Charley Ellis once said, “Investment policy does not enjoy much popularity. Almost everyone agrees that it is a “good” thing, but almost no one does anything about it.”
I’ve had conversations with a number of institutional investors over the past few months because a crisis is typically the time organizations either (a) realize they don’t have a thorough enough plan in place or (b) realize they need to dust off the plan they have and actually adhere to it.
I wrote an entire chapter in my book, Organizational Alpha: How to Add Value in Institutional Asset Management, about investment policy that I’ve been reviewing for an upcoming project for working with smaller nonprofits (stay tuned on this).
So I figured I may as well share that chapter here. It covers everything from the investment policy statement to the investment committee charter to spending policies and cash management guidelines.
This material was written for endowments, foundations, pension plans, family offices and the like but can definitely translate to individuals as well.
Here are five questions to consider as you read this material:
- Do we have a comprehensive investment policy statement (“IPS”) in place that we can both follow and understand?
- Do we have an investment committee charter that outlines our duties and responsibilities?
- Do we have documented spending policies and cash management guidelines in place to plan for liquidity events?
- Have we documented all policies, guidelines, contingencies and plans to ensure continuity in our investment program?
- Will we have the courage and discipline to follow our plan even when it’s painful to do so?
INVESTMENT POLICY STATEMENT
The IPS is your ultimate checklist as an organization. Without an IPS your investment program is like a rudderless ship that is likely to drift aimlessly because it has no established direction. An IPS is the document that lays out the purpose of the funds in question.
Every IPS will be different based on the unique needs and circumstances of the organization in question, but the following list will provide a good starting point for what should be included in a comprehensive plan:
- State the purpose of the document and the organization’s mission.
- Lay out the goals and objectives for the fund.
- Define the role of the investment committee.
- Define the risk profile of the organization.
- Discuss how those objectives are going to become a reality.
- Define any spending or liquidity needs and constraints.
- State your investment philosophy.
- Spell out performance and risk expectations and targets.
- Define a benchmark portfolio (and make sure it is liquid and investable).
- List the policy portfolio or asset allocation targets for each asset class or investment style.
- Discuss the rebalancing policies and procedures.
- Be specific about investment criteria in terms of guidelines, policies, restrictions, and constraints.
- Clarify the exact types of assets, fund structures and investment styles the fund will and will not invest in.
- Lay out the various risk management and diversification policies.
- Determine when investment performance will be reviewed and spell out how investments will be evaluated.
I’ve seen many organizations that have an IPS in place but it’s something they put together a number of years ago, never to be seen or heard from again. The point of reviewing the IPS on a periodic basis – say, once a year – is not to continually make changes to an investment program and portfolio. That would defeat the purpose. You should only make changes when necessary. The point of reviewing the IPS is to remind everyone involved why you’re investing in the first place. If the document is set up correctly, going over it on an annual basis will be a great way to remind all parties involved what the original goals were to begin with. It can be a conversation starter – or conversation ender – depending on the current proposals. An IPS can also act as something of a benchmark to ensure that your investment program is successful or not.
INVESTMENT COMMITTEE CHARTER
Being a member of the Investment Committee is an important role because you act as something of a go-between for the rest of the organization and the investment funds. It’s important for committee members to understand their roles within the construct of the fund and the organization. As we mentioned earlier in the book, the average tenure for a board member is relatively short. Having a document in place that describes what the job entails when a new trustee enters the board can help with the transition process and ensure current members know their role.
This is important because very few institutional Investment Committee members have professional investment experience. One study looked at nearly 900 trustees on various pension plans across the U.S. It discovered that only 23 percent of trustees had any experience in asset management while just 2 percent held the Chartered Financial Analyst (CFA) designation.
There’s nothing wrong with having people outside the world of finance oversee the investments. In fact, it can be a benefit to have a diversity of opinions. But it then becomes very important for the Investment Committee to understand their roles and where they can or cannot add value. This is the point of the Investment Committee Charter. You want to have documentation in place, a regular meeting schedule, well-qualified and knowledgeable people and ensure that no conflicts of interest exist.
Here are some of the main points and/or tasks to consider for a useful Investment Committee Charter:
- Establish the purpose of the Investment Committee.
- Examine the makeup of the membership (number of people, tenure, etc.).
- Define and outline the various roles and responsibilities of the board members, investment committee members, consultants, advisors and money managers.
- Define how trustees can fulfill their fiduciary duty on behalf of the fund’s beneficiaries and organizational mission.
- Lay out the frequency of investment meetings and reviews.
- Outline the duties, authorities and responsibilities for all those involved with the investment funds.
- Document compensation arrangements.
- Discuss expectations for future members.
- Determine how members of the Investment Committee are selected and who is to be Chair.
- Determine what reports the Board expects from the Investment Committee, and how often they are to receive these reports.
- Solidify which decisions of the Investment Committee must be ratified by the Board.
- Create a payout policy for the Fund that meets the organization’s needs.
There should also be an understanding of the structure of the periodic meetings and what is expected to be covered on a regular basis. At least once a year there should be a review of the portfolio, organizational needs, goals, IPS, liquidity profile, procedures and costs. You don’t want to get in the habit of simply reviewing the most recent performance numbers. You want the focus to be policy – fees, asset allocation, process, planning, risk management and communications – not short-term market events.
Investment committee meetings really shouldn’t take all that long. You discuss the progress towards your goals and go over any changes in organizational structure or needs. If not, re-state your goals, discuss your investment philosophy and figure out if there are any legitimate reasons to make changes to your portfolio that fall outside of your current plan and policy guidelines. The majority of the time there should be no changes made, assuming you have done the requisite upfront work and planning. You simply follow the agreed-upon decision-making process. Committees should spend the vast majority of their time on important topics that require them to think in terms of probabilities and outcomes. You should talk to your money managers, consultants or advisors at least once a year for these meetings, but anyone you’re outsourcing for asset management purposes should be communicating with you in-between these meetings with periodic letters and conference calls anyways.
It’s also critical for the Investment Committee to remind all involved with the portfolio the importance of long-term thinking and admitting their limitations. In an interview with financial writer Jason Zweig, Charles Ellis describes how a successful long-term investor should think much like a tree farmer over time:
If you ran a commercial tree farm, would you ask for up-to-the-minute bulletins on how the forest was growing today? How many people are investing for success this year, this month, this week, this day? Most people’s true time horizons are much longer than they think – 50 years, even more. They should be investing for success over a lifetime – or more than one lifetime, because part of what they’re investing will go to their kids after they’re gone.
When given enough water, light, air and space a tree can grow to great heights as long as you pretty much leave it alone. The same is true of a well-constructed portfolio.
SPENDING POLICY STATEMENT
The long-term is the only time frame that truly matters but nonprofits still have to be able to survive the short-term and meet their operating needs. That’s the entire point of the funds, after all. Plenty of organizations learned this lesson the hard way during the Great Financial Crisis of 2007-2009. A number of both large and small institutions ran into a liquidity or funding crisis during this period because they didn’t really understand the risks involved in the financial markets. Many didn’t have contingency plans in place and were forced to cut back on spending, let go of employees or even close their doors.
This is where the importance of a comprehensive investment plan really earns its stripes. Anyone can invest successfully when things are going well. But when things turn ugly, that’s where you really discover where a true process and plan are in place. The Spending Policy Statement can play a huge part in surviving these downturns.
Just as there are no perfect investment portfolios, there are also no perfect spending policies. Every policy will require some trade-offs between current and future spending needs. Higher expected returns lead to more short-term volatility, while predictable spending patterns tend to accompany lower expected returns. That means you have to consider spending goals in terms of the current market value of the portfolio along with the sensitivity to past market values and spending levels.
Spending rules are meant to help deal with the trade-off between the desire for long-term capital preservation and short-term spending smoothness. The type of fund can have a lot to do with figuring out where to begin with this process. Here are some considerations for the various types of institutional funds:
Pensions. Pensions typically have the least amount of flexibility with their investment approach because they have a defined liability – future or current payouts to their beneficiaries. Pensions can thus match their assets with their liabilities when creating a portfolio. That’s not always an easy task – especially with interest rates nearly on the floor at the moment – because any time you’re dealing with risk assets you can’t predict what’s going to happen with any certainty. Pensions can calculate their funded status to determine the amount of risk they can or should take along with any need for additional contributions to the plan. With a large number of underfunded plans, this will be something worth paying attention to in the years ahead as millions of baby boomers continue to retire.
Foundations. Charitable foundations have more investment flexibility but many have to make a minimum payout of 5 percent of their assets each year to support charitable purposes or face tax penalties. Typically, this means that foundations will have lower risk profiles than endowments, but higher risk profiles than pensions. There are a number of unique variables that can determine where each fund risk profile ends up depending on the unique circumstances involved, such as the number of charitable donations brought in. However, most foundations rely heavily on investment returns to meet spending needs. In 2006, 8 of the 10 largest grant-making foundations received almost 100 percent of their total revenues from investment portfolios.
Endowments. Endowments have a general lack of constraints on investment and spending needs so they have greater flexibility than either pensions or foundations. Not only do they have longer time horizons, but many college endowments, particularly large funds, enjoy gifts from alumni which decreases the need to spend from the investment portfolio. Endowments and foundations are both generally looking to balance out competing goals: preserving their long-term purchasing power against the ability to plan for a smooth payout policy.
There are a number of variables that will affect an organization’s spending policy and payout:
- Contributions, distributions, and investment earnings.
- Liquidity preferences and needs.
- Asset allocation decisions.
- Available resources.
- Percentage of the overall operating budget that comes from investments.
- The timing of cash flows.
- Spending requirements.
- Actual vs. expected returns.
- Cash reserves.
Donations are always a good problem to have but they can be hard to plan for because they tend to ebb and flow with the economic and market cycles. It’s difficult to rely on gifts as a hedge against a stock market crash because those are the times when charitable donations tend to dry up. And the closer your expected return number is to your expected spending rate, the harder it is to stay consistent with your spending levels because you don’t leave the fund with a huge margin for error. All of these variables must be considered when selecting the policy that works for your particular fund.
A few examples can be helpful to consider how most institutions handle their spending policies in the real world:
1. Percentage-of-Assets Spending Rate. This policy would simply use a fixed percentage (say 5 percent of total assets) and grow it by the rate of inflation each year.
Pros: It’s a simple policy.
Cons: Your spending amount will vary considerably if you have a portfolio invested in risk assets.
2. Smoothed or Moving-Average Spending Rate. To smooth out the potential volatility in the annual payout many funds utilize a moving average. For example, you could take the average of the previous three or five years’ spending amounts to determine your current spending amount or rate.
Pros: Less variable than a flat rate and a relatively simple policy.
Cons: Current year spending could be determined by stale values in the past that don’t reflect new organizational or market realities.
3. Hybrid Spending Rate. This is a combination of the first two where you could use a partial dollar amount grown by inflation and a partial smoothing factor. You could also add a ceiling and a floor to keep things in line and not go too high or too low when times are either wonderful or horrible in the markets. Swensen says that Yale’s endowment utilizes a hybrid approach that’s equal to 80 percent of spending in the previous year plus 20 percent of the long-term spending rate.
Pros: Reduces the impact of volatile investments on current spending.
Cons: Introduces more complexity into the equation when trying to balance the current and past values.
According to one study, up to 75 percent of institutions use a smoothing policy, with over 70 percent of institutions ending up spending somewhere in the 4 percent to 6 percent range in terms of their current market values. Regardless of the spending policy chosen, you have to learn to accept the tradeoffs involved and understand the volatility characteristics of your asset mix. Higher expected returns come from higher expected volatility. Introducing higher allocations to stocks should lead to higher expected long-term returns, but also more variability in short-term market values. That means you should expect a higher probability of preserving capital over the long-term, but also a higher probability of seeing large swings in your spending rates when using a simple percentage of assets approach.
Policies should guide your actions but flexibility will likely be a key component when trying to plan organizationally. Spending policies can’t be completely controlled by the volatility of the portfolio but it can’t be completely ignored either. A prudent plan would create reserves in good times to help during the times when markets are down.
There’s no one-size-fits-all spending policy that will work for every fund or organization. The best policy will take into account what is most important for the institution in question. The constant tug-of-war between current and future spending needs must be hashed out when thinking through this decision. The right spending policy will be the one that is able to balance out these two competing initiatives.
CASH MANAGEMENT GUIDELINES
Once you have your spending policies in place you have to actually figure out how to manage your liquidity. Cash management is an often overlooked aspect in all of this. That money has to be there when you need to spend it. They say liquidity is like oxygen – you don’t notice it until you need it and it’s not there. The goal should always be to ensure that you can meet your short-term spending distributions with as little risk as possible. There are places to take risk and there are places to avoid risk. Cash management is one of the places in which you should be looking to avoid taking on too much risk.
Here are some considerations when thinking about cash management:
- The size of the portfolio allocation to cash or cash equivalents that are bookmarked for spending purposes.
- Banking services and fees.
- Safety of principal.
- Liquidity needs and timelines.
- The desire or need for current returns.
- The acceptable level of risk.
I’ve seen some organizations who want 1-2 years’ worth of spending cash in ultra-safe holdings; for others, it could be 1-3 months. Some organizations use their rebalancing proceeds to fund current payouts while others have the luxury of using donations or gifts. This is another decision that comes down to knowing and understanding your own personal needs and tolerance for risk. Some organizations are very conservative while others want every last cent to be fully invested for as long as possible. Investing is a form of regret minimization so there needs to be a balance in place.
You’ll notice that each of these policies eventually comes down to trade-offs. As they say, investing is simple but never easy.
This was adapted from Organizational Alpha.
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