assumptions)are difficult to forecast As shown above there are several methods to developinput assumptions each of which provides different numbersThe only thing wecan be certain of is that we are likely to be wrong on all three inputs Even thesmallest change in an expected return input can have a dramatic effect on outputFor example a 1 reduction in the expected return on large-cap stocks (from 9to 8) can make a tremendous difference in the construction of the ldquooptimalrdquoportfolio In Exhibit 77 the large-cap allocation declines from 56 to 0
Statisticians make a distinction between accuracy and precision Precise meanssharply defined or measured while the term accurate means truthful or correctData can be very precisebut inaccurate It would be precisebut inaccurate to saythat a meter equals 2949734 inches It would be more accurate to say that ameter equals a little over one yard although that may not sound as impressiveByoveremphasizing the importance of ldquoprecise inputsrdquo relative to ldquoaccurate inputsrdquotraditional MVO forces the investor to forecast precise assumptions that cannotbe accurate For example it may be accurate to say that small-cap stocks havehigher expected return and risk relative to large-cap stocks However traditionalMVO requires the practitioner to go beyond such a simple forecast and actuallyassign a precise number to the risk premium between the two assets Should theexpected return difference be 050 or should it be 15 Such a small differ-ence can lead to enormous differences in output
Another problem with MVO is that it assumes that asset class returns fall intoa normal distribution (the bell-shaped curve)This assumption is not completelyaccurateFor example the four worst monthly returns for the SampP 500 index be-
62 chapter 7 asset allocation
07 schneider 22505 925 AM Page 62
63
ex
hib
it 7
7la
rg
e-c
ap
allo
ca
tio
n d
ec
lin
e
Sce
nari
o 1
Sce
nari
o 2
Asse
tsRe
turn
Ris
kAs
sets
Retu
rnR
isk
Larg
e-ca
p9
00
16
00
La
rge-
cap
80
0
160
0
Sm
all-c
ap9
50
200
0
Sm
all-c
ap9
50
200
0
Inte
rmed
iate
bon
d5
40
610
In
term
edia
te b
ond
540
6
10
C orr
elat
ion
Mat
rix
Corr
elat
ion
Mat
rix
Inte
rmed
iate
Inte
rmed
iate
Larg
e-ca
pSm
all-
cap
bond
Larg
e-ca
pSm
all-
cap
bond
Larg
e-ca
p1
Larg
e-ca
p1
Sm
all-c
ap0
831
Sm
all-c
ap0
831
Inte
rmed
iate
bon
d0
270
171
Inte
rmed
iate
bon
d0
270
171
Mos
t eff
icie
nt a
lloca
tion
to a
chie
ve a
n 8
re
turn
Mos
t eff
icie
nt a
lloca
tion
to a
chie
ve a
n 8
re
turn
Larg
e-ca
p56
La
rge-
cap
0S
mal
l-cap
14
Sm
all-c
ap63
In
term
edia
te b
ond
30
Inte
rmed
iate
bon
d37
07 schneider 22505 925 AM Page 63
tween 1978 and 2004 were October 1987 (ndash215) August 1998 (ndash145)September 2002 (ndash109) and March 1980 (ndash98) Based on the observedmonthly returns and standard deviation between 1978 and 2004you would onlyexpect a 215 loss (egOctober 1987) to occur once every 441322 years Onewould also only expect a 145 loss to occur once every 353 years The lossesobserved in September 2002 and March 1980 would only be expected to occuronce every 24 and 11 years respectively (Exhibit 78)On the other hand the bestmonthly return which occurred in January 1987 (+135) would only be ex-pected to occur about once every 28 years Based on our 26-year sample a 1 in28-year event is not far off from what we would expectThe monthly returns ofthe SampP 500 index have exhibited both excess kurtosis (fat tails) and negativeskewness (more observations on the left side of the distribution) just what youdonrsquot wantAt least for the past 26 years the normal distribution has not been agood predictor of downside risk
The ultimate conclusion must be that traditional MVO is helpful as an exerciseto demonstrate the value of diversification but has little practical value in deter-mining a specific optimal mix of assets in the portfolio construction process Inorder for a portfolio optimization model to have value as a practical tool it mustaccount for the likelihood that an assetrsquos short-term results may not match long-term expectations
the long run
Letrsquos make the assumption that large-cap US stocks are expected to achieve theirlong-run historical return and risk characteristics over a specified future horizonWhat is ldquothe long runrdquo There were 56 rolling 20-year periods between 1928 and2002The average annualized return (of the SampP 500) for these 56 twenty-yearperiods was 1133The returns ranged from 24 to 177About two thirdsof 20-year returns (or one standard deviation) ranged between 149 and 78In Exhibit 77 we saw how the efficient portfolio (generating an 8 return) wentfrom a 56 allocation to large-cap stocks to 0 with just a 1 decline in the ex-pected return for large-cap stocks but large stocks have had a 7 spread over 20-year periods To state the obvious one standard deviation events are prettycommon2
A nonprofit organization may have an infinite time horizon but the membersof your investment committee probably donrsquot have infinite patienceTherefore
64 chapter 7 asset allocation
2Calculated by DiMeo Schneider amp Associates LLC using data presented in Stocks Bonds Bills andInflationreg 2004 Yearbookcopy 2004 Ibbotson Associates IncBased on copyrighted works by Ibbotson andSinquefieldAll rights reserved Used with permission
07 schneider 22505 925 AM Page 64
probabilistic optimization models 65
exhibit 78 sampp 500 histogram of monthly returns(1978ndash2004)
your investment horizon should not be defined as ldquoinfiniterdquo but should be de-fined as the length of time that the committee will stick with a strategy that doesnot appear to be working Much like casinos human beings have hard-wiredldquotable limitsrdquo
In Las Vegas a $5 minimum bet table might have a $500 table limitWhy woulda casino want to prevent anyone from betting over $500 at this table For a gam-bler with infinite patience and resources (and no table limit) there is a perfectgambling strategy that will always win eventually If every time the gambler losta hand at Black Jack he doubled the bet the gambler would eventually make backeverything that was lost plus the value of the initial bet Exhibit 79 illustrates thetheoretical payoff diagram for such an investor (assumes a 50 chance of victory)
Trustees of your fund may not be able or willing to wait 5 10 or 20 years formean reversion to bail out the investment or investment strategy So whatrsquos the solution
probabilistic optimization models
The Frontier Engineer (a proprietary DiMeo Schneider amp AssociatesLLCpro-gram) and other probabilistic optimization models are evolutionary improve-ments to the Markowitz portfolio optimization processTen tosses of a coin wonrsquotalways yield five heads and five tails Probabilistic models account for short-termuncertainty Markowitz developed his optimization model in the first place be-
(1978ndash2004)
0
10
20
30
40
50
60
70
SampP 500
Num
ber o
fObs
erva
tion
s
ndash22
ndash20
ndash18
ndash16
ndash15
ndash13
ndash11
ndash9
ndash8
ndash6 ndash4
ndash2 ndash1 1 3 5 6 8
10
12
13
SampP 500
07 schneider 22505 925 AM Page 65
cause he realized an investmentrsquos expected return might not be realized over aninvestorrsquos time horizon Presumably if the high-returnhigh-risk assets alwaysoutperformed low-returnlow-risk assets over the investorrsquos time horizon wewouldnrsquot need the model in the first placeWe would just invest in the highest-returning asset class Unfortunately no such guarantee is available in the realworldHigher-risk assets have a nasty habit of achieving a much lower time hori-zon return than expected (Exhibit 710)Markowitzrsquos model implies that a 1-yearreturn is uncertain as defined by the one-year standard deviation measure as a dis-persion of possible annual returns but remains silent on the time horizon ex-pected returnThis silence leads the model to be applied (through no fault ofMarkowitz) so that the long-term expected performance of the asset equals theone-year forecast
Probabilistic optimization models run Monte Carlo simulations to generatemany possible outcomesThese multiple outcomes are generated by simulating
66 chapter 7 asset allocation
exhibit 79 theoretical payoff diagram
Profit GeneratedChance of Bet to Make Total upon
Cumulative if Lost Accumulated EventualTrial Losing Last Hand Loss Victory
1 50 $5 ($5) $5 2 25 $10 ($15) $5 3 13 $20 ($35) $5 4 6 $40 ($75) $5 5 3 $80 ($155) $5 6 2 $160 ($315) $5 7 1 $320 ($635) $5 8 04 $640 ($1275) $5 9 02 $1280 ($2555) $5
10 01 $2560 ($5115) $5 11 005 $5120 ($10235) $5 12 002 $10240 ($20475) $5 13 001 $20480 ($40955) $5 14 001 $40960 ($81915) $5 15 0003 $81920 ($163835) $5 16 0002 $163840 ($327675) $5 17 0001 $327680 ($655355) $5 18 00004 $655360 ($1310715) $5 19 00002 $1310720 ($2621435) $5 20 00001 $2621440 ($5242875) $5 21 000005 $5242880 ($10485755) $5 22 000002 $10485760 ($20971515) $5 23 000001 $20971520 ($41943035) $5 24 000001 $41943040 ($83886075) $5 25 0000003 $83886080 ($167772155) $5
07 schneider 22505 925 AM Page 66
numerous ldquowhat if rdquo scenarios based on the annual expected return and standarddeviationFor example in one simulation large-cap stocks may be assumed to re-turn 11 in the next 4 and so onThen all the possible outcomes are sortedand somehow combined to produce an ldquoall-weatherrdquo efficient frontierThere arevarious methodologies to accomplish this goal (see Appendix G for a list of ven-dors)The greater the expected precision of inputs (for longer time horizons) themore the probabilistic models look like the traditional Markowitz efficient fron-tierThe less confident you are about the inputs the more broadly diversified theportfolios become
The traditional model requires three inputs expected risk expected returnand expected correlation among asset classes Probabilistic models add a fourthinput an uncertainty adjustment
summary
Modern Portfolio Theory provides an academic rationale for the benefits of di-versification but unfortunately is less helpful in forecasting efficient portfoliosTraditional MVO requires the heavy use of constraint in order to generate port-folios that make intuitive sense (The model is faulty the inputs are faulty or theintuition is faulty)
Recently developed probabilistic-based optimization models produce output
summary 67
exhibit 710 returns on high-risk assets
Annual 10-Year Pessimistic OptimisticExpected Standard Standard 10-Year 10-Year
Asset Class Return Deviation Deviation Return Return
Large-cap 81 154 49 ndash32 194Small-cap 83 197 62 ndash62 228Mid-cap 82 176 56 ndash47 211International
Equity 81 171 54 ndash45 207REIT 76 156 49 ndash39 191High-yield Bond 58 87 28 ndash06 122Short Bond 32 32 10 08 56International
Bond 56 103 33 ndash20 132Em Mkt Eq 75 288 91 ndash137 287TIPS 46 86 27 ndash17 109Intermediate
Bond 46 63 20 00 92
Optimistic and pessimistic returns are defined as three standard deviation eventsFor illustrative purposes only
07 schneider 22505 925 AM Page 67
that is more useful for an investor with a finite time horizon Even if your timehorizon is 30 years you will see very different output from that of the traditionalmodelAlthough it is impossible to make error-free input assumptions proba-bilistic optimization models equip us to make asset allocation decisions that donrsquot ldquobet the ranchrdquo on the precision our forecasts As a fiduciary overseeingyour nonprofit organizationrsquos investment allocation you might conclude that aprobabilistic-based approach will help you to minimize your maximum regretAnd thatrsquos a good thing
68 chapter 7 asset allocation
07 schneider 22505 925 AM Page 68
chapter 8
New Asset Classes
We have explored the importance of asset allocation and some of the latestenhancements to the modelsPerhaps we should mention a useful rule of thumbin general the more broadly diversified the portfolio the better If you hold sev-eral noncorrelated asset classes in your portfolio it is likely that at least one or twomay perform well even if everything else is declining Nowadays most nonprofitfunds hold large and small US stocks US bonds cash (Treasury bills) and evennon-US stocks In this chapter we discuss additional asset classes that can en-hance your portfolio diversification We examine real estate investment trusts(REITs) high-yield bonds non-US bonds and inflation-indexed bonds
real estate investment trusts
Real estate investment trusts are companies that buy develop manage and sell realestate assets REITs afford investors an opportunity to invest in professionallymanaged portfolios of properties So long as at least 90 of income is paid out inthe form of dividends to shareholders and at least 75 of the investments are inreal estate the cash flows of REITs can be distributed to investors without taxa-tion at the corporate levelTax-qualified investors escape direct and indirect in-come taxation altogetherAs pass-through entities REIT business activities arerestricted to the generation of property rental income
REITs offer a major advantage over direct ownership of real estate liquidityREIT shares are traded on the New York Stock Exchange and other major ex-changes making it easier to acquire and liquidate real estate than to buy and sellprivate properties
REITs share some performance characteristics with small-cap stocks andfixed-income investmentsThe relatively low market capitalization of REITs puts
69
08 schneider 3405 533 PM Page 69
them in the small-cap category In fact REITs make up a significant portion ofthe Russell 2000 small-cap index But real estate and therefore REITs are trulya separate asset classREITs have some advantages over stocks and bonds in termsof dividends Between 1995 and 2002 the average dividend yield on REITs wasover 7 far greater than the dividend yield on traditional equity investmentsFurthermore all REITs pay dividendswhereas less than half of the Russell 2000stocks pay dividends REITs show a relatively low correlation with other equi-ties including small-cap stocks (Exhibit 81)
The long-term investment performance of REITs is determined by the cashflow yields generated by rents the growth in the underlying nominal value of thereal estate over time and multiple expansion (or contraction) afforded REITs inthe marketplace One of the primary incentives for REIT investment is the lowcorrelation with other financial assetsREITs have low correlation with other fi-nancial assets because (1) they are income-generating assets and (2) they providesome degree of inflation protection REITs are some of the few financial assetsthat wonrsquot necessarily react adversely to unanticipated increases in inflation Asudden increase in inflation (and interest rates) may cause the yield componentof REITs to become less attractive but it also increases the terminal value of the
70 chapter 8 new asset classes
Correlation Matrixdagger
International IntermediateLarge-Cap Small-Cap Equity REIT Bond
Large-cap 1Small-cap 083 1International equity 057 051 1REIT 051 062 031 1Intermediate bond 025 015 016 022 1
Period beginning 179ndash1004 (risk is measured by standard deviation)daggerLarge-cap (Russell 1000) small-cap (Russell 2000) international equity (MSCI EAFE) REIT (Wilshire REIT)intermediate bond (Lehman Aggregate Bond)
Historical Return and Risk
Asset Class Return Risk
Large-cap 139 155
Small-cap 143 196
International equity 118 170
REIT 145 145
Intermediate bond 91 63
exhibit 81 returns and risks of reits
08 schneider 3405 533 PM Page 70
underlying real estate In one sense a REIT may be viewed as a fixed-income in-strument with an embedded call option on inflation
However as with other publicly traded equity vehiclesREITs can rapidly winand lose the favor of the investing publicThis can lead to periods of over - or un-dervaluation REITs have experienced painful market sell-offs when the lusterfades and their prices fall to a discount to the value of the real estate held by the trust In recent years more and more investors have recognized thetremendous diversification benefit that REITs offer a portfolioAs of this writ-ingREITs are ldquoin favorrdquo trading at the high end of their normal valuation range(Exhibit 82)
An efficient portfolio (containing large-cap stocks small-cap stocks REITsinternational stocks and intermediate investment grade bonds) that generated a14 annual return from January 1979 to October 2004 would have had about62 allocated to REITs (Exhibit 83) Had you excluded REITs from the allo-cation to achieve a 14 return you would have increased your portfoliorsquos risk byabout 36 (16 vs124) Although history is not destiny (and few would sug-gest a 62 allocation to REITs) the diversification benefit seems obvious
the statistical properties of historicalreit returns
At the risk of getting too technicalREITs have historically exhibited excess kur-tosis (fat tails) relative to what the normal distribution (the traditional bell-shapedcurve) would predictThey have also shown a slight negative skew (more observa-tions in the left or negative tail) Based on the assumption of a normal distribu-tion and the observation of historical monthly returns and standard deviationsyou would have expected an 83 monthly price decline in REITs three times
the statistical properties of historical reit returns 71
-40ndash364
282
ndash88
335
102 90
ndash196
1-9
0
1-9
1
1-9
2
1-9
3
1-9
4
1-9
5
1-9
6
1-9
7
1-9
8
1-9
9
1-0
0
1-0
1
1-0
2
1-0
3
1-0
4
-20
0
20
40
exhibit 82 reit share price premiums to greenstreet nav estimates (11990ndash102004)
08 schneider 3405 533 PM Page 71
ex
hib
it 8
3e
ff
icie
nt f
ro
ntie
r (
119
79
ndash10
2
00
4)
72
8
9
10
11
12
13
14
15
50
7
5
100
12
5
150
17
5
20
0
22
5
Risk
Effi
cien
t Fr
onti
er
wit
h R
EITS
Effi
cien
t Fr
onti
er
wit
hou
t R
EITS
Asse
t Cla
sses
62
REI
TS
0
REI
TS
Return
08 schneider 3405 533 PM Page 72
over the past 25 years In reality it occurred six timesor twice as frequently as ex-pected Conversely you would have expected a 107 monthly increase threetimes over the last 25 years It occurred six times again twice as frequently as ex-pected REITs appear to exhibit more extreme values (or fat tails) than a normaldistribution would predict (Exhibit 84)
So what does all of this mean for your not-for-profit fund Simply this notonly does this asset class offer a diversification benefit but if you rebalance system-atically the fat tails allow you to ldquoengineerrdquo excess return into the portfolio (SeeChapter 12 for more information on rebalancing)
high-yield bonds
High-yield is a euphemism for bonds that are rated ldquobelow investment graderdquo bythe major rating agencies Moodyrsquos and Standard amp Poorrsquos (SampP)The highest-quality bonds get AAA ratingswhile the lowest-quality bonds (not in default) getC ratings based on the creditworthiness of the issuerAnything in default gets aD rating Bonds considered to have an acceptable default risk are deemed ldquoin-vestment graderdquo and encompass BBB bonds and higherBonds BB and lower arecalled high-yield or ldquojunk bondsrdquo and have a higher risk for default High-yieldbonds offer greater yields to compensate investors for the significant increase incredit risk Like any other fixed-payment bond high-yield bonds are also subjectto interest rate risk Oftentimes liquidity risk is also greater for high-yield bondsthan for their investment-grade counterparts In periods of stress when investorsseek to unload their high-yield holdings en massebid-ask spreads can widen dra-matically So why would anyone want to own junk bonds
History
Before the 1980s most junk bonds resulted from a decline in credit quality offormer investment-grade issuersThese issues are known as ldquofallen angelsrdquoAnygiven high-yield bond has a substantially greater default risk than an investment-grade bond However a portfolio of such bonds is another matter entirelyThe tenets of Modern Portfolio Theory (MPT) led researchers to observe thatthe risk-adjusted returns for portfolios of junk bonds were quite highThe higheryields associated with a portfolio of such bonds more than compensated for the credit risk the actual default losses were exceeded by the higher-interest payments
In addition to having higher coupon payments high-yield bonds offer in-vestors potential capital appreciation (or increase in the bondrsquos price) For exam-
high-yield bonds 73
08 schneider 3405 533 PM Page 73
74
Wils
hir
e
RE
IT
Mo
nth
ly
Re
turn
D
istr
ibu
tio
n
of
Re
turn
s (1
79
-20
4)
050520
25
30ex
hib
it 8
4w
ils
hir
e r
eit
mo
nth
ly r
etu
rn
dis
tr
ibu
tio
n o
f r
etu
rn
s(1
19
79
ndash22
00
4)
ndash16
ndash14
ndash13
ndash11
ndash10
ndash9
ndash7
ndash6
ndash4
ndash3
ndash1
0
2
3
5
6
8
9
11
12
30 25 20 15 10 5 0
08 schneider 3405 533 PM Page 74
ple if the borrowerrsquos debt rating is upgraded due to a merger improved earningsor positive industry developments one would expect to see the yield spread be-tween a high-yield bond and investment-grade corporate bond tighten signifi-cantly In other words the junk bond price would riseAlso if investors becomeless risk-averse credit spreads can tighten between the high-yield bond marketand the investment-grade bond market as a whole
Although risk for default is higher for high-yield bond holders they do havesenior claim over preferred and common stock holders in the event of liquida-tion Of course the greatest reason to include junk bonds in a portfolio is thatthey may zig when other investments are zaggingFor example in the latter stagesof an economic recovery interest rates may rise causing a sell-off in investment-grade bondsHowever the strong economy may make high-yield bond investorsmore sanguine about default risk So junk bonds may increase in value while thevalue of investment-grade bonds is falling In fact high-yield bonds have rela-tively low correlation with most of the major asset classes (Exhibit 85)
High-yield bond due diligence requires significant credit analysis Creditanalysis concentrates on fundamentals and a ldquobottom-uprdquo processThe focus is
high-yield bonds 75
Correlation Matrixdagger
International High-Yield IntermediateLarge-Cap Small-Cap Equity Bond Bond
Large-cap 1Small-cap 083 1International equity 057 051 1High-yield bond 051 055 036 1Intermediate bond 025 015 016 032 1
Period beginning 1184ndash1004 (risk is measured by standard deviation)daggerLarge-cap (Russell 1000) small-cap (Russell 2000) international equity (MSCI EAFE) high-yield bond(Merrill Lynch High Yield Master) intermediate bond (Lehman Aggregate Bond)
Historical Return and Risk
Asset Class Return Risk
Large-cap 133 155
Small-cap 123 193
International equity 122 174
High-yield bond 100 62
Intermediate bond 88 45
exhibit 85 correlation of high-yield bonds to assets
08 schneider 3405 533 PM Page 75
generally on the downside risk of default First you need to calculate the likeli-hood of defaultNext you need to gauge the consequence of a potential defaultHigh-yield bond managers typically diversify by industry group and issue typeDue to the high minimum size of bond trades and the credit expertise requiredmost investors use high-yield mutual funds or commingled investment vehiclesrather than separate accounts
The Portfolio Construction Benefits of High-Yield Bonds
An historically optimal portfolio (containing large-cap stocks small-cap stockshigh-yield bonds international stocks and intermediate investment-grade bonds)that generated an 11 annual return from November of 1984 to October 2004would have had about 54 allocated to high-yield bonds Had high-yield bondsbeen excluded from the allocation you would have increased portfolio risk by070 (83 vs 76) (Exhibit 86)As with REITs it seems compelling to in-clude high-yield bonds in a diversified portfolio
All Junk Is Not the Same
It is important to differentiate among the various components of the high-yieldbond market For example there is a big difference between the risk and correla-tion factors of BB- and C-rated securitiesC-rated securities have the lowest cor-relation with both stocks and investment-grade bonds and possess the highestvolatility BB- and B-rated securities show higher correlations with investment-grade bonds and stocks but lower risk than C-rated bondsHigh-yield managersthat focus on BB and B securities perform quite differently than do those managers that focus on B- and C-rated securitiesWithin an MPT context BBand B securities have relatively attractive returnrisk relationshipsbut C-rated se-curities may offer greater diversification potential See Exhibit 87 for a more de-tailed analysis
The Statistical Properties
Like REITs high-yield bonds have historically exhibited excess kurtosis (fat tails) and negative skew (more observations in the left tail) In hindsight ex-tremely negative monthly return events (1100 probability events) should have happened about two times over the past 16 years For B- BB- and C-ratedsecurities these events actually occurred two to three times more often than ex-
76 chapter 8 new asset classes
08 schneider 3405 533 PM Page 76
77
8
9
10
11
12
13
14
4
6
8
10
1
2
14
1
6
18
2
0
Risk
Effi
cien
t Fr
onti
er
wit
h H
igh
Yi
eld
Effi
cien
t Fr
onti
er
wit
hou
t H
igh
Yi
eld
Ass
et C
lass
es54
H
igh
Yie
ld
0
Hig
h Y
ield
ex
hib
it 8
6e
ff
icie
nt f
ro
ntie
r (
1119
84
ndash10
2
00
4)
Return
08 schneider 3405 533 PM Page 77
pected Investment-grade bonds saw two such eventsmatching predictions basedon the normal distributionWhile the highest-quality BB-rated bonds had twiceas many extremely negative return events they had no extremely positive returnevents (Exhibit 88)You couldnrsquot ask for a worse combinationmdashnegative skew-ness coupled with excess kurtosis
Particularly for this asset class the unconstrained traditional (mean variance)optimization model allocates a higher percentage to high-yield bonds than maybe warranted (see Chapter 7)This is partly why high-yield bonds are usuallyconstrained in optimization models Nonetheless high-yield bonds still warrantshelf space in the portfolio construction process because of their relatively lowcorrelation with other asset classes
international bonds
After nearly 20 years of declining interest rates the prospect of rising rates loomson the horizon Fund fiduciaries wonder what to do with their fixed income al-
78 chapter 8 new asset classes
Correlation Matrixdagger
High-Yield Intermediate High-Yield High-Yield High-YieldLarge-Cap Bond Bond Bond (BB) Bond (B) Bond (C)
Large-cap 1
High-yield bond 051 1
Intermediate bond 025 032 1
High-yield bond (BB) 046 09 045 1
High-yield bond (B) 048 097 017 078 1
High-yield bond (C) 036 086 001 066 084 1
Period beginning 988ndash1004 (risk is measured by standard deviation)daggerIntermediate bond (Lehman Aggregate Bond) BB (ML high-yield BB) HY B (ML high-yield B) HY C (ML high-yield C) large-cap (Russell 1000)
Historical Return and Risk
Asset Class Return Risk
Large-cap 124 145
High-yield bond 91 64
Intermediate bond 80 40
High-yield bond (BB) 92 51
High-yield bond (B) 89 72
High-yield bond (C) 77 113
exhibit 87 returnrisk relationships
08 schneider 3405 533 PM Page 78
BB
R
ated
In
dex
In
dex
(9
19
88
-32
00
4)
05
10
15
20
25
30
35
40
45
50
C
Rat
ed
Ind
ex
(91
98
8-3
20
04
)
05
10
15
20
25
Inve
stm
en
t G
rad
e
Ind
ex
(91
98
8-3
20
04
)
05
10
15
20
25
30
35
40
B
Ra
ted
In
dex
(9
19
88
-32
00
4)
05
10
15
20
25
30
35
40
79
ex
hib
it 8
8n
eg
ativ
e v
er
su
s p
os
itiv
e r
etu
rn
ev
en
ts
Sour
ce
Mer
rill
Lync
h H
igh-
Yiel
d B
ond
Inde
xes
(BB
B C
) L
ehm
an A
ggre
gate
Bon
d in
dex
40 35 30 25 20 15 10 5 0
40 35 30 25 20 15 10 5 0
ndash109
ndash92
ndash76
ndash59
ndash43
ndash27
ndash10
06
23
39
56
72
89
105
111
40 35 30 25 20 15 10 5 0
Inve
stm
entG
rade
Inde
x(9
198
8ndash3
200
4)B
BR
ated
Inde
x(9
198
8ndash3
200
4)
ndash109
ndash92
ndash76
ndash59
ndash43
ndash27
ndash10
06
23
39
56
72
89
105
111
40 35 30 25 20 15 10 5 0
ndash109
ndash92
ndash76
ndash59
ndash43
ndash27
ndash10
06
23
39
56
72
89
105
111
B R
ated
Inde
x(9
198
8ndash3
200
4)C
Rate
d In
dex
(91
988
ndash32
004)
ndash109
ndash92
ndash76
ndash59
ndash43
ndash27
ndash10
06
23
39
56
72
89
105
111
08 schneider 3405 533 PM Page 79
location (Nearly every asset allocation strategy for all types of funds includesbonds) The primary reason you include bonds is risk management Low volatil-ity and low correlation with stocks make bonds the ldquobedrockrdquo of a portfolio Ifthe stock market goes down hopefully the bond portion of a portfolio will holdits value which will help prevent large losses But what happens if the US bondmarket goes down What if the stock and bond markets both decline While do-mestic bonds generally provide some of the diversification that a portfolio needsforeign bonds can further diversify a portfoliorsquos total risk
Why do foreign bonds make sense They offer a large opportunity set of secu-rities in which to invest provide access to alternative interest rate environmentsand provide a strong tool for risk managementThis section touches on all threeof these reasons plus the impact of foreign currencies on US investorsAvailableinvestment vehicles are also discussed
Opportunity Set
Nearly 60 of all bonds are issued outside the United StatesNowadaysnon-USstocks are a part of most pension foundation and endowment fundsrsquo equity allo-cations Foreign bonds offer similar diversification benefits for the fixed-incomeportion Non-US bonds offer access to some of the worldrsquos most financiallysound governments and corporationsSovereign debt (bonds issued by foreign gov-ernments) currently makes up the lionrsquos share of the overseas bond marketGovernments in developed markets such as the EuroZone Scandinavia GreatBritain JapanAustralia and New Zealand all issue traditional fixed-income se-curities In addition a number of those countries also issue inflation-indexedbondsThese bonds offer the full faith and credit of their respective governmentsand behave in their local markets in a similar fashion to US government bondsExhibit 89 shows the foreign bond market broken down by issuer
Foreign Corporate Debt
The fastest growing sector in the non-US fixed-income market is corporate-is-sued debt Foreign corporations have historically used direct bank borrowing and the equity markets to finance growth but have started turning more towardthe bond markets as a source of funds Corporations have increased their debt issuance in most developed countries and in many emerging markets (Exhibits810 and 811) As in the United States purchasing nongovernment fixed-in-come securities carries added risk but investors are rewarded for that additional risk with higher yields Credit risk or the risk that a company may default on its
80 chapter 8 new asset classes
08 schneider 3405 533 PM Page 80
debt obligations is a primary risk associated with such securities Credit ratingagencies such as SampP and Moodyrsquos have increased their coverage of non-UScorporate debt making it easier for a purchaser to identify investment-grade se-curities overseas
As can be seen in Exhibits 810 and 811 the size of these markets offers avastly increased opportunity set for US investors
An important subsector of the foreign bond market is emerging market debtEmerging or developing markets are generally considered to be those outside the
international bonds 81
4 3 8 0 United States
0 6 0 O t h e r
0 3 0 South Korea
0 4 0 Sweden
0 3 0 Switzerland
0 4 0 Denmark
1 2 0 Canada
2 2 0 Emerging Markets
4 1 0 United Kingdom
0 3 0 Taiwan
0 5 0 Austral ia
060India
1530Japan
020South Africa
3000 EMU Europe
exhibit 89 foreign bond market by issuer
Total Size $228 trillion
Source Bank for International Settlements
Source Merrill Lynch
exhibit 810 government share of global bond market
08 schneider 3405 533 PM Page 81
Morgan Stanley Capital International Europe Australia and Far East (MSCIEAFE) index Countries in Latin America Eastern Europe and Asia (excludingJapan) issue both sovereign and corporate debt to finance government spendingand corporate growth Emerging market bonds offer opportunities althoughwith an additional layer of risk Increased government spending and lower inter-est rates have had a significant impact on the size of the bond markets in some ofthese developing countriesWhile accounting for less than 5 of the world bondmarkets emerging countries are experiencing tremendous growth in terms ofboth gross domestic product (GDP) and the size of their capital markets
Volatility in the local economies and political instability are the most signifi-cant factors effecting debt securities in these countriesThe Russian debt crisis of 1998 is an example In that year Russia defaulted on its debt obligations andthrew the entire emerging debt market into crisis However with higher riskscome higher yields Government debt issued by emerging market countries often carries significantly higher yields than bonds issued in the United StatesUnited Kingdom or EuroZone countries Moreover credit quality seems to beslowly improving in these markets Nearly 49 of the securities in the JPMorgan Emerging Markets index are now rated as investment grade Improvingcredit quality may provide price appreciation if economic conditions around theworld improve
A second equally important benefit of these securities is their low correlation
82 chapter 8 new asset classes
exhibit 811 global corporate bond issuance
Source Goldman Sachs
08 schneider 3405 533 PM Page 82
with other asset classesCorrelation is the degree to which two investments movetogetherAs we have mentioned earlier the prospect of rising interest rates maydim investorsrsquo enthusiasm for domestic bondsWhy should international bondsbe any different Why do we think they can help an overall asset allocation struc-ture Take a look at Exhibit 812 which details how both hedged and unhedgedforeign bonds correlate with other major asset classes
A correlation coefficient of 100 is perfect positive correlation In other wordsevery time one asset class moves a certain direction the asset class being comparedmoves in exactly the same directionA correlation coefficient of -100 means thatevery time one asset moves one direction the other asset moves in exactly the op-posite directionThe correlation of unhedged international bonds to domesticbonds is 036This means that the returns of these two asset classes move in ex-actly the same direction only 36 of the time That is over 60 of the timewhen US bonds decline in price foreign bonds may stay flat or even appreciate
Interest Rate Environments
Regardless of where a bond is issued it responds similarly to changes in local in-terest rates Foreign central banks (European Central Bank Bank of EnglandBank of Japan etc) control the interest rate environment in their economies inmuch the same way as the Federal Reserve dictates rates domesticallyWhy is thisimportant
As each regionrsquos economy strengthens or weakens the central banks raise or
international bonds 83
Large- Hedged UnhedgedCap International Domestic International International
Equity Equity Bonds Bonds Bonds
Large-cap equity 100
International equity 057 100
Domestic bonds 025 016 100
Hedged 010 021 060 100international bonds
Unhedged ndash005 044 036 048 100international bondsdagger
Hedged international bonds Citigroup Currency-Hedged Non-US World Government Bond Ten-MarketdaggerUnhedged international bonds Citigroup Non-US Dollar World Government BondLarge-cap = Russell 1000 international equity = MSCI EAFE domestic bonds = Lehman US Aggregate Bond
exhibit 812 asset class correlation data(11985ndash102004)
08 schneider 3405 533 PM Page 83
lower rates in order to effect economic growthTheir actions shape the interestrate environment in each market Foreign economies are seldom on exactly thesame path as that of the United States Exhibit 813 details average annual inter-est rates for several major countries
The manager of a foreign bond fund has more interest rate environments fromwhich to choose than does a domestic bond managerWhen rates are low in theUnited States they may be higher in Europe and the United Kingdom Beliefthat the European Central Bank may lower rates to encourage economic growthmay stimulate the European bond markets at a time when the US bond marketsare looking at rate increases and the prospect of falling bond prices
Currency Risk and Hedging
Why does it matter to a US investor if the dollar gains or loses value against theeuro pound or yen Currency movement can at times have the single greatestimpact on a portfoliorsquos return Here is an easy way to think about the impact ofcurrencyAssume that the US dollar and the euro trade at about the same level$1 for euro1You buy a German government bond that is issued with a par value ofeuro1000At this exchange level it costs $1000 to buy the bond Over time thevalue of each currency changesAssume that now euro1 can be exchanged for $115(a loss of 15 in the value of the US dollar)After selling the bond the euro1000is exchanged for US dollarsBecause the U S dollar weakened against the Eurothe 1000 Euros is converted into $1150This represents a 15 gain on a bondthat has not really appreciated in value
But currency movements work both ways If instead of rising in value againstthe US dollar the euro declines US investors can suffer substantial losses Forexample if euro1 can only be exchanged for $085 your $1000 investment is nowworth $850 a loss of 15 from currency movement alone
But there is a solution hedge away the impact of currency Derivative instru-ments can remove the impact of currency swings (both positive and negative)Futures contracts primarily in the major currencies (euro yen and Britishpound) and currency swaps can be used to remove currency risk while not ef-fecting the value of the underlying bondsThis hedging directly impacts the re-turn that a US-based investor can earn from foreign securitiesWhile itrsquos almostimpossible to predict the direction of a particular currency about half the timeUS investors gain from currency exposure and half the time they lose Some in-vestors prefer to avoid the risk and adopt a hedged strategy
One of the primary decisions the investment committee must make is whetheror not to allow currency exposure International bond managers generally fall
84 chapter 8 new asset classes
08 schneider 3405 533 PM Page 84
85
ex
hib
it 8
13
av
er
ag
e a
nn
ua
l i
nte
re
st r
ate
s b
y c
ou
ntr
y
Long
-Ter
m In
tere
stRa
tes
Perc
enta
ge p
er A
nnum
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Aus
tral
ia13
210
79
27
39
92
82
69
55
61
63
56
58
54
Cana
da10
79
58
17
28
48
27
26
15
35
55
95
55
34
8D
enm
ark
106
93
97
37
88
37
26
35
49
57
51
51
43
Finl
and
132
117
128
89
88
71
64
84
75
55
54
1Fr
ance
99
98
66
87
27
56
35
64
64
65
44
94
94
1G
erm
any
87
85
79
65
69
69
62
57
46
45
53
48
48
41
Irel
and
103
94
93
76
88
27
26
34
74
85
55
54
1Ita
ly13
513
313
311
210
512
29
46
94
94
75
65
25
43
Japa
n7
63
53
43
44
34
31
24
15
17
17
13
13
11
Kore
a15
116
515
112
112
312
410
911
712
88
78
56
76
55
Mex
ico
349
197
161
156
138
399
344
224
248
241
169
138
85
74
Net
herla
nds
89
87
81
64
69
69
62
56
46
46
54
54
94
1N
ew Z
eala
nd12
410
18
46
97
67
87
97
26
36
46
96
46
55
9N
orw
ay10
710
96
69
74
74
68
59
54
55
62
62
64
5S
pain
146
128
117
102
1011
38
76
44
84
75
55
15
41
Sw
eden
132
107
108
59
510
28
66
55
54
51
53
46
Sw
itze
rland
64
62
64
46
54
54
34
33
39
34
32
27
Uni
ted
King
dom
118
101
91
75
82
82
78
71
55
51
53
49
49
45
Uni
ted
Sta
tes
86
79
75
97
16
66
46
45
35
66
54
64
Euro
are
a10
910
39
87
98
84
71
59
47
46
54
54
94
1
Not
eTe
n-ye
ar b
ench
mar
kgo
vern
men
tbon
d yi
elds
whe
re a
vaila
ble
or y
ield
on
prox
imat
ely
sim
ilar f
inan
cial
inst
rum
ents
(for
Kor
ea a
five
-yea
r bon
d is
used
)
Sour
ce O
rgan
izat
ion
for E
cono
mic
Coop
erat
ion
and
Dev
elop
men
t
08 schneider 3405 533 PM Page 85
into two categories currency hedged and unhedgedHow large are the potentialreturn differences between hedged and unhedged managers Exhibit 814 detailsannual returns and annualized standard deviations for 5- and 10-year periods forboth the Citigroup Currency-Hedged Non-USDollar and the Citigroup Non-US Dollar World Government Bond indexes
Investors face a dilemma when looking at currency riskAn unhedged portfo-lio provides the opportunity for equity-like returns but also exposes the investorto equity-like downsideThe period 1999 through 2001 represents three consec-utive years of losses Could your fund afford to take nearly four times the risk inorder to achieve high returns in years like 2002 and 2003 Or is it more appro-priate to hedge away most of the currency risk in order to achieve a smootherride These are questions for your investment committee and consultant Oneoption is to split the foreign bond allocation between these two strategies Asmentioned earlier there is about a 5050 chance of coming out on the right sideof a currency bet By using both the hedged and unhedged strategies and rebal-ancing (see Chapter 12) the fund may get the best of both worlds higher returnsthan expected from the hedged approach alone and less potential downside thanis typical for an unhedged portfolio
mutual fund or separate account
This decision may be an easy one Most non-US bond managers have require-ments of $100 million or more to open a separate account For investment allo-cations smaller than thatmutual funds are the only possibilityEven if an investorcould find a manager who accepts smaller mandates increased trading and custody costs may be prohibitive Custody costs for a foreign bond portfolio are significantly higher than for a comparable domestic bond portfolio Custodycosts include asset-based fees transaction-based fees foreign exchange fees and
86 chapter 8 new asset classes
exhibit 814 calendar year returns and standarddeviation
Index 2003 2002 2001 2000 1999 1998
Hedged 188 685 612 964 288 1153Nonhedged 1852 2199 ndash354 ndash263 ndash507 1779
Index 1997 1996 1995 Standard Deviation
Hedged 1107 1185 1792 256 301Nonhedged ndash426 408 1955 891 845
08 schneider 3405 533 PM Page 86
the cost of hedging (if applicable) Large investment funds can offset these feeswith reduced management expenses but the only viable alternative for smallerendowments or foundations is often to use an institutional mutual fund Suchfunds carry expense ratios that are lower than those of ldquoretailrdquo fundsThe expenseratio includes most of the above-mentioned costs as well as the investment man-agement feesTrading costs are not included in the expense ratio but are nettedagainst returns
Donrsquot ignore liquidityMost foreign bonds are fairly liquid and sovereign debtis very liquid but if your nonprofit organization needs regular cash distributionsit is important to have a clear understanding of true liquidity
experience counts
The world is a big place More than half of all fixed-income securities are issuedoutside the United StatesThis is not an asset class for rookie managers It is ex-tremely important (as it is with virtually any asset class) to hire an investmentmanager with experience depth of staff knowledge and understanding of for-eign fixed-income markets Performing credit research on a company in Brazil isvery different from performing credit research on a company headquartered inBostonAccounting standards differ and there are cultural and managerial differ-ences Only a dedicated team of professionals can adequately perform the taskLeave implementing a currency futures overlay to the experts
summary
Although the thought of using foreign bonds may raise the blood pressure ofsome investment committee members such bonds can be a good tool for portfo-lio diversification Considering the huge pool of fixed-income instruments out-side the United States and the different interest rate environments it is an assetclass worth considering
inflation indexed bonds
Inflation indexed bonds are also known as TIPS (an acronym for their originalname Treasury inflation protection securities)TIPS and other types of inflation pro-tection bonds (IPBs) represent a new asset classThese bonds have special appli-cations for not-for-profit funds
TIPS are relatively new instruments in the United StatesHoweverother gov-
inflation indexed bonds 87
08 schneider 3405 533 PM Page 87
ernments have used them for years In addition several corporations have issuedsuch bondsThe advantage to the issuer is lower interest expenseThe advantageto the purchaser is a positive rate of return even in periods of rising inflationThe purchaser should also enjoy less volatility
TIPS are issued with a stated real rate of return Every six months the bondrsquosprincipal amount is adjusted based on changes in the consumer price index(CPI)The semi-annual interest payment is calculated by multiplying the newprincipal amount by one half the stated rate
TIPS and Not-for-Profit Funds
Your fund shares many characteristics with other institutional pools of money(defined benefit pension plans defined contribution retirement plans insurancecompany reserves etc) However there are some crucial differences
First of all you generally have a spending requirement Second your invest-ment committee is probably a volunteer groupThe members are usually intelli-gent people often highly respected in their particular field But their financialunderstanding may be unevenThere is often a tendency toward an overly con-servative investment posture (Itrsquos human nature to regret a loss more than amissed opportunity for an equal gain)
One particularly problematic tendency is that of categorizing return into in-come and capital gains The idea that ldquowe can only spend incomerdquo is inherentlyflawed In times of low interest rates this posture forces the fund into a large per-centage of debt instruments virtually assuring that there wonrsquot be enough growthto stay ahead of inflation
A more savvy approach is the total return concept (see Chapter 3)Return is re-turn regardless of the sourceThis brings us to the question of why bonds shouldbe part of a diversified portfolio at all Since 1926 intermediate USGovernmentbonds have produced an anemic 24 per year over inflationThat includes the1980s when those bonds produced 649 per year above inflation In fact inmany of the decades since the 1920s bonds have produced negative real returnsSo why would a rational investor include such securities in a portfolio
The answer is that the bonds are included because of their diversification ef-fectTheir relatively low correlation with stocks dampens the inherent volatilityof an all-stock portfolio If you could find another asset class with even lower cor-relation with stocks and that also happened to produce positive returns above in-flation you could shift the entire efficient frontier upwardThatrsquos exactly whatTIPS do
88 chapter 8 new asset classes
08 schneider 3405 533 PM Page 88
Nominal Bonds
Traditionalor nominal bonds pay a stated rate of interest and promise to repay thelenderrsquos principal at maturityWhen a bondrsquos yield is initially set that rate is madeup of several componentsYou can think of the basic component as the currentinflation rateThe second building block is a real return above the current infla-tion rateBut since inflation rates can change over time there is also a third com-ponent of the nominal rate an inflation risk premiumThis component compensatesthe investor for the uncertainty of future inflation Exhibit 815 depicts thosecomponents
When interest rates rise in the marketplace the value of existing bonds fallsThink of opposite ends of a teeter-totter
Inflation Indexed Bonds
TIPS and other inflation protection securities however promise to pay a statedrate of return above inflationEvery six months the principal value of such bondsis adjusted upward based on changes in the CPI The stated interest rate orcoupon is paid on the new principal value so both principal and interest riseThere is no inflation risk component built into the bondrsquos yield (Exhibit 815) If
inflation indexed bonds 89
exhibit 815 inflation risk component of bondyields
Nominal BondsYield
Real Return
Inflation Risk Premium
Inflation
Yield Components
Inflation Indexed Bonds
Yield Real Return
Inflation
Yield Components
Source DiMeo Schneider amp Associates LLC
08 schneider 3405 533 PM Page 89
real yields rise in the marketplace existing TIPS will fall in price However nomi-nal interest rates often rise because of increasing inflation or inflationary expecta-tions Real yields have been relatively stable In periods of rising inflationTIPSand other IPBs may experience little price fluctuation
Diversification
To illustrate an after-inflation optimization using TIPS as an asset class we usedhistorical returns standard deviations and correlation coefficients for large-capstocks small-cap stocks foreign stocks nominal bonds and TIPS from March1997 through October 2004 (period of existence for TIPS) (Exhibit 816)
Exhibit 817 shows the comparison between an optimized portfolio usingnominal bonds and a portfolio including TIPSWersquove summarized a comparisonin Exhibit 818 By using TIPS instead of nominal bonds volatility was cut from 79 to 49 In other words you had significantly lower risk at the samereturn level
90 chapter 8 new asset classes
Correlation Matrixdagger
IntermediateLarge-Cap Small-Cap International TIPS Bonds
Large-cap 1Small-cap 083 1International 057 051 1TIPS ndash018 ndash014 ndash016 1Intermediate bonds 025 015 016 075 1
Period beginning 397ndash1004 (risk is measured by standard deviation)daggerLarge-cap (Russell 1000) small-cap (Russell 2000) international equity (MSCI EAFE) TIPS (CitigroupInflation Linked Securities) intermediate bond (Lehman Aggregate Bond)
Asset Class Return Risk
Large-cap 78 171
Small-cap 100 217
International 54 162
TIPS 77 51
Intermediate bonds 70 37
exhibit 816 historical return and risk
08 schneider 3405 533 PM Page 90
91
ex
hib
it 8
17
ef
fic
ien
t f
ro
ntie
r (
19
97
ndash10
2
00
4)
Ris
k
Return
5
2
46
8
10
12
14
16
18
2
0
22
678
9
10
11
Effi
cien
t Fro
nti
er w
ith
TIP
SEf
fici
ent F
ron
tier
wit
ho
ut T
IPS
Ass
et C
lass
es6
6
TIP
S0
T
IPS
08 schneider 3405 533 PM Page 91
risk factors
Of course a major risk in the analysis discussed in the preceding section is thatthe estimates for TIPS are in errorBecause these are relatively new securitieswecanrsquot rely on a wealth of historic data (currently less than 8 years) If such bondsturn out to have greater correlation to other asset classes than they exhibited dur-ing their short history the relative advantage may be less If real yields riseTIPSwill fall in price Since their stated interest rate is low these bonds will have greatsensitivity to real interest rate changes
conclusion
Not-for-profit funds face a variety of challengesTypically there is a spending re-quirementThat is an ongoing real liability over time the fund must increasenominal spending in order to stay even with inflation In additionmost nonprofitfunds tend toward a conservative investment postureTIPS may prove to be avaluable tool to help your trustees face these challenges
92 chapter 8 new asset classes
exhibit 8i8 asset allocation analysis
Asset Allocation TablePercentage of Portfolio
Current TIPSPortfolio Portfolio
Return 8 8Standard deviation 79 49Intermediate bonds 67 0TIPS 0 66Large stocks 0 0Small stocks 12 33
08 schneider 3405 533 PM Page 92
chapter 9
Investment Style
There are two broad categories of equity styleGrowth managers seek to iden-tify companies with above-average earnings growth ratesValue managers attemptto buy a dollarrsquos worth of company for 50 centsBoth styles work but they workat different times In other words they go in and out of favor
Exhibit 91 examines US stock returns from 1989 through 2003 It is worthnoting that not only do the winning and losing styles change from year to yearbut also that the spread between them is frequently in double digits It would bewonderful if we could predict which style was going to be in favor over the nextyear but that type of forecasting is as hard as predicting whether the market isgoing to go up or down (ie itrsquos impossible) In fact the best policy is to have astyle-neutral portfolio that waynot only is some part of the fund always in favorbut you have the opportunity to increase return through strategic rebalancing(see Chapter 12)
academic research
William SharpeStanfordrsquos Nobel Prize winner and other researchers have foundthat style is the most important determinant of return at the manager level Hefound that over 90 of a managerrsquos return is attributable to style and less than10 to skill or luck1
In late 1996 Yale Professor Roger Ibbotson published the first research show-ing any predictive value whatsoever for performance numbers2 His research in-dicates that managers who rank well within a style category over one period are
93
1William Sharpe ldquoDetermining a Fundrsquos Effective Asset Mixrdquo Investment Management Review(NovemberDecember 1988) 56ndash592Roger Ibbotson TMA Journal (NovemberDecember 1996)
09 schneider 22505 935 AM Page 93
more likely to score high within that category over succeeding periods (althoughthe entire style category may go in or out of favor with the market)
It is crucial to identify a managerrsquos style But how do we do that Well wecould ask the manager or look at his or her marketing materials But managersdonrsquot always tell the truth Their glossy brochure might talk about their adher-ence to a disciplined value approach It might go into great detail about screeningfor companies that trade below their break-up value or at a discount to marketmultiples However when you examine their portfolio you discover that theirlargest holding is Cisco Systems In fact many managers exhibit some style drift
So you need to independently ascertain the managerrsquos styleThere are twobasic approaches holdings-based style analysis and returns-based style analysis Eachhas its pluses and minuses
Holdings-Based Style Analysis
Holdings-based style analysis is the traditional methodAn analyst examines thesecurities in a managerrsquos portfolio and sorts them by style and capitalization Forexample the analyst might categorize Intel as a large-cap growth stock and GMas a large-cap value stockThe securities are usually sorted on the basis of somemetrics such as price-earnings (PE) ratio price-book value (PB) or forecastearnings growth
94 chapter 9 investment style
exhibit 91 spread between minimum and maximumreturns by us equity style
Large Large Small Small HindashLoGrowth Value Growth Value Spread
1989 36 25 20 12 241990 0 ndash8 ndash17 ndash22 221991 41 25 51 42 261992 5 14 8 29 241993 3 18 13 24 211994 2 ndash2 ndash2 ndash2 41995 37 38 31 26 121996 23 22 11 21 121997 30 35 13 32 221998 39 16 1 ndash6 451999 33 7 43 ndash2 452000 ndash22 7 ndash22 23 452001 ndash20 ndash6 ndash9 14 342002 ndash28 ndash16 ndash30 ndash11 192003 30 30 49 46 19
Source DiMeo Schneider amp Associates LLC
09 schneider 22505 935 AM Page 94
Although very thorough this method has some significant drawbacks First itis extremely labor intensive Every security must be categorized And knowl-edgeable analysts are high-priced talent Furthermore because of the labor in-volved it is impossible to screen a large number of managers at a single passSecond managers know how to ldquogamerdquo things Since holdings are generally re-ported as of some cut-off date like the end of a quarter itrsquos common for man-agers to change the portfolio with a large number of buys and sells on the last dayIn fact Wall Street calls such quarter-end trading activity ldquowindow dressingrdquoThird therersquos the problem of categorizing certain securities For example is GE agrowth or value stock
Returns-Based Style Analysis
Based on William Sharpersquos research returns-based style analysis doesnrsquot tell youwhat securities a manager holds It tells you how the portfolio behavesThe re-turns-based method solves many of the problems listed above
Using quadratic analysis the managerrsquos quarterly or monthly returns are re-gressed against those of four indexes (eg the Russell 1000 Growth the Russell1000 Value the Russell 2000 Growth and the Russell 2000 Value indexes) Onecan then calculate an exact blend of the four indexes that replicates the managerrsquosreturn pattern Using the four style indexes as corners of a style map itrsquos easy toplot the managerrsquos relative position (Exhibit 92)
You can also perform the analysis over rolling periods for example rolling 12quarter windowsThis gives you an idea of how the managerrsquos style may havechanged or drifted over time (Exhibit 93)The smaller symbols represent earlierperiods the larger symbols represent more recent performance
One additional benefit of this approach is that instead of comparing the man-agerrsquos performance to some generic benchmark like the Standard amp Poorrsquos 500index you can compare him to his true style benchmarkA manager that appearsskillful when compared with the generic benchmark may turn out to underper-form the more accurate style benchmark (Exhibit 94)
The development of returns-based style analysis was a great advanceThere arenow several commercial programs to perform such analysesAlthough the soft-ware is expensive it allows rapid screening of literally hundreds of managers at atimeNow style analysis can be the start of a screening process rather than occur-ring somewhere near the endAnd you are no longer dependent on analyzing se-curity holdings that may be out of date (Mutual funds are only required to reportholdings every six months)
However there are flaws with this methodAlthough the software is accurate
academic research 95
09 schneider 22505 935 AM Page 95
96 chapter 9 investment style
exhibit 93 manager style map reflecting change
Zephry StyleADVISOR Zephyr StyleADVISOR DiMeo Schneider amp Associates
Manager Style36-Month Moving Windows Computed Monthly
October 1999ndashSeptember 2004
rvalue rgrowth
r2 growth
Sample Manager
Russell Generic Corners
Large
1
0
ndash1
SmallValue ndash1 0 1 Growth
exhibit 92 manager style map
Zephry StyleADVISOR Zephyr StyleADVISOR DiMeo Schneider amp Associates
Manager StyleSingle Computation
rvalue rgrowth
r2 growth
Sample Manager
Russell Generic Corners
Large
1
0
ndash1
SmallValue ndash1 0 1 Growth
r2 value
r2 value
09 schneider 22505 935 AM Page 96
the vast majority of the time sometimes there are false readings For exampleimagine that we are in a period when value stocks are very much in favor (andgrowth is out of favor) If you analyze a growth manager who turns in large num-bers the software may think that the manager holds value stocks (since he or sheis winning at the moment) Sometimes managers who hold a large number ofutility stocks show up as having a weighting in fixed incomeLike bonds utilitiesare interest-rate sensitive It is usually best to corroborate returns-based analysiswith a look at the holdings
ancillary uses
The returns-based technology allows you be very specific in your manager searchas well Imagine that you have an excellent value style manager with whomyoursquove worked for many years If the goal is to have a style-neutral portfolio youwill need to add a growth manager However you need to add a manager who isan exact opposite match for your current manager By first plotting your currentmanager on the style mapyou can determine the exact style point that will makethe portfolio style neutralThe name for this counterbalancing manager is a com-pleteness fund Exhibit 95 shows such an analysis
ancillary uses 97
exhibit 94 style benchmark
Zephyr StyleADVISOR Zephyr StyleADVISOR DiMeo Schneider amp Associates
Manager PerformanceSingle Computation
Out-of-sample
October 1999 - September 2004
65
70
80
90
100
110
120
SampP 500 IndexStyle BenchmarkManager ABC
-22
-20
-10
0
10
Sep 1999 Jul 2000 May 2001 Mar 2002 Jan 2003 Nov 2003 Sep 2004
Cumulative Excess Returnvs Style Benchmark
Created with Zephyr StyleADVISOR Manager returns supplied by Morningstar Inc
09 schneider 22505 935 AM Page 97
the current state
Over the past decades institutional funds have adopted the practice of hiringstyle-specific managers In fact one well-known consulting firm has staked out anldquoiconoclasticrdquo position advocating indexing the bulk of a portfolio and then hir-ing non-style-specific managers to add alpha by pursuing whatever style is infavor (This is a flawed premiseWho are these managers that are equally skilled inselecting small-cap growth stocks and large-cap value stocks and know exactlywhen to switch)
summary
Style is the key determinant of manager performanceAnd only within a stylecategory is past performance at all predictive In the next chapter wersquoll examinehow returns-based style analysis can help you select appropriate managers to im-plement your asset allocation
98 chapter 9 investment style
exhibit 95 completeness fund analysis
Zephry StyleADVISOR Zephyr StyleADVISOR DiMeo Schneider amp Associates
Manager StyleSingle Computation
November 1999ndashOctober 2004
rvalue rgrowth
r2 growth
Harbor Capital Appreciation Inst
Completion Fund
Resultant Portfolio
SampP 500
Russell Generic Corners
Large
1
0
ndash1
SmallValue ndash1 0 1 Growth
r2 value
09 schneider 22505 935 AM Page 98
chapter 10
Manager Selection
Once you have formulated an asset allocation strategy the next step is to findappropriate investment managers to implement itThis is the second most im-portant decision Unfortunately many nonprofit organizations have done a poorjob of selecting managersDespite your committeersquos good intentions certain fac-tors may overwhelm the process and lead to poor decisions Corporate retire-ment plans must operate within the Employee Retirement Income Security Act(ERISA) and Financial Accounting Standards Board (FASB) rulesFiduciaries formost nonprofit funds have greater freedomUnfortunately this can result in a lesssystematic and effective process
Too often money is given to a local bank or investment adviser Sometimesthese managers are simply not qualified or appropriate for the fund This can leadto subpar results Nonprofit boards tend to include some bright successful typeA personalitiesThey often preempt the kind of procedural prudence used incorporate plans There is a tendency to short-circuit detailed manager due dili-gence in favor of selecting the familiarmdasha bank a retail stock broker or a refer-ence from a friend The two primary reasons why you should be prudent andthorough in the selection process are
1 Itrsquos your fiduciary responsibilityA fiduciary has an obligation to act pru-dently in all regardsmdashincluding the selection of investment managersDecisions should be informed and carefully executed Fiduciaries are well-advised to generate full written documentation concerning all aspects offund oversightYour investment decisions are more defensible if you docu-ment the decision process See Chapter 18 for more details
2 Enormous sums of money are at stakeWith billions of dollars in nonprofitassets generating incremental return is extremely important Exhibit 101illustrates the impact of an additional 1 annual return
99
10 schneider 22505 936 AM Page 99
overview
Manager selection is not easy First there are thousands of available money man-agers (and more daily) Second there are no easy measures to identify investmentmanagers who will perform well in the futureThe required disclaimer ldquopast per-formance is no guarantee of future resultsrdquo is actually true FinallyWall Street hasnot helped investors to understand financial markets In fact most financial ldquoin-formationrdquo is actually misinformationldquofactoidsrdquo that are either untrue or irrele-vantPredictions about future market movements fall into the first category If theseer could actually forecast market directionshe or she would not be working fora salary
herd mentality
For eons mothers have chided their peer-pressured adolescents with ldquowould youjump off the bridge because your friends didrdquoAdults are also subject to the herdmentalityHumans are not always logical We have emotions and the ability to ra-tionalize based on incomplete information Many investors become fixated onthe money managers with the best absolute performance recordsUnfortunatelymost investors focus on recent performance with no regard for riskWhy is thisflawed Styles of investing come in and out of favor and often the manager withthe best recent performance is hired merely because its style was in favorAll toooften managers are hired just as the pendulum swings away from that particularstyle
100 chapter 10 manager selection
exhibit 101 impact of additional annual return
$10 Million Initial Investment Value
$21589250$19671514
$46609571
$38696844
Growing at 8year Growing at 7year
10 years 20 years
$10 Million Initial Investment Value
10 schneider 22505 936 AM Page 100
Investors seek the easy answer They rely on the ldquotop picksrdquo from various non-professional publications For example a trustee may demand the inclusion of afund that was ranked among the ldquo10 best funds for next yearrdquo by a favorite busi-ness periodicalThis trustee doesnrsquot understand that such recommendations aregeneric usually given by journalism majors and donrsquot address the nonprofit or-ganizationrsquos specific policies in any way Furthermore magazines have no ac-countability If todayrsquos recommended manager flops so be itNext year there willbe a new list Readers never seem to ask why there are so few repeatsUnfortunately most mass-market publications ignore the prime determinant ofa managerrsquos performance style See Chapter 9 for additional details
avoiding the star system
Morningstar Inc is a well-respected provider of financial informationThey pro-duce extensive financial analysis of mutual fundsThis analysis includes risk returnstyle expensesand portfolio dataThey also rank funds according to their highly rec-ognized star system Ratings incorporate return and risk measures and funds re-ceive from one to five stars with five being the best
Mutual fund marketers love the starsThey splash a fundrsquos Morningstar star rating across full-page ads As we said many investors seek an easy solutionThey donrsquot understand what is behind the star ratingThis can lead to poor in-vestment decisions
What is the star system The Morningstar rating (the star system) for funds is ameasure of a fundrsquos risk-adjusted return relative to its peersThe funds are scoredover three time periods 3 5 and 10 years and these ratings are combined to produce an overall rating Funds are graded on the curve Ratings range from one to five starsThe top 10 of the funds in each category receive the highestrating of five starsThe next 225 receive four stars the next 35 receive threestars the next 225 receive two stars and the final 10 receive one star To itscredit Morningstar regularly cautions readers that the star ratings are a tool for identifying funds for further research but shouldnrsquot be considered buy or sellrecommendations
But shouldnrsquot a five starndashrated fund be superior First the star rating relies en-tirely on past performance which academic research shows to be a poor predic-tor of future resultsThe star ratings will likely result in the choice of a fund withstrong recent performance since all the above periods include the most recentone year
Second the system relies on the ability of Morningstar to accurately catego-rize the funds Until June 2002 Morningstar lumped all stock funds into twogroups domestic equity and international equity This meant that large-cap
avoiding the star system 101
10 schneider 22505 936 AM Page 101
growth funds were ranked alongside small-cap value funds and international eq-uity funds were ranked against emerging markets funds In response to significantcriticismMorningstar changed its methodologyNow categories are based on theunderlying holdings of each fund Morningstar places funds in a given categorybased on portfolio statistics and composition over the past three years Howevermisclassification can still be a problem
Frequently the fundrsquos holdings are stale (currently mutual funds are required toreport complete holdings only twice a year) and funds do not always stick totheir stated investment stylesFor example small-cap funds often migrate into themid-cap category This reduces the reliability of a fundrsquos historyMorningstar alsohas difficulty classifying sector fundsAlthough they have a separate category forsector funds because the classification uses holdings sector funds can find theirway into other categories For example as of this writing Fidelity SelectAutomotive is classified as a mid-cap value fund
We are not knocking MorningstarThey provide a great deal of useful infor-mation that can help investors However no rating system can replace the con-siderable amount of research and due diligence one should perform especiallywhen the organizationrsquos decision makers are held to fiduciary standards
where to begin
Assume that your nonprofit fund has already developed an appropriate asset allo-cation strategyThis allocation was well thought out and takes into account therisk tolerance and spending policyYou selected multiple asset classesThe com-mittee decided to retain the current large-cap value managerTherefore to main-tain a style-neutral posture the fund needs to add a large-cap growth manager
The following example shows a mutual fund search however you would fol-low virtually identical steps when conducting a separate account manager search
Top on the to-do list is to seek input from the committee members and otherkey decision makersTrustees are usually well connected and have some level ofinvestment experience Itrsquos best to solicit this input up front to keep the processflowing Otherwise you run the risk that spurious managers will be inserted latein the process delaying a decisionExhibit 102 is an example of a form to gathersuch input
Letrsquos define money managers It may be helpful to say what professional moneymanagement is not Stock brokers consultants and financial planners are not con-sidered professional money managers
A broker is a salesperson who recommends investments for a commissionLarge brokerage firms understand the negative connotation of ldquostock brokerrdquo so
102 chapter 10 manager selection
10 schneider 22505 936 AM Page 102
where to begin 103
exhibit 102 committee member questionnaire
I Investment Categories Research will be performed to produce appropriate candidates foreach investment category with a check mark_____ Money market funds _____ Large company US stocks_____ Emerging market stocks _____ Small company US stocks_____ Bonds (investment grade) _____ International funds (foreign only)_____ TIPS bonds _____ Real estate funds_____ High-yield bonds
Please indicate any additional investment categories which you strongly feel should receiveconsideration___________________________________________________________________________
___________________________________________________________________________
II General Screens Dozens of screens will be used in each category The following appliesto most searchesbull Portfolio manager tenure of at least three yearsbull Below average fund expensesbull Adequate infrastructurebull Organizationrsquos depth and resourcesbull Administrative compatibilitybull Reasonable growth in asset basebull Well-defined investment processbull Consistency of stylebull Appropriate average market capitalizationbull Risk-adjusted returnbull Absolute returnbull Returns in up marketsbull Returns in down marketsbull Information ratiobull Sharpe ratiobull Alphabull Tracking errorPlease provide any specific criteria you would like incorporated into the screening process___________________________________________________________________________
___________________________________________________________________________
III Specific FundsInvestment Organizations Please indicate specific funds or organizationswhich you strongly feel should receive consideration (Please provide as much detail aspossible)___________________________________________________________________________
___________________________________________________________________________
Completed by___________________________________________________________________________
___________________________________________________________________________
10 schneider 22505 936 AM Page 103
they now call their registered representatives ldquofinancial counselorsrdquo or ldquofinancialadvisersrdquo However their job description remains the same
Most of the large firms have also created managed money productsThese areoften called wrap fee products because the money managerrsquos fee the trading costsand the brokerrsquos commission are ldquowrappedrdquo into one feeSuch programs typicallyinvolve a certain measure of manager due diligence on the part of the brokeragefirm and are certainly an improvement over the traditional transaction-orientedmind-set of most brokers Critics of such programs point out that often clientsonly have a handful of managers from which to choose There may be only 40 or50 in the entire programThe due diligence has also come in for criticism In de-ciding which managers to include in their programs the brokerage firms weightwo variables most highly
1 Which managers will cut their fees significantly in order to be in the program
2 Which managers will create a large marketing staff to support individualbrokers in their sales efforts
Critics also point out that the individual brokers who are the actual point ofdelivery to the client exhibit widely varying levels of knowledge Some under-stand and espouse the diversification principles outlined in this book Unfortu-nately many sell the product as if it were another mutual fund That is theyrecommend the managers with the best recent performancemdashusually thosewhose styles have been in favor
The brother in-law who works for a consulting firm is not an investment man-ager either A consultant should be an expert in the design implementation andoversight of investment strategies for nonprofit organizationsConsultants do notbuy and sell individual securities for a clientrsquos account Instead they assist in theselection and ongoing monitoring of managers
Professional investment managers are first of all investment advisers registeredwith the Securities and Exchange Commission (SEC)They are paid a fee for onething and one thing only to select securities for purchase and sale on a discre-tionary basisThey are not paid commissionsThey should have a Federal formADV and a track record of performance results that is AIMR-PPS compliantpreferably audited by a third party
manager selection
Effective manager selection can be broken into 4 steps
1 Quantitative screens
2 Minimum criteria
104 chapter 10 manager selection
10 schneider 22505 936 AM Page 104
3 Qualitative analysis
4 The interview
The first three steps of the process are designed to produce a manageable num-ber of candidates for face-to-face due diligenceThe final step is geared towardthe actual selection of managers for inclusion in the portfolio Unfortunately nosingle proven objective test can identify managers who will perform well in thefuture Past performance alone is a poor predictor of future results Althoughquantitative data such as risk measures style and other portfolio statistics are im-portant qualitative factors are even more importantThese include the firmrsquos de-cision-making process and the experience and breadth of the firmrsquos personnel
One should begin with as broad a universe of potential candidates as possibleAs of this writing Morningstar identified 1370 large-cap growth mutual fundsObviously this number is too large for the investment committee to considerThe screens shown in Exhibit 103 help narrow the field
Step 1 Quantitative Screens
Armed with a list of criteria you can begin to narrow the list of candidates to amore manageable numberA convenient way to begin is to use a computerizeddatabase screen Computers are great toolsmdashthey just canrsquot make the truly cru-cial decisions Quantitative screens provide a rear-mirror view of past success orfailureThe model only shows results not how they were achievedA managerthat ranks number one may have taken considerable risk to achieve that rankingQuantitative screens are useful when used in conjunction with other crucialanalysis particularly investment style
Style screening is the first pass Style can be analyzed using a returns-based re-gression methodology There are several commercially available pieces of softwarethat use William Sharpersquos quadratic algorithm to analyze a managerrsquos return rela-tive to pure style indicesThis analysis precisely identifies the managerrsquos positionon a style map (see Chapter 9)You should pay particular attention to style driftbecause this is a key measure of managementrsquos adherence to the stated investmentprocess Returns-based analysis as this type of analysis is called may be comple-mented by holdings-based analysis Returns-based analysis tells how the managerbehaved holdings-based analysis looks at the actual positions he or she heldTheholdings at various points in time reveal the portfoliorsquos fundamental characteris-tics and sector exposure relative to the benchmarkAlthough using both methodspaints the most accurate picture a returns-based analysis is easier and cheaperThedata (historical returns) are readily available for analysis
Garbage in equals garbage out Data can be manipulated to produce the de-
manager selection 105
10 schneider 22505 936 AM Page 105
106 chapter 10 manager selection
sired resultsYou need to think carefully about the riskreturn profile of the de-sired manager and adjust the screensrsquo weighting accordingly In other words ifprotection during down markets is foremost a higher weight should be given tothat criterionBe certain that ldquoindependentrdquovariables are not proxies for one an-other For example a high Sharpe ratio (see Glossary) often correlates highly withstrong historical returnsThereforeyou should not overweight both these factorsExhibit 104 is an example of a multifactor riskreturn model that can be used asa first pass to identify attractive managers
Step 2 Minimum Criteria
In the next step you should analyze the surviving managers from a qualitativeperspective Past performance is just thatThe key is future performance which
exhibit 103 potential candidate analysis
Minimum Criteria
Assets Under Management Market Capitalization Bands Portfolio Composition
Consistency of Personnel Expense Ratio etc
Quantitative Screens
1370 Large Growth Managers
50 Large Growth Managers
15 Large Growth Managers
3-4 Large Growth Managers
Final Candidate
Multi-Factor RiskReturn Model Style Analysis
Qualitative Analysis
Detailed Questionnaire
Interview
Organization People Process Philosophy Performance etc
10 schneider 22505 936 AM Page 106
can only be estimated through qualitative judgmentsExhibit 105 is an example ofminimum screening criteria for a large growth mandateThe following are ex-planations of the minimum set of qualitative standards that managers should meet
bull Assets Under Management The size of the product is very importantWeconsider the minimum acceptable size of a product to be $50 millionTheprimary risk to a product with fewer assets is viability A small fund canquickly disappear if it does not attract enough assets to become profitableLarger asset bases can allow expenses to be dispersed over a wider baseHowever too large of an asset base can hinder a managerrsquos ability to effec-tively maneuver among the marketsThis is especially true for small-capproductsThere is some evidence that alphaor value-added tends to vanish
manager selection 107
exhibit 104 multifactor riskreturn model
5-Year Up 5-Year Down
5-Year 5-Year 5-Year 5-Year 5-Year Market Market
Annualized Standard Sharpe Annualized Information Capture Capture
Returns Deviation Ratio Alpha Ratio Ratio Ratio
Weighting 10 10 10 20 30 10 10
exhibit 105 large company growth search
The Screening Process
bull Assets of greater than or equal to $50 million bull Median market capitalization of $10 billion or greaterbull Foreign stock of less than 15bull Cash holdings of less than 15bull Bond holdings of less than 5 bull Manager tenure greater than or equal to three yearsbull Fund inception date of three years (preferably earlier but will consider funds with shorter his-
tory under special circumstances)bull Expense ratio less than equal to or less than peers
Intermediate Fixed-Income Search The Screening Process
bull Assets of greater than or equal to $50 million bull Average credit quality of at least A bull Average maturity between four and twelve yearsbull Average duration between three and six yearsbull Cash holdings of less than 20bull Foreign holdings of less than 10bull Manager tenure greater than or equal to three yearsbull Fund inception date of three years (preferably earlier but will consider funds with shorter his-
tory under special circumstances)bull Expense ratio less than or equal to peers
10 schneider 22505 936 AM Page 107
as a small-cap productrsquos assets climb above $15 billion Make sure that youaggregate all share classes and separate accounts when reviewing asset bal-ances
bull Market Capitalization of a stock is the number of shares outstanding timesthe companyrsquos share price The market capitalization of a portfolio is usu-ally described as its median market cap (the capitalization of the middlestock in a portfolio arranged from lowest to highest) Definitions changeover time however generally accepted guidelines arebull Large-cap stocksmdash$10 billion and abovebull Mid-cap stocksmdash$15 to $10 billionbull Small-cap stocksmdash$15 billion and below
bull Portfolio Composition Review the portfoliorsquos allocation to equity fixed-in-come cash and other asset classesThe cash component of an equity portfo-lio should be less than 10After all you do not pay large fees to managecashAlso for domestic equity products foreign exposure should be mini-mal (under 15) Fixed-income portfolios may hold preferred stocks con-vertibles and other nontraditional bonds Occasionally these securities areused as a tactical play but should not be the majority of assetsunless allowedin the investment policy In fixed-income portfolios the use of cash may ac-tually be strategicThe manager may use cash to shorten portfolio durationor create a barbell structuremdashlegitimate uses
bull Consistency of Personnel Look for a stable organization with minimalturnover among investment professionalsA manager should be in place forat least three years preferably five yearsOtherwise the track record is mean-ingless
bull Expense Ratio Expenses eat into total returnThe higher the expense ratiothe less return on the investment For example a manager who charges anannual fee of 10 and has an additional 10 in trading costs needs to add2 per year of value just to break evenA good rule of thumb is to excludemanagers with expense ratios above the group average
bull Fixed Income investors face several types of riskbull Interest Rate Risk As interest rates rise bond prices fallA bondrsquos coupon
and maturity are wrapped together in a single measure called durationDuration is the measure of the sensitivity of a bondrsquos price to changes in in-terest rates Longer-duration bonds are more sensitive to changes in interestrates than shorter ones For example a bond with a duration of 20 will in-creasedecrease in price approximately 2 for a 100 basis point (10)fallrise in interest rates Duration is often expressed in years In the afore-mentioned example the bondrsquos duration is two years
108 chapter 10 manager selection
10 schneider 22505 936 AM Page 108
bull Credit Spread and Downgrade Risk An unanticipated downgrading of an is-suer increases the credit spread on yields above treasuriesThis results in a de-cline in price
bull Default Risk is the risk that the bond issuer will be unable to repay theloan Standard amp Poorrsquos Moodyrsquos Investors Service and Fitch are themajor credit rating agencies that evaluate the creditworthiness of variousissuers
bull Convexity is a measure of the curvature of the priceyield relationshipPositive convexity indicates prices rise at an increasing rate as yields falland decline at a decreasing rate as yields rise The opposite is true fornegative convexityMost bonds exhibit positive convexityHowever cer-tain bonds with embedded optionality show negative convexity For exam-ple mortgage-backed bonds have negative convexity Mortgage holdershave the option of prepaying their mortgages If interest rates rise theygenerally stop prepayinggiving the bond a longer effective maturity (ex-actly what the bond holder does not want in a rising rate environment)
Step 3 Qualitative Analysis
Steps 1 and 2 should result in a manageable list of managers who screen well ona riskreturn basis and meet the minimum requirementsThe next step requiresadditional fundamental research on the remaining candidatesThis analysis helpsdetermine if all the factors that contributed to the past performance are still inplaceYou need to contact the management firms to solicit their responses to spe-cific questions
In this step you focus on issues such as the stability of an organization and theinvestment team consistency of the investment strategy compliance operationsand compensation structureAn example of a detailed questionnaire to be com-pleted by an equity manager can be found in Appendix BMake sure that you re-view a copy of the firmrsquos most recently filed Form ADV Parts I and II
As part of the qualitative analysis pay particular attention to the following
bull Organization Consider the history and stability of the organizationReview its ownership structure tenure of personnel and goals for growthof assetsCan the firm grow substantially without corrupting the investmentprocess Has the firm been subject to any litigation or censured by a regu-latory body What compliance systems are in place
bull People How many members are on the investment team and what is theirtenure Review their credentials to determine investment acumenAre theyknowledgeable in their strategy How are they compensated Does the
manager selection 109
10 schneider 22505 936 AM Page 109
compensation package include incentive bonuses Are they performancebased or asset based How much personal money is invested in their prod-uct What is the succession plan if a key member of the team departs
bull Investment Philosophy Process and Portfolio Construction Does the producthave a well-defined investment process Is management able to clearly ar-ticulate the buy and sell process Is this process driven by an individual oran investment committee Do the managers and the analysts articulate aconsistent message What are the normal minimum and maximum per-centages of a total portfolio that would be invested in any one sector indus-try or stock (both absolute and relative to a benchmark) Can managementoverride these guidelines Are checks and balances in place to ensure thatthe investment process is implemented uniformly across all accounts
bull Performance During this phase of the process it is important to take a de-tailed look at the productrsquos performanceThis step only adds value in thecontext of a thorough understanding of the investment processChapter 13provides greater detail on analyzing a managerrsquos returns In general youwant to see consistency of performance over rolling time periodsA positiveratio of quarters in which the manager outperforms to the quarters inwhich it underperforms is good Examine performance over various mar-ket cycles including up and down markets How does a manager performwhen its style is in favor compared to when it is out of favor Donrsquot forgetriskModern Portfolio Theory statistics such as alphaSharpe ratio informationratio and tracking error measure how much performance is generated per unitof risk (see Glossary)To get the most complete picture compare the man-agerrsquos performance to both an index and peer group
Step 4 The Interview
This is the crucial stepThe goal should be to make the final manager selectionThe earlier steps exist only to narrow the list of qualified managersAt this pointitrsquos time to use the discrimination skills that humans have developed over millen-niaYou can discriminate between a good ballerina and a poor one between agood basketball player and a poor one between a good author and a hackHuman brains donrsquot turn off just because theyrsquore evaluating money managersProper homework minimizes mistakes Look beyond slick marketing materialsand recent performance assess the investment process If your committee under-stands and appreciates the investment procedures and people it is capable of mak-ing an informed decision
It is easy to arrange the interviews for a private manager search If the resources
110 chapter 10 manager selection
10 schneider 22505 936 AM Page 110
are available make an on-site visit to the managerrsquos officeYou can glean a lot ofvaluable information just by seeing their place of business However a presenta-tion in the nonprofit organizationrsquos office will work as well Provided that yourfund meets the minimum account size a manager will be glad to attend the pres-entation Itrsquos more difficult to get mutual fund managers to come in Howeveryou should be able to arrange a conference call with the portfolio manager or an-other member of the investment team Presentations by a marketing person arethe least helpful If you canrsquot arrange a conference call they are telling you thatthey donrsquot want your business
Trustees for not-for-profit funds are generally very busy individualsTo opti-mize their time limit the number of manager candidates to three or fourAlsoprior to the presentations give the trustees reference data in an easy-to-followformat An example of such a comparative format can be found in Appendix C
Arrange the candidates to present back to back Provide strict time limits andadhere to themFor exampleyou may tell managers to limit their presentation to30 minutes and plan for an additional 15 minutes of QampA Be sensitive to thetime commitmentDonrsquot be afraid to tell the presenterldquoYoursquove got about 5 min-utes left do you have any final commentsrdquo
Although the marketer may put a slick spin on the presentation the actualportfolio decision maker will provide the most useful insightBe consistentmdashaskall the candidates the same questionsTake notes so that you can compare man-agers question by question A sample interview questionnaire is located inAppendix E
passive versus active management
The previous steps make sense when selecting active managers Passive manage-ment is an investment approach that seeks to merely replicate the performance ofa specified indexThis is the least expensive approach and is often used for assetclasses that are efficientHighly liquidwell-researched market segments like large-cap domestic stocks are deemed to be efficient It is difficult for a large-cap coremanager to know something about a stock that is not already widely understoodand factored into the priceAcademic research indicates that in such segmentsmost active managers underperform the benchmarkThereforewhy not settle forthe performance of the index and enjoy much lower fees
On the flip side the markets for small company stocks and foreign stocks areless efficient Informational value can be added by money managers who are ableto exploit the inefficiencies of these markets Foreign equity managers have mul-tiple opportunities to add value by making the right call on country currency orregional economies as well as through individual security research
passive versus active management 111
10 schneider 22505 936 AM Page 111
Everything goes in cycles During certain environments it is difficult for ac-tive managers to beat the indexeswhile at other times they fare bestTrustees maywant to hedge against these cycles by using both passive and active managers inyour fund For example you might want to index the allocation to large-com-pany core and use active managers for large-company value and growthRemember index funds capture the full return of the market but also the fullrisk If the goal is to preserve capital in down markets consider active managerswho have a consistent history of performing well in down markets
databases
There are several databases and computer programs that provide the necessary in-formation to begin a manager search See Appendix G for a list of resources forthis information
A mutual fund is one large pool of assets with numerous investors Its per-formance is reported according to strict guidelines Itrsquos easy to obtain and verifyfund results with various data vendors Separate account managersrsquo performanceresults are more suspectThe managers provide monthly and quarterly results tothe databases When firms present performance they use composite figures Acomposite is a mathematical calculation of the combined performance of a groupof several accounts that the firm managesThe performance presented is a syn-thetic number
This is an appropriate format for a manager to present performanceHoweverfiduciaries should not take these returns at face value It is important to have agood feel for the data and understand how the composite was constructedFollowing are some helpful questions to ask the manager
bull Are the returns compliant with the standards of the AIMR-PPS Is thisverified by a third-party source
bull How many accounts are in the composite
bull Which accounts are included in the composite
bull Which are excluded
bull Do the returns represent any simulated results
bull Are accounts size weighted or equally weighted
bull Are returns gross or net-of-fees
Appendix D is an example of a comprehensive report on a separate accountmanager provided by eVestmentAlliance (wwwevestmentalliancecom) The eASE Database is an excellent source for investment manager informationManyconsulting firms use this database as a tool for identifying sourcing and monitor-ing managers
112 chapter 10 manager selection
10 schneider 22505 936 AM Page 112
administrative compatibility
It is important to consider managers or mutual funds that are easily accessedMake certain that the products are still available for new investors and that yournonprofit fund meets their minimum size requirementsAlso some mutual fundsor commingled trusts can only be purchased by retirement plansAlthough themajor mutual fund families are readily available on most trading platformsbe sureto confirm that a selling agreement is established with the organizationrsquos custo-dian so they can execute your trades If one is not establishedwork with the fundfamily and the custodian to put one in place
trade execution
You need to understand separate account managersrsquo policies on trading Reviewtrading costs and pay particular attention to both commissions and trade execu-tions Commissions on stock transactions are fairly easy to determineThey areusually expressed as a ldquocents-per-sharerdquo rate An appropriate range is 15 to 5cents per share depending on the size of the trade Itrsquos a bit more difficult to eval-uate commissions charged on a bond transaction Most bond trades are principaltransactions that is the brokerdealer buys or sells the bond to you from its owninventory rather than acting as an agent In such cases the purchase or sale is usu-ally quoted as a net priceAsk the investment manager to describe its approach totrading bonds Most get quotes from two or three brokers and strive for a com-petitive price
Although commissions are important trade executions can have an even greaterimpact on performance How well does the manager buy that new stock added to the portfolio Does the manager take it on the chin when selling a securityPoor execution on stock transactions can have a hidden cost of one eighth or onefourth per share (1212 or 25 cents) which comes straight out of performanceFortunately most managers seek good execution because poor execution hurtstheir performance And ultimately they must live or die by their performance
social investing
Some nonprofit organizations have policies that restrict the types of companiesin which they may invest (eg no gambling or tobacco stocks) If the fund im-poses restrictions be sure to incorporate them into your screening process
Traditionally social investing meant that the trustees identified restricted in-dustries and found managers who would avoid purchases in those industriesToday many managers offer a more proactive approach using various strategies
social investing 113
10 schneider 22505 936 AM Page 113
They can actively screen for socially responsible companies for inclusion in aportfolio See Chapter 14 for more information
the commonfund
Plenty of investment firms want to manage your assets However many donrsquotunderstand the specific needs of nonprofit institutions One that does is theCommonfund
In the late 1960s college endowments struggled to earn enough to match therate of growth in operating budgets Historically they had managed funds inter-nally Their goals were income and capital preservationmdashnot to maximize total re-turn In 1969 the Ford Foundation published a study The Law and the Lore ofEndowment Funds It challenged the long-held belief that endowment trusteesfaced restrictive legal constraints in managing their funds A second FordFoundation studyManaging Educational Endowments attacked the income-orientedinvestment approach used by most institutions It emphasized the need to achievebetter returns over the long term Together the studies sparked a new way ofthinking for trustees and brought their investment process into the modern age
The Ford Foundation granted $28 million to establish The Common Fund forNonprofit Organizations (Commonfund) in 1969 The Commonfund was offi-cially founded in 1971A total of 63 endowments invested $72 million on thefirst day of operations
Eligible Commonfund clients include educational institutions foundationshealth-care organizations and other mission-based and public benefit non-profit organizations and their pension plans Certain investment vehicles knownas the Educational Endowment Funds are open to qualifying educational insti-tutions only
Commonfund uses a ldquomanager of managersrdquoapproach The objective is to hirehigh-quality managers with diversified and complementary investment ap-proaches Multiple managers are combined in a single fund Multimanager fundsare offered in each asset class For example Commonfund International allocates itsdollars among several international investment firms each specializing in growthvalue large-cap or small-cap international stocks Through this approachCommonfund seeks consistent results enhanced returns and low volatilityTheCommonfund process includes rigorous market analysis in-depth manager re-search active portfolio construction and disciplined portfolio monitoring
The Commonfund offers several benefits It provides access to well-regardedmanagers at reasonable cost Nonprofit organizations that lack the internal re-sources to research and monitor individual managers may benefit from
114 chapter 10 manager selection
10 schneider 22505 936 AM Page 114
Commonfundrsquos investment process Commonfund portfolios also include assetclasses or strategies that small to mid-sized organizations canrsquot access For exam-ple Commonfund Multi-Strategy Bond allocates a portion of assets to private debtA small college endowment would have trouble meeting the minimums for mostprivate debt managers Clients also benefit from Commonfundrsquos continuing re-search and education
The Commonfund approach does have some drawbacksThe Commonfundorganization is in essence a money management shopAlthough Commonfundemploys nonproprietary managers and is willing to give advice it is not a substi-tute for an independent consultant Additionally not all nonprofit organizationsare eligible to invest in Commonfund or all of its investment offeringsAs is thecase with any investment firm some of Commonfundrsquos offerings are better thanothersAny money manager including Commonfund should be thoroughly an-alyzed and evaluated prior to selection Although Commonfund does a lot ofwork selecting underlying managers ultimately your investment results will bedetermined by the total portfolio Itrsquos critical to examine qualitative characteris-tics and quantitative performance prior to investing
proxy voting
Corporations regularly ask their shareholders to vote on a variety of issues affect-ing the company One can vote in person at an annual meeting or the share-holder can appoint a proxy to vote in his or her place Most investors appoint aproxyTrustees often delegate the responsibility of voting proxies to investmentmanagers If you choose this route be sure the managers acknowledge their re-sponsibility in writing Carefully review their voting procedures which shouldinclude documentation of their actions ERISA plans are required to documentproxy voting procedures and itrsquos a good idea for nonprofit organizations as well
account types
In todayrsquos environment you can choose from among several investment vehiclesFactors that influence your decision include the type and size of the fund the sizeof the initial investment and your liquidity requirementsBelow is a list of differ-ent vehicles available today
bull Mutual Funds are registered investment productsThey are open-end fundsoperated by an investment company The company raises money fromshareholders and invests in a portfolio of stocks or bondsMutual funds offer
account types 115
10 schneider 22505 936 AM Page 115
diversificationprofessional management and daily liquidityFederal regula-tions and SEC reporting requirements add a layer of cost and complexity tothis vehiclepartially offsetting the cost efficiencies gained by pooling funds
bull Separate Accounts are individually managed accounts for high-net-worth per-sons or institutionsThey act in many ways like a private mutual fundhold-ing a portfolio of individual stocks or bonds These accounts are eachspecific to one individual or holderThey are designed for long-term in-vestors as are mutual funds but may not offer the same liquidity as mutualfunds where shares can be sold and settled in one day Separate accounts arenot subject to the same reporting rules as mutual funds and have greaterflexibility for taxable investors
bull Commingled Funds are unregistered investment products that combine someof the benefits of mutual funds with the cost efficiencies of separate ac-counts Similar to a mutual fund investors in a commingled trust pool theirassets with other investors and the holdings are ldquounitizedrdquo into individualsharesThey lack the overhead of mutual funds which keeps costs downThey are designed for long-term investors and liquidity provisions vary perproduct
negotiate fees
Mutual funds are closely regulated and fees are specified in the prospectusRetailmutual fund shares often have a relatively high price tagAfter all funds provide awide range of services to shareholders including such add-ons as toll-free phonenumbers and printed educational materialsThese all add to the total cost of thefund However if the initial investment is large you should seek cost advantagesas an institutional investor Certain funds are available only to institutional in-vestors through either an institutional share class or via a commingled trust Suchfunds are generally managed by the same portfolio managers as their retail coun-terparts but have higher minimum investment requirements and significantlylower expenses If you must use retail shares of mutual funds avoid paying anyfront-end load or back-end loads By prospectus virtually all mutual funds allowsuch fees to be waived for institutional investors
It is generally easier to negotiate fees with private managers One should ap-proach the management of the not-for-profit fund as if it were a businessThismeans maximizing top line growth (investment returns) while minimizing costs(investment expenses) in an effort to enhance the bottom line earnings (net re-turn) Carefully scrutinize the fees proposed by the investment managerDetermine whether fees being proposed are in line with fees charged by other
116 chapter 10 manager selection
10 schneider 22505 936 AM Page 116
comparable managers If your committee has done its homework and candemonstrate to an investment manager that the fees are out of line with what thefund would pay elsewhere you should be able to negotiate the fees downwardOften costs can be dramatically reduced through effective negotiation andeconomies of scale
Fees can be assessed on a fixed or performance basis (or a combination ofboth) Fixed fees are much simpler to monitor Performance-based fees provideadditional incentive for results Performance-based fees can sometimes act as adouble-edged sword by tempting the manager to expose the fund to additionalrisk in order to obtain higher returns Furthermore in periods of down marketsthe fund can experience a loss but still pay the incentive fee if the manager losesless than the market
When it comes to fees you can seek a ldquomost favored nationrdquoclause in the con-tractThat is the manager acknowledges in writing that your organizationrsquos feeswill be at least as low as those of any similar clients of the managerAlso inquire ifspecial fee discounts apply to nonprofit organizations it never hurts to ask
negotiate fees 117
10 schneider 22505 936 AM Page 117
10 schneider 22505 936 AM Page 118
chapter 11
Alternative Investments
Over the past two decades not-for-profit organizations have shown an in-creasing interest in alternative investments These are investments beyond theplain vanilla world of stocks bonds and cash instrumentsThey include absolutereturn strategies (hedge funds) real estate timberland private equity structuredproducts and commodity fundsWhy the interest First of all several of the mostprominent universities have used alternative investments for years with verystrong results HarvardYale the University of Chicago Notre Dame Universityand others allocate 30 to 50 of their endowments to alternative investmentsSo there is a bit of a ldquofollow the leaderrdquo mentality
The bear market of 2000ndash2002 was also a trigger Lower return expectationsfor both stocks and bonds have forced most nonprofit organizations to at leastconsider alternative investmentsAlternative managers tend to find niches wheretheir skills can capitalize on market inefficiencies
In theory these investments can enhance the risk-adjusted return of a portfo-lio Most alternative investments exhibit low correlation with stocks and bondsTheir addition to a traditional asset allocation pushes the efficient frontier up-ward creating higher expected returns at each risk level
However there are a number of reasons to approach alternatives with somemeasure of caution
bull Most of these investments are illiquid
bull Fees tend to be high
bull There is often a limited ability to price the investments on an ongoing basis
bull There is limited transparency into the underlying strategies and positions
119
11 schneider 22505 936 AM Page 119
bull Short track records and survivorship bias make manager selection challeng-ing and manager selection is very important in the alternative spaceThespread between top quartile and bottom quartile alternative managers ismuch larger than among traditional stock and bond managers
bull The explosion in popularity of alternative investmentsparticularly of hedgefunds may be the kiss of death Normally it is not a good sign when WallStreet brokerage firms begin to tout a particular strategy
bull For most of these strategies there is no passive index which makes model-ing almost impossible Attempting to shoehorn alternatives into a meanvariance optimization creates output that is highly suspect (A more prudentapproach is to come to agreement on the percentage of portfolio to be al-located say 5ndash20 as a ldquocarve-outrdquo)
Following is a brief overview of the various alternative investment types
hedge funds (absolute return strategies)
There are no definitions of exactly what constitutes a hedge fundHowever thereare certain common characteristicsThey are usually private investment pools thatfall outside of the rules of the Investment Company Act As such they are limitedto a small group of accredited investors institutions with at least $5 million in liquidassets 3(c)1 funds are limited to no more than 99 accredited investors 3(c)7 fundsare limited to 499 qualified purchasers institutions that have a minimum of $25million in investment assetsThe hedge fund managers have broad discretion tobuy securities sell securities short employ leverage and buy and sell options andother types of derivatives
Hedge funds are also called absolute return strategies because their goal is to pro-duce positive return regardless of market directionAlthough hedge funds havebeen around since the late 1940s their popularity has exploded in recent yearsOver the past decade assets have grown eightfold By 2003 there were morehedge funds than the number of stocks on the New York Stock Exchange Over6300 hedge funds manage over $800 billion
Hedge funds usually target an absolute return objective such as ldquoTreasury billsplus 800 basis pointsrdquo (a basis point is 1100 of 1) Hedge funds use a wide va-riety of strategies Many seek to exploit valuation disparities across several mar-kets (Exhibit 111) Some strategies are directional (net long or short) Amultistrategy fund may use a combination of several of these strategies to maintaina more market-neutral stance
120 chapter 11 alternative investments
11 schneider 22505 936 AM Page 120
funds of funds
Extremely large nonprofit funds may use several single-strategy managers How-ever if you do not have at least $50 million to allocate to hedge funds you willprobably work with multistrategy managersThere are single managers that use amultistrategy approach But more commonly you will need to invest through ahedge fund of funds (Hfof)There are a number of private partnerships that invest inportfolios of hedge fundsThe managers research select and monitor the under-lying hedge fundsThe benefits of Hfofs include diversificationprofessional man-agement and access to funds that may have a very large minimumThe Hfof canprovide an easy way to ldquostick your toe in the waterrdquo
funds of funds 121
exhibit 111 types of hedge fund strategies
Strategies Description
Nondirectional strategies (market neutral)Convertible arbitrage Typically involves being long a convertible bond and short the un-
derlying stock The goal is to exploit the inefficiency in pricing byprofiting on the long position and protecting downside with theshort
Equity market neutral Involves being long and short matched positions An example mightbe long GM short Ford Net equity exposure and market beta aredesigned to be very low This relies on the managers ability to pickstocks The goal is that longs go up and shorts go down
Event driven Attempts to capture mispricing of corporate events such as mergersreorganizations and takeovers Merger arbitrage involves goingshort the acquirer and long the acquiree The risk is that the eventdoes not materialize
Fixed-income arbitrage Arbitrage between interest rate securities through several tech-niques The goal is steady lower volatility returns The risk is thathigh leverage used to exploit the small inefficiencies can amplifylosses if spreads between cheap and expensive continue to widen
Distressed securities Investment in a company in financial distress or bankruptcy withthe goal of the company returning to financial health
Directional strategiesLongshort Different from market neutral Manager may be net long or short
and shift between style market capitalization sector or country
Global macro Managers carry long and short positions in world capital marketsincluding stocks bonds currencies commodities and derivativesThese positions reflect news on overall market andor economictrends
Futures trading Typically use technical analysis in the trading of commodities andfutures
Short bias A profitable strategy during the 2000ndash2002 period The managermaintains a net short position in equities and derivatives
11 schneider 22505 936 AM Page 121
Hfofs are clearly the fastest growing areas of alternatives However they havedrawbacks as wellOf course the managers charge for their professional oversightThis represents an added layer of fees the Hfof manager may charge a manage-ment fee of up to 15 and may take a percentage of profits as wellThese fees areon top of the underlying hedge fund managersrsquo feeswhich are also usually 1 to15 plus a percentage of the profits (Exhibit 112) See Appendix G for a listingof sources of information on Hfofs
risks
Risks that apply to other alternative investments include
bull Lack of Transparency Most funds are unregistered so they have no obliga-tion to report positions on a regular basisThey may report net asset value(NAV) daily or weekly However audited review of actual positions maybe available only quarterly or annually In any case hedge funds may re-port risk exposures but generally will not report actual positionsYou maythink you understand a managerrsquos strategy but the reality is that theseportfolios are quite dynamic Managers may make large global macro betscarrying substantial riskThey may also use high leverage From a market-ing standpoint a manager may present a strong case for not reporting po-sitions or strategies to keep his competitive advantage at findinginefficienciesAlthough this may be partially accurate it shouldnrsquot hinderappropriate transparency for investorsThe ability to have at least limitedtransparency should be one of the primary objectives in initial screeningof managers
bull Lack of Liquidity Most funds have an annual lockupAfter the first year youmay have quarterly liquidity with a 45- to 90-day notice In addition thereare also liquidity concerns at the security level Many trading positions maybe in very thin markets Mispricing and extreme illiquidity have played arole in several fraud or blow-up situationsThe managerrsquos goal of a positivereturn with low monthly volatility can be in direct conflict with the pricingof these illiquid issuesEven though a fund may be audited some funds havecarried positions at inflated values (such as purchase price)Another prob-lem is a highly volatile position Managers have been known to smoothvolatility by gradually adjusting prices In adverse conditions the price of athinly traded security may change dramaticallyThe bid-ask spread is the dif-ference between the price a dealer will bid to buy a security and the priceat which the dealer will sell that same security Spreads can widen sharplyduring times of crisis Managers who have sold short borrowed securities
122 chapter 11 alternative investments
11 schneider 22505 936 AM Page 122
can be squeezedThat is they can be forced to buy back the borrowed secu-rities at much higher prices
bull Leverage Hedge funds often use leverage sometimes in large amountsTheir goal is to generate greater returns than the cost of borrowing fundsWith approximately $150 billion a year projected to flow into hedge fundsmany arbitrage opportunities have become more efficient the hedge fundmanagers have responded by increasing leverageThis substantially increasesthe risk for a potential blow-upThe downside of leverage can be a cata-strophic event like the Long Term Capital debacle High Fees Itrsquos no secretthat hedge fund fees are highThatrsquos why so many traditional money man-agers are tripping over themselves to start hedge fundsYou need to under-stand what you are paying for and the potential hurdle rate to generate alphain your portfolio (Exhibit 112)
Exhibit 112 shows a typical fee structure for Hfofs Hedge fund man-agers typically charge a 1 to 15 fee with an incentive of 20 of profitsSome managers establish a low hurdle rate of return that a manager mustbeat before taking an incentiveVariation may be a high water markA man-ager cannot take incentive fees after down periods until asset value use isback up to the old high If a manager falls too far below he may close thefund and reopen an identical fund to reestablish the ability to receive incen-tive fees
bull Data Collection With so many institutional investors adding hedge funds orHfofs to their portfolios a number of data collection firms now track per-formance Their goal is to measure risk and returns of these managers Sincethere is no passive index some firms simply track a large group of activemanagers and establish the aggregate return as an index A look at the re-sults of these indexes (Exhibit 113) shows huge dispersion Each firm usesa different group of managers with different weightingsSome indexes such
risks 123
exhibit 112 hedge fund-of-funds fees
Gross return 120
Base fee 1 ndash10
Net before incentive 110
Incentive fee 20 of profit ndash22
Net return 88
Fund-of-funds base fee 1 ndash10
Net after fund-of-funds fee 78
Fund-of-funds incentive fee 10 of profit ndash78
Net fund-of-funds return 702
11 schneider 22505 936 AM Page 123
as the CSFBTremont index are asset base weighted while others areequally weighted across fundsWeighting itself has a big impact For exam-ple in a study by Bernstein Wealth Management in 2000 one index re-ported an average longshort manager return of 17 Removing the top 3of 94 managers dropped the average to 103
There are other data collection problems First performance reporting ison the honor systemManagers often only report good numbersSome man-agers fund several small portfolios or incubator fundsThe top performersstay open and are marketedThe poor performers are simply closed Itrsquos esti-mated that 15 to 20 of funds close each year through natural attrition
Discrepancies in data huge dispersion and survivorship bias may over-state index performance dramatically It has been estimated that index re-turns may be overstated by as much as 200 to 400 basis points per year Theaddition of Hfof expenses might push that number over 500 basis points
benefits
Hfofs clearly offer certain benefits
bull Diversification The ability of an Hfof to invest in several substrategies givessmaller investors the diversification without making large dollar commit-
124 chapter 11 alternative investments
exhibit 113 hedge fund indexes annual returns
Index 2002 2001 2000 1999 1998
Fund of funds
HRFI FOF Diversified 12 28 25 285 ndash55
MAR Hedge FOF Diversified 07 50 74 224 18
VAN Fund of Funds 13 42 87 249 44
Market neutral
CSFBTremont 74 93 150 153 133
MAR Hedge Market Neutral 20 73 139 99 112
Van Market Neutral Arbitrage 85 100 115 209 91
Global Macro
CSFBTremont 147 184 117 58 ndash36
HRFI macro 74 69 20 176 62
MAR Hedge Global Macro 28 56 100 85 81
Distressed
CSFBTremont ndash07 200 19 222 ndash17
HFRI Distressed 53 133 28 169 ndash42
MAR Hedge 69 92 59 179 ndash48
11 schneider 22505 936 AM Page 124
ments to each individual fundAn Hfof may have 10 to 100 managers in itsportfolio
bull Due Diligence It takes time resources and expertise to identify good man-agersThis research capability doesnrsquot come cheaply Hedge fund due dili-gence is not a do-it-yourself project for the amateur
bull Access to Top ManagersOften top performing hedge funds have limited or noaccessA good Hfof can secure capacity to closed or limited access funds
bull Risk Management Ongoing oversight of each manager can add substantialvalue Often the Hfof also has a robust portfolio construction process forboth allocating and rebalancing among the underlying fundsA good Hfofmanager should keep a close watch on risk and leverage parameters bothon the manager and fund level
fund-of-funds search
Although similar to traditional manager searches the Hfof search process tends tobe somewhat more subjective In the initial screening less emphasis should beplaced on performance numbers and more on qualitative issuesThis is not to saythat performance is not important itrsquos that process and risk control are crucial tocreating that performance
Initial screening should focus on defining objectives and parametersYou mayhave a specific target on expected return potential maximum loss maximumleverage liquidity reporting and transparency Your initial screens might producea smaller list to focus on An example of initial screens might include
Projected return Treasury bills +4 Maximum drawdown lt6
Actual 3 year annualized return 8+ Maximum no of managers lt40
Correlation with Standard amp Poorrsquos 500 lt04 Maximum leverage 25 to 1
Minimum track record 10 years
From this short list of managers you now want to focus on more qualitative is-sues Sending a detailed request for proposal can be extremely helpful in identi-fying managers with solid risk control measures as well as a diligent processAsample request for proposal can be found in Appendix E
Again while numbers are important yoursquoll need to put a lot more art intoyour judgment of qualitative issuesYou should be looking for positive responsesin the following areas
bull Peoplebull Proven experience Little turnover
fund-of-funds search 125
11 schneider 22505 936 AM Page 125
bull High integrity check referencesbull Depth of team diverse talent with specialistsbull Any intangibles
bull Analysis of investment processbull Disciplined processbull Identify competitive advantage over competitorsbull Understandable and well-quantified risk measuresbull Low emphasis on global macrobull Appropriate use of leveragebull Appropriate infrastructure bull Sufficient diversification
bull Business of firmbull Focused business modelbull Lack of conflictsbull Equal terms among investorsbull Satisfactory liquidity and transparencybull Solid auditing and administrative procedures
bull Performancebull Past performance in several markets monthly data for review of appro-
priate risk characteristicsbull Evaluation of poor performing periods and what changes were made
bull Feesbull Reasonable fee structure with well aligned incentives
The goal is to find funds with a consistent well-defined and repeatable ap-proach The request for proposal responses can help weed out managers that passinitial screens but may have inconsistencies in responses or potential conflicts
Meeting with no more than four finalists can help you make your final decision
real estate
Many nonprofit organizations use publicly held real estate investment trusts(REITs see Chapter 8) but privately owned real estate also plays a role in manyportfolios Real estate provides protection against unexpected inflationA well-diversified real estate portfolio provides cash flow from leasesWith inflation in-come flows can rise as leases mature or roll over Inflation can also causeappreciation of the underlying properties
The lack of liquidity in the private sector presents opportunities for the astutemanagerAlthough REITs provide similar benefits their daily liquidity and use
126 chapter 11 alternative investments
11 schneider 22505 936 AM Page 126
of some leverage have resulted in more apparent short-term volatility than ex-hibited by private real estate Of course private real estate values are appraisedrather than transaction based so you are less certain about the value of each prop-erty until it is sold
As with hedge funds unless you have several hundred million dollars to allo-cate to private real estate you are relegated to investing in a limited partnership orother commingled vehicle The primary disadvantage of these vehicles is the lackof liquidityThe term is usually 10 to 15 years and there is generally not a goodsecondary market for partnership units
timberland
Large institutional investors have added timberland to their investment portfoliosfor over 20 yearsThe recent bear market in equities has accelerated the trendPrior to 1980most timberland properties were owned by forest product compa-niesAlthough these assets were profitable they were often carried on the balancesheet at substantially discounted values Changes in tax laws and fears of hostiletakeovers caused many companies to sell properties to monetize their investmentsand generate cash flowsThis created an opportunity for institutional investorsthe trend continues Globally timberland holdings by institutions now total over$12 billion
Benefits of Timberland
Timberland provides competitive returns low volatility and low correlation withother financial assets
Competitive Returns Timberland as represented by the National Council ofReal Estate Investment Fiduciaries (NCREIF) Timberland indexhas historicallyproduced returns 7 to 10 above inflation or between 10 and 15 nomi-nally The return comes from four sources
bull Appreciation in the Value of Trees and Lumber Historical price appreciationhas been approximately 2Analysis of data suggests that increases in popu-lation and increases in living standards drive these price increases Globalpopulation growth and improving standards of living may well continue tosupport price appreciation
bull Cash Flows Income is generated throughout the life of an investment astrees are harvested and soldTypically income has been approximately onethird of the annual total returns generated
timberland 127
11 schneider 22505 936 AM Page 127
bull Growth of Trees Depending on the type of tree and location annual growthranges from 4 to 8 Additionally as trees get older and larger they can beused for more valuable productsTrees less than 15 inches in diameter areonly suitable for pulp wood used in paper production Trees greater than 15inches in diameter are more valuable They are converted to saw timber usedfor lumber The largest hardwoods are most valuable for their use in furni-ture products
bull Increase in Land Value Timberland often contains valuable mineral resourcessuch as ore and coalTimberland in some cases may be converted to higheruses including commercial developmentAt the very least land prices tendto increase with inflation
Low Volatility Exhibit 114 illustrates the historical riskreturn pattern of tim-berland relative to other major asset classesNot only has timberland offered com-petitive returns but its volatility has actually decreased over the past few decadesOver this period timberland has posted returns in line with domestic equities butvolatility closer to long-term corporate bonds Buying pressure from large insti-tutional investors and a reduction in supply caused by environmental concernshave enhanced the stability of timberland returns Continued capital inflowshould enhance liquidity and help reduce demand shocks
Diversification From a portfolio theory standpoint the most desirable attrib-ute of timberland is its low correlation with most other assets (Exhibit 115) Infact timberland has shown zero to negative correlation with all major assetclassesmdasha portfolio managerrsquos ldquoHoly GrailrdquoTimberland has the potential to re-duce overall volatility when added to a portfolio of stocks bonds and commer-cial real estate
Risks of Timberland
As with any financial asset higher returns come with corresponding riskTheprimary risks are as follows
bull Lack of Liquidity Typical cash commitments can be from 8 to 10 yearsSome investments may take up to 20 years to realize the return potentialMost timberland investments are structured as limited partnershipsAlthough there may be periodic cash flow there is little opportunity to freeup principal prior to the final sale of the underlying propertiesThereforenonprofit fiduciaries should carefully consider their cash flow requirementsbefore investingThe lack of liquidity also effects portfolio rebalancingThe
128 chapter 11 alternative investments
11 schneider 22505 936 AM Page 128
limited partnership structure makes it difficult for your nonprofit fund to re-balance to a specific overall target allocation
bull Natural DisastersNatural disasters include fire storms insect infestation anddisease One can easily recall television images of wildfires blazing out ofcontrol and destroying thousands of acres of timberland Surprisingly thesenatural risks are actually rareTotal loss for industrial managed forests in theUnited States is less than one half of 1 per yearThose dramatic televisionimages are actually of public as opposed to privately owned forest landHowever it is still important to diversify a portfolio regionally to furthermitigate this risk
bull Price Fluctuations Pulp and lumber prices are subject to the laws of supplyand demandHarvesting timber during a period of falling prices would ob-
timberland 129
exhibit 114 long-term timberland returns andvolatility
Asset Class 1960ndash2000
Return SD
Timberland 1330 1312Commercial real estate 943 555SampP 500 1164 1565Small-cap equities 1399 2455International equities 1200 2133Long-term corporate bonds 738 1079US Treasury bills 598 261CPI 444 309
Data for commercial real estate and International equities are from 1969 to 2000Source Hancock Timber Resource Group
exhibit 115 timberland has low correlation withstocks and bonds
Historical Correlation with Timberland 1960ndash2000
Timberland 100Commercial real estate ndash011SampP 500 ndash029Small-cap equities ndash012International equities ndash022Long-term corporate bonds ndash030US Treasury bills ndash002CPI 037
Based on annual returns from 1980 to 1999Source Hancock Timber Resource Group
11 schneider 22505 936 AM Page 129
viously impair the return on investmentHoweverunlike other agriculturalcommodities timber is less subject to this riskThere are virtually no costs toldquostore trees on the stumprdquo and wait until prices rise In fact every year thatharvest is delayed the timber grows and becomes more valuable Longerterm there is some concern about the supply part of the equationThere aresubstantial timber resources in Asia and RussiaAt this time they donrsquot havethe infrastructure to readily harvest those forests but that situation maychange
bull Government Intervention Supply shocks can occur if the government craftslegislation to protect threatened or endangered species The spotted owlcrisis of the early 1990s is a prime example The most impact has been onpublic rather than private timberland
Other Considerations
Geographic Diversification Return and volatility vary substantially by regionand species of tree Due to soil and climate conditions certain areas favor certaintypes of trees The United States is typically divided into three regions theNorthwest Northeast and SouthThe Northwest and Northeast typically pro-duce superior hardwoods (cherry oak maple and ash) while southern timber-land properties generally produce softwoods (pine fir and spruce)Additionallyareas such as New Zealand (similar to the southern United States) and BritishColumbia (similar to the northwestern United States) offer further opportunitiesto diversify a portfolio
Monitoring It is not as easy to track the performance of timberland as it is tomonitor equity or bond managersThere are currently two timberland indexeseach with some limitationsThe Timberland Performance Index (TPI) primarilyconsists of southern USpropertiesThe NCREIF Timberland index is a broaderindex of all three US regions It consists of approximately 250 propertiesAlthough this index is more diversified it contains no global properties and maynot be in line with your investmentrsquos portfolio mixAlthough performance is cal-culated quarterly most appraisals are performed annually This gives the appear-ance of a seasonal effect (most of the return appears to be in the fourth quarter)Appraisal data skew the apparent volatility as well Either index should be takenwith a large grain of salt
Active Management Most institutions invest via pooled vehicles because of thecost and time horizon involved in owning timberlandPooled funds are managedby timberland investment management organizations (TIMOs)The typical investment
130 chapter 11 alternative investments
11 schneider 22505 936 AM Page 130
structure is a limited partnership investing in a portfolio of properties diversifiedby location timber market tree age species and end productAs is the case withother alternative investments fees are on the high side (generally a managementfee of 1 to 2 and a portion of the profits above a hurdle rate for exampleldquo15above a hurdle of 6rdquo) The length of investment is usually 7 to 15 years
A manager can potentially add value in several ways
bull Due Diligence in Negotiating Purchases and Sales One of the bigger risks isoverpaying for timber properties Paying too much for a property or payingfor trees that are not there can substantially reduce return potential Havingexperienced foresters on the ground is crucial
bull Diversification Investing in multiple diverse properties can enhance therisk-adjusted return
bull Ongoing Forest Management to Maximize Timber Output per Field Managerresearch should focus heavily on the quality and depth of the managementteamYou need to have a strong understanding of the people process andphilosophy of the management team as well as the structure of any limitedpartnership
Conclusion
Despite the potential risks timberland offers returns competitive with those ofequities and lower volatility Timberland also offers significant diversification po-tential These benefits may somewhat offset the illiquidity and nonsystematicrisks of the timberland portfolioTimberland should be particularly attractive ifyour nonprofit fund has a long time horizon
private equity
Since the 1980s institutional allocations to private equity have increased steadilySeveral billion dollars are committed annually Private equity refers to ownershippositions in securities that are not publicly traded or listed on an exchangePrivate equity investment takes several forms
bull Venture Capitalmdashfinancing of new businesses
bull Buyout Fundsmdashrefinancing of existing or more mature businesses
bull Mezzanine Financingmdashhigh yield debt senior to equity financing
bull Special Situationsmdashinvestments in distressed debt or turnaround situations
private equity 131
11 schneider 22505 936 AM Page 131
Each of these market segments is characterized by limited available informa-tion flow and few able or willing investors In short there can be large inefficien-ciesKnowledgeable investors can generate excess returnMany institutions viewthese types of investments as ldquoalpha generatorsrdquoAlthough these strategies are cat-egorically different from traditional equity management they do have some sim-ilar characteristics and can be highly correlated with the listed markets
Private equity funds are generally structured as limited partnerships Outsideinvestors are the limited partnersThe sponsoring private equity firm acts as thegeneral partner There are usually 10 to 30 underlying investments per fundInvestments committed to the partnership are typically called over a period of several years For example a foundation might agree to invest a total of $10 million dollars But the money will actually be called by the private equity fundover the next 2 to 5 years as needed The fund managers make capital calls as theyfind acceptable opportunities The not-for-profit organization controls the capi-tal until it is drawn down by the manager The investor may put up only $1 to 2million initially but will need to keep the rest of the funds available for futurecalls There are rather severe penalties if an investor fails to honor capital com-mitments when called The life of the fund is usually 7 to 12 years It is not un-usual for a private equity sponsor to be raising money for a second fund eventhough all of the commitments from a first fund have not yet been called
Fees
The fee structure for private equity is similar to that of hedge fundsmdashin otherwords richAnnual management fees range from 1 to 3The general partneris also typically entitled to a share of any profits (the carry or carried interest) Thesplit usually is 80 to the limited partners and 20 to the general partner Aswith hedge funds a not-for-profit organization could invest directly with a singlefund manager focusing on one stage or industry such as ldquoearly-round venturecapitalrdquoAlternately the investor might choose a more diversified manager or afund-of-funds approach In a fund-of-funds the general partner invests in a num-ber of other private equity funds Although this approach provides diversificationit adds an extra layer of management fees
Calculating Returns
The investor in a fund may actually start receiving back capital from early invest-ments prior to the original commitment being fully drawn down For this rea-
132 chapter 11 alternative investments
11 schneider 22505 936 AM Page 132
son returns are calculated only on the capital that has been drawn down Oftenmanagers target a return of 300 to 500 basis points (3 to 5) above traditionalequity A look at long-term returns on over 1750 funds in the VentureEconomics US Private Equity Performance index provides a good comparisonwith traditional markets (Exhibit 116) Venture Capital which typically carriesmore riskhas significantly outperformed the Standard amp Poorrsquos (SampP) 500 indexHowever overall private equity returns are slightly above those of the SampP 500index over a 20-year period (136 vs 129)
Risks
Private equity seems to offer higher performance than traditional equitiesThegeneral partners have hands-on involvement in the management of each of thecompanies in their portfolio The theory is that without Securities and ExchangeCommission regulations or public scrutiny the general partner can focus onadding real value over the life cycle of a company He can identify unique situa-tions that can be home runs for the portfolioHoweveryou must consider severalpotential risks
bull Liquidity Because investments in each portfolio company are usually threeto five years returns in the first few years are often negativeLength of com-mitment is usually 10 years after the last funds are called
bull Leverage The use of leverage often two to three times the original capitalmagnifies risk and rewardThere is no simple way to quantify the additional
private equity 133
exhibit 116 venture economicsrsquo us private equityperformance index investment horizon performance through12312003
Fund Type 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr
EarlySeed VC ndash70 ndash233 549 370 191Balanced VC 110 ndash139 194 204 133Later-stage VC 254 ndash188 35 170 138All venture 810 ndash189 228 254 155All buyouts 241 ndash21 22 78 124Mezzanine 57 11 56 73 96All private equity 183 ndash70 68 127 136Nasdaq 500 ndash67 ndash18 99 124SampP 500 264 ndash56 ndash20 91 129
VC venture capital
11 schneider 22505 936 AM Page 133
risk assumed since positions are not priced regularly Although clearly thereis much more risk Private equity looks much less compelling when com-pared with traditional markets adjusted for leverage
bull Reporting Issues As is the case with hedge funds private equity reporting ispositively skewedThat is results are only shown for deals completedThiseliminates poor-performing funds that do not report returns and fundswhere managers are simply prolonging the life of the partnershipThere isan even larger dispersion of manager returns than in hedge funds Resultscollected by Plan Sponsor Network show that for the decade endingDecember 31 2000 the difference in performance between top quartilemanagers and median managers was over 20 per year This compares withan approximate 2 spread between top quartile and median managers inthe domestic equity universe
In summary private equity is potentially an alpha generator rather than a riskreducerAlthough top quartile managers can clearly add excess returnmost man-agers have not produced a substantial increase in returns over traditional marketsThere are additional risks including liquidity leverage and high feesThe duediligence process should again focus highly on qualitative issuesYou should tryto identify strong management teams who can impose discipline on the compa-nies in which they invest
structured equity
An accepted strategy in Europe for years structured equity has become more popular with US institutions in the past few yearsThese products are derivativeinstruments linked to a popular index such as the SampP 500 or Nasdaq 100They are derivatives because their risk and return characteristics are derived fromthe behavior of some other financial instrument In design the product is a for-ward contract a customized agreement between two parties to deliver a speci-fied amount of money based on the agreed price of an underlying financialinstrumentYour nonprofit organization might be one party putting up cashcurrently to be paid by a counterparty (typically a large money center bank orinvestment bank) upon maturity of the contract The products are called equity-linked notes
The bank profits from effectively designing a product that appeals to the par-ticular needs and risk parameters of its customersThe counterparty uses a seriesof derivatives such as put and call options to manage the risk of the underlyingindexThe major risk is the financial strength of the counterparty
134 chapter 11 alternative investments
11 schneider 22505 936 AM Page 134
Although structured notes may seem very straightforward it is not easy for theaverage investor to understand the underlying mechanicsThe term derivative hasreceived a lot of bad press However structured investments range from very lowrisk to very high riskThe key is the amount of leverage usedMany nonprofit or-ganizationsrsquo investment policy statements prohibit the use of derivatives
The structured product uses a stated formula based on the movement of theunderlying index to come up with an end value Here are two examples
1 Example A (Limited downside)Structure The note has an 18-month maturity It is linked to the per-
formance of the SampP 500 indexThe investor receives any price increase inthe index up to a cap of 30 over the period of the contract However ifthe index declines in price over that period the first 10 of decline is pro-tectedThe investor participates in losses greater than 10
2 Example B (Leveraged upside)Structure The investor receives three times the upside of the SampP 500
index to a cap of 18 over 15 months However if the index declines theinvestor participates in all of the downside
Often the investor is distracted by the participation rate or protection featureThese products can have very complex triggers to dynamically manage the risk ofthe note over the life of the contract It is important to have a good understand-ing of the following risks
bull How is money invested Specifically what derivatives are being used andhow are they managed
bull Are there any circumstances where the investment can be terminated priorto maturity by the counterparty
bull What is the credit rating of the underlying counterparty Does the coun-terparty have the ability to pay
bull Is there any secondary market for the note
bull How are end values calculatedmdashat a specific date or some rolling average
bull How much leverage is being used
If you have a clear understanding of the risk and return characteristics theseproducts may be useful in meeting a unique need For example one client withspecific spending requirements used the aforementioned leveraged product to re-duce the overall equity exposure by two thirds without giving up the upside re-turn expectation of 6 (Note the trade-off was that this client was willing togive up upside above the return expectation)
structured equity 135
11 schneider 22505 936 AM Page 135
managed futures
The term managed futures refers to professional money managers known as com-modity trading advisers (CTAs) who manage client assets on a discretionary basisusing forward contracts futures and options For the investor managed futuresprovide exposure to many financial and nonfinancial asset sectors beyond stocksand bondsThese include financial currency and commodity futures and optionsManaged futures are touted as improving the riskreturn characteristics of a port-folio especially in difficult environments for traditional investmentsThis poten-tial benefit did not go unnoticed by investors during the recent bear market forstocksAssets in managed futures grew from under $40 billion in 2000 to over$415 billion by mid-2004
an investment strategy
Because the industry is made up of money managers itrsquos important to note thatmanaged futures are a skill-based strategy not an asset class Managers have theability to go long or short (sell short) these markets in an effort to generate re-turn The managerrsquos skill plays an important role in overall performance Morerecent studies suggest a portion of return comes from basic trading strategies be-hind most CTAsThese strategies may be one of two approaches
bull Systematic This approach is common where trading is mostly automatedUsing technical analysis a manager evaluates the price and volume move-ment of markets He develops a model to go long or short a market basedon its trend
bull Discretionary Far fewer managers will take a total discretionary approachPersonal experience and judgment define their trading decisions
Futures markets are a ldquozero sum gamerdquo If CTAs were only trading againstother CTAs returns would be based solely on manager skill Someone has to losea dollar for somebody else to make a dollarHowever some investors are hedgingother positions so they may expect to lose For example an airline might buy oilfutures to hedge its fuel costs If oil prices fall the airline loses money on the fu-tures contract but saves money on their fuel costs they are indifferent Managedfutures traders provide liquidity to commercial hedgers and in return capture aprofitThere seems to be a high correlation of performance among similar trend-following approaches
136 chapter 11 alternative investments
11 schneider 22505 936 AM Page 136
benefits of diversification
A review of performance of the largest 39 CTAs in existence from 1990 through2003 tracked by the Center for International Securities and Derivatives Mar-kets shows returns in line with the SampP 500 index and a standard deviation thatis slightly less Compared with other alternatives such as Hfofs however therisk-adjusted performance has been substantially lower (Exhibit 117) Thegreatest benefit comes from the low to negative correlation with equity andbond markets
Times of economic uncertainty or turmoil which are typically bad for stocksand bonds are exactly when CTAs have had their best performanceExhibit 118shows that the correlation of CTAs with the SampP 500 indexwhile virtually zerohas become negative in down markets By contrast the hedge fund index actu-ally increased slightly
risks
Leverage
The use of options and futures allows managers to have large national exposure tomarkets with small capital commitments Studies have shown that the higher theleverage the more volatile the managerrsquos performanceLeverage for CTAs is often10 to 1 and sometimes higher
In a trend-following strategy managers attempt to control this risk by diversi-fying across several markets or several positionsThe use of stops seeks to controldownside risk of any position to 1 to 2 of the portfolioA stop or ldquostop lossrdquoorder is placed below the current price It is triggered and becomes a market
risks 137
exhibit 117 performance from january 1990 todecember 2003
Composite LehmanHedge Government
CISDM CTAs Fund Index SampP 500 Corporate
Annualized return 1134 1387 1094 803Annualized SD 1005 582 1505 445Minimum monthly return ndash600 ndash692 ndash1446 ndash419
Source Center for International Securities and Derivatives Markets (CISDM)
11 schneider 22505 936 AM Page 137
order if the security falls to that priceA manager often incurs several small lossesthat are offset by a few very large gains in the positions that have run
Survivorship Bias
A 2003 study by Liang of 1510 CTAs from 1994 through 2001 shows that sur-vivorship bias is even higher than in hedge fundsThe study found an averageannual attrition rate of over 20 Returns were overstated by survivorship biasto the tune of more than 589 annuallyThis figure was higher than in previ-ous studies and clearly shows the risk of looking simply at returns of survivingmanagers
Fees
As with other alternativesmanager fees are performance basedAverage managerfees are high at 2 Incentive fees take another 20 of profits
138 chapter 11 alternative investments
exhibit 118 correlations in best and worst 48 sampp500 ranked months (11990ndash122003)
Worst 48 Best 48All SampP SampP 500 SampP 500Months Months Months
Managed futuresCISDM CTA$ ndash012 ndash030 009CISDM CTAEQ ndash018 ndash041 012CISDM Currency 005 022 037CISDM Discretionary ndash006 ndash018 ndash005CISDM Diversified ndash016 ndash044 004CISDM Financial ndash010 ndash032 015CISDM Trendfollowing ndash018 ndash040 013
Hedge fundsComposite Event Drive 058 069 ndash018CISDM Fund of Funds 051 053 000Composite Equity Hedge 064 054 002Composite Market Neutral 007 002 014
Traditional assetsLehman GovernmentCorporate Bond 014 ndash026 004
CISDM Center for International Securities and Derivatives Markets
11 schneider 22505 936 AM Page 138
Passive Approach
There is a passive investable index that is quite similar to many trend-followingCTAsThe MLM index consists of the 25 most liquid futures contracts (Exhibit119) They are equally weighted and rebalanced monthly based on a trend-fol-lowing algorithmThe algorithm looks at the 12-month moving average of eachfutures market to determine a long or short position on the first day of eachmonth Long term the index has shown similar benefits to that of active CTAs
conclusion
Although the risk-adjusted return of managed futures does not seem as attractiveas other alternative investments the strategy does offer the ability to lower stan-dard deviation An institutional investor needs to recognize both the potentialrisks and the fact that the performance may be subpar in most economic envi-ronments It is periods of rising inflation or economic uncertainty that show thebenefit of a hedged position
conclusion 139
exhibit 119 mlm index fund contract
Financials EnergyTen-year notes Crude oilTreasury bonds Heating oilFive-year notes Unleaded gas
Natural gas
Currencies GrainsBritish pounds Soybean oilCanadian dollar CornAustralian dollar SoybeansEuro currency Soybean mealJapanese yen WheatSwiss francs
Metals SoftsCopper CoffeeGold CottonSilver Sugar
MeatsLive cattle
11 schneider 22505 936 AM Page 139
11 schneider 22505 936 AM Page 140
chapter 12
Portfolio Rebalancing
As mentioned in Chapter 7 asset allocation is the single most important de-terminant of investment performance Appropriately investment committeesdedicate substantial time and effort to determine their risk tolerance and optimalasset allocationThen capital market fluctuations change everything Stocks godownbonds go up and suddenly your fund is overweight fixed incomeSo whenand how do you rebalance Countless tools have been developed to help deter-mine an optimal allocation yet committees often ldquofly by the seat of their pantsrdquowhen it comes to the rebalancing decision
First of all is it even necessary to rebalance Wonrsquot market fluctuations evenout in the long run The answer to these questions is that rebalancing is one ofthe most important things you must do Markets tend to be mean revertingPeriods of outperformance tend to be followed by periods of underperformanceIf you ride your winners up and then back down again you have lost a marvelousopportunity to harvest and recycle those gains In fact a disciplined and system-atic rebalancing strategy can ldquoengineerrdquoadditional return into the portfolio (Youtake some of the chips from winning asset classes and feed them to losing classesthat have become underweightWhen the former losers become winners in thenext cycle you profit)
traditional rebalancing methods
Institutional investors employ a handful of rebalancing techniques Each has itsown benefits and drawbacksThese methods include the following
bull Arbitrary Rebalancing based on gut feeling or emotionThe investmentcommittee sits around a table and asks each otherldquoWell do you think itrsquos
141
12 schneider 22505 937 AM Page 141
time to reallocate back into stocksrdquo Of course it is human nature to wantto wait until all information is known (and the markets have already re-acted)
bull Tactical Rebalancing based on short-term fundamental or technical con-siderations
bull Time-dependent Rebalancing every month quarter or year
bull Percentage Bands This is the favored methodology for most consulting firmsbull Fixed Percentage Band For exampleldquorebalance if the asset class is plus or
minus 5 from the target allocationrdquo (eg your fixed-income target is20 so you rebalance at 15 or 25)
bull Percentage Change Relative to Target Allocation For example rebalance ifthe asset class is 10 different from the target If your fixed-income targetis 20 you rebalance at plus or minus 2 (10 of 20) So you rebal-ance when the allocation falls outside an 18 to 22 band
bull Standard Deviation Rebalance as a function of a multiplier times the assetclass expected standard deviationThe larger the multiplier the less fre-quently you will rebalanceWith the help of your consultant your invest-ment committee may define the multiplier Here is an example thatassumes a 125 multiplierbull Asset class trigger = (asset class standard deviation) times (multiplier)bull Equity trigger = 20 (standard deviation) times 125 = plusmn25 (of the
allocation)bull Debt trigger = 10 (standard deviation) times 125 = plusmn125 (of the
allocation)bull Cash trigger = 1 (standard deviation) times 125 = plusmn125 (of the
allocation)
Considerations
The arbitrary method has severe drawbacks Humans seem to be ldquohard-wiredrdquoto lose money when investing based on gut reaction (see Chapter 17)There is no evidence that investment committees are more immune to emotion than individuals
Tactical rebalancing might be effective if the decision makers are armed withsuperior information and employ a thoughtful and contrarian strategyUnfortunately tactical rebalancing often turns out to be indistinguishable fromthe arbitrary method For one thing fear and greed typically govern short-term
142 chapter 12 portfolio rebalancing
12 schneider 22505 937 AM Page 142
investment decision making Second frequent and costly trading is required tomake tactical bets excessive trading is the enemy of long-term portfolio returnThird most investment committee structures require some degree of consensusamong the committee membersConsensus building takes time and can lead to aldquoworst of all possible worldsrdquo outcome In other words the tactical rebalancingstrategy that results from a compromise may be worse than that of either partyRemember the old sawldquoA camel is a horse built by committeerdquo
The time-dependent and percentage band methods are disciplined rebalancingstrategies As such they are superior to arbitrary and tactical rebalancing method-ologiesBut they donrsquot factor in the interaction of the various asset classesOf thethree percentage band rebalancing strategies the standard deviation method makesthe most senseAt least it factors the volatility of the assets into the rebalancingdecision However none of these methods account for the correlations amongthe assets
An effective rebalancing strategy should seek to minimize rebalancing fre-quency and transaction costs while keeping expected return and risk objectivesconstant In other wordsonly rebalance when you must And you must rebalanceonly when the riskreturn profile of the entire portfolio changesThe key is thecorrelations among the asset classes in the portfolio
There is a trade-off between maintaining the portfoliorsquos risk and return objec-tives and minimizing trading expenses If we rebalance infrequently transactionfees will be lower which is a good thing On the other hand the less frequentlywe rebalance the farther the portfolio drifts away from the policyrsquos stated returnand risk objectiveswhich is a bad thingTherefore a compromise is requiredWemust rebalance only frequently enough to make sure the portfolio doesnrsquot drifttoo far
a new approach
Portfolio decisions should be made to maximize return while minimizing riskand expenses Frequent rebalancing can dampen returns by pulling money awayfrom strong-trending asset classes too soonThe Portfolio Engineertrade is a rebalanc-ing overlay that seeks to generate optimal rebalancing trigger pointsThe goals areto maximize return hold risk constant and minimize transaction expensesThePortfolio Engineer is a proprietary product to the best of our knowledge thereare no commercial programs that perform the same function However we willexplain how to approximate at least some of the functionality of the overlay
a new approach 143
12 schneider 22505 937 AM Page 143
Underlying Premise
As discussed in Chapter 7 the efficient frontier is generated based on three inputassumptions risk return and correlation among asset classesBecause we are un-certain about those three inputswe should be skeptical of the apparent precisionof our target asset allocation Mixes that at first glance appear to be off the effi-cient frontier may in fact be efficientWe have no way of knowingYou shouldnot rebalance unless you are certain that the portfolio has really moved from thetarget in other wordsuntil the risk and return characteristics become statisticallymeaningfully differentThink of a band of uncertainty around your target asset al-location As long as the portfolio stays within the band you have no way ofknowing whether the risk and return characteristics have really changedTherefore you donrsquot rebalance
The Key Difference
Unlike traditional rebalancing methods the modelrsquos rebalancing trigger is basedon the riskreturn parameters of the target and current portfolios rather than theweightings of individual asset classesThe Portfolio Engineer looks at how farfrom the target the current portfolio has drifted on an expected riskreturngraph If the current portfolio strays from the target portfolio by the critical dis-tance you rebalance back to your targets (Exhibit 121) One of the great bene-fits of such a systematic approach is that committee members donrsquot have tosecond guess their timing or reasoning when making the rebalancing decision
In Exhibit 121 the hollow dot represents the expected return and risk of thetarget allocationThe small dots represent monthly historical returnrisk snap-shots as the asset allocation has fluctuated around the target (between January1988 and November 2003) The large circle represents the band of uncertaintyaround the target allocation Only if the portfolio drifts outside the circle do wedeem that the risk and return have become statistically different from the targetallocationThis constraint circle is set with a radius (R) of 040 from the center(or target portfolio) 040 was chosen for this portfolio because the target allo-cation and all portfolios with risk and return characteristics that fall within thecircle have been statistically indistinguishable based on historical analysis
Exhibit 122 shows results for that period (January 1988 to November 2003)The vertical axis is risk The horizontal axis represents degree of portfolio drift priorto rebalancingThink of the left side as constant rebalancing and the right side asnever rebalancing The graph illustrates the impact of waiting to rebalance untilthe portfolio touched the R constraint (the vertical line)Up until that point risk
144 chapter 12 portfolio rebalancing
12 schneider 22505 937 AM Page 144
a new approach 145
exhibit 121 historical portfolio observations
The Circlersquos Radius is the Optimal ldquoRrdquo
800
780
760
740
720
700
88 90 92 94 96 98 100 102 104 106
E (Standard Deviation)
exhibit 122 annualized standard deviation(11988ndash112003)
840
835
830
825
820
815
810
805
00 02 04 06 08 10
ldquoRrdquo (Radius of Constraint Circle)
E(R
etur
n)R
isk
(Ann
ualiz
ed S
tand
ard
Dev
iati
on)
stayed constant (actually there was a statistically insignificant decline in volatility)Once the portfolio drifted beyond R = 04 volatility increased
Exhibit 123 shows that by waiting to rebalance until the R constraint wasreached there was an increase in return as well Not only would the fund havesaved on transaction expenses by rebalancing less frequently than most other dis-
12 schneider 22505 937 AM Page 145
ciplined rebalancing methods would suggest but it also could have generated ex-cess return By rebalancing when R reached 040 the fund would have added040 of return per year compared with the index benchmark (which is rebal-anced monthly) It is worth noting that you did not have to pinpoint a single spe-cific R for the constraint circle to add value As you can see from the positiveslope of the chart in Exhibit 123 you could have rebalanced at any point be-tween R = 0 and 040 and still increased portfolio returnOf coursewhen Rwas greater than 040 risk increased and when R was less than 020 the port-folio was rebalanced frequently resulting in unnecessary transaction fees
The upward sloping line we see when R is between 0 and 040 is fairlypredictable and consistent over a variety of portfolio mixesmarket environmentsand time intervals
In Exhibit 124ABCrsquos portfolio would have been rebalanced about once peryearThe greater the market volatility the more frequently you rebalance ForABCrsquos portfolio two rebalances occurred in back-to-back quarters (September2001 and December 2001) Over another period (February 1992 to August1994) there were 10 quarters (or 25 years) between rebalancesAt the modelrsquosrebalancing trigger points the actual stockbond asset class weightings can varydramatically (Exhibit 125)
At dates 1 and 3 the portfolio was more than 5 from its target of 60 stocksand 40 bondsbut no rebalancing was triggeredHowever in time periods 2 and4 the aggregate allocations were still at the overall 6040 stockbond target allo-cation but rebalancing was warrantedWhy The answer is that not all stocks and
146 chapter 12 portfolio rebalancing
exhibit 123 cumulative annualized returns(11988ndash112003)
104
103
102
101
100
99
98
9700 02 04 06 08 10
ldquoRrdquo (Radius of Constraint Circle)
Annu
aliz
ed R
etur
n
12 schneider 22505 937 AM Page 146
bonds are created equal Emerging markets being overweight relative to their tar-get allocation pushed the portfolio toward higher risk (and higher expected re-turns) more than large-cap domestic equities being overweight On the otherhand being overweight in investment-grade intermediate bonds pulls theriskreturn characteristics of the portfolio down more than if high-yield bondsare overweight If emerging markets and investment grade bonds are overweightat the same time you have a netting effect on risk and return
Disclaimer
The results described above are those of a statistical back testAlthough the logicis intuitively compelling and actual results have been encouraging past perform-ance does not guarantee future results
building your own model
If you donrsquot own a software package like the Portfolio Engineer you can still ap-proximate the outputYou can use features already offered in most commercialmean variance optimization softwareThe manual process can be somewhat te-dious but should be well worth the effort
Most software packages allow you to input a current portfolioThis feature is de-
building your own model 147
exhibit 124 abcrsquos rebalancing frequency(11988ndash112003)
$500
$450
$400
$350
$300
$250
$200
$150
$100
Date
Dol
lars
(Gro
wth
of$
1)
Nov
-87
Jul-8
8
Mar
-89
Nov
-89
Jul-9
0
Mar
-91
Oct
-91
Jun-
92
Feb-
93
Oct
-93
Jun-
94
Feb-
95
Oct
-95
Jun-
96
Jan-
97
Sep
-97
May
-98
Jan-
99
Sep
-99
May
-00
Jan-
01
Sep
-01
May
-02
Dec
-02
Aug
-03
Rebalance
12 schneider 22505 937 AM Page 147
148
ex
hib
it 1
25
po
rtf
olio
en
gin
ee
r r
ad
ius
ca
lc
ula
to
r
Circ
le R
adiu
s=
04
0
Pres
ent
Shou
ldIn
ter-
Inte
r-Em
ergi
ngH
igh-
Infl
atio
nD
ista
nce
You
med
iate
Fore
ign
Larg
e-S
mal
l-na
tion
alM
arke
tRe
alYi
eld
Inde
xed
from
Reba
l-As
set
Cash
Bon
dB
ond
Cap
Cap
Equi
tyEq
uity
Esta
teB
ond
Bon
dsEq
uity
Fixe
dRe
turn
Ris
kTa
rget
ance
Targ
et0
14
10
18
10
17
78
8
8
60
40
7
61
102
0N
A
NA
10
00
Ris
kan
d Re
turn
Dec
lines
Dat
e 1
016
12
15
14
12
8
5
8
10
54
46
746
9
97
027
N
o10
00
Dat
e 2
016
10
20
8
17
5
10
68
60
40
7
54
975
0
46
Yes
100
0
Ris
kan
d Re
turn
Incr
ease
s
Dat
e 3
012
8
21
10
19
5
11
77
66
34
776
10
47
031
N
o10
00
Dat
e 4
013
10
15
13
15
9
8
10
760
40
7
65
106
60
45
Yes
100
0
Em
ergi
ng m
arke
tsan
d ca
sh a
re o
utof
ldquoove
rvie
w ra
nge
rdquo
Return
510
15
20
Ris
k(S
tand
ard
Dev
iati
on)
120
110
100
90
80
70
60
50
40
30
Ove
rvie
w
Return
Circ
le R
adiu
s8
3
80
78
75
73
70
Targ
etA
lloca
tion
Dat
e 1
Dat
e 2
Dat
e 3
Dat
e 4
95
100
10
5
110
0R
isk
(Sta
ndar
d D
evia
tion
)
bullTa
rget
Allo
cati
on
As
setC
lass
es
12 schneider 22505 937 AM Page 148
signed to allow you to compare the current portfolio to the efficient frontier butcan also be used to calculate current portfolio expected risk and return Followthese steps
1 Calculate your target asset allocation choosing a specific mix on the ef-ficient frontier Implement the asset allocation and monitor the shifts inportfolio weights caused by market action
2 Every month (or at least quarterly) input your new portfolio asset classweights as ldquocurrent portfoliordquo The software will generate risk (standarddeviation) and return numbers for the current portfolio
3 Using the Pythagorean Theorem you can calculate the RThat is R =the square root of [(rt ndash rc)
2 + (σt ndash σc)2]
Where rt = expected return of the target portfolio
rc = expected return of the current portfolio
σt = expected standard deviation of the target portfolio
σc = expected standard deviation of the current portfolio
4 Define a critical rebalancing trigger between 03 and 05 [Note theactual optimal R should be calculated for each separate asset allocationThat is a 6040 target mix will have a different optimal R than will a5545 targetHowever the vast majority of optimal Rs lie between 03and 05 Knowing that there is a benefit to this approach even if yourrebalance trigger is not the most optimal you can arbitrarily pick a num-ber within that rangeAn R of 03 will result in more frequent rebal-ancing an R of 05 will result in less frequent rebalancing]
5 If the R that you calculate exceeds your trigger rebalance the entire port-folio back to target
The Portfolio Engineer leads to contrarian rebalancingThis is one of its in-herent strengthsWersquove observed that investors are most reluctant to rebalanceduring periods of market stress or periods of market exuberanceHowever rebal-ancing is most necessary in both of those environments During bear markets anunrebalanced portfolio automatically becomes less aggressive because higherriskreturn assets decline as a percentage of total assetsThis reduces your chanceto benefit from an eventual recovery The opposite happens during periods of ldquoirrational exuberancerdquo In the absence of a rebalancing strategy your portfoliowill be too conservative at market bottoms and too aggressive at market peaks Involatile markets the Portfolio Engineer preserves stable risk and takes advantageof both pessimism and exuberance by rebalancing back to the targets
building your own model 149
12 schneider 22505 937 AM Page 149
conclusion
For every asset allocation along the efficient frontier a scenario analysis can beused to determine an appropriate rebalancing constraint circle with radius RUnfortunately there is no single best R for every portfolio structure Typicallythe more evenly diversified a portfolio is the larger the R can become withoutcreating a meaningful riskreturn shift Even portfolios with the same target allocations might be managed using different Rs For example a fund using separately managed accounts that have larger implicit and explicit rebalanc-ing costs may be better suited by a larger R On the other hand an endowmentusing mutual funds will have lower transaction expenses So a smaller R may beappropriate
Your committee can define an optimal R and write it into the investment pol-icy statement Each quarter the committee quickly compares the present R tothe optimal trigger point If the ldquodistancerdquohas become greater than the constraintcirclersquos R simply rebalance to targetThis provides unambiguous direction
150 chapter 12 portfolio rebalancing
12 schneider 22505 937 AM Page 150
chapter 13
Performance Measurementand Evaluation
Itrsquos the fifth game of the NBA finalsThe Pistons and the Wizards (this is fan-tasy) are tied two games apiece Commissioner Clinton calls a press conferenceto announce a new policyldquoThese young men become too stressed about theoutcome of a simple gameSome may even suffer psychological damageStartingtoday we are removing the scoreboards Henceforth teams will play for the loveof the game there will be no winner or loser And another thingwe wonrsquot keeptrack of fouls eitherCertain players have developed low self-esteem by constantlyfouling outrdquo
Can you imagine the reaction This would be an extraordinarily bad approachfor a professional sports leaguemdashor for fiduciaries of an investment fund
Performance measurement is a critical part of a sound investment programOnce managers have been selected fund fiduciaries have an ongoing duty tomonitor the quality of the managerrsquos performanceAlthough this responsibilityhas always existed under the Employee Retirement Income Security Act(ERISA) the bear market of the early 2000s highlighted the importance of theseduties for fiduciaries of other fund types as well Your nonprofit organizationshould monitor the investment portfolio to ensure that each manager adheres tohis or her investment policy guidelines and stated philosophy By effectivelymonitoring performanceyou will be in a position of strength in moments of cri-sis During volatile markets or when occasional problems arise you will knowabout it promptly and will be better positioned to take appropriate action
For many people evaluating investment performance has meant answering asingle questionldquoAm I beating the marketrdquo (usually defined as the Standard ampPoorrsquos [SampP] 500 index) This simple-minded approach was prevalent during the
151
13 schneider 22505 937 AM Page 151
bull market of the 1990s Domestic large-cap stocks soared particularly technol-ogy stocks As the US economy raced into the Internet era investors exuber-antly jumped on the bandwagononly to see many of those gains evaporate Yourfund should focus less attention on ldquobeating the marketrdquo and more on achievingreasoned financial objectivesHowever investors still need to know whether theirreturn and risk expectations are reasonable Investment objectives should be spe-cific and need to be outlined in an investment policy statement (see Chapter 6)Objectives typically include an appropriate index benchmark stated returnsabove inflation and performance versus a peer group of similar investment man-agersHowever return is only half the equation Investors must also consider riskTypically an investment policy statement includes a risk measure for examplethat the manager produce positive annualized alpha (Alpha is excess performanceabove the indexmdashas adjusted for beta or market sensitivity)
performance calculations
Performance measurement begins with the calculation of a rate of returnThetotal rate of return can be calculated on a dollar-weighted or a time-weighted basisThe dollar-weighted method also known as internal rate of return includes the im-pact of cash flow on total performance It explains how the portfolio increased ordecreased in value from one point in time to another including cash flowsHowever because contributions and distributions are outside the managerrsquos con-trol it is not an appropriate measure of investment manager performance
The time-weighted method eliminates the impact of cash flow and thereforeallows the investor to evaluate the decisions of the investment manager Thismethod determines the rate of return for the periods between cash flows andthen links those periods together to calculate longer-term returns
The two methods can produce very different ldquosnapshotsrdquo of performance Forexample suppose the XYZ Foundation places a million dollars with a newmoney manager In the first year the manager returns 35The foundation in-vestment committee is ecstatic and gives the manager an additional $8650000Unfortunately in the second year the manager loses 15When the managermeets with the investment committee to review performance he proudly an-nounces ldquoLast year was tough But since Irsquove been working with you Irsquove re-turned 71 per yearmdashnot bad for this environmentrdquo
At this point the foundationrsquos president leaps to his feet and shouts ldquoYoucrook What are you trying to pull We gave you a total of $9650000 and weonly have $8500000 left You didnrsquot have a gain you lost over a millionrdquo($1000000 + $350000 + $8650000 - $1500000 = $8500000)
152 chapter 13 performance measurement and evaluation
13 schneider 22505 937 AM Page 152
The problem is that the manager is using a time-weighted calculation whilethe foundation president uses a dollar-weighted methodAs we said the time-weighted method best measures a managerrsquos abilities
Occasionally there are return discrepancies between the investment managerand the account custodianWhile not all-inclusive here are the most commonreasons for discrepancies
bull Trade date valuation versus settlement date reporting
bull Accrued income calculations particularly for fixed-income investments
bull Pricing differences for individual security positions
bull Frequency of return linking (monthly vs quarterly)
bull Weighting of transactions particularly large cash flows
A few spectacular implosions have been triggered when mispriced securitieswere eventually ldquomarked to marketrdquo (adjusted to their true market value) Thesedisasters might have been prevented if accounts were independently verified andreconciled regularly
After returns are calculated and reconciled you need to determine whether tolook at returns gross or net of management fees Gross of fees means performancecalculated before the deduction of management fees Performance calculatedafter the deduction of management fees is considered net of fees Fees are a signif-icant factor because they reduce the overall value of the portfolioThereforenet-of-fee returns reflect the actual return earned by the investor Howevernet-of-fee evaluations can be misleading Because managers charge differentmanagement fees for clients with different asset levels gross-of-fee comparisonsare generally more appropriate However a managerrsquos fee schedule should ac-company gross-of-fee returns
benchmarks
The purpose of a benchmark is to provide a frame of reference for manageranalysis You want to know if the rate of return is reasonable when comparedwith that of similar investment managers and the appropriate indexThe most ef-fective benchmarks are widely known representative of the asset class or mandateand have a clear construction methodology
In addition to peer group and index benchmarks each asset class has an em-bedded expected returnThis expected return is expressed in two ways a nomi-nal return expressed as a single number and an inflation-adjusted return (returnabove inflation)The consumer price index (CPI) is the most common measure
benchmarks 153
13 schneider 22505 937 AM Page 153
of the impact of inflation Since spending policy is ultimately concerned withpurchasing power outperforming the CPI is a relevant investment objectiveAsan example of the use of benchmarks when evaluating a large-cap equity man-ager the appropriate index could be the SampP 500The nominal target might be1051 (the long-term average return for large cap stocks)The real target wouldthen be 74 adjusting for inflation2These absolute targets should be part of theperformance evaluation processWhile good starting points these simple com-parisons by themselves are insufficient and further benchmark comparisons arenecessary Additional benchmarks should include a style-specific market indexand a universe or peer group Exhibit 131 gives an example of such benchmarksas outlined in the investment policy statement for a large-cap growth manager
A common mistake is to compare the manager with the wrong benchmarkThis paints a false picture of manager skill and can create unrealistic return ex-pectations Investors who make the mistake of using the wrong benchmarks canend up terminating a perfectly good manager This can be both costly and cum-bersome Style is the key determinant of performance at the manager level (seeChapter 9) It is crucial to measure each manager against a style-specific index in-stead of a single benchmark like the Nasdaq Composite or the Dow JonesIndustrial Average By using an appropriate benchmark you can better under-stand whether an investment manager has added value
In addition to providing a useful tool to portfolio measurement benchmarks
154 chapter 13 performance measurement and evaluation
1Calculated by DiMeo Schneider amp Associates LLC using data presented in Stocks Bonds Bills andInflationreg 2004 Yearbookcopy 2004 Ibbotson Associates IncBased on copyrighted works by Ibbotson andSinquefieldAll rights reserved Used with permission2Ibid
exhibit 131 manager xyz objectives evaluationbenchmarks
Over a rolling three-year period the managerrsquos performance is expected to exceed at leastthree of the established benchmarks
1 Before inflation benchmark 105
2 After inflation (CPI) benchmark CPI + 74
3 Appropriate universe benchmark (return) Median
broad large cap
4 Appropriate index benchmark
SampP 500 index
5 Appropriate risk-adjusted performance Positive annualized alphaversus the policy
13 schneider 22505 937 AM Page 154
play critical roles in performance attribution asset allocation and style reliabilityThey also provide a mechanism for passive investing
market indexes
An index is a basket of securities selected to represent a broad market segmentYou determine the appropriate blend of index benchmarks during the asset allo-cation processThe closer the market benchmark fits the style of the investmentmanager being evaluated the more useful it becomes for comparison purposesInvestors should recognize that all indexes have limitations particularly duringtimes of extreme market movement
Performance benchmarks now exist for virtually every sector and subsectorIndexes can be broad based which means they are composed of a large number ofsecurities and designed to represent an entire marketrsquos price movement The mostwidely used broad-based index is the SampP 500 composite index A narrow-basedindex consists of a small number of securities and is designed to avoid overlapwith other indexes
One of the most important factors in benchmark construction is the systemused to determine the relative influence or weight each security has in theindex In a cap-weighted index each stock is held in proportion to its capitaliza-tion relative to that of the entire stock marketldquoCapitalizationrdquo means the priceper share times the number of shares outstanding In an equal-weighted indexeach security is assigned an equal weight regardless of its relative market capital-izationA cap-weighted index will be dominated by a handful of relatively largestocks often in a few sectors or industries On the other hand an equal-weighted index may be unduly influenced by the performance of small rela-tively unimportant companies
style
Many investment managers follow one of two basic investment styles value andgrowthValue managers attempt to buy ldquoa dollarrsquos worth of assets for 50 centsrdquothey are very concerned with the price they pay for a securityGrowth managerson the other hand seek companies growing faster than the economy they are lessconcerned with price
Nowadays equity indexes are constructed based on market capitalization andinvestment style So for example the Russell 1000 index (representing the 1000largest domestic companies) is sorted into growth stocks and value stocks (theRussell 1000 Growth and the Russell 1000 Value indexes) The securities are
style 155
13 schneider 22505 937 AM Page 155
sorted based on relative valuation and forecasted earnings growthValue stockshave prices that are low relative to their earnings dividends or assets Earningsgrowth for these stocks tends to be relatively modest and often is heavily influ-enced by short-term fluctuations in the economy Growth stocks on the otherhand tend to have prices that are high relative to their current earnings divi-dends or book value Usually their earnings are projected to grow faster than the market averageTypically this growth is driven by specific industry trendssuch as rapidly rising demand for a new product or service Therefore earnings ofgrowth companies are less influenced by economic cycles
Style-based indexes are broken down into medium and small capitalizationcomponentsThe Russell Midcap Value Russell Midcap Growth Russell 2000 Valueand Russell 2000 Growth indexes perform similar functions for mid- and small-capitalization stocks
Fixed-income indexes are based on the sector maturity and creditworthinessof the issuer Indexes exist for government mortgage and corporate debt securi-tiesOne index widely used as a proxy for the entire investment-grade bond mar-ket is the Lehman Brothers Aggregate Bond (LBAG) index It includesgovernment corporate and mortgage-backed securities
There are also benchmarks for below investment-grade or high-yield securitiesThese low-rated bonds are also called ldquojunk bondsrdquo Moodyrsquos and SampP are inde-pendent agencies that rate bonds Below investment grade means below one ofthe top four ratings
There are also sector- and industry-specific indexesCountry and regional in-dexes focus exclusively on a single country or region of the worldHedged and un-hedged foreign stock and bond indexes also exist A hedged benchmark reflectsthe effect of strategic hedging of currency exposure Unhedged indexes reflectthe effect of currency swings
picking the right index
R-squared is a statistic that measures how closely correlated an investment man-agerrsquos returns are with those of the market index Investors should choose a mar-ket index benchmark which has a high R-squared (08 or higher) to the managerA basic style analysis of the investment manager can help you select an appropri-ate market index benchmark (see Chapter 9)
A number of financial companies create domestic equity market indexes in-cluding Wilshire Associates SampP and the Frank Russell Company MorganStanley and Citigroup are leading vendors of international index dataCitigroupLehman Brothers and Merrill Lynch are the dominant index vendors for thefixed-income markets
156 chapter 13 performance measurement and evaluation
13 schneider 22505 937 AM Page 156
multiple benchmarks
In some cases investment managers do not limit themselves to a particular seg-ment of the market but rather invest in a mix of asset classes or styles For exam-ple a balanced fund may be invested 50 in equities and 50 in fixed incomeOr you may have multiple managers of differing styles each representing part ofthe overall composite In such instances a blended index would be appropriateFor exampleyou might benchmark the manager against a blend of 50 SampP 500and 50 LBAG
Sometimes it becomes necessary to roll a benchmark if an investment man-agerrsquos mandate changesFor examplea small-cap manager may be forced into buy-ing midcap stocks due to his portfoliorsquos growing size In that instance the historicalbenchmark would be rolled to the new benchmark at the time of the change
presenting the data
Although you should review the investment manager on a quarterly basis no onethinks that three months is long enough to decide whether or not to fire a man-agerThe general rule of thumb is that you should evaluate a manager over thecourse of a market cycle that includes up and down periods Convention hasshortened this ldquomarket cyclerdquo evaluation to three years Exhibit 132 shows alarge-cap BLEND equity manager compared with the SampP 500 index and nom-inal and real targets of 105 and 74 respectively3
universe comparisons
Itrsquos all well and good to compare the manager to the market but itrsquos equally im-portant to compare your results to those of other similar managersThis is calleda peer group or universe comparisonFor example compare fixed-income managersto other fixed-income managers and domestic equity managers to other domes-tic equity managers A universe provides a range of returns for a given periodun-like a market index which represents just a single return number Itrsquos helpful toknow your investment managerrsquos performance rankWas he top quartile Bottomquartile Average
Exhibit 133 shows a typical universe comparison In this example the man-ager is represented by the white diamond and the index by the triangle
universe comparisons 157
3Ibid
13 schneider 22505 937 AM Page 157
The results are normally reported in terms of percentile rankings of managersA percentile ranking of 1 is the best and 100 is the worstA ranking of 50 meansthe manager outperformed half of the peer universeA ranking of 25 means themanager was in the top 25 of the universeA ranking above 50 is acceptablewhereas above 25 is considered excellentHigh rankings over all time periods areidealhowever it is more important to rank highly over longer rather than shorterperiods A manager who scores consistently above median in shorter periods willend up in the top quartile over longer periodsThis is because managers who
158 chapter 13 performance measurement and evaluation
exhibit 132 manager xyz objective comparison
Fund SampP 500
CPI+74 105
Value
Quarter Ending
$0
$1000
$2000
$3000
$4000
$5000
$6000
$7000
$8000
J99 S99 D99 M00 J00 S00 D00 M01 J01 S01 D01 M02 J02 S02 D02 M03 J03 S03 D03 M04 J04
Inception date is December 31 1989 All dollar values are shown in thousands
13 schneider 22505 937 AM Page 158
ldquoshoot the lights outrdquo for one or two quarters often fall into the bottom quartilein subsequent quarters
Universes have certain limitations including the fact that results are not avail-able in real time It usually takes at least two weeks after the end of a quarter tocompile the universe data Universes are also subject to survivor bias Over timesome investment managers are removed from the universemdashtypically the worstperformers Poor-performing managers may go out of business Or more fre-quently (at least in the case of mutual funds) poor performers are merged into
universe comparisons 159
exhibit 133 manager xyz universe comparisons(broad large cap)
Trailing Returns through June 30 2004
5-25th tile 25-50th tile 50-75th tile
75-95th tile Fund SampP 500
-1500
-1000
-500
000
500
1000
1500
2000
2500
3000
3500
1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr
Trailing Returns through June 30 2004
Fund
Return
-tile
SampP 500
Return
-tile
Universe
5th -tile
25th -tile
50th -tile
75th -tile
95th -tile
1 Yr
2116
20
1911
35
2746
2036
1818
1552
1169
2 Yr
1051
19
927
32
1407
971
840
647
402
3 Yr
152
23
-069
48
572
115
-089
-286
-639
4 Yr
-177
36
-443
57
636
033
-387
-651
-1225
5 Yr
-069
43
-220
59
827
139
-150
-325
-676
6 Yr
233
38
157
50
877
365
157
028
-283
7 Yr
640
25
524
40
1083
637
494
345
089
8 Yr
942
20
853
32
1232
896
763
623
385
9 Yr
1119
17
1035
27
1309
1043
909
763
538
10 Yr
1234
17
1183
24
1411
1175
1032
895
650
Returns are percentages ldquo-tilerdquo is the percentile ranking within the universe
Returns for periods exceeding one year are annualized
Incept is December 31 1990 to June 30 2004
13 schneider 22505 937 AM Page 159
better performing but similar funds so that the better track record survivesManagers may also fail to report their returns to the firms that maintain the peeruniverses and are therefore dropped As a result the historical performance of theuniverse actually overstates the performance of the peer group
Universes can be purchased from organizations that collect maintain and an-alyze data on a large number of investment managers A partial list of such or-ganizations includes eVestment Alliance InvestorForce Checkfree InvestmentServicesMobius Group Plan Sponsor Network and Zephyr Associates (seeResources in Appendix G)
portfolio analysis
Portfolio analysis including attribution analysis helps you to understand what spe-cific actions created the fundrsquos returns Many databases provide quarterly ormonth-end portfolio holdings for each reporting manager Analyzing thoseholdings can help build an accurate picture of the characteristics of the portfolioWas performance achieved through asset allocation or security selection Was itaccomplished by skillfully picking individual securities or by selectively taking onmore risk than the benchmark Did the manager overweight or underweight in-dustry sectors If you understand how the managerrsquos track record was generatedyou will have some basis for expectations going forward
Attribution analysis attempts to identify and quantify the contributions thatasset allocation stock selection currency country and sector weightings made tooverall portfolio performance Knowing how an investment manager producesreturns can be just as important if not more important than knowing how largeor small those returns were Portfolio attribution compares a managerrsquos returnssector by sector to the same sectors of the appropriate benchmark Sectors may be economic or statistical For example did the manager overweight or underweight a particular industry or did the manager favor stocks with higherprice-earnings ratios Exhibit 134 shows such an analysis for a large-cap growth manager
Attribution analysis programs provided by companies such as StokTribVestekand Baseline can help you determine whether the investment managerrsquos resultswere based on skill or luck
style analysis
Style analysis is related to performance attribution in that it seeks to explain whya manager performed in the way he did Style analysis is used to determine port-
160 chapter 13 performance measurement and evaluation
13 schneider 22505 937 AM Page 160
161
Ana
lysi
s of
Ski
ll
Sta
ples
Dis
crtn
ry
Hea
lthca
re
Mat
eria
ls
Info
Tec
h
Ene
rgy
Indu
stria
l
Tel
Util
Fin
ance
Act
ivity
Por
tfolio
AB
Com
mitt
men
tR
etur
nR
ank
Ben
chm
ark
CD
Com
mitt
men
tR
etur
n(D
- b
) (
A -
C)
A(B
- D
)S
ecto
rS
elec
tion
489
-37
895
118
31
110
06-0
24
366
18
588
228
00
20-0
25
307
191
25
7713
151
41
74-0
01
077
000
000
599
060
008
000
253
45
0426
197
22
090
010
75
000
000
170
799
-01
00
00
682
247
9710
31
996
-02
8-0
51
000
000
177
441
-00
40
00
722
-90
899
107
4-1
33
012
-05
6
485
165
201
98-0
41
328
025
b
510
14
ex
hib
it 1
34
an
alys
is o
f s
kil
l f
or
la
rg
e g
ro
wth
(q
ua
rte
r e
nd
ing
63
00
4)
r
us
se
ll 1
00
0 g
ro
wth
Sta
ple
s
Dis
cret
ion
ary
Hea
lth
Car
e
Mat
eria
ls
Info
Tec
h
En
erg
y
Ind
ust
rial
Tele
ph
on
eU
tilit
ies
Fin
ance
Com
mitm
ent
Com
mitm
ent
Act
ivit
y
13 schneider 22505 937 AM Page 161
folio exposures to various investment styles Because recent research shows thatover 90 of a managerrsquos performance is attributable to its style we have devoteda complete chapter to style analysis (see Chapter 9)Growth style managers seek toidentify companies with the best prospects for rapid earnings growth whereasvalue style managers seek to buy stocks at a discount to their true valueHistorically both styles have produced similar returns over longer periods oftime but one style is usually in favor while the other is out of favor dependingon market conditions Investors often shift from out-of-favor to in-favor stylesjust at the wrong timeThey often end up selling low and buying high a recipefor disaster
In 1984 DALBAR Inc an independent research firm began a continuouslyrunning study of investment behavior and market performance called theQuantitative Analysis of Investor Behavior (QAIB) In the most recent update ofthis study DALBAR examined the 19-year period ending on December 312002 Over that time the SampP 500 index earned an average annual return of122 The ldquoaveragerdquo individual equity mutual fund investorhoweverhad a fundholding period of just over 2 years and earned an average annual return of just26 over the same period of time (less than the 31 average rate of inflation)The inference is that by chasing the best recent performance investors ended upshooting themselves in the foot
An investment manager should exhibit a clear consistent definable style InExhibit 135 closely clustered symbols show style consistencyA manager whosestyle has not remained consistent is said to driftThe exhibit shows two differentmanagers with similar investment styles However one has shown style consis-tency while the other clearly exhibits style drift
risk analysis
There are many definitions of risk the chance of losing money the probability ofnot meeting your objectivesor the likelihood of being criticizedHowevermostinvestment professionals view risk as the volatility of returns It is crucial to meas-ure the risk that a manager has taken to produce the return It is an underpinningof Modern Portfolio Theory (MPT) that the returns of various asset classes are re-lated to their riskThe greater the expected volatility the greater return investorsshould expect for taking that risk MPT holds that the markets are relatively effi-cient and that over time the returns of specific asset classes will reflect their rela-tive volatility MPT uses statistical concepts to define risk These include riskmeasures such as beta alpha and standard deviation
Beta measures risk relative to the benchmarkA portfolio with a beta of 1 has
162 chapter 13 performance measurement and evaluation
13 schneider 22505 937 AM Page 162
risk equivalent to that of the benchmark If the market were up 5 one wouldexpect the portfolio also to be up 5A portfolio with a beta greater than 1 hasmore risk than the indexFor example a portfolio with a beta of 15 would be up(or down) 50 more than the index (relative to the risk-free rate) Alpha meas-ures the return adjusted for beta Positive alpha implies that the managerrsquos deci-sions added valueR-squared measures the validity of the relationship between thebenchmark and the managerThe higher the R-squared the more reliable thealpha and the beta R-squared may range from 0 to 100 Beta alpha and R-squared are derived from statistical regression analysis using the manager and thebenchmark returns as the dependent and independent variables respectively
Standard deviation measures the total volatility of the manager by measuring thedispersion of returnsUnlike betawhich measures market risk standard deviationis a measure of total risk (market risk and security-specific risk)A high standarddeviation means greater volatility
The Sharpe ratio measures return per unit of standard deviation Developed byWilliam Sharpe the Sharpe ratio is simply the ratio of the portfolio return in ex-cess of the risk-free rate (Treasury bills) to the portfoliorsquos standard deviationThehigher the Sharpe ratio the more return per unit of riskA similar method theTreynor ratio was developed by Jack TreynorThe Treynor ratio is the ratio of thereward again defined as the portfolio return minus the risk-free rate to the port-folio betaAgain a higher Treynor ratio is better Exhibit 136 shows a risk analy-sis for a specific manager
exhibit 135 zephyr styleadvisor manager style
36-Month Moving Windows Computed Monthly Zephyr StyleADVISOR DiMeo Schneider amp Associates
October 1999ndashSeptember 2004
rvalue rgrowth
r2value r2growth
Small
-1
0
1
Large
Value -1 0 1 Growth
Manager ABCManager XYZRussell Generic Corners
risk analysis 163
13 schneider 22505 937 AM Page 163
recent developments
In the past few years consultants and academics have developed new techniquesto plug the holes in traditional manager benchmarks Index and universe com-parisons are almost always flawed For example an underperforming manageroften complains ldquoTrue I trailed the Russell 1000 value index but I only buystocks with a market cap above $10 billion less than 20 debt dividends above3 and with positive earnings So you can see that the benchmark really isnrsquot agood fitrdquo The normal portfolio attempts to solve the problem of index misfit
To construct a normal portfolio you list all the securities that fit the particularmanagerrsquos buy criteria In the example in the preceding paragraph screens wouldinclude market cap above $10 billion debt below 20 dividends above 3 andpositive earnings You can then calculate the total return for each of the securitiesand the normal portfolio as a whole The managerrsquos results can then be comparedwith those of the normal portfolio (the stocks he or she could have bought)Albeita stronger benchmark than a standard index there is still a drawbackThe man-ager either beats the normal portfolio or he doesnrsquotThere is no ranking system
Portfolio opportunity distribution sets (PODS) are artificial universes created fromthe normal portfolioDeveloped by Ronald J SurzPODS universes are designedto rank managersThey also do away with the problem of survivor bias As wementioned the ldquobadrdquo track records vanish from the universe dataThe result isthat the median of the universe appears higher than it shouldOne might say thatldquoraising the barrdquo is not necessarily a bad thing However your investment policymay force you to fire managers who seem to fall into the bottom half over athree-year periodThis results in increased cost to the fund (to sell manager Arsquospositions and replace them with manager Brsquos picks can cost 2)
According to Ron SurzldquoPeer groups suffer from a collection of biases onlyone of which is survivor bias and each peer group has its own unique set of idio-syncratic distortionsAs a result the exact same performance number will rankdifferently against different peer groups even when all of the peer groups are forthe same management mandate such as large cap growthrdquo
PODS universes start with the normal portfolio You then apply the man-agerrsquos portfolio construction rules For example the manager might build portfolioswith ldquo40 to 50 equal-weighted positions with no sector more than 112 timesthe index weightrdquo The normal portfolio is then sorted into individual ran-domized portfolios based on the portfolio construction rules Results for eachare calculated and sorted into quartiles just as are traditional manager universesAlthough the PODS approach avoids the problem of survivor bias it is labor in-tensiveCreating customized PODS universes for a specific manager may be toocostly for smaller fundsAn evolutionary step has been the creation of generic
164 chapter 13 performance measurement and evaluation
13 schneider 22505 937 AM Page 164
165
5-
Year
Manager
Ris
kR
etu
rnS
ingle
Com
puta
tion
July
1999 -
June 2
004
Return
0
2
4
6
8
10
11
Sta
ndard
Devia
tion
0
5
10
16
Ma
na
ge
r A
BC
Ma
rke
t B
en
ch
ma
rk
Ru
sse
ll 1
00
0 V
alu
eC
ash
Eq
uiv
ale
nt
Citi g
roup
3-m
on
th T
-bill
Perf
orm
ance A
ttribution
Sin
gle
Co
mp
uta
tion
July
19
99
- J
un
e 2
00
4
Resid
ual
R-S
quare
d to B
enchm
ark
Sty
le B
enchm
ark
Russell 1
000 V
alu
e
887
113
864
136
Ma
na
ge
r vs U
niv
ers
e A
lph
a th
rou
gh
Ju
ne
20
04
(no
t a
nn
ua
lize
d if le
ss th
an
1 y
ea
r)
Ze
ph
yr
La
rge
Va
lue
Un
ive
rse
(M
orn
ing
sta
r)
Alpha
-6-505
10
1 y
ear
3 y
ea
rs5 y
ea
rs
Manager A
BC
Russell 1
000 V
alu
e
5th
to 2
5th
Perc
entile
25th
Perc
entile
to M
edia
nM
edia
n to 7
5th
Perc
entile
75th
to 9
5th
Perc
entile
Manager
vs U
niv
ers
e S
harp
e R
atio thro
ugh J
une 2
004
(not annualiz
ed if le
ss than 1
year)
Ze
ph
yr
La
rge
Va
lue
Un
ive
rse
(M
orn
ing
sta
r)
Sharpe Ratio -050123
32
1 y
ear
3 y
ears
5 y
ears
Ma
nage
r A
BC
Russell 1
000 V
alu
e
5th
to 2
5th
Perc
entile
25th
Perc
entile
to M
edia
nM
edia
n to 7
5th
Perc
entile
75th
to 9
5th
Perc
entile
ex
hib
it 1
36
zep
hyr
style
ad
vis
or
Crea
ted
wit
h Ze
phyr
Sty
leA
DVI
SO
R M
anag
er re
turn
ssu
pplie
d by
M
orni
ngst
ar I
nc
Zeph
yr S
tyle
AD
VIS
OR
DiM
eo
Sch
neid
er amp
Ass
ocia
tes
13 schneider 22505 937 AM Page 165
PODS universes called PIPODSmdashpopular index PODS These are style-spe-cific universes created in the same manner as the customized PODS universesbut using portfolio rules common to most managers of a particular styleAlthough acceptance of PODS and PIPODS is growing as of this writing theiruse is not widespread
performance reporting
Performance reports should provide a clear and concise evaluation of a portfoliorsquosperformanceThese reports measure and analyze investment performance in aformat that answers the following questions
bull Has the manager achieved the expected return and investment objective
bull Is the manager abiding by the intended investment policy
bull What factors contributed to the total return of the portfolio
bull How does performance compare with the appropriate market benchmarkand peer group
bull Is the content of the report adequate to make the necessary evaluations oris additional information necessary
bull Is continued use of this manager prudent given the responses to these ques-tions
Regular performance evaluation encourages a proactive rather than reactiveapproach Quarterly evaluation should generally be sufficient
terminating a manager
Performance evaluation extends to more than preparing performance reports andreviewing performance You should routinely ask the managers if there have beenany changes at their firms that could impact future performance It is a good prac-tice to require managers to report any such changes without exception It is alsorecommended that fund fiduciaries regularly meet with the managers at least onan annual basis In general the following events warrant placing a manager onldquowatch listrdquo status
bull Is the manager trailing two of three of the stated investment policy guide-lines over a trailing three-year period
bull Is the manager exhibiting style drift
bull Has there been a change in the firmrsquos investment process or philosophy
166 chapter 13 performance measurement and evaluation
13 schneider 22505 937 AM Page 166
bull Has there been a significant change in assets under management
bull Have any senior investment professionals left the firm
bull Has a lead portfolio manager andor two or more members left the team
bull Has there been an organizational change or change in ownership due tomerger or acquisition
bull Is the firm facing any legal or compliance issues
Once a manager is on watch list status fiduciaries should implement strict duediligence procedures including
bull Discussions with current and new portfolio manager or team
bull In cases of mergers and acquisitions discussions with individuals from bothfirms involved
bull Analysis of current fund strategy and holdings relative to historical posi-tioning
bull Gathering and reviewing related news items and press releases
After rigorous due diligence fiduciaries face two choices retain or terminatethe manager If you are not confident that the changes may in facthave a positiveimpact on future performance then terminating the manager is appropriateTheldquocorrectnessrdquoof the decision to terminate or retain a manager will not be knownuntil the managerrsquos future returns are reviewedThe important point is that nomatter what the outcome the decision-making process is prudent
Although not all-inclusive a list of performance analysis software and dataproviders can be found in Appendix G
terminating a manager 167
13 schneider 22505 937 AM Page 167
13 schneider 22505 937 AM Page 168
chapter 14
Socially Responsible Investing
Judging by recent trends many nonprofit organizations have already begunsocially responsible investing (or may be having the discussion soon) Socially re-sponsible investing (SRI) has evolved considerably in the past few decades and isno longer strictly the province of religious organizations SRI investors tackleconcerns far beyond simple restrictions on holdings in tobacco alcohol and en-vironmentally unsafe companies Due to recent high-profile corporate scandalsSRI has expanded to include issues of corporate governance business ethics fi-nancial responsibility and transparency More and more investors are concernednot only with the financial and economic performance of companies but alsohow their policies and practices contribute to our societyWith interest in SRIon the rise and the expanding range of issues asset growth has followedAccording to the Social Investment Forum from 1995 to 2003 assets investedaccording to socially responsible guidelines have grown 40 faster than all pro-fessionally managed assets
SRI can be loosely defined as the use of social moral or ethical guidelines inevaluating investments in addition to considering financial metrics SRI is alsosometimes referred to as ldquosocially conscious investingrdquoldquovalues-based investingrdquoand ldquoethical investingrdquo
history
Socially responsible investing had it origins in the beliefs of various religiousfaiths Dating back several hundred years religious investorsrsquo belief in peace andnonviolence led them to avoid investments in products that could cause harmsuch as alcohol tobaccoguns and gamblingWith the passage of time those con-cerns evolved and the focus of SRI expanded Civil Rights womenrsquos rights the
169
14 schneider 22505 937 AM Page 169
environment and nuclear energy concerns all came to the forefront during theperiod of activism in the 1960s and 1970sThe anti-apartheid movement (op-posing investments in South Africa) and opposition to the Vietnam War were two causes that greatly increased awareness of SRI More recently SRI has ex-panded to include labor relations and corporate governance issues SRI asset lev-els continue to grow along with the causes that SRI strategies seek to addressAccording to the Social Investment Forumrsquos 2003 Report on Socially ResponsibleInvesting Trends in the United States $216 trillion in assets was identified as profes-sionally managed in SRI strategies accounting for ldquomore than one out of everynine dollarsrdquo under professional management in the United States SRI assets in-creased 7 in 2001ndash2002 a period when the markets suffered through a difficultdownturn and the broader universe of all professionally managed portfolios fellby 4 During the eight-year period 1995 to 2003ldquoportfolios involved in SRIgrew by more than 240compared with 174 growth of the overall universe ofassets under professional managementrdquo
socially responsible investing strategies
Most investors may think of SRI purely in terms of screeningor excluding com-panies that donrsquot fit the desired social criteria However there are other methodsto effect social goalsMany investors pursue SRI through active ownership strate-gies often referred to as shareholder advocacy Shareholder advocacy can be imple-mented through corporate dialogue shareholder resolutions and proxy voting Throughthese methods investors donrsquot simply exclude companies whose activities theymay disagree with they become shareholders in these companies and try to ef-fect change in the policies or practices with which they disagree
A third SRI strategy community investing is less commonbut is also experienc-ing growth Community investing strategies provide support for economic de-velopment in disadvantaged or financially impoverished communitiesEconomicdevelopment is generally accomplished through community development bankscredit unions and loan funds that offer savings and investment options as well asloans and access to capital that may not otherwise be available in low-incomeareas
Screening
The exclusion of stocks due to social criteria is the oldest method of SRI imple-mentation In order to follow this or any other SRI strategy you need to beginwith a thoughtful discussion regarding the values that your organization wishes
170 chapter 14 socially responsible investing
14 schneider 22505 937 AM Page 170
to be reflected in the portfolio Common exclusions include alcohol tobaccogaming militarism pornography and environmentally ldquounfriendlyrdquo companiesOther exclusions may involve human rights labor relationsemployment equal-ity abortion and birth control
Some religious organizations have written guidelines for their various affiliatedorganizations For instance the US Catholic Conference of Bishops (USCCBwwwusccborg) has offered guidelines that may be used by Catholic organiza-tionsThe USCCB investment policies include specific areas of concern undersix broad social goals
1 Protecting human life
bull Abortionbull Contraceptivesbull Embryonic stem cellhuman cloning
2 Promoting human dignity
bull Human rightsbull Racial discriminationbull Gender discriminationbull Access to pharmaceuticals (eg HIVAIDS)bull Curbing pornography
3 Reducing arms production
bull Production and sale of weaponsbull Antipersonnel landmines
4 Pursuing economic justice
bull Labor standardssweatshopsbull Affordable housingbanking
5 Protecting the environment
6 Encouraging corporate responsibility
Once you have identified the areas of social concern the process of screeningmay seem somewhat straightforward However an individual companyrsquos SRIconformity is rarely a clear-cut case Many larger corporations have businessesand affiliates in diverse industries and geographic regionsThese subsidiaries maymanufacture myriad products that are unrelated to the parent companyrsquos primaryrevenue sources and commonly known lines of businessFor instance a companysuch as General Electric is involved in such business lines as media and entertain-ment (NBC Universal) consumer and commercial financehealth care (includingmedical imaging and diagnostic technologies) transportation (such as the manu-facture of aircraft engines) consumer and industrial products (appliances light-ing) and insurance and investment productsmdashjust to name a few At any given
socially responsible investing strategies 171
14 schneider 22505 937 AM Page 171
point in time such a conglomerate may have a business line involved in activitiesthat violate a nonprofit organizationrsquos stated SRI policiesThese policy violationsmay or may not be readily apparent to an outside observer
Another consideration is the supply and end-product relationships that com-panies may have Suppose a paper company that has an otherwise exemplary en-vironmental and labor relations track record produces products that are ultimatelyused by tobacco companies to manufacture cigarettes Should holdings in a largegrocer be excluded simply because they sell alcohol and tobacco products Whatabout an apparel company that is an active contributor to its communitybut usesfabrics and materials produced by underage workers overseas in a sweatshop
Ultimately reasonable allowances can be built into an SRI policy so that com-panies with significant noncompliant activities are screened out but lesser in-volvement can be considered tolerable Itrsquos possible with certain social screeningtools to set a revenue threshold such that companies that derive greater than xof their total revenues are excluded In any case the nonprofit organizationrsquos con-sultant andor investment managers can help sort through these issues
Shareholder Advocacy
Some socially conscious investors pursue a strategy of shareholder advocacyThethree main components of an activist shareholder strategy are corporate dialogueshareholder resolutions and proxy votes
Corporate dialogue is generally the first step in shareholder advocacy Throughthis dialogue shareholders convey their concern on social issues directly to thecompany By articulating the position in a thoughtful and consistent manner in-vestors have the potential to shape policy in areas such as the environment em-ployment equality and corporate governance Lobbying shareholders need to bepersistent It may take several years of dialogue to change a given policyHoweveryour conversations can be successful if you can convince the company that theissue if unresolved will ultimately be brought to a shareholder resolution
A shareholder resolution is a formal request made to a company by a currentshareholderThe resolution seeks or recommends action by the company on aspecific issueThe Securities and Exchange Commission (SEC) has set forth cer-tain regulations regarding the eligibility timing and filing of shareholder resolu-tions Each shareholder is limited to one resolution per year so it is quitecommon for several shareholders to join together and coordinate their resolutionefforts choosing a designated sponsoring shareholderOrganizations that provideproxy research services and shareholder advocacy support include the InvestorResponsibility Research Center (IRRC wwwIRRCorg) and the Interfaith
172 chapter 14 socially responsible investing
14 schneider 22505 937 AM Page 172
Center on Corporate Responsibility (ICCR wwwICCRorg) They can behelpful resources in building a network of support
Proxy Voting
The initial goal of a shareholder resolution is to get the issue on the proxy state-ment so that all shareholders can vote on it at the companyrsquos annual meeting Ifthe resolution fails to meet certain guidelines the company has the right to omititThis prevents the issue from reaching a shareholder vote If the resolution issuccessfully placed on the proxy statement then it will be voted on at the annualshareholderrsquos meeting Depending on the shareholder vote the company maymove to adopt or change their policies in accordance with the resolutionHowever regardless of the support level the shareholder resolution is generallynot binding on a companyrsquos board of directorsThey can simply choose to ignoreitFor example in 200454 of Intel Corporationrsquos shareholders voted in favor ofadopting the practice of expensing stock options1 but Intelrsquos board disagreedwith the majority vote and the resolution was not implemented At GeneralElectricrsquos 2004 shareholder meeting the board rejected a resolution supported by68 of voting shareholders2 calling for annual board elections According toInstitutional Shareholder Services (ISS) of the 172 shareholder proposals that re-ceived a majority vote in 2003 only 70 of them were acted upon by companymanagement3 Conversely itrsquos possible for a resolution to be successful with as lit-tle as 10 of the shareholder vote if the board believes the recommendations havemerit Guidelines sometimes restrict the resubmittal of failed shareholder resolu-tions Generally first-time resolutions must receive at least 3 of the vote to beconsidered for the following yearrsquos proxy statementSecond-year resolutions mustreceive at least 6 of the vote and third-year resolutions must receive 10 of thevote in order to be eligible to continue on the proxy statement
For shareholders other than the resolutionrsquos sponsor the proxy voting processprovides an opportunity to voice their opinion either for or against the resolu-tion You need to understand the company-specific proxy issues in order to votein a consistent thoughtful manner that reflects the values of your organizationWhile keeping track of numerous proxy voting issues may seem a daunting taskthere are several organizations such as ISS the IRRC the ICCR and many
socially responsible investing strategies 173
1William BaueldquoCompanies Ignore Majority Votes on Shareowner Resolutionsrdquo Socialfundscom May20 20042Ibid3Barry B BurrldquoAll Investor Eyes On Busy Proxy Seasonrdquo Pensions amp Investments 14 June 2004 p 3
14 schneider 22505 937 AM Page 173
others that provide research and recommendations on individual company proxy votes
Current high levels of shareholder activism should make 2004 a record year forshareholder resolutions surpassing even 2003According to data from ISS 1050shareholder resolutions were filed in 2003 and estimates for 2004 are at 1100resolutions4 Given the recent focus on corporate governance shareholders arelikely to keep the pressure on companies for greater transparency and board in-dependence
If corporate dialogue and shareholder resolutions fail to bring about the de-sired change in policy shareholders can still resort to divesting or selling a stockholdingA small shareholder may not have much leverage in suggesting this al-ternativebut a group of shareholders especially large institutionsmay commandattention (Significant selling pressure will drive the price down impacting in-centive stock options and management bonuses)
Community Investing
Although generally not the centerpiece of most nonprofit organizationsrsquo SRIprograms community investing plays a small yet meaningful role Community in-vesting supports low-income and disadvantaged communities by providing fi-nancial services for individuals and small business enterprises that may nototherwise have access Community investing also provides loans and access tocapital for local businesses and organizations to provide services in the commu-nity such as day-care centers and affordable housingThese resources are createdwhen nonprofit and other investors open certain savings and checking accountsmoney market accounts certificates of deposit and other investment optionsInvestment options are generally available through four types of vendors com-munity development banks community development credit unions communitydevelopment loan funds and community development venture capital funds
The simplest form of community investment is to merely open a checkingsavings or money market account at a community development bank or creditunionThe accounts are federally insured similar to traditional banks and creditunions and generally offer rates that are competitive with traditional banksThesedeposits can then be used by the community bank to extend credit or to fundsmall business loans and worthwhile projects in the community
Community development loan funds pool investorsrsquo resources and extendloans that are generally below market interest rates to those within the commu-
174 chapter 14 socially responsible investing
4Ibid
14 schneider 22505 937 AM Page 174
nity These investments are not federally insured and usually require an invest-ment commitment of several yearsThough these types of investments producelower returns than available elsewhereproponents of community investing arguethat even a 1 commitment from individual investors and institutions if followedbroadly would have a tremendous impact in disadvantaged communities Inessence the nonprofit organization gives up some portfolio gain in an effort toldquoprime the pumprdquo of grass roots capitalism Proponents argue that the perform-ance impact from a 1 community investment allocation has a minimal overallaffect on portfolio returns
separate accounts versus mutual funds
Depending on the overall size of your organizationrsquos portfolio the asset classesyoursquove selected and their corresponding weights separate account management mayoffer significant advantages in implementing an SRI strategy Separate accountmanagement means that your portfolio managers run stand-alone accounts con-taining only your organizationrsquos assetsThe management of these accounts can betailored to follow your specific investment directionsThis customization meansthat the portfolio will follow the exact social screens you desire In addition youcan set limits on cash or foreign exposure sector weighting and acceptable creditquality to name a few In addition to customization separate account expenses arefrequently lower than those of mutual funds or commingled trusts Virtuallyevery investment manager will run assets in a separate account (if you meet theirminimum) so you have a broad universe of managers from which to choose
If your nonprofit organization has a small amount of assets mutual funds mayoffer the most practical solutionAlthough the universe of SRI mutual funds isnot nearly as large as the universe of SRI separate account managers the numbercontinues to grow According to the 2003 Report on Socially ResponsibleInvesting Trends in the United States there are 200 socially screened mutual fundsas of 2004 up from 139 in 19975 Available mutual funds use all three primarySRI methods screening shareholder advocacy and community investing Somemay offer only one or two of the three strategies
Another key differentiator among SRI mutual funds is the screening criteriathat each may use The most commonly used mutual fund screens are (in order ofprevalence) tobacco alcohol labor relations environment and gambling Otherless common screens include pornography abortion and animal testing ManySRI mutual funds use five or more individual screens and the vast majority use at
separate accounts versus mutual funds 175
5Social Investment Forum ldquo2003 Report on Socially Responsible Investing Trends in the UnitedStatesrdquo (December 2003) p ii
14 schneider 22505 937 AM Page 175
least two One drawback to using mutual funds is that finding a fund that incor-porates the exact screens that your organization desires (within a given invest-ment discipline) may prove to be very difficult If screening in a certain area isimportant you may have to accept screening in other areas that your organiza-tion does not feel as strongly about
Another consideration is cost SRI mutual funds usually have higher invest-ment expenses (as a percentage of assets) compared with similar separate accountmanagers Since mutual funds expenses are largely driven by economies of scalefunds that have been around longer and have larger asset bases are more likely tohave lower expenses than newer smaller funds
You should also consider commingled products Even fewer in number thanmutual funds some investment firms offer these products as a means of offeringtheir SRI capabilities to prospective clients who are too small for separate accountmanagementThese commingled products are similar to mutual funds in somekey ways The manager pools investorsrsquo assets and runs the portfolio according toa uniform set of guidelinesSimilar to mutual funds custom screening is not avail-able through a commingled product Unlike a mutual fund commingled fundsusually offer monthly rather than daily liquidityCertain SRI commingled prod-ucts may limit liquidity to once per quarter If the ability to move cash quickly isimportant yoursquoll want to clarify this during the due diligence process
Depending on the commingled fund the expenses may be lower than a com-parable mutual fund because commingled funds are designed with institutionalinvestors in mind Institutional investors donrsquot generally require the ancillary serv-ices that mutual fund companies provide for example toll free phone lines staffedaround the clock with investment representatives So the additional costs ofthose services arenrsquot built into the expense ratio
performance impact of sociallyresponsible investing
For some nonprofit organizations adhering to specific social guidelines in invest-ing is not a subject for serious debateTo them it is critical that their portfoliosreflect the values and beliefs of their organization However other nonprofit or-ganizations may fear being ldquopenalizedrdquo with lower returns for following sociallyresponsible guidelines In realitymuch of the research conducted over the past 10to 15 years points to no discernable ldquopenaltyrdquo for following socially responsibleguidelines
Some research done during the 1990s found that much of the difference inperformance of SRI versus traditional investing could be accounted for by dif-ferences in market cap style and risk Generally speaking social screens have re-
176 chapter 14 socially responsible investing
14 schneider 22505 937 AM Page 176
sulted in portfolios characterized by smaller market capitalizations higher beta(market-related risk) and higher growth characteristics (eg higher price-earn-ings ratios) when compared with traditionally managed portfolios that lack socialguidelinesWhen the market favors these characteristics SRI portfolios benefit
By taking into account the impact of these characteristics two significant stud-ies completed in the past several years concluded that an SRI approach does notunderperform traditional investing approaches Rob Bauer Koedijk Kees andRoger Otten wrote a paper titled ldquoInternational Evidence on Ethical MutualFund Performance and Investment Stylerdquo in January 20026 Bauer Kees andOtten analyzed a database of more than 100 socially screened mutual funds usingmultifactor models to examine returns and investment style from 1990 to 2001Their research affirmed that SRI mutual funds tend to be more growth orientedthan value oriented due to their screening process However their research alsofound that after accounting for investment style there was no significant differ-ence in returns on a risk-adjusted basis between SRI strategies and traditionalstrategies Bauer Kees and Otten concluded that SRI (or ethical) funds ldquodo notunder-perform relative to conventional fundsrdquo
Another important piece of research in this area reaches a similar conclusionBernell K Stone John B Guerard Jr Mustafa N Gultekin and Greg Adamswrote a research piece in 2001 titled ldquoSocially Responsible Investment ScreeningStrong Evidence of No Significant Cost for Actively Managed Portfoliosrdquo7 Thisresearch examined the impact of size risk growth and dividend yield on socially re-sponsible investment returns Stone and co-authors concluded that after adjust-ing for these factors there was ldquono significant cost to social screeningrdquoMoreovertheir research also found that the conclusion of ldquono significant costrdquoalso held overmany shorter-term periods as well as the entire 1984 to 1997 period on whichthey conducted their research
The Social Investment Forum looked at the Morningstar ratings of SRI mu-tual funds versus the overall universe of mutual fundsAccording to the method-ology behind Morningstarrsquos rating system a four- or five-star rating is awarded tothe top 325 of mutual funds based largely on risk-adjusted returnsAccordingto the Social Forum from 2001 to 2003 anywhere from 38 to 43 of all SRIfunds were awarded four- and five-star rankings in those years The conclusion isthat a higher percentage of SRI funds received four- and five-star rankings thanwould be expected relative to the entire mutual fund universe
performance impact of socially responsible investing 177
6Rob Bauer Koedijk Kees and Roger Otten ldquoInternational Evidence on Ethical Mutual FundPerformance and Investment StylerdquoWorking Paper January 20027Bernell K Stone John B Guerard Jr Mustafa N Gultekin Greg Adams ldquoSocially ResponsibleInvestment ScreeningStrong Evidence of No Significant Cost for Actively Managed Portfoliosrdquo Journalof Investing forthcoming
14 schneider 22505 937 AM Page 177
incorporating socially responsibleinvesting into investment policy
A nonprofit organizationrsquos desired approach to SRI (screening advocacy etc)should be incorporated in the investment policy statement (IPS)This languagecan be either detailed or general depending on the specific issues to be screenedthe desired level of adherence and whether separate accounts commingled trustsor mutual funds are used If the portfoliorsquos size allows for the use of separate ac-counts and the nonprofit organization subscribes to various research and proxyvoting services they may have access to company-specific data that would allowthe formulation of a list of individual company restrictions to be included in theinvestment policy However that process is likely to be too time consuming andcumbersome for many nonprofit organizationsFor this reasonbroader languageis commonly used to convey the types of business and activities that should be re-stricted from the portfolioSeparate account managers often subscribe to softwareand various research services to ensure that the holdings in the portfolio adhere tothe IPS objectives (and exclude holdings that donrsquot) Provide your SRI separateaccount managers with an individual IPS that is specific to your desired portfolioguidelinesAs with traditional separate accounts managers should sign the IPSacknowledging their understanding of the guidelines
When your overall portfolio size precludes the use of separate accounts applyeven more general language in the main IPSBecause mutual fund investors havevirtually no control over the screening decisions made in mutual funds itrsquos im-portant that the IPS does not require screening to which your mutual funds man-agers may not adhere Your mutual fund or commingled trust investments will bepooled with the investments of others and be screened according to predeter-mined criteria identified in the fundrsquos prospectus
Each manager or fund in the portfolio should be incorporated into the mainIPSAlso list your criteria for oversight selection of managers and ongoing per-formance evaluation measuresThe same performance measures that are used toevaluate traditional managers should be applied to SRI managers For instance alarge-cap value equity manager following SRI guidelines should be measuredagainst the Russell 1000 Value index or the Standard amp Poorrsquos Barra Value index(large-cap value stocks) and against a peer group of other large-cap value managers
The inclusion of screening criteria in the IPS helps ensure that the values andbeliefs of your nonprofit organization are consistently reflected in the portfolio Inaddition to the other aspects of an IPS the SRI screening criteria should receiveperiodic (annual) review by your investment committee
178 chapter 14 socially responsible investing
14 schneider 22505 937 AM Page 178
chapter 15
Selecting Other Vendors
In addition to all the other important decisions you have had to make yournonprofit organization may need to select a trustee or custodian for the invest-ment portfolio a record keeper for your retirement plan assets or charitable trustsor a broker to execute trades
A custodian holds most if not all of the assets of your fundCustodians can bebanks (local regionalor global) trust companies and even brokerage firms Theyhold the securities in safekeeping facilitate or execute transactions and providean accounting of assets and any activity in your accounts Many banks and trustcompanies may also provide trustee servicesTrustee status means that they as-sume a fiduciary role in the oversight of the fundsThe use of such an outsidetrustee can provide some comfort to your nonprofit organizationrsquos decision mak-ers
A record keeper can be a bank trust companymutual fund companyor inde-pendent third-party administratorThere are many financial institutions that ad-minister 401(k) or 403(b) (defined contribution) retirement plans as well as DBpension plans Record keepers can also handle the administration of charitableremainder trusts and other annuity trusts that may be gifted to your organizationThey track individual accounts and process distributions
Finally brokersdealers execute and clear transactionsThey also sell invest-ments and custody assets However because of the sales component you need acomplete understanding of the services offered the brokerrsquos capabilities and anypotential conflicts of interest
step one
Your first step should be to completely assess your organizationrsquos needsThere arevarious types of vendorswith different areas of specialization It is important that
179
15 schneider 22505 937 AM Page 179
you have a clear sense of exactly where you need help before embarking on thesearch process There is no ldquoone size fits allrdquo solution it is rare that one vendorcan excel in providing multiple services to nonprofit organizationsA firm thatdoes a terrific job administering 401(k) or 403(b) plans may not have the capa-bilities to custodytrustee and administer a DB pension plan A firm that handlescustody of your assets may not provide record keeping for charitable trustsManyvendors offer ancillary services so that they can manage the investments Moneymanagement is where the profits lie See Exhibit 151 for a sample questionnairethat can help you clarify your goals
Letrsquos assume that your organization needs trust and custody services you canconsider a number of different types of firms Perhaps your local bank providesthese services If your needs are more complex larger regional and national banksor trust companies have robust trust and custody operations and provide thesesame services for large numbers of clientsAlso your nonprofit organizationrsquos fi-nancial adviser or investment management consultant may have an affiliationwith a brokerdealer that can provide custody services for little or no costYoucan start with a list of such firms as potential recipients for your request for pro-posal (RFP)
step two
The next step is to draft the RFP Your specific needs will determine if the RFPshould be shorter and simpler or if it needs to include great detail In general thesmaller the portfolio the simpler your trust and custody needs may be particu-larly if the portfolio predominantly holds mutual funds If your portfolio is largeror you use separately managed accounts your custody needs may be greaterSeparate accounts holding foreign securities present an additional layer of com-plexity
The RFP should address a few broad areaswith detailed questions in each sec-tion You need to understand the background of each firm and their experiencein providing trust and custody services How many clients do they service Whatlevel of assets does that represent How many clients similar to your size andneeds How committed is this firm to the trustcustody business Are they likelyto exit this business (do they have critical mass)
Along with the firm background it is important to learn about the individu-als who will service your accountWhat is their average industry and firm expe-rience What is the level of personnel turnover How do they compensate thesepeople What incentives do they have to provide superior service
A second area of importance in the RFP relates to the capabilities of the po-tential custodian Can they provide master trust administration In other words
180 chapter 15 selecting other vendors
15 schneider 22505 937 AM Page 180
step two 181
exhibit 151 vendor search needs assessment sample questionnaire
1 Identify the most important items that should be addressed as they relate to the custodyadministrationrecord keeping of your funds
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
2 What are the distribution (cash flow) requirements of the organization Are there any com-plexities associated with these requirements
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
3 Is master trust accounting desired Are there numerous subaccounts within the largerfund(s) that require detailed reporting
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
4 Does your organization have charitable annuities If so is assistance needed in their administration
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
5 Does your organization have retirement plans that require record keeping If so what type ofplan Defined benefit (pension) plan Defined contribution [401(k) or 403(b)] plan What isworking well and what could be improved
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
6 Identify any other obstacles goals or thoughts you have about improving the efficiency of ad-ministration of these funds_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
Source DiMeo Schneider amp Associates LLC
15 schneider 22505 937 AM Page 181
can a portfolio be managed as one large pool even though the custodian has thecapability to track several subaccounts as individual segments Does the custodianhave global custody capabilities For larger portfolios can they facilitate securi-ties lending (Securities are loaned to various brokers in exchange for a feeSecurities lending can provide an additional source of revenue to your fund) If they do what is the minimum account size theyrsquoll consider for lending Gen-erally the individual separate accounts need to be fairly sizeable ($50ndash75 millionor more depending on the asset class) If you have a small portfolio can the cus-todian work with a large universe of mutual funds Is it a finite list or do theyhave the capability to custody and place transactions in any publicly traded mu-tual fund What do their statements look like Do they provide the level of re-porting that your nonprofit organization desires How often are the statementsgenerated and how promptly after each period will you receive yours
A third area you need to examine is technology How much does the firm in-vest annually in technology Can clients access account data via the InternetWhat functions can you perform via the Internet How is your data protectedWhat are their disaster recovery contingency plans What new capabilities are onthe horizon
The fourth major section of the RFP should address fees Describe your ex-pected investment structureProvide an estimate of the number and types of sep-arate accounts and mutual funds this will allow the potential vendor to gauge thecomplexity of their trustcustody dutiesThe vendor may propose a flat-dollarfee a percentage of assets and transaction fees If the fee is a percentage of assetsit should include break pointsThe RFP should require details on any transactionfees For how long will they guarantee their fees Is there a service guarantee
The fifth section of the RFP should include a request for references It is mostproductive to ask for references that are similar to your organization Presumablythey face many of the same issues that you do Three or four current client refer-ences should be sufficient See Exhibit 152 for a sample RFP
step three
Send the RFP with a brief introduction Describe a bit about your organizationits history and mission Include specific instructions about how and to whom torespond Itrsquos a good idea to clearly set a response deadline no later than threeweeks from the date you send the RFP Also communicate the name and contactinformation for a point person who can respond to vendorsrsquo questions Clearlystate that any questions should be directed to this personThis will prevent ven-dors from hounding board members
182 chapter 15 selecting other vendors
15 schneider 22505 937 AM Page 182
step three 183
exhibit 152 request for proposal trusteecustody services
Background Information
1 Please state the name title address and telephone number of the person we may contactwith questions about your responses to this request for proposal
2 Please provide a brief overview of your firmrsquos trusteecustody department including thesespecifics
bull Date foundedbull Total employees in the departmentbull Total trust assetsbull Number of clientsbull Number of clients by size
mdashUnder $20 millionmdash$20ndash$100 millionmdash$101ndash$500 millionmdash$501 million +
bull From where would the account be servicedbull Any parentsubsidiary relationships
3 Please provide a brief overview of the account officer who would be assigned to the account
bull Name of account officerbull Background and experiencebull Number of clients servicedbull Who is this personrsquos backup
4 Please describe forms of insurance regarding errors and omissions
5 What is your firmrsquos commitment to the trustcustody area for the future
Technological Capabilities
1 Do you provide online services to your customers How long has this been offered
2 How current is online information and how many hours per day is this available
3 Please describe your backup process and your disaster recovery plan How often is yourbackup system tested
Accounting Systems
1 Explain your process for pricing portfolio securities (also discuss your reconciliation process)
2 What services do you use for pricing held securities
3 Describe your firmrsquos process in resolving errors How are they corrected
4 How are global custody services provided
5 Are there any specific requirements of international managers
6 Does your firm have any special concerns with emerging markets Small or illiquid securities
Reports
1 Please describe your standard reporting package Provide a complete description and copiesof all reports available to clients Which standard reports are available online
2 Are you willing and able to prepare special reports from available data Is there an additionalcharge for this service
3 Is reporting provided on a trade date or settlement date basis
(continued)
15 schneider 22505 937 AM Page 183
184 chapter 15 selecting other vendors
exhibit 152 (continued)
4 Can you integrate the two outside trust assets into your reporting
5 When are the reports sent out
6 Please provide a sample statement
Disbursements
1 What information (and in what format) is required to make disbursements What is the mini-mum time required to issue a payment once information is received
2 What is the charge for checks Wires
3 Will you coordinate and assist in planning timelines for disbursements
Fees
1 Are you willing to offer service guarantees and to put your fees at risk
2 How long will you guarantee fees
3 Please describe any costs incurred for terminating the agreement prior to contract expiration
4 Please provide an estimate of overall first year fees
5 Please provide an estimate of overall ongoing fees (after first year)
6 Please be specific on base fee versus transaction fees Will you cap transaction fees
7 Can trades be placed through your firm If so what are the trading costs
8 Are transaction costs waived or reduced when placed through your firm
9 Please detail fees associated with custody of mutual plan and commingled trusts
10 What are the conversionset-up fees if any
11 What are the trustee fees
12 Is there a set-up andor annual fee for online access
13 Are there global custody fees
14 Please provide a detailed estimate of all fees for administration custody and trustee serv-ices Include in your fee quote all assumptions used
Source DiMeo Schneider amp Associates LLC
step four
When the RFP responses are received it is helpful to place the individual vendorresponses into a matrixThis will make it easier for you to compare and contrastvendorsrsquo responses question by question This method is particularly helpfulwhen reviewing proposals in a committee setting Time may be limited and ef-ficiency is important You will find it easier to compare vendors if you set up agrid where each type of fee is broken out line by lineWhen preparing this analy-sis carefully consider any transaction-related fees Estimate a total annual feeCompare those bottom-line numbers side-by-side Also estimate any asset-basedfees based on a recent market value of the portfolio See Exhibit 153 for a sam-ple of such a matrix
With this information in hand your committeersquos review will be more organ-ized and efficient
15 schneider 22505 937 AM Page 184
185
ex
hib
it 1
53
sa
mp
le
cu
sto
dytr
us
te
e f
ee
su
mm
ar
y
Vend
or A
Vend
or B
Vend
or C
Conv
ersi
on F
eeW
aive
d$
50
00
$
0
Ass
et-b
ased
fee
$0
010
ndash
$30
00
00
05
ndash$
150
00
Rate
010
o
fmar
ketv
alue
ofa
sset
s0
05
ofm
arke
tval
ue o
fass
ets
Acc
ount
tru
stee
fees
$8
40
0
$15
00
0
$7
200
$
350
ann
ually
per m
utua
lfun
d
Mon
thly
mai
nten
ance
of$
50 p
er$
300
mut
ualf
und
acco
unt(
24)
= $
84
00
subf
und
(cha
pter
sch
olar
ship
acco
unt(
24) =
$7
200
acco
unts
) 2
5 to
tals
ubfu
nds
$50
times12
(mos
) times25
= $
150
00
yea
r
Inte
rnet
acce
ss$
0
$0
$
0
Esti
mat
ed to
talf
ees
$8
40
0
$50
00
0
$22
50
0
Min
us
Esti
mat
ed 1
2b-1
fee
cred
it$
0
$0
$
285
75
Esti
mat
ed n
etco
st$
84
00
$
500
00
$
0
Assu
mpt
ions
$
30 m
illio
n in
ass
ets
Trus
tee
will
serv
e as
cust
odia
nLi
kely
to b
e al
lmut
ualf
unds
wit
h as
man
yas
12 p
er fu
nd
Acc
ount
sw
illbe
val
ued
atle
astm
onth
ly
12b-
1 fe
e es
timat
es
AB
CM
utua
lFun
d (0
35
) = $
945
0D
EFM
utua
lFun
d (0
25
) = $
712
5XY
ZM
utua
lFun
d (0
25
) = $
120
00
Sour
ce D
iMeo
Sch
neid
er amp
Ass
ocia
tes
LL
C
15 schneider 22505 937 AM Page 185
record keepers
Your nonprofit organization may also need to perform a search for a recordkeeper If you offer a 401(k) or 403(b) plan for staff members you need a firmwith record-keeping abilities Record keepers need to account for numerous in-dividual accounts within a larger planThey have to process purchase and salestransactions as well as contributions to the plan and distributions from the plan
You can access retirement plan record keepers in several different waysBundled providers offer record keeping compliance and regulatory reportingparticipant and plan level servicing and investment management ldquobundledrdquo intoone product Large mutual fund families insurance companies and banks oftendedicate significant resources to the retirement plan business
An alternative is the semibundled approach In a semibundled plan recordkeeping and some investment management is typically provided by one firmHowever they may also allow outside mutual funds In a semibundled approachthe compliance testing and regulatory reporting may also be outsourced by therecord keeper
A third alternative is to search for an unbundled record keeper In an unbun-dled environment you usually have the greatest investment flexibility since therecord keeper does not manage any competing offeringsAlso compliance testingand regulatory reporting are usually separate functions performed by other firmsFirms that specialize in providing unbundled record keeping solutions are some-times referred to as third-party administrators
The entire record-keeping vendor search process (from the very beginning toconversion to the new vendor) can often take six monthsBecause there are manyimportant steps along the way it is important to start the process by putting to-gether a time lineThis time line lists specific actions their due date and the re-sponsible party In creating this time line consider the work preparation and allof the intermediate steps involved Allow enough time to create the RFPdevelopthe recipient list await vendor responses summarize their answers schedule semi-finalist presentations conduct on-site finalist visits negotiate fees and prepare forplan conversion See Exhibit 154 for a sample time line
The RFP should include many of the same broad categories addressed in atrusteecustodian RFP The vendorrsquos background the people the capabilitiescommitment to technology and the fees are all important issues to be addressedHowever record keeping is more complex than trustcustody services There areseveral other important areas you need to include
Most likely the record keeper will provide services directly to plan participantsBe sure to inquire about the availability of toll-free customer service representa-tives and Internet functionality Are there participant research and advice tools
186 chapter 15 selecting other vendors
15 schneider 22505 937 AM Page 186
record keepers 187
exhibit 154 record-keeping request for proposal(rfp) time line sample work plan
Action Item Responsibility Date Completed
Solicit plan information and committee input Consultant Week 1
Provide plan information and committee input Nonprofit By week 3
Analyze and resolve committee input Consultant By week 4
Provide draft RFP Consultant By week 4
Provide potential candidate list Consultant By week 4
Meet to discuss and finalize Nonprofit and Week 6bull Committee objectivesgoals consultantbull RFPbull RFP recipient list
Forward final RFP to potential candidates Consultant Week 7
Receive completed RFPs from candidates Vendor candidates Week 10
Produce RFP summary of all services and costs Consultant By Week 13
Meet to review RFP summary and select Nonprofit and Week 13semifinalist candidates consultant
Arrange and facilitate semifinalist Nonprofit and Week 16presentations consultant
Select finalists Nonprofit and Week 16consultant
Arrange on-site due diligence and check Consultant Week 17references
Conduct on-site visits Nonprofit and Week 18consultant
Negotiate fees and contract issues Nonprofit and Week 19consultant
Provide final recommendation letterreport Consultant Week 20
Select new vendor (a meeting may be Nonprofit Week 22necessary)
Negotiate and finalize vendor agreement Nonprofit and Week 22consultant
Meet to select specific funds to fill menu slots Nonprofit and Week 23consultant
Recommend changesupdates to investment Consultant Week 24policy statement (IPS)
Approve and adopt IPS Nonprofit By conversion date
Conversion begins (initiate contributionsto new vendor) Nonprofit Week 36
Oversee conversion Consultant Week 36
Monitor plan rollout Consultant Ongoing
Commence investment performance Consultant Ongoingevaluation
Indicates meeting
15 schneider 22505 937 AM Page 187
Participant education services should also be addressed in the RFP Will thevendor do in-person education meetings If so how many per year How manydays of initial enrollment meetings are included in their proposal Can they provide targeted education campaigns for different segments of the participantpopulation
You also need to inquire about investments Managerfund selection andmenu design are two crucial areasDo they have proprietary investment productsIf so must you use a minimum number of their funds Are there a percentage ofassets that need to be invested in these proprietary products What other fundscan they accommodate How large is this universe Do they offer lifestyle fundsDo they offer a stable value fund How many funds are allowed in the lineupwithout an increase in record-keeping costs Ask them to recommend a specificfund in each of the following categories large-cap US equity (in value growthand blend styles) small-cap US equity (value and growth) international equityreal estate (ie real estate investment trusts) and intermediate bondsAsk them toprovide information on returns risk and expenses for each of the proposedfunds A sample RFP can be found in Appendix F
Once the RFP responses are received again summarize the individual re-sponses in a grid The table should have a column for each vendorwith the RFPquestions in the far left column and the individual vendor responses across eachrow This can be time consuming but it is time well spent Also create a spread-sheet comparison of the proposed fund lineups for each vendor Reflect annualreturns risk and expenses in individual columns on the spreadsheet This type ofanalysis allows the committee to easily make comparisons
narrow the field
Using this summary information the committee should narrow the field to threeor four semifinalist firms Invite the semifinalists to present to the committee It isbest to have the vendors in one after the other or at worst on two consecutivedays The presenting firms should be encouraged to bring along the people whowill service youPresentations should be limited to one hour and allow sufficienttime for questions If possible provide the vendors with topics that are most im-portant to the committee It can be helpful to distribute a rating sheet to thecommittee members before the presentationThis rating sheet covers the majorelements yoursquoll use to judge the vendors and allows committee members to scoreeach vendor on a scale of 1 to 5 This is an especially helpful tool after you havelistened to three or four different presentations over the course of a day SeeExhibit 155 for a sample rating sheet
188 chapter 15 selecting other vendors
15 schneider 22505 937 AM Page 188
narrow the field 189
exhibit 155 sample provider rating worksheet
1 Define the importance of each selection criteria (based on percentages)2 Rank each provider in each selection criteria area (highest 5 lowest 1)3 Calculate weighted score for each selection criteria (criteria score x criteria weighting)4 Total weighted scores at bottom of page
CriteriaSelection Criteria Weighting Vendor A Vendor B Vendor C Vendor D
Organization ____ _____ _____ _____ _____
bull Capability
Client service ____ _____ _____ _____ _____
bull Participant services
bull Plan sponsor services
Record keepingadministration ____ _____ _____ _____ _____
bull Technology
bull Efficiencies
Educationcommunication ____ _____ _____ _____ _____
bull Education meetings initialongoing
bull Qualityquantity of materials
People ____ _____ _____ _____ _____
bull Trainingexperience
bull Account coverage
Investments ____ _____ _____ _____ _____
bull Quality
bull Quantity
bull Ability to use outside funds
bull Lifestyleasset allocation funds
bull Other
Cost ____ _____ _____ _____ _____
bull Initial
bull Ongoing
Total weighted score 100 _____ _____ _____ _____
15 schneider 22505 937 AM Page 189
190 chapter 15 selecting other vendors
final steps
After the vendor presentations are complete try to narrow the field to two ven-dors for on-site visitsWe encourage the on-site visit but many nonprofit organ-izations simply select a winner on the basis of the presentation On-site visits canbe particularly helpful if the field has been narrowed to two vendors but the com-mittee has no clear preference On-site visits typically involve a half or full day oftours and meetings at the vendorrsquos record-keeping facility Committee membersget a look at the vendorrsquos infrastructure view the service team in action and canspend more time getting to know the people who will service the plan
Check references when yoursquove decided on the finalistsDepending on staff re-sources you may perform this reference check yourselves or delegate it to yourinvestment consultantBefore placing calls formulate a list of reference questionsMake sure you pose the same question to each reference Yoursquoll get more infor-mation if you ldquoloosen uprdquo the reference Start out with general information suchas the personrsquos position and details about the plan size and demographicsThenask about particular services that the vendor provides First ask the reference todescribe the vendorrsquos strengths Then ask ldquowhere is there room for improve-mentrdquo People generally donrsquot like to start out by saying anything bad aboutsomeone
Probe specific areas such as plan conversion blackout periods and payroll in-tegration How have problems been resolved Does the main contact respond ina timely and efficient manner Has there been turnover among the individualsworking on the account Have they increased fees If so what was the rationaleExhibit 156 provides some sample questions
As part of fee negotiations also discuss related issues such as the number ofnonproprietary funds allowed or the number of education meetings to be pro-vided If the vendor wonrsquot budge on the overall fee structure perhaps there areadditional services that they could include This is the time to address any ele-ment of the proposal that you donrsquot like
Ideally fee negotiations should take place before the winner is selectedThis isyour time of maximum leverage use it to your advantage
defined benefit plans
You may also need to search for a provider of trustcustody and administrationfor a defined benefit (DB) pension planAlthough DB plans are a dying breedsome older organizations including many hospitals still have them DB plans aresimilar to other trusteecustodian searches but they have the added wrinkle of
15 schneider 22505 937 AM Page 190
ongoing benefit payments to retirees Organizations with trust departments(banks trust companies and some mutual funds companies) are equipped to pro-vide this service
In the RFP you should include the number of estimated monthly benefit pay-ments Request details on processing or transaction-related feesWill the vendorhandle tax reporting such as providing a W-2 or 1099 to the beneficiaries Willthey provide federal and state tax withholding The investment structure of thepension may also have some bearing on fees Does the vendor have proprietaryinvestment products If so would inclusion of any of those products in the pen-sionrsquos asset allocation impact the overall fee structure
gift annuities
You may also need an administrator for gift annuities that have been donated tothe organization Donors often make gifts that ultimately pass to your nonprofitorganization but provide the grantor with an income stream in the interim Thegrantor enters into a contract that stipulates the amount to be paid back to thegrantor on an annual basis as an annuity These are irrevocable gifts that may payincome for life or a specific period of years The payments are generally fixedWhen both the grantor and surviving beneficiary pass the remaining funds be-come the sole property of the nonprofit organization There are tax advantagesfor the grantor as well as the comfort of a steady income stream
Your organization undoubtedly appreciates such gifts but they come with theresponsibility to oversee the investment strategy remit payments handle tax re-porting and issue statements to the donors Administration of these annuities canbe complexparticularly if you oversee a large number Itrsquos possible for the annualpayments to represent taxable income taxable capital gains or even nontaxableincome to the grantor A nonprofit organization has to either hire staff to ad-minister these annuities or find a record keeper or administrator to perform these duties for them Outsourcing is a growing trend because many schools hospitalsand religious organizations recognize the liability and complexity in servicingthese annuities
If the annuities are custodied at a large trust company or bank they may pro-vide software to help you manage the accounting and general administrationButif the process has become too cumbersome you may want to search for a vendorto take over the administration
The search process can begin with local financial institutions that have trustservicing capabilitiesBut generally only large banks with significant trust opera-tions offer these planned giving services If your bank says that they offer this
gift annuities 191
15 schneider 22505 937 AM Page 191
192 chapter 15 selecting other vendors
exhibit 156 sample reference questions
ProviderCompany NameContact NameDate
1 Are you the individual who works most frequently with this vendor within your company
2 What industry is your company in How do you classify your work force (blue collar profes-sional etc)
3 How many participants are in your plan
4 How many total employees are in your company Of those how many are eligible to partic-ipate
5 What is the total asset value of the plan
6 How long has ______ been your vendor
7 What are their strengths
8 Where are there areas for improvement
9 Have they been able to do everything that they initially said they could do
10 Are they doing everything that they said they would do
11 Did you feel the conversion process and steps were well communicated to you To partici-pants
12 Was the conversion completed on time
13 What was the biggest problem encountered in the conversion process How was it re-solved
14 How long was the blackout period Overall did you feel like a partner in the conversionprocess
15 Who was your former provider and what was your reason for leaving
16 Did you receive accurate statements on a timely basis the first quarter after conversionSubsequent statements
17 Comment on the usefulness of the statements Were they able to customize them
18 How are record keepingadministrative issues resolved
19 Do you use ______ for your payroll If so are they integrated with the vendor
20 How would you describe your employeesrsquo understanding of retirement planning concepts
21 Do communication materials address all segments of your population
22 What do participants think of the voice response system Internet
23 What do you as an administrator think of the Internet capabilities and voice response sys-tem
24 Do you feel phone representatives are knowledgeable and well-trained Have there beenany participant comments regarding phone representative service
25 Does this vendor conduct annual on-site education meetings
26 Were enrollment meetings conducted in a professional and lively manner (Did they sellthe plan to the participants)
27 How did your employees view these meetings
28 Did they customize the ongoing education meetings for you
29 How effective wereare the communications pieces Did you realize an increase in partici-pation A decrease
30 Do you feel you receive accurate and timely responses from your main contacts
15 schneider 22505 937 AM Page 192
service ask for a list of clients they currently serve Some smaller trust companiesmay claim that they can perform these duties when in reality they are geared toservice individual trusts and are not structured to administer a hundred or moreannuity trusts for one client
Modify the custodial RFP to focus on the key services needed to administerthese annuities How will the bank perform tax reporting How timely can theyprocess payments to donors How often will statements be sent to donors Whatdo the statements look like What type of investment flexibility is allowed in theseannuity accounts Is there a proprietary investment requirement
Fees for this service can be paid directly out of the annuity trusts By virtue ofthe workload relief outsourcing this service can actually reduce your institutionrsquos
gift annuities 193
31 Do you feel your account manager is knowledgeable Do you have confidence in the an-swers to your questions
32 Has there been any turnover among the individuals working on your account If so hasthis caused any problems
33 Have they increased fees What has been the frequency or motivation behind the in-creases
34 If you had it to do over what would you have done differently
35 Given the benefit of hindsight would you have
A Selected this provider
B Retained your previous provider
C Selected a different provider
36 Do you believe there is any reason to seek a new vendor today or at some point in the nearfuture
37 Did you feel that the relationship was and continues to be important to them
38 On a scale from 1 to 10 with 10 being the highest how would you rate this vendor on thefollowing
A Plan sponsor service
B Participant service
C Record keepingadministration
D Communications
E Investments
F Overall
39 On a scale from 1 to 10 with 10 being the highest how do you think participants would ratethis vendor on the following
A Internet services
B Phone services
C Statements
D Communications
E Investments
40 Would you or have you recommended this vendor to other companies
41 Notes
15 schneider 22505 937 AM Page 193
costs Fees are generally quoted as a percentage of assets Fees in the 05 to075 range are quite common
Large nonprofit organizations that hold hundreds or even thousands of theseannuity accounts may find that the larger financial institutions with great pro-cessing capabilities are the best fit for their needs However if your nonprofit or-ganization only has a few banks and trust companies below that top tier maywork
brokers
You may also consider using brokersdealers for some of these functionsWhenconsidering utilizing a brokerrsquos services itrsquos important to understand the natureof their business and how they are compensated Individual brokers are first andforemost sales peopleMost are paid based on transactionsThese transactions cangenerate a commission on a stock purchase or sale the markup or spread on abond that is purchased or sold or the front-end loads (sales charge) that are as-sessed on mutual fund transactions Brokers also receive compensation on a trail-ing basis as 12b-1 fees that are embedded in some fundsrsquo expenses If it seems asthough a broker (or anyone for that matter) offers a host of services at little or nocost chances are that there may be hidden fees or commissions
When considering a broker for custody services be conscious of the fact thatwhile the custody costs may be ldquofreerdquo you need to keep a close eye on tradingcosts You should make a distinction between institutional brokers and the tradi-tional retail firmsThe institutional firms are generally accessed through inde-pendent registered investment advisers or money managers They arecharacterized by salaried service peopleThe retail Wall Street firms tend to ac-tively pursue your businessThey are characterized by commissioned sales peo-ple (More and more firms now seek to compensate their sales people via a ldquowrapfeerdquo as a percentage of assets)
Brokersdealers are generally not well suited for trustcustody of a DB pen-sion plan Unless they own a trust company they cannot accomplish the impor-tant functions of benefit payment processing and tax reporting
194 chapter 15 selecting other vendors
15 schneider 22505 937 AM Page 194
chapter 16
Hiring an InvestmentManagement Consultant
Once nonprofit organizations cross a certain financial threshold they are welladvised to obtain assistance in the management of their assets The problem isthat there are far more pretenders than playersMost vendors offering ldquohelprdquohavea product to sell that may or may not provide a solution
Nonprofit organizations tend to be passionate about their programs and mis-sionsThis is goodTheir desire to manage their money prudently sometimestakes a back seatThis is not good However a nonprofit organizationrsquos ability tofulfill its mission is almost always constrained by financial resources Higher in-vestment returns translate directly into accomplishing more
identifying the need a tale of the typicalnonprofit organization
Investment for nonprofit organizations at least in the beginning is practically anafterthoughtThe portfolio is small and the organizationrsquos dependency on it isminimalBut over timeassets grow and the portfolio takes on greater importance
An investment committee is eventually formed and its members include keyindividuals on staff as well as successful businesspeople gracious enough to vol-unteer their timeThe committee considers suggestions and adopts policies oneverything from asset allocation to the hiring of managers to socially responsibleinvesting
A local bank is hired to ldquohandlerdquo the investmentsThe portfolio continues togrowA shrewd committee member contends that diversification is good and asecond local bank is hired Over the years the committee continues to diversify
195
16 schneider 22505 938 AM Page 195
Money is placed with a mutual fund that uses social screens a money managerthat a staff member met at a conference and a well-intentioned broker thebrother-in-law of a committee member
Is the nonprofit fund prudently diversified Hardly Although each decisionwas made with the best of intentions committee members did not truly possessthe information and expertise to make good decisions Unless you are knowl-edgeable in all of the following areas it may make sense to hire a consultant
bull Investments Working at a financial institution in an unrelated role does notqualify Do committee members possess direct knowledge and experiencein the capital markets Do they oversee similar investment pools for othernonprofit organizations
bull Fiduciary Stewardship Do committee members understand their legal (andmoral) duties and can they effectively document their compliance
bull Impartiality Do committee members apply a completely independent andobjective perspective in the decision-making process
bull Fees and Expenses Do committee members understand pricing structuresAre they capable of negotiating favorable terms with investment managersand other vendors
bull Time Can they commit the required time
the general contractormdashaka theinvestment consultant
You can imagine how difficult if would be to construct a home by haphazardlyhiring tradesmen without a clear understanding of the role each playsAlthougheach carpenterplumber and electrician may be a skilled worker and possess goodreferences they may not be right for the specific assignment Is there a rationaleas to when and how each subcontractor should be hired Are they capable of fol-lowing the blueprint Who coordinates all of this Every well-run constructionproject has a general contractor In the investment world an investment consult-ant is the general
A good investment consultant will help to
bull Crystallize the organizationrsquos goals and objectives
bull Develop a ldquoblueprintrdquo (investment policy spending policy and asset allocation)
bull Hire subcontractors (appropriate investment managers)
bull Closely monitor performance to ensure that the project is a success
196 chapter 16 hiring an investment management consultant
16 schneider 22505 938 AM Page 196
bull Negotiate fees
bull Coordinate time lines among the various parties
Simply put a good investment consultant should help the nonprofit organiza-tion to achieve its goals with less time cost and burdenMost importantly a goodconsultant will accomplish this in a completely impartial fashionThere is neithera product to sell nor an axe to grind Each and every recommendation should bethe result of independent analysis Developing the very best solution should be agood consultantrsquos only goal
There are several resources that list consulting firmsThe Investment Manage-ment Consultants Association (IMCA) can provide references and The NelsonsrsquoConsultantsrsquo Directory is quite comprehensive (see Resources in Appendix G)
Exhibit 161 is a questionnaire that can help one decide if it makes sense toseek outside expertise
Although properly overseeing the management of a nonprofit fund may notbe rocket science it is time consuming And the stakesmdashthe long-term existenceof the fundmdashare high
An experienced consultant has probably already dealt with every challenge theorganization facesAnd therersquos no substitute for objective advice Even if com-mittee members happen to be expert and have the time to devote to this taskthey still may not have all the resources needed Good consulting firms have allthe necessary hardware software and most importantly people
the general contractor 197
exhibit 161 do we need a consultant
Do I have the expertise to handle this project yes no
Do I understand all the fiduciary requirements yes no
Am I clear on all the players and their exact duties (eg custodian trustees asset manager etc) yes no
Can I establish successful spending and investment policies yes no
Do I understand portfolio theory and asset allocation yes no
Do I have the expertise to analyze investment managers or funds yes no
Do I adequately understand risk as well as return yes no
Do I understand the operationaladministrative procedures yes no
Do I have enough time to devote to this project yes no
Do I have staff to work on this yes no
Do I have the budget for this (data sources software etc) yes no
Do I even want to do this on my own yes no
Key Two or more no answersmdashfind a consultant
Source DiMeo Schneider amp Associates LLC
16 schneider 22505 938 AM Page 197
Identifying a Qualified Investment Consultant
Assuming that you have made the decision to seek outside help it rapidly be-comes apparent that every salesperson with a financial product to push now isidentified as ldquoconsultantrdquo or ldquoadviserrdquo How can a fund fiduciary identify the realthing
Itrsquos relatively easy A true consulting firm derives virtually all of its revenuefrom consulting it is not a part-time occupationA good consultant does not rec-ommend proprietary money management or financial productsThe firm shouldbe able to provide numerous references from current clients similar in structureThe IMCA Code of Professional Responsibility (Exhibit 162) provides a goodsense of the proper mind-set
Exhibit 163 is a sample request for proposal (RFP) that you can adapt As withall RFPs shorter is betterAsk only for information that will help the committeemake a decision Identify only needed services
198 chapter 16 hiring an investment management consultant
exhibit 162 investment management consultantsassociation code of professional responsibility
Each professional investment management consultant shall
bull Serve the financial interests of clients Each professional shall always place the financial in-terests of the client first All recommendations to clients and decisions on behalf of clientsshall be solely in the interest of providing the highest value and benefit to the client
bull Disclose fully to clients services provided and compensation received All financial relation-ships direct or indirect between consultants and investment managers plan officials ben-eficiaries sponsors or any other potential conflicts of interest shall be fully disclosed on atimely basis
bull Provide to clients all information related to the investment decision-making process as wellas other information they may need to make informed decisions based on realistic expecta-tions All client inquiries shall be answered promptly completely and truthfully
bull Maintain the confidentiality of all information entrusted by the client to the fullest extentpermitted by law
bull Comply fully with all statutory and regulatory requirements affecting the delivery of consult-ing services to clients
bull Endeavor to establish and maintain excellence personally and among colleagues in all as-pects of investment management consulting and all aspects of financial services to clients
bull Support and participate in the activities of the Investment Management ConsultantsAssociation to enhance the investment management consulting profession
bull Maintain the highest standard of personal conduct
Source Investment Management Consultants Association
16 schneider 22505 938 AM Page 198
the general contractor 199
exhibit 163 request for proposal
I Background Information
A Name and address of firm
B Name address telephone numbers and e-mail address of key contact
C Business focusclient base
1 Provide a brief history of your firm and parent organization and a current organizationchart
2 Discuss the ownership structure of your firm Are there unique attributes in the own-ership structure that act to encourage the retention of key personnel
3 What is the median and mean size of the portfolio of your foundationendowmentclients
4 List any senior level hires and departures over the past two years Indicate reasons fordeparture
5 What is the number of clients the consultant has that would be handling our accountWhat is the maximum number of clients you allow each consultant to service
6 List the personnel you would expect to assign to the foundation Please provide briefbiographical information on each individual including position in the company edu-cation years and type of experience in investment management
7 Is your firm affiliated with a brokerage firm or other financial service enterprises Doyou manage money for any clients
8 What percentage of your income comes from consulting activities
9 Identify other sources of income
10 How many clients have you added in the past two years
11 How many clients have you lost in the past two years
12 Indicate any future plans which your firm has regarding investment consulting in-vestment management or other business activities
II Investment Management Process
A Asset allocation methodology
1 How are projections of your capital markets derived
2 Is your asset allocation software developed in-house or externally Please provide asample
B Investment Policy Statements
1 Describe in detail the process you undertake to analyze and make recommendationsregarding our investment policy statement Please provide a sample statement
C Money manager structure and search (see attached list of current investment managers)
1 Does your firm maintain a database of money management organizations If so is thedatabase compiled internally or purchased from an outside source Does the data-base include minority- and female-owned firms
2 How many managers do you currently track
3 How do you gather your money manager information and how often is the data up-dated
4 Are managers required to pay a fee for inclusion in your database
5 Please describe your due diligencesearch process for manager selection
6 How often does your staff visit money managers both in house and on site What type
(continued)
16 schneider 22505 938 AM Page 199
Useful Hints
Send the RFP only to viable candidates For example if the committee wouldnot really consider the consulting department of a large broker-dealer donrsquotwaste the committeersquos time or the brokerrsquos One should narrow the list of candi-dates before sending out the questionnaire
Keep the RFP short and insist on complete but concise responses Describeminimum selection requirementsmdashldquodeal-killersrdquoThis will keep noncandidatesout of the process
Exhibit 164 may prove useful when you check referencesThese questions aredesigned to help solicit information that the reference might not volunteer
200 chapter 16 hiring an investment management consultant
exhibit 163 (continued)
of reports do you provide the client after meetings with the money manager Do youhave a proprietary quality rating system for managers in your database
7 What guidelines do you use with respect to a possible money manager termination
D Performance measurement
1 Describe your process of monitoring money managers for a client
2 List comparisons including databases used to analyze the performance of portfo-lios What peer groups would you propose and what are the characteristics of thosegroupings (foundations endowments pension funds etc) Do you have informationon endowment funds comparable to us
3 How soon after the quarter end are your reports available
4 Please provide a sample report that includes performance measurement and otherportfolio analysis
5 What is your position on the effectiveness of performance fees
III Conflicts of Interest
Please disclose any potential conflicts of interest or appearance of conflict which mightarise if selected to represent the foundation
IV References
Please provide a list of at least five references preferably including any INSERT YOUR TYPE OFPLAN clients Please indicate contact name address and phone number
V Fee Schedule
A Please outline your proposed fee structure for the foundation including fixed and variablefees and any performance-based fees Please indicate all services you propose to provideand their associated fees Assume participation at quarterly meetings of the Investmentand Finance Committee
B The stated fee schedule must include all charges associated with your service provisions
C If hired will firm receive any other form of compensation including soft dollars fromworking with this account that has not yet been revealed If so what is the form of com-pensation
D Do you provide modified or specialized fee schedules for foundations andor philan-thropic organizations
16 schneider 22505 938 AM Page 200
Once the committee has sent out the RFPs and evaluated the answers it istime to narrow the fieldThe goal should be to perform face-to-face due dili-gence on no more than four finalist candidates It is best to interview all candi-dates on the same day or at least during a two-day period If too much timeelapses between interviews distinctions among the finalists will blur
The Interview
Your committee already knows most of the quantitative information about thefinalists before the face-to-face meeting Presumably all are competentWhatthen is the purpose of the interview
First which of the candidates best fits the organizationrsquos objectives Personalcompatibility is important as wellThe committee will work closely with theconsultant on important projects with tight deadlines You shouldnrsquot be too quickto overlook personality quirks that may become hugely irritating with constantcontact
Try to understand the philosophy of the firm If the nonprofit organization andthe consultant share a common point of view many of the details will fall intoplace Philosophical differences can lead to friction
The interview is the time to confirm or deny initial perceptions developedearlier in the processFor example several years ago our firm a midsize Midwest-
the general contractor 201
exhibit 164 consultant reference questionnaire
1 How long have you worked with _____________ [the consulting firm]
2 What do they do best
3 Where is there room for improvement
4 Describe how they reduce your workload
5 What could have been streamlined
6 Rate their capabilities in each of these areas from highest (5) to lowest (1)
bull General expertise
bull Goal settingfund design
bull Spending policies
bull Asset allocation
bull Manager search
bull Performance evaluation
bull Pricing
bull Overall client service
Note This is designed for a phone interview Although the list of questions is short it is designed to un-cover areas of weakness Itrsquos important to keep the questions in this order
16 schneider 22505 938 AM Page 201
202 chapter 16 hiring an investment management consultant
based consultwas in competition for an assignment for a $60 million foundationClose to a dozen consulting firms were in the RFP process and the firm was se-lected as one of two finalists to be interviewed by the committee
Although we enjoy a strong reputation for client service and ldquooutside the boxrdquoproactive thinking the other finalist was a very large East Coast firmThey enjoya fine reputation and an absolutely star-studded list of endowment and founda-tion clients
As the process unfolded we interviewed with the committee our referenceswere checked and we were fortunate enough to be hiredAfter the fact it cameto light that before the interviews one of the committee members strongly feltthat meeting with us would be a waste of timeWhy wouldnrsquot the committeesimply make the ldquoIBM decisionrdquoand hire the big firm with the sterling client list
It turns out that during the interview the committee members truly appreci-ated the time we had spent preparing for the meeting and some of the potentialsolutions presented It was also only in the meeting that the committee learnedtheyrsquod work with principals of the firm compared with relatively junior profes-sionals from the big firm
So what is the message Not that the big firm was bad or even that they couldnot have done a nice jobThe lesson is that fit is important and that certain thingscan only be learned in these important face-to-face meetings
Proof
In the interview the committee should ask for demonstrations or specific exam-ples For each area of service donrsquot let the candidates claim to be goodmdashmakethem prove itEach candidate should review the fund specifics prior to the meet-ing and make observations and suggestionsThe investment committee will beable to easily judge the candidatesrsquo level of preparation and expertise
Verification
What have the finalists done for other clients How have the strategies theyrsquoverecommended performed Get the numbers
Exhibit 165 provides some sample interview questions Make certain to askeach finalist the same questions Keep the list of questions relatively shortYou wonrsquot get through a long list anyway Finally open-ended questions (ldquoessayquestionsrdquo) will help the committee understand how the consultant candi-dates think
16 schneider 22505 938 AM Page 202
The On-Site Visit
Often nonprofit investment committees want to skip this stepThey are well ad-vised not to It is very telling to visit the finalists in their shopAnyone can talkabout their capabilities but it is quite another thing to demonstrate the hardwareand software Reading a biography is a poor substitute for actually meeting thepersonnel who will provide the work
The Agreement
Once the committee has made its decision itrsquos necessary to get the agreement inwritingWhat services will be provided Is there a satisfaction guarantee Whatare the remedies if the consultant fails to meet expectations What is the term ofthe contract How do they bill
The client should have the right to end the contract with 30 days written notice and to be obligated only for services rendered up to that pointThe non-profit organizationrsquos attorney should review the contractWe are not in the busi-ness of rendering legal advice and so have intentionally excluded a sample contract or worksheet Suffice it to say legal review is not the area in which to cut costs
the general contractor 203
exhibit 165 consultant interview questions
1 Why do you want to do business with us
2 Describe your ideal client
3 What sets you apart
4 What is your greatest shortcoming
5 How would you foresee helping us
6 When you donrsquot win a competition why do you lose
7 How many clients have you lost in the past year
8 Why did they leave
9 If I were to hire two consulting firms what would I hire you for
10 What would I hire the other firm to do
11 What steps have you taken to eliminate conflict of interest with regard to fund or managerselection
Note Most factual information should come from the response to the RFP Of course any questions that areraised by a response should be addressedSource DiMeo Schneider amp Associates LLC
16 schneider 22505 938 AM Page 203
Fees
Fees are typically quoted in one of three ways
1 Project Basis There is a fee for each specific service egX dollars for an in-vestment policy Y dollars for a manager search and so on
2 Fixed Retainer There is an annual fee to include all services If the organi-zationrsquos needs are fairly broad the retainer may be more cost effective thanare project-based fees Retainer fees quoted as a set dollar amount are gen-erally more restrictive in terms of the services covered than the asset-basedretainer
3 Asset-Based Retainer The annual fee is quoted as a percentage of assets Thisis generally the broadest contract in terms of services (ldquoall services whenneededrdquo) The asset-based retainer has the advantage that your committeewill make full use of the consultant without worrying about ldquostarting themeterrdquo This arrangement is most advantageous if the organization may havestable or even declining asset balances or if the committee is concernedabout the market outlook
effective use of a consultant
How does the organization get its moneyrsquos worth after it has hired a consultingfirm First think of them as an extension of staff and help them understand whatis expectedAlso someone on the committee should help them understand theorganization including the personalities of the players
Next give them as much of the work as possibleTheyrsquoll make it obvious ifthey donrsquot consider a certain task to be a part of their assignment If the commit-tee is unsure of which way to go at key turning points let the consultant researchthe alternatives Instruct them to succinctly present the pros and cons Let themcreate the detailed backup
Ask them to explain their process How do they come to their conclusionsFor instance in conducting an investment manager search get the details Howare candidates to be screened The committee may want to add or subtract cer-tain criteria
Use their experienceThey probably know what works and what doesnrsquotTrustthem For example if the committee wants 11 different fund choices but theconsultant says that 5 or 6 will be sufficient and a more manageable number lis-ten Obviously the client controls the decision but it pays to be open minded
If committee members donrsquot understand something they should make the
204 chapter 16 hiring an investment management consultant
16 schneider 22505 938 AM Page 204
consultant explain Part of their job is to educate the committee so you can bebetter trustees
summary
A good investment consultant should add value many times its fee by
bull Improving investment performance
bull Helping committee members satisfy their fiduciary responsibilities
bull Reducing expenses
bull Providing continuity for a committee with regular changes in its member-ship
bull Increasing contributions to the nonprofit organization by helping to com-municate well-founded investment and spending policies
summary 205
16 schneider 22505 938 AM Page 205
16 schneider 22505 938 AM Page 206
chapter 17
Behavioral Finance
Every Wall Street trader knows that ldquofear and greed move marketsrdquo This starkreality that human emotions are a major driver of the global financial marketsflies in the face of the ldquorational investorrdquo assumptions rooted deep in ModernPortfolio Theory and the Efficient Market HypothesisOver the years academic re-searchers have built mathematical models to describe financial marketsWilliamSharpe developed the Capital Asset Pricing Model to explain security and portfo-lio price movementsOther models such as Arbitrage Pricing Theory attempt to fur-ther refine the theories For years the Efficient Market Hypothesis has ruledacademia Its basic tenet is that all known information is already reflected in se-curity pricesThe implication is that it is impossible for an investor to ldquobeat themarketrdquo over timeThe entire index fund industry is built on that premise
But there have always been nagging questionsThere is some evidence thatvalue stocks tend to outperform over long periodsWhy Is there a measurableldquoJanuary effectrdquo What causes it What leads to market bubbles and crashes
Academics have claimed that long-term successful investors like WarrenBuffet Peter Lynch Bill Miller and Bill Gross are merely the lucky survivorsBut others have had their doubts Some basketball players are better than othersYou can identify superior ballerinas singers actors business people even politi-ciansWhy should investing be the only human activity where itrsquos impossible tobe skillful
Over the past 10 or 15 years a new line of research has developed a theory thatis 180 degrees opposite to the Efficient Market Hypothesis Behavioral financetakes a psychological view of market behavior Professors Richard Thaler at theUniversity of ChicagoTerence OrsquoDean at the University of California-BerkleyHersh Shefrin at Santa Clara University and others have developed a body ofwork that has gradually come to ascendancyTheir basic premise is that humans
207
17 schneider 22505 938 AM Page 207
are not rational when it comes to investing Furthermore investors are not onlyirrational but they are irrational in predictable ways
In this chapter we will identify some of these human tendenciesOver millen-nia people have evolved mental short-cuts called heuristics to deal with the com-plexities of existenceThese heuristics while generally helpful sometimes resultin conceptual flaws Think of these flaws as ldquobugsrdquo in a computer programHopefully this overview will help your committee avoid some of the all toohuman tendencies to shoot ourselves in the foot
trying to break even
As an addicted gambler can attest people often prefer large uncertain losses tosmaller certain onesThis is clearly not logical either for a gambler or an investorYet investors often behave like desperate gamblers trying to quickly break evenafter sour bets by increasing portfolio risk A rational investor would be guidedby portfolio objectives and constraints that do not change based on short-termportfolio fluctuations
snake bitten
An investor may become ldquosnake bittenrdquo after suffering portfolio lossesThe op-posite of trying to break even a snake-bitten investor may suddenly reduce oreliminate portfolio risk in order to avoid making the same mistake twice Beforethe recent bear market many investors overestimated their risk tolerance Onlyafter they experienced the loss did they adopt a more conservative posturethereby guaranteeing that they wouldnrsquot participate in the reboundThey expe-rienced the entire downside consequence of risk-taking activities while missingthe longer-term upside potential
biased expectations and overconfidence
Many investors have too much confidence in their ability to forecast the futureBelieving their expectations are more likely to be realized than those of othersoverconfident investors tend to discount any information that doesnrsquot supporttheir opinionsAn investment committee member once statedldquoSince the dollaris going to rise relative to the euro and yen next yearwe should sell all of our in-ternational investmentsrdquoNotwithstanding the facts that exchange rate forecasting
208 chapter 17 behavioral finance
17 schneider 22505 938 AM Page 208
is notoriously difficult and there has often been low or negative correlation be-tween domestic currency returns and foreign asset performance the committeemember was absolutely certain about his expectations and discounted any infor-mation to the contrary By the way he was forecasting 2004 a year in which thedollar declined precipitously Overconfident investors often ldquoput too many eggsin the wrong basketrdquo
herd mentality
Investors sometimes blindly follow the majority position or the ldquoloudestrdquo high-conviction ideaThey fall prey to the herd mentality Psychological studies showthat people often have a difficult time dissenting within a group In a committee-driven investment process groupthink can be damaging Such portfolios tend tohave poor risk controls and to be poorly diversified
asset segregation or mental accounting
Instead of evaluating an investmentrsquos return and risk impact on the overall port-folio investors often fixate on individual asset return and risk characteristicsThiscan lead to a breakdown in effective portfolio construction principals For exam-ple if you fixate on the risks of high-yield bonds you might ignore their diversi-fication benefits for the portfolio as a whole
Investors apply the mental accounting heuristic to returns as wellAn invest-ment committee member once statedldquoSince the target return of our portfolio is9 per year we should eliminate all asset classes that wonrsquot get at least 9 in-cluding all of our investment-grade bondsrdquo This is an example of naiumlve mentalaccountingThis committee member has fixated on individual assets when theobjective return of 9 is for the whole portfolio As we saw in Chapter 7 byblending noncorrelating assets you produce portfolios with higher expected re-turns at each risk level
Another example of mental accounting is ldquoplaying with the housersquos moneyrdquoGamblers are willing to take greater risk with their winnings than their prin-cipalThey donrsquot view a dollar of winnings as equal to a dollar of principalLike the gambler investors are often more willing to lose what they view as the ldquogainrdquo rather than what they view as ldquoprincipalrdquoAsset segregation like thisresults in suboptimal total portfolio risk-adjusted returnsTherersquos a reason casi-nos thrive
asset segregation or mental accounting 209
17 schneider 22505 938 AM Page 209
cognitive dissonance
Cognitive Dissonance Theory was developed in 1957 by former StanfordUniversity Psychology Professor Leon Festinger Festinger proved that the brainrecords historic feelings more vividly than facts Cognitive dissonance is createdwhen peoplersquos actions differ from their beliefs People are driven to be consistentand therefore to avoid cognitive dissonanceThey either alter the behavior ormore commonly they alter their beliefsFestingerrsquos thesis is that people often con-veniently avoid or ignore information that might cause cognitive dissonanceBecause investors want to believe they are successful they tend to recall invest-ment successes more vividly than investment failures Cognitive dissonance ex-plains many irrational tendencies For example at least half of the worldrsquosinvestors have below average ability yet most believe they are in the top half
anchors
An anchor is a reference point that shapes thought Professor Thaler demonstratesanchoring during group lecturesHe asks audience members to write down theirbirthday as a number If someone was born on December 20 they would writedown 1220 He then asks the audience to estimate Charlemagnersquos year of birthSince most people donrsquot study history they are relegated to guessing An inter-esting phenomenon occurs people tend to make their estimates as a function oftheir own birthday In other words an audience member who was born on May19 would be likely to guess Charlemagne lived in the sixth century Someonewho was born in November might guess the 12th century (He was actually bornin 742mdashthe 8th century)
Quantitative and moral anchors often end up overwhelming the investment de-cision-making process Quantitative anchors measure an investment relative tosome arbitrary reference price For example an investor buys a stock at $100 andwatches it decline precipitously to $50 In the investorrsquos mind the stock remainsa $100 stockThe investor is anchored to $100 and is unwilling to sell at $50 re-gardless of the fundamental outlook for the stock
Moral anchors center around qualitative factors such as narratives storiesshared with others and rationalizations In 1999ldquopie in the skyrdquo stories about theInternet kept hyperventilating investors buying even though some of their pur-chases were trading at multiples of 100 or 200 times earnings (In fact companieswith no earnings whatsoever did best) The moral anchor overwhelmed funda-mental considerations and even common sense
210 chapter 17 behavioral finance
17 schneider 22505 938 AM Page 210
fear of regret and seeking pride
Fear of regret refers to the pain felt after making a bad investment decision It causesinvestors to hold on to losers too longldquoIf I havenrsquot sold I havenrsquot taken a lossrdquoConversely investors seek prideThey want the joy of making a wise investmentdecision Seeking pride can lead investors to sell too quickly so they can bragabout the associated profit
representativeness
Investors often rely on certain characteristics to be representative of future in-vestment success For example the ldquovalue expressiverdquo investor might view aldquogoodrdquo company as a ldquogoodrdquo investment However good companies are oftenbad investments if the marketrsquos optimistic expectations are already factored intothe current stock price You are better off buying an underpriced ldquobadrdquocompanythan an overvalued ldquogoodrdquo one But to the value expressive investor the goodcompany is always preferred over the bad companyno matter what the valuation
familiarity
Investors often choose investments they are most familiar withThey feel morecomfortable with things they recognizeThis can lead to poorly diversified port-folios that are overly concentrated in domestic blue chip stocks and domestic investment-grade bonds It also often leads to little or no allocations to small-capstocks foreign stocks high-yield bonds real estate foreign bonds inflation in-dexed bonds emerging market stocks or bonds or alternative asset classes or in-vestment strategies
investor personality types
You can categorize individuals within broad investor personality typesThis canbe helpful in understanding the way they make investment decisions Lookaround at your committeeThere are at least four broad investor personality types
bull The Suspicious Investor Suspicious investors are very cautious and exhibit astrong desire for financial securityThey are the most risk averse They focuson very safe investment vehicles with little potential for loss Individuals inthis category tend to overanalyze investment opportunities but once they
investor personality types 211
17 schneider 22505 938 AM Page 211
make investment decisions their portfolios exhibit relatively low turnoverand low volatility
bull The Process-Oriented Investor Process-oriented investors are methodical andmaintain a keen eye on riskThey perform their own research and rarelymake emotional investment decisionsTheir investment decisions tend to beconservative or risk averse Working with these investors on investmentcommittees can be difficult due to the confidence they place on their owninvestment processes
bull The Structured Investor Structured investors are the most individualisticTheydo their own homework and are confident in their abilitiesThey are capa-ble of questioning inconsistencies in analyst or consultant recommendationsor conclusions They are unlikely to get caught up in a herd mentalityStructured investors are less risk averse than process-oriented investors
bull The Unstructured Investor Unstructured investors are spontaneous Theyoften chase the latest hot investments They are also often risk seeking ratherthan risk averseTheir portfolios typically exhibit high turnover and supe-rior investment decisions are often negated by high transaction costs Riskconsiderations are often secondary to their investment decision-makingprocess Investment decisions are often attributed to ldquogut instinctrdquo
risk-seeking behavior
A fundamental tenet of Modern Portfolio Theory is that all investors are rationalpreferring less risk In reality investors are often risk seeking as they search forshort-term ldquolottery-typerdquo payoffs rather than long-term superior risk-adjustedreturns Risk seekers get caught up in the hype of the latest hot investmentThegambling culture in the United States or a powerful adrenaline rush might ex-plain why investors frequently seek risk rather than work to minimize itldquoGetrich quickrdquo stories told by successful risk seekers (egdot-com millionaires in thelate 1990s) can cause others to seek out similar low-probability investment op-portunities Unsuccessful risk seekers are either less vocal or they block out theirfailed investment decisions
naturally occurring ponzi schemes and market bubbles
According to the Merriam-Webster Online Dictionary a Ponzi scheme is ldquoan in-vestment swindle in which some early investors are paid off with money put up
212 chapter 17 behavioral finance
17 schneider 22505 938 AM Page 212
by later ones in order to encourage more and bigger risksrdquo Charles Ponzi con-cocted a scheme in 1909 to sell notes promising a 40 profit in 90 days Insteadof actually investing the money Ponzi used new investor dollars to pay out priorinvestorsAs the number of new investors grew it eventually became impossibleto continue the schemeThe highly publicized collapse led to the term Ponzischeme
Speculative bubbles are naturally occurring Ponzi schemesLater investors hearsuccess stories from early-stage investors and eagerly jump into the marketAsshare prices keep going up the irrational exuberance of the rising prices them-selves causes a positive feedback loop When the world runs out of ldquonew in-vestorsrdquo the market collapsesOnce the collapse begins a negative feedback loopis created and prices fall faster and faster In 1928 apparently Joseph Kennedy (de-tails of the story vary) got a stock tip from his shoeshine boy and decided to sellall his holdings If the shoeshine boy was in stocks he figured there must be no-body left to keep the Ponzi process going
Bubbles in specific market sectors (eg technology stocks in the late 1990s) orwithin a whole stock market (eg 1929) can take years to formValue-consciousinvestment professionals who remain on the sidelines during the early stages ofthe positive feedback loop are often ostracized by clients and peers for missing theboatThey are often compelled to join the party in later stages to save their in-vestment jobs Unlike in the 1920s a large percentage of investment profession-als donrsquot own the assets they manage
conclusion
It is important to balance the logic-driven tenets of Modern Portfolio Theoryagainst the irrational human tendencies that are revealed in Behavioral FinanceTheoryAfter all the human beings that drive global financial markets are not ro-bots designed to be logical Harry Markowitz the father of Modern PortfolioTheory himself described his own investment strategyldquoI should have computedthe historical covariances of the asset classes and drawn an efficient frontierInstead I visualized my grief if the stock market went way up and I wasnrsquot in itmdashor if it went way down and I was completely in it My intention was to min-imize my future regret So I split my contributions fifty-fifty between bonds andequitiesrdquo If the father of Modern Portfolio Theory can fall prey to behavioral fi-nance tendencies like fear of regret your investment committee should be care-ful as well
conclusion 213
17 schneider 22505 938 AM Page 213
17 schneider 22505 938 AM Page 214
chapter 18
Legal Aspects of InvestingCharitable Endowment Restrictedand Other Donor Funds
overview
Although it is difficult to generalize about the legal issues involving every aspectof investing charitable endowment restricted and other donor funds fiduci-aries involved in such activities should be aware of several legal parameters andguidelines
Factors that may influence legal consequences include whether the investing isbeing done by a corporation or trust whether the donor of gifted funds has ef-fectively restricted the nature of the investmentswhether the gift is for ldquoendow-mentrdquo restricted or unrestricted purposes the applicability of a wide variety ofcommon and statutory laws including the application of the ldquoprudent manrdquorulethe Uniform Prudent Investor Act the Uniform Principal and Income Act andthe Uniform Management of Institutional Funds Act and the ldquoPrivateFoundationrdquo restrictions imposed by Chapter 42 of the United States InternalRevenue Code of 1986 and equivalent state statutes
This chapter does not discuss the Employee Retirement Income Security Act(ERISA) or other rules applicable to investments by fiduciaries of pension orother employee benefit plans or the applicability of rules of jurisdictions outsidethe United States (see Chapter 19)
This chapter also does not discuss extensively the issue of legal ldquostandingrdquo thatis who has the right to enforce the rules applicable to investing by fiduciaries ofcharitable and similar endowment or restricted funds However it should be
215
18 schneider 22505 939 AM Page 215
noted that (depending on the laws of a particular state) attempts to enforce therules may be brought by a statersquos attorney general or other public official by theinstitution as beneficiary or in the case where the institution is itself doing theinvesting by members of the Board of Trustees clients (such as students or pa-tients) of the institution or other legally interested parties or in what may be agrowing trend in the law by donors or their heirs
the nature of endowment or restricted funds
When a donor writes a check to an institution for unrestricted purposes (such asthe annual operating campaign) the institution typically segregates and normallyspends those funds for ordinary operating purposes If a donor writes a check forrestricted capital purposes the institution typically segregates and normallyspends those funds over time for the intended capital purposes In both cases theinstitution typically invests the funds in such a manner that market risk is mini-mized and the funds remain available for the intended purposes
However when a donor makes a contribution for ldquoendowmentrdquo or custom-designed ldquorestrictedrdquo purposes particularly if the restriction includes restrictionon investment a variety of legal issues may arise The word ldquoendowmentrdquo is oftenused fairly loosely but in fact the legal nature of an ldquoendowmentrdquo reflects a vari-ety of different circumstances
endowments created by the board
Perhaps the most common type of endowment is one created by resolution of thegoverning board of the organization (which may be called a Board of Directorsor some other designation) Sometimes the resolutions are quite broad and oftenthey are quite old (in fact the original resolution and its several amendments mayoften be difficult to locate) Several endowments might be created over a periodof years
The original resolution is an important document but so are the many vari-eties of fund-raising letters and materials submitted to potential donors over theyearsAll of these form the basis for defining how the endowment has been pre-sented to the donors and what self-imposed restrictions on investment exist
For instance an endowment may simply have been created that said ldquoincomerdquoshall be used for the benefit of the institution (or in some cases departments orprograms) and ldquoprincipalrdquo shall not be used
The endowment may have been created as a separate ldquotrustrdquo (complete with a
216 chapter 18 legal aspects of investing charitable endowment
18 schneider 22505 939 AM Page 216
mechanism for naming trustees or stating or implying that the Board of Trusteesas it is constituted from time to time acts as trustees) or it may simply be a com-ponent part of the institutionrsquos asset base
donor-created endowment funds
Sometimes donors create their own ldquoendowmentrdquo funds for particular purposessuch as a named scholarship or support of a department or program Thesedonor-created endowment funds typically have a separate gift instrumentwhichmay be very specific as to distributions of income and principal investment re-strictions and so forthHowever they may at timesbe simple one-paragraph let-ters or provisions in wills or other estate planning documents (for example ldquoIbequeath $XXX to Boola Boola University for endowment in support of thefine arts departmentrdquo)
The endowment may be created as or purport to be a separate trust either ingeneral language (for example ldquoI bequeath $XXX in trust to Boola BoolaUniversity for endowment purposesrdquo) or in specific language naming trustees(for exampleldquoI bequeath $XXX to my friends Bill and George as trustees of atrust to be used in support of Boola Boola Universityrdquo)
donor-created restricted gifts or funds
A donor may make a gift to a charitable institution with program restrictions (ldquotofund a chair of capitalism and economic freedomrdquo) that may not constitute a trustand that may or may not be regarded as an ldquoendowmentrdquoFor instance gifts withtime restrictions (ldquoto be used to build a new gymnasium within 10 yearsrdquo) arerarely treated as ldquoendowmentrdquo but rather as ldquorestrictedrdquo gifts all of whose fundsand earnings thereon can be expended at the free discretion of the institution forthe stated purposes
And of course often it is difficult to tell what the legal nature of the gift is at all
general statement about investingendowment and other funds
Although the legal rules applicable to investment of endowment or similar fundsmay be influenced by whether the fund is or is not a separate ldquotrustrdquo the stan-dards to which fiduciaries and managers should pay attention will not differ ma-
general statement about investing endowment and other funds 217
18 schneider 22505 939 AM Page 217
terially between the two and neither will the possible confusion about whichstandards or rules apply What those standards are may also vary from state tostate and are subject to ongoing change as states modernize their applicablestatutes and rules
the prudent man rule
For instance the classic Massachusetts Supreme Court case of Harvard v Amoryestablished in 1830 the standard that trustees ldquoshould observe how men of pru-dencediscretion and intelligence manage their own affairs not in regard to spec-ulationbut in regard to the permanent disposition of their funds considering theprobable income as well as the probable safety of capital to be investedrdquo
This was in its time a radical extension of the trusteersquos duties particularly con-sidering that trusts (once called ldquousesrdquo) were created in England to avoid the rulethat the eldest son would inherit the family property and that for several cen-turies the primary role of the trustee (usually a friend burdened by the respon-sibility since corporate trustees were not permitted until the late 18th and early19th centuries) was to maintain the family farm and deliver it after a period ofyears to one or more named beneficiariesThis system for escaping the reins offeudalism has developed into a vehicle for the investment of vast sums of per-sonal wealth
This so-called ldquoprudent manrdquorule became part of American common law andwas enacted as legislation in varying forms in the several states Some state lawswent further and prohibited (in the absence of language in the applicable instru-ment) investments in common stocks in excess of certain percentages of value
The prudent man rule is still the law in many states although it is being sup-planted over time and in several states by the ldquoprudent investorrdquo rule
the prudent investor act
Many states have adopted some version of what is called the Uniform ModelPrudent Investor Act developed by a group called the National Conference ofCommissioners on Uniform State Laws in 1994 Of course as various statesadopt slight variations to this ldquouniformrdquo act the uniformity disappearsThus thegeneral statements in this chapter need to be evaluated by reference to thespecifics of each statersquos laws in those states that have adopted some form of theUniform Prudent Investor Act
As in the case of the prudent man rule discussed in the preceding section the
218 chapter 18 legal aspects of investing charitable endowment
18 schneider 22505 939 AM Page 218
application is technically to fiduciaries of ldquotrustsrdquo and the application of the pru-dent man rule to investment of board-created and other nontrust endowments isby analogyThe reader should also refer to the discussion later in this chapter ofthe Uniform Management of Institutional Funds Act which has clear and directapplication to endowment funds that are not in the form of trusts with outsidetrustees
The prudent investor rule is one that will give investment managers comfort inthe sense that it speaks in terms that are familiar to them Although it may be var-ied by the terms of particular instruments the Uniform Prudent Investor Actgenerally makes what the Commissioners describe as five fundamental alterationsin the former criteria for prudent investing (all also found in an important docu-ment called the Restatement of Trusts of Prudent Investor Rule)
1 The standard of prudence is applied to any investment as part of the totalportfolio rather than to individual investments In the trust setting the termportfolio embraces all the trustrsquos assets
2 The trade-off in all investing between risk and return is identified as thefiduciaryrsquos central consideration
3 All categorical restrictions on types of investments have been abrogated thetrustee can invest in anything that plays an appropriate role in achieving theriskreturn objectives of the trust and that meets the other requirements ofprudent investing
4 The long familiar requirement that fiduciaries diversify their investmentshas been integrated into the definition of prudent investing
5 The much criticized former rule of trust law forbidding the trustee to del-egate investment and management functions has been reversed Delegationis now permitted subject to safeguards In fact in some circumstances and invarying circumstances in the various states that have adopted the Acttrustees may be able to absolve themselves of personal liability for investingif the responsibility is delegated to and accepted by an investment managerHowever notwithstanding delegation authority trustees have responsibilityfor monitoring investment in light of trust goals and guidelines establishedby the trustees
The comments to the Uniform Prudent Investor Act state that the Act is cen-trally concerned with the investment responsibilities arising under the privatetrust but that the prudent investor rule also bears on charitable and pensiontrusts Furthermore although the Uniform Prudent Investor Act by its terms ap-plies to trusts and not to charitable corporations the comments state that the
the prudent investor act 219
18 schneider 22505 939 AM Page 219
standards of the Act can be expected to inform the investment responsibilities ofdirectors and officers of charitable corporations
uniform management of institutionalfunds act
The Uniform Management of Institutional Funds Act (UMIFA) was approvedand recommended for enactment by the National Conference of Commissionerson Uniform State Laws in 1972 UMIFA is currently being reconsidered by theCommissioners and a national debate is being aired in the nonprofit communityabout the potentially extensive changesThus the discussion in this chapter re-flects the generally current state of UMIFA and any consideration of UMIFA inthe future must take into account those potential changes
Application
UMIFA applies to an ldquoendowment fundrdquo held by an institution (whether or notincorporated) organized and operated exclusively for educational religious char-itable or other eleemosynary purposes It does not apply to a ldquotrustrdquo held by atrustee such as a bank or trust company for such an institution (refer to earliersection on the prudent man and prudent investor rules applicable to such atrustee) or to a fund (such as a charitable remainder trust) in which any benefici-ary that is not such an institution has an interest (see later discussion about possi-ble application of private foundation rules to such a trust)
An ldquoendowment fundrdquo means such an institutional fund or any part thereofthat is not wholly expendable by the institution on a current basis under theterms of the applicable gift instrument
The ldquogift instrumentrdquo by which the terms of an endowment fund can be dis-cerned means a will deedgrant conveyance agreementmemorandumwritingor other governing document (including the terms of any institutional solicita-tions from which an institutional fund resulted) under which property is trans-ferred to or held by an institution as an institutional fund
That means that a board-created endowment fund can become an endowmentfund subject to UMIFA if a donor makes a gift to the board-created endowmentfund and the terms of the endowment fund are then discerned not only by ref-erence to the original board resolution but also by reference to agreementsmemoranda or fund-raising materials used to solicit gifts to the endowmentfund It should be no surprise that these are not always consistent
220 chapter 18 legal aspects of investing charitable endowment
18 schneider 22505 939 AM Page 220
Investment Authority Delegation and Standards
In terms of investment authority UMIFA states that (in addition to any invest-ment otherwise authorized by law or by the applicable gift instrument and with-out restriction to investments a fiduciary may make) the governing board of theinstitution (subject to any specific limitations set forth in the applicable gift in-strument or in the applicable law other than law relating to investments by fidu-ciaries) may
bull Invest and reinvest an institutional fund in any real or personal propertydeemed advisable by the governing boardwhether or not it produces a cur-rent return including mortgages stocks bonds debentures and other secu-rities of profit or nonprofit corporations shares in or obligations ofassociations partnerships or individuals and obligations of any governmentor subdivision or instrumentality thereof
bull Retain property contributed by a donor to an institutional fund for as longas the governing board deems advisable
bull Include all or any part of an institutional fund in any pooled or commonfund maintained by the institution
bull Invest all or any part of an institutional fund in any other pooled or com-mon fund available for investment including shares or interests in regulatedinvestment companiesmutual funds common trust funds investment part-nerships real estate investment trusts or similar organizations in whichfunds are commingled and investment determinations are made by personsother than the governing board
UMIFA also makes it clear that (subject to the gift instrument) the governingboard may delegate investment authority to committees and investment counseland may contract with and pay investment counsel
UMIFA provides that in the administration of the powers to appropriate ap-preciation (see next section) to make and retain investments and to delegate in-vestment management of institutional fundsmembers of a governing board shallexercise ordinary business care and prudence under the facts and circumstancesprevailing at the time of the action or decision In so doing they shall considerlong- and short-term needs of the institution in carrying out purposes its presentand anticipated financial requirements expected total return on its investmentsprice level trends and general economic conditions
Current debates on modification of UMIFA include updating the foregoinginvestment standard of conduct in light of more current investment trends the
uniform management of institutional funds act 221
18 schneider 22505 939 AM Page 221
above statement being an advance beyond the prudent man rule but short of theprudent investor rule
Appropriation of Appreciation
One of the most important aspects of UMIFA is its sanction of the use of appre-ciation by the governing board of an institution notwithstanding a limitation inthe gift instrument that ldquoprincipalrdquo may not be invaded
UMIFA accomplishes this by permitting the appropriation of the value of anendowment fund over its ldquohistoric dollar valuerdquowhich generally means the valueat the time of each gift to the fund Funds wholly expendable by the institutionare not affected by this limitationAn institutionrsquos good faith determination ofhistoric dollar value is respected
This converts the concept of ldquoprincipalrdquo used in private trusts In privatetrustsldquoprincipalrdquoordinarily includes not just the value of the original funding butalso realized and unrealized investment growth in that value However even thatconcept is being eroded in the case of private trusts through the enactment of amore modern version of the Uniform Principal and Income Act that would per-mit more flexible definitions of ldquoincomerdquo than has been the case in the past
Recent stock market losses experienced by many institutions have caused thisprovision to be problematic (intended to free up principal for use by institutions)because the investment value may have fallen below historic dollar value in caseswhere appreciation has been aggressively appropriated in the past) Much of thecurrent debate over modification of UMIFA by the National Conference ofCommissioners on Uniform State Laws revolves around modification of this pro-vision to permit further appropriation of endowment assets
The standard of conduct for determination of the circumstances under whichappreciation should be appropriated by the governing board is the same standardapplicable to investments discussed in the preceding section
In light of potential changes in UMIFA and in light of the fact that UMIFAhas been enacted in a variety of different forms by the various states referenceshould always be made to the specific statutory language of UMIFA in each statethat has adopted it
private foundation rules
For federal tax purposes all charitable and other organizations classified as tax ex-empt under Section 501(c)(3) of the US Internal Revenue Code are classifiedeither as ldquoprivate foundationrdquoor organizations that are not ldquoprivate foundationsrdquo
222 chapter 18 legal aspects of investing charitable endowment
18 schneider 22505 939 AM Page 222
Organizations that are not private foundations include churches schools hos-pitals and public fund-raising and membership organizations (such as the UnitedWay the Boy and Girl Scouts and organizations such as symphony orchestras)that meet arithmetic fund-raising tests described in Internal Revenue Servicerules All other ldquoSection 501(c)(3)rdquo organizations are private foundations
The fact that the word foundation is included in the organizationrsquos name is ir-relevant A typical ldquocommunity foundationrdquo for instance is not a ldquoprivaterdquo foun-dation However the typical family foundation or privately funded charitabletrust is a private foundation
An organization that is a private foundation is subject to Chapter 42 of theInternal Revenue Code (and equivalent state law) which among other thingscontains investment restrictions
Section 4944 of the Internal Revenue Code (and equivalent state law) pro-vides that a private foundation may not make investments that ldquojeopardizerdquo theorganizationrsquos tax-exempt purpose a provision that is interpreted by the TreasuryRegulations as imposing what is effectively a prudent man rule within the taxcode Since these regulations were adopted in 1972 they have not kept up withModern Portfolio Theory (eg puts calls and straddles are supposed to be givenldquospecial scrutinyrdquo) Excise tax penalties may be imposed on the organization andits officers directors and managers for violation of the rules
Section 4943 of the Internal Revenue Code (and equivalent state law) pro-vides that a private foundation may not hold any investment in a particular busi-ness enterprise to the extent it exceeds 20 less the amount held by so-calleddisqualified persons (essentially the trustees officers managers and substantialcontributors to the foundation and members of their families and trusts or otherentities in which they hold a requisite interest) Excise tax penalties may be im-posed on the organization and its officers directors and managers for violationof the rules
summary
The investment rules applicable to the investment of charitable funds is depend-ent on a number of detailed questions about the nature of the fund and the insti-tution for which it is being invested
summary 223
18 schneider 22505 939 AM Page 223
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chapter 19
Fiduciary IssuesmdashRetirement Funds
Offering a retirement plan can be one of the most challengingyet rewardingdecisions an employer can makeThe employees participating in the plan theirbeneficiaries and the employer all benefit when a retirement plan is in placeHowever administering a plan and managing its assets require certain actions andinvolve specific responsibilities
To meet their responsibilities as plan sponsors employers need to understandsome basic rules specifically the Employee Retirement Income Security Act of 1974(ERISA) ERISA sets standards of conduct for those who manage an employeebenefit plan and its assets (called fiduciaries)
This chapter addresses the scope of ERISArsquos protections for private sector re-tirement plans (Generally public sector plans and plans sponsored by churchesare not covered by the fiduciary responsibility standards of ERISA) This chapterprovides a simplified explanation of the law and regulations It is not a legal in-terpretation of ERISAnor is it intended to be a substitute for the advice of a re-tirement plan professional Finally this chapter does not cover the numerousprovisions of Federal tax law related to qualified retirement plans
erisa
ERISA was enacted to protect the assets of workers so that funds contributed toretirement plans during their working lives would be available when they retireERISA is a federal law that sets minimum standards for pension plans in privateindustry For example ERISA specifies when employees must be allowed to be-come a participant how long employees have to work before they have a non-forfeitable interest in their pension how long they can be away from their jobbefore it might affect their benefit and whether a participantrsquos spouse has a right
225
19 schneider 22505 1104 AM Page 225
to part of the participantrsquos pension in the event of the participantrsquos death Most of the provisions of ERISA are effective for plan years beginning on or afterJanuary 1 1975
ERISA does not require any employer to establish a pension plan or specifyany minimum benefit level It only requires that those who establish plans mustmeet certain minimum standards For example ERISA does the following
bull Requires plans to provide participants with information about the plan in-cluding important information about plan features and fundingThe planmust furnish some information regularly and automatically Some is avail-able free of charge some is not
bull Sets minimum standards for participationvestingbenefit accrual and fund-ingThe law defines how long a person may be required to work before be-coming eligible to participate in a plan to accumulate benefits and to havea nonforfeitable right to those benefits The law also establishes detailedfunding rules that require pension plan sponsors to provide adequate fund-ing for plans
bull Guarantees payment of certain benefits if a defined plan is terminatedthrough a federally chartered corporation known as the Pension BenefitGuaranty Corporation (PBGC)
bull Requires accountability of plan fiduciaries and provides participants theright to sue for benefits and breaches of fiduciary duty
The balance of this chapter addresses who is a fiduciary the fiduciaryrsquos respon-sibilities the penalties for breaches of those responsibilities and how an employercan establish prudent procedures to ensure compliance with ERISArsquos fiduciaryduty requirements
The USDepartment of Labor (DOL) enforces Title I of ERISAwhich in partestablishes participantsrsquo rights and fiduciariesrsquo duties The Employee Benefits Secur-ity Administration (EBSA) portion of the DOL is the agency charged with enforc-ing the rules governing the conduct of plan managers investment of plan assetsreporting and disclosure of plan information enforcement of the fiduciary provi-sions of the law and workersrsquo benefit rights
Other federal agencies also regulate retirement plansFor example the TreasuryDepartmentrsquos Internal Revenue Service (IRS) is responsible for ensuring compli-ance with the Internal Revenue Codewhich establishes the rules for operating atax-qualified pension plan including pension plan funding and vesting require-ments In addition the PBGC guarantees payment of certain pension benefitsunder defined benefit plans that are terminated with insufficient money to pay
226 chapter 19 fiduciary issuesmdashretirement funds
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benefitsDetailed explanations of the roles of the IRS and the PBGC are beyondthe scope of this chapter
who is a fiduciary
ERISA requires plans to have at least one fiduciary (a person or entity) named inthe written plan or through a process described in the plan as having controlover the planrsquos operationThe named fiduciary can be identified by office or byname For some plans it may be an administrative committee or a companyrsquosboard of directorsAs one court notedldquothe first place courts look to determinewhether a defendant is a fiduciary is the plan documentsrdquo
Merely because one is not a named fiduciary however does not mean that theindividual is ldquooff the hookrdquo as far as potential fiduciary liability is concernedAnyone who uses discretion in administering and managing a plan or controllingthe planrsquos assets is a fiduciary to the extent of that discretion or controlThus fi-duciary status is based on the functions performed for the plannot just a personrsquostitleThese types of fiduciaries are sometimes referred to as ldquofunctional fiduciar-iesrdquo to distinguish them from named fiduciaries (although note that the term func-tional fiduciary does not exist anywhere in ERISA)
Many of the actions involved in operating an employee benefit plan make theperson or entity performing them a fiduciaryA planrsquos fiduciaries will ordinarilyinclude the trustee investment advisers all individuals exercising discretion in theadministration of the plan all members of a planrsquos administrative committee (if ithas such a committee) and those who select committee officialsAttorneys ac-countants and actuaries generally are not fiduciaries when acting solely in theirprofessional capacitiesThe key to determining whether an individual or an entityis a fiduciary is whether they are exercising discretion or control over the planNote that the law makes a person a fiduciary only to the extent that the person ex-ercises discretionary authority over the plan As one court has phrased itldquofiduci-ary status is not an all or nothing propositionrdquo
Finally note that there are at least two other broad types of decisions that mayaffect a retirement plan that are not fiduciary decisionsThe first type of decisionsare so-called ldquosettlor functionsrdquo meaning business decisions made by the em-ployer For example the decisions to establish a plan to determine the benefitpackage to include certain features in a plan to amend a plan and to terminate aplan are business decisionsWhen making these decisions an employer is actingon behalf of its business not the plan and therefore is not a fiduciary Howeverwhen an employer (or someone hired by the employer) takes steps to implement
who is a fiduciary 227
19 schneider 22505 1104 AM Page 227
these decisions that person is acting on behalf of the plan and in carrying outthese actions may be a fiduciary
The second type of decisions regarding a plan that are not fiduciary decisionsinvolve individuals who exercise purely ldquoministerial functionsrdquo and who have nopower to make discretionary decisions as to plan policies interpretations prac-tices or procedures these individuals are not fiduciaries However any activitiesthat require discretionary judgment are not ministerial The following are exam-ples of activities that may be ministerial
bull Application of the plan administratorrsquos rules to determine eligibility for par-ticipation or benefits
bull Calculation of service and compensation credits for benefits
bull Calculation of benefit amounts
bull Maintenance of participantsrsquo service and employment records
bull Preparation of reports required by government agencies
bull Orientation of new participants and advising participants of their rights andoptions under the plan
bull Collection of contributions and application of contributions as provided inthe plan
bull Preparation of reports concerning participantsrsquo benefits
bull Processing of benefit claims
bull Making recommendations to others for decisions with respect to plan administration
Because these tasks are ministerial they may be delegated to others (in accor-dance with plan provisions or procedures) without creating fiduciary liability forthe delegateeThe key concern is whether these functions involve discretionaryauthority or control with respect to management of the planmanagement or dis-position of plan assets or formally rendering investment advice with respect toplan funds If not the task is likely considered ministerial
One common question is whether boards of directors are treated as fiduciariesA companyrsquos board of directors can be a fiduciary to the extent that the board per-forms fiduciary functions such as the selection and retention of other plan fidu-ciariesHowever the mere power to amend or terminate a plan does not give theboard of directors fiduciary status because those are settlor functions
On the other hand if a board of directors is responsible for the selection andretention of plan fiduciaries or fiduciary committeesbut does not have any otherdiscretionary functions the board will have a fiduciary function to oversee thosefiduciaries In this instance the boardrsquos fiduciary responsibility (and liability) is
228 chapter 19 fiduciary issuesmdashretirement funds
19 schneider 22505 1104 AM Page 228
limited to that delegation functionThis means that if fiduciary duties are prop-erly delegated the board will generally not be liable for any acts undertaken bythe delegatee that were within the scope of the delegation and the boardrsquos re-sponsibilities are limited to oversight of the appointed fiduciary (and to avoidingcofiduciary liability as described below)
fiduciary requirements
Being a fiduciary is significant because fiduciaries have important responsibilitiesand are subject to standards of conduct because they act on behalf of participantsin a retirement plan and their beneficiaries These responsibilities include the following
bull Duty of Loyalty (Exclusive Benefit Rule) Fiduciaries must discharge their du-ties solely in the interests of participants and beneficiaries and for the exclu-sive purpose of providing benefits to participants and beneficiaries anddefraying reasonable expenses of administering the planThis is also knownas the exclusive benefit ruleA fiduciary violates the duty of loyalty by plac-ing his or her own interests or the interests of a third party including theemployer above those of the plan participants ERISArsquos duty of loyalty hasbeen described as ldquothe highest known to the lawrdquo This duty is based ontrust law principles and according to the US Supreme CourtldquoThe mostfundamental duty owed by the trustee to the beneficiaries of the trust is theduty of loyalty It is the duty of a trustee to administer the trust solely inthe interest of the beneficiariesrdquo
bull Duty of Care (Prudent Person Rule) The duty to act prudently is one of afiduciaryrsquos central responsibilities under ERISA It requires expertise in a va-riety of areas such as investments Although this rule is commonly referredto as the prudent person rule the standard is sometimes thought of as that ofa ldquoprudent expertrdquo or as one court determinedldquoa prudent fiduciary withexperience dealing with a similar enterpriserdquoAs another court has notedldquothis is not a search for subjective good faithmdasha pure heart and an emptyhead are not enoughrdquo
Practically applied this means that a fiduciary will have an active duty tounderstand what actions it is required to take with respect to the ERISAplans for which it is a fiduciary and how where and when to take themIf the fiduciary does not have sufficient understanding of an area it has the responsibility to conduct appropriate research and take such othermeasures to gain a proper understanding of the issue If necessary a fiduci-
fiduciary requirements 229
19 schneider 22505 1104 AM Page 229
ary must also seek the advice of experts with appropriate background andexperience
Prudence focuses on the process for making fiduciary decisionsTherefore it is wise to document decisions and the basis for those decisionsFor instance as described later in this chapter in hiring any plan serviceprovider a fiduciary may want to survey a number of potential providersasking for the same information and providing the same requirements Bydoing so a fiduciary can document the process and make a meaningfulcomparison and selection
bull Duty to Diversify Plan InvestmentsThe fiduciary of a funded ERISA retire-ment or welfare benefit plan has a duty to diversify plan investments so asto minimize the risk for large losses unless it is clearly not prudent to do so Accordingly fiduciaries generally should avoid investing disproportion-ately in a particular investment or enterprise Diversification helps to min-imize the risk for large investment losses to the plan Fiduciaries shouldconsider each plan investment as part of the planrsquos entire portfolioFiduciaries will want to document their evaluation and investment deci-sions See Chapter 7 for a further discussion of asset allocation and the im-portance of diversification
bull Duty to Comply with the Plan Documents (unless inconsistent with ERISA)Following the terms of the plan document is also an important responsibil-ity The document serves as the foundation for plan operations Employerswill want to be familiar with the plan document (especially when it isdrawn up by a third-party service provider) and periodically review thedocument to make sure it remains current For example if a plan officialnamed in the document changes the plan document should be updated toreflect that change
bull Duty to Avoid Prohibited Transactions ERISArsquos general duty of undivided loy-alty is supplemented by specific rules prohibiting fiduciaries from causing theplan to enter into certain transactions with parties affiliated with the plan orplan sponsor (called ldquoparties in interestrdquo and including the employer theunionplan fiduciaries service providers and statutorily defined ownersof-ficers and relatives of parties-in-interest) who may be in a position to exer-cise improper influence over the plan Some of the prohibited transactionsare (1) a sale exchange or lease between the plan and party-in-interest (2)lending money or other extension of credit between the plan and party-in-interest and (3) furnishing goods servicesor facilities between the plan andparty-in-interest In addition fiduciaries are prohibited from engaging inself-dealing and must avoid conflicts of interest that could harm the plan
230 chapter 19 fiduciary issuesmdashretirement funds
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