How To Select Investment Managers & Evaluate Performance

The key to successful investment management is to select investment professionals who can best meet clients’ investment goals, objectives, and needs.

How to Select Investment Managers & Evaluate Performance provides those who are responsible for the investment performance of their institution’s funds including pension plan trustees, endowment fund board members, and investment committee board members with the essential knowledge and skill set required to properly select investment managers and to evaluate their performance in a systematic manner.

This book describes cutting-edge techniques used to evaluate the performance of investment funds and their managers and provides valuable insight into the roles and responsibilities in light of the Sarbanes-Oxley Act of 2002 of those charged with this oversight. In a clear and understandable fashion, the authors offer key advice on such topics as establishing investment policy statements, alternative investments, investment approaches and styles, return-risk measurements, how overall portfolio performance is evaluated, how to conduct a search for investment managers, and much more.

G. Timothy Haight, DBA, is the President of Menlo College, Chairman of the Board of Commonwealth Business Bank, and a member of the Board of Advisors of St. Cloud Capital Partners, LLC. He also serves as a member of Southern California Edison’s Nuclear Power Decommissioning Fund Committee. Dr. Haight earned a Doctorate in Business Administration (DBA) with a major in business finance and investments from George Washington University. He received his MBA and BS degrees from the University of Dayton.

Dr. Stephen O. Morrell is Professor of Economics and Finance in the Andreas School of Business of Barry University. He has been a visiting professor at the Monterey Institute of Technology and the Georg-Simon-Ohm University in Nuremberg, Germany. Dr. Morrell also serves as a consultant specializing in portfolio strategies for endowment funds, and has served as senior vice president and chief economist for Southeast Banking Corporation; as a financial economist for the Federal Reserve System; and as chairman of the Board of Directors of First State Bank of Ft. Lauderdale, Florida. Dr. Morrell received his BS degree from Virginia Commonwealth University, and his MA and PhD degrees in economics from Virginia Polytechnic Institute.

Glenn E. Ross serves as a member of Towson University’s College of Business and Economics Board, and its Alumni Board, and has been an adjunct professor in Towson University’s Finance Department. Mr. Ross is President of the Board of Directors of the Albert P. Close Foundation and is a member of the Board of Directors of the Upper Chesapeake Health System Foundation. Mr. Ross earned his undergraduate degree from Towson University and his MBA at Loyola College in Baltimore. Mr. Ross is a Registered Investment Advisor Representative with the SEC.

How to Select Investment Managers & Evaluate Performance

A Guide for Pension Funds, Endowments, Foundations, and TrustsBy G. Timothy Haight Glenn Ross Stephen O. Morrell

John Wiley & Sons

Copyright © 2008 G. Timothy Haight
All right reserved.
ISBN: 978-0-470-04255-7

Chapter One

Investment Sponsors

Individuals, households, businesses, governments, and nonprofit organizations have a number of motives for designing, developing and implementing saving and investment programs. Essentially, the savings component of these programs involves reducing current expenditures in order to set aside a portion of such things as current income, earnings, tax receipts, and contributions, while the investment component involves allocating these savings among seemingly ever-growing varieties and combinations of asset classes, investment vehicles and securities.

Individuals and households establish saving and investment programs, among other reasons, to provide retirement income security in order to maintain a desired standard of living during the portion of their lives when income is no longer being derived from work. Businesses and governments may be motivated to organize saving and investment programs as incentive devices to boost employee productivity, reduce worker turnover and take advantage of tax shelters in the case of businesses. Non-pofit organizations arrange saving and investment programs to support current operations, finance capital expenditures, and strengthen the financial basis of the organization. Clearly, there are numerous reasons for establishing saving and investment programs. These motives combined with the investment goals and processes of the investing entities in conjunction with the universe of investment alternatives determine the investment choices and investment portfolios of the saving and investing entities.

Regardless of the entity establishing it, assessing, analyzing and evaluating the performance of an investment program is a critical element in its success. Thorough, timely and accurate investment performance evaluation is a vital step in determining if the objectives of a saving and investment program are being attained, and in taking subsequent actions. Performance evaluation must be undertaken regardless of the decision to either manage the investment program internally or to employ outside investment professionals to manage all or parts of it.

While many entities have established their own saving and investment programs, for example roughly 4.6 million individuals have established their own retirement based saving and investment programs with assets totaling approximately $3.7 trillion, there are several reasons why certain organizations and individuals may be more effective and efficient in establishing programs for others, particularly those programs with long anticipated lives. Individuals considering establishing retirement programs on their own as well as those who seek to contribute on their own to the viability and longevity of organizations such as universities, museums, hospitals and foundations confront difficult planning challenges and potentially high expenses. Specialized knowledge and skills, and substantial information in addition to initial and ongoing administrative costs are required. Moreover, sustained discipline is often necessary to implement such programs.

In contrast, some organizations and individuals may already possess the specialized knowledge and skills and be able to acquire information more easily. They may also enjoy the advantage of declining costs per participant in the development, maintenance, record keeping, compliance and the like for saving and investment programs. Besides economies of scale related to an existing knowledge base, information acquisition, and administrative costs, these organizations and individuals may have strong economic incentives, such as greater employee and contributor loyalty, for arranging saving and investment programs. They may also obtain for themselves and be able to offer tax benefits to participants in saving and investing programs.

Investment sponsors is the term used to refer to organizations and individuals who undertake the responsibility for establishing, designing, developing, implementing, monitoring, and evaluating saving and investment programs on behalf of, and for the benefit of, other persons and groups. The number and variety of sponsored programs have soared over the last several decades. As illustrated in Table 1.1, the most recently available data show there are approximately 1.1 million tax exempt organization-sponsored investment programs with more than 100 million participants and total investments of roughly $12.1. trillion; more than 1.1 million taxable personal trusts with total assets of $1.0 trillion; and, as noted above, about 4.6 million IRA and Keough programs with investments of close to $3.5 trillion.

The explosive growth in the number of sponsored investment plans indicates that the market for saving and investment programs has become significantly broader and deeper. Several factors appear to account for this robust growth. In terms of provision or supply, ongoing technological progress in communications and information processing combined with a wide range of product, investment management, market structure, institutional and regulatory innovations and changes in the financial sector have likely lowered the costs of establishing and maintaining saving and investment plans. Far reaching changes in the U.S. tax code and persistent, heightened competition for qualified employees have also enabled and motivated tens of thousands of midsized to smaller organizations to sponsor saving and investment programs. Sponsored programs are no longer the sole purview of organizations with large numbers of participants and large dollar portfolios-organizations that may experience economies of scale in operating such programs.

With regard to demand, healthy and sustained long-term growth in the U.S. economy has led to continuous increases in incomes and rising wealth, providing the necessary savings and net worth to fund such programs. Demographic trends, perhaps most notably the aging of the baby-boom generation, have spurred the desire to participate in retirement plans and stimulated the willingness for sizable increases in bequests, contributions, gifts and grants to charitable organizations, foundations and trusts.

THE INVESTMENT COMMITTEE

Organizations establishing saving and investment programs have ultimate fiduciary responsibility for the plans they sponsor. These substantial fiduciary responsibilities are vested in the governing body, such as the Board of Directors of a corporate sponsored pension plan and the Board of Trustees of a university endowment fund, of the organization sponsoring the saving and investment program. Governing bodies in turn frequently establish investment committees and delegate and entrust to them the responsibilities for fulfilling the investment mandates set forth by the sponsoring organization. These responsibilities may vary widely, ranging from placing a few thousand dollars of excess cash in a money market mutual fund to overseeing the investment of billions of dollars apportioned among a number of investment managers across several asset classes.

Committee Composition

The investment committee is chaired by a member of the organization’s governing body, that is, a member of the Board of Directors or Board of Trustees, as it is a committee of the governing body. In those infrequent instances when a Board member does not chair the investment committee, at least one Board representative will nonetheless sit as a voting member of the committee. In addition the President, Chief Financial Officer and Chief Investment Officer-if one exists-of the organization will sit as ex oficio members of the investment committee.

The size of the investment committee is ultimately a decision of the organization’s governing body. Factors such as the complexity of the investment mandate, the number of participants in the plan, the dollar amounts to be invested, and legal and regulatory compliance requirements appear to determine the size of the investment committee. For example, the California Public Employees Retirement System (CALPERS), the nation’s largest public pension plan with roughly $210 billion in invested assets, has a 13 member Board of Administration and a 13-member investment committee comprised solely of Board members. In contrast, the John D. and Catherine T. MacArthur Foundation, one of the largest philanthropic foundations in the country with about $5.5 billion in invested assets also has a 13-member Board of Trustees, but a seven-member investment committee comprised of four trustee and three nontrustee members.

Trade-offs obviously exist in setting the size of the investment committee. Large committees may suffer from a diffusion of responsibilities, communications challenges, and tendencies to “group” decision making. Smaller committees may face responsibilities simply too daunting to adequately address. In recent years a trend towards reducing investment committee size from 10 to 15 members to five to seven members appears to have emerged.

While the size of the investment committee is important to its success, the qualifications and dedication of committee members are considerably more important. Individuals invited to serve on the investment committee should be selected based on their education, knowledge, experiences and background in a range of investment management and plan administration issues. Indeed, investment committee members of pension plans coming under the jurisdiction of the Employee Retirement Income Security Act (ERISA) are required to not just act in accordance with the “prudent man” rule but to act per the “prudent expert” rule; that is with the prudence someone familiar with investment management matters would exercise.

Prospective investment committee members should be clearly informed about their requirements, duties, responsibilities and expectations prior to joining the committee. Policies regarding potential conflicts of interest and disclosures should be fully addressed at this time. Orientation seminars for new members and ongoing education programs for all members will serve to keep the committee informed and current about important new developments.

Committee Responsibilities

The overarching responsibility of the investment committee is to design, develop and implement investment strategies and policies in order to achieve the investment goals of the saving and investment program. Effective committees focus on broad issues of strategy and policy rather than the micro-management of the investment process.

There are nine primary strategic and policy issues under the investment committee’s purview:

1. Determining investment goals. Investment goals include specifying return objectives for the monies being invested; setting the risk tolerance(s) about the return objectives; and defining any constraints or limitations on the investment process.

2. Identifying and monitoring asset classes and investment vehicles. Determining investment goals will help direct the committee in selecting asset classes whose returns and risks are likely to be most consistent with its investment goals. As the number of asset classes and the variety of instruments for investing continue to rapidly expand the committee must also monitor the growing universe of asset classes and investment vehicles.

3. Internal versus external investment management. The committee must decide whether the day-to-day investment of the funds will be delegated to an in-house group of investment professionals and support staff under the direction of a Chief Investment Officer, or if external investment management professionals will be given this responsibility. If the decision is to build in-house capacity for investment management then the investment committee may have strategic and policy responsibilities for such things as its structure and organization. If the committee decides to employ outside investment professionals then procedures for hiring, monitoring, evaluating as well as terminating such firms must be established.

4. Passive versus active investment strategies. The committee must determine if monies should be invested such that returns and risks closely track those of relevant benchmarks-a so-called passive investment strategy or, instead, if monies should be invested to earn returns adjusted for risks and costs that consistently exceed relevant benchmarks-a so-called active strategy. Previous decisions regarding investment goals as well as anticipated results, expenses, and evaluation and monitoring costs play important roles here.

5. Asset allocation guidelines. The committee should specify permissible ranges for allocating funds among the identified asset classes. These ranges will be influenced by the committee’s decisions on investment objectives, asset classes, and a passive versus active investment strategy. 6. Establishing performance criteria. In order to properly measure, assess and analyze success in achieving its investment objectives the committee must establish criteria and benchmarks against which actual performance results will be judged. The number and types of criteria have increased substantially in recent years in conjunction with the growth in the number and variety of asset classes and investment vehicles. Consistency and appropriateness with investment goals, permissible asset classes, and investment strategy and portfolio composition are important in this regard.

7. Performance evaluation. The committee must decide how frequently actual investment performance results will be evaluated, the most useful methodologies for evaluating performance, and the parties responsible for undertaking the performance evaluation. The committee must be skilled in assessing and analyzing the performance evaluation data and information presented to it.

8. Changes to the process. A host of factors may cause the investment committee to reexamine the strategies and policies in items 1 through 7 above. For example, the tolerance for risk may diminish on a long-term basis; new constraints may emerge; new asset classes may be available for investments; the costs of maintaining an in-house investment department may be considerably increasing; fiduciary responsibilities may become more stringent; or the performance of outside investment professionals may be disappointing. The committee must decide when incremental changes as opposed to more fundamental changes to its strategies and policies need to be made.

9. Communications and reporting to governing body. As a committee of the Board the investment committee is responsible for periodically and regularly informing the Board on its progress in successfully implementing the mandates it received from the Board. Key reporting requirements include information on strategy and policy issues noted above; investment performance results and performance evaluations; and recommendations for substantial changes to investment strategy and policy which require Board approval.

Written Investment Policy Statements are the preferred and probably best device for the investment committee to communicate its investment strategy and policy to the Board, participants in the saving and investment programs and any regulatory officials. Investment Policy Statements are the subject of our next chapter.

THE VARIETY OF INVESTMENT SPONSORS

Taxable Status

The two primary types of investment sponsors are tax-exempt sponsors and taxable ones. Over the years the U.S. Congress has enacted, amended, and overhauled an array of laws under which organizations and individuals may sponsor saving and investment programs and qualify for either exemption or deferral from federal taxation. Qualified organization and individual sponsored retirement plans, public charities, and private foundations are the most prominent tax exempt-tax-deferred investment sponsors with trillions of dollars of invested assets. In contrast, individuals-except for their qualified retirement plans-corporations, partnerships and most trusts are taxable investment sponsors.

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