The Practical Guide to Managing Nonprofit Assets

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

00 schneider fm 22405 714 PM Page i

William A Schneider

Robert A DiMeo

This book is printed on acid-free paper

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

ndash20

onndashV

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

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

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

HCE highly compensated employees NHCE nonndashhighly compensated employeesSource American Hospital Association Diversified Investment Advisors Retirement Plan Trends in TodaysHealthcare Market 2003

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

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-

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

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

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

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

1Richard M Ennis and J Peter Williamson Spending Policy For Educational Endowments (Westport CTThe Common Fund January 1976) 6

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

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)

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

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

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

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

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

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

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

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

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

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

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

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

exhibit 51 the impact of spending policy

$11000

$10000

$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

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

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

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

Stocks

exhibit 53 average annual returns over variousmarket periods

10301190

17501820

2 Inflation $9056807921

35 Inflation $14033968520

5 Inflation $21609711870

$0 $50000000 $100000000 $150000000 $200000000 $250000000 $300000000

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

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

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

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

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

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

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 Rebalancing

bull Manager selection

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

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

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

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

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

1Gary P Brinson L Randolph Hood and Gilbert L BeebowerldquoDeterminants of Portfolio ReturnsrdquoFinancial Analysis Journal (JulyAugust 1986)

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

00 2 4 6 8 10 12 14 16

Risk (Std Dev)

MIX C MIX A

exhibit 71 what determines success

Market Timing2

Asset Allocation94

Security Selection4

Components of Investment Return

Source Brinson Hood Beebower 1986

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

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

case study the capital asset pricing model

ndash20

Russell2000

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

ndash20

Wilshire REITIndex

ndash20

MLM CommodityFuturesIndex

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

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-

456789

Expected Return

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-

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

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)

SampP 500

ndash22

ndash20

ndash18

ndash16

ndash15

ndash13

ndash11

ndash9

ndash8

ndash6 ndash4

ndash2 ndash1 1 3 5 6 8

SampP 500

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

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

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

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

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

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

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

ndash88

102 90

ndash196

exhibit 82 reit share price premiums to greenstreet nav estimates (11990ndash102004)

ndash10

Return

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

050520

ndash22

ndash16

ndash14

ndash13

ndash11

ndash10

ndash9

ndash7

ndash6

ndash4

ndash3

ndash1

30 25 20 15 10 5 0

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

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)

Large-cap 133 155

Small-cap 123 193

High-yield bond 100 62

exhibit 85 correlation of high-yield bonds to assets

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-

ndash10

Return

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-

High-Yield Intermediate High-Yield High-Yield High-YieldLarge-Cap Bond Bond Bond (BB) Bond (B) Bond (C)

Large-cap 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)

Large-cap 124 145

High-yield bond (BB) 92 51

High-yield bond (B) 89 72

High-yield bond (C) 77 113

exhibit 87 returnrisk relationships

40 35 30 25 20 15 10 5 0

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

40 35 30 25 20 15 10 5 0

8ndash3

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

40 35 30 25 20 15 10 5 0

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

8ndash3

ndash32

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

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

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

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

exhibit 811 global corporate bond issuance

Source Goldman Sachs

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

Large- Hedged UnhedgedCap International Domestic International International

Equity Equity Bonds Bonds Bonds

Large-cap equity 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)

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

ilar f

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

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

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

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

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

exhibit 815 inflation risk component of bondyields

Nominal BondsYield

Real Return

Inflation Risk Premium

Inflation

Yield Components

Yield Real Return

Inflation

Yield Components

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

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)

Large-cap 78 171

Small-cap 100 217

International 54 162

TIPS 77 51

Intermediate bonds 70 37

exhibit 816 historical return and risk

ndash10

Return

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

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

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

1William Sharpe ldquoDetermining a Fundrsquos Effective Asset Mixrdquo Investment Management Review(NovemberDecember 1988) 56ndash592Roger Ibbotson TMA Journal (NovemberDecember 1996)

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

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

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

ndash1

SmallValue ndash1 0 1 Growth

exhibit 92 manager style map

Manager StyleSingle Computation

rvalue rgrowth

r2 growth

Sample Manager

ndash1

r2 value

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

SampP 500 IndexStyle BenchmarkManager ABC

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

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

exhibit 95 completeness fund analysis

November 1999ndashOctober 2004

rvalue rgrowth

r2 growth

Harbor Capital Appreciation Inst

Completion Fund

Resultant Portfolio

SampP 500

ndash1

r2 value

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

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

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

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

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___________________________________________________________________________

___________________________________________________________________________

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

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

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

3-4 Large Growth Managers

Final Candidate

Multi-Factor RiskReturn Model Style Analysis

Qualitative Analysis

Detailed Questionnaire

Interview

Organization People Process Philosophy Performance etc

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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 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

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

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-

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

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

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

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

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

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

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

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

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

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-

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)

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

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

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

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

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

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)

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

As with other alternativesmanager fees are performance basedAverage managerfees are high at 2 Incentive fees take another 20 of profits

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

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

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

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

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

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

a new approach 145

exhibit 121 historical portfolio observations

The Circlersquos Radius is the Optimal ldquoRrdquo

88 90 92 94 96 98 100 102 104 106

E (Standard Deviation)

exhibit 122 annualized standard deviation(11988ndash112003)

00 02 04 06 08 10

ldquoRrdquo (Radius of Constraint Circle)

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-

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

exhibit 123 cumulative annualized returns(11988ndash112003)

9700 02 04 06 08 10

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)

Rebalance

ldquoove

Return

bullTa

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

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

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

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

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

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

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

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

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

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

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

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

exhibit 132 manager xyz objective comparison

Fund SampP 500

CPI+74 105

Quarter Ending

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

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

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

1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr

Return

SampP 500

Return

Universe

5th -tile

25th -tile

50th -tile

75th -tile

95th -tile

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

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-

tfolio

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

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

rvalue rgrowth

r2value r2growth

Value -1 0 1 Growth

Manager ABCManager XYZRussell Generic Corners

risk analysis 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

Manager

1999 -

June 2

Return

Citi g

ance A

ttribution

d to B

Russell 1

r vs U

d if le

-6-505

Manager A

Russell 1

entile

n to 7

entile

Manager

atio thro

(not annualiz

ed if le

ss than 1

Sharpe Ratio -050123

Russell 1

entile

n to 7

entile

er amp

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

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

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

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

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

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

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

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

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-

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

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-

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

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

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

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

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_____________________________________________________________________________

_____________________________________________________________________________

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

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)

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

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

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

ndash$

times12

) times25

er amp

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

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

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

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 _____ _____ _____ _____

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

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

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

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

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

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

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

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

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

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

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)

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

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

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-

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 Manager search

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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 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

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

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

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

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

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

For example fiduciaries cannot receive money or any other considerationfor their personal account from any party doing business with the plan re-lated to that business

There are a number of exceptions (called ldquoexemptionsrdquo) in the law thatprovide protections for the plan in conducting necessary transactions thatwould otherwise be prohibited For example exemptions are provided inthe law for many dealings with banks insurance companies and other fi-nancial institutions that are essential to the ongoing operations of the planOne exemption in the law allows the plan to hire a service provider as longas the services are necessary to operate the plan and the contract or arrange-ment under which the services are provided and the compensation paid forthose services is reasonableAnother important exemptionmdashand a popularfeature of most plansmdashpermits plans to offer loans to participantsThe loanswhich are considered investments of the plan must be available to all par-ticipants on a reasonably equivalent basis must be made according to theprovisions in the plan and must charge a reasonable rate of interest and beadequately secured The Labor Department has the authority to grant addi-tional exemptions that cover either individual transactions or a ldquoclassrdquo oftransactions

bull Duty with Respect to Cofiduciaries A fiduciary should be aware of others whoserve as fiduciaries to the same plan since all fiduciaries have potential lia-bility for the actions of their cofiduciaries For example if one fiduciaryknowingly participates in a second fiduciaryrsquos breach of responsibility con-ceals the breach or does not act to correct it the first fiduciary is liable aswell

bull Bonding Requirement As an additional protection for plans those who han-dle plan funds or other plan property generally must be covered by a fidelitybond A fidelity bond protects the plan against loss resulting from fraudu-lent or dishonest acts of those covered by the bondA fidelity bond is notthe same as fiduciary liability insurance Fiduciary liability insurance is notmandatory but is maintained by many employers

penalties for fiduciary breaches

When a fiduciary breaches its fiduciary duties the fiduciary can be personally li-able for any losses suffered by the plan and subject to such other equitable or re-medial relief as a court may determine as follows

bull Compensatory Damages and Equitable Relief A fiduciary is personally liable torestore plan losses and any profits made through the improper use of plan

penalties for fiduciary breaches 231

assets The fiduciary may also be subject to such other equitable or remedialrelief as the court may deem appropriate If the fiduciary has benefits underthe plan involved the plan may obtain a judgment or settlement providingfor the offset of the amount ordered or required to be paid to the planagainst the participantrsquos benefits under the plan A civil action may bebrought against a fiduciary by a plan participant a beneficiary the DOL orby another fiduciary

bull Statutory PenaltiesThe DOL may assess a civil penalty of 20 of the amountrecovered in an action brought by the DOL (whether the amount recoveredis through a settlement or court order) The DOL may waive this penalty ifthe DOL determines that the fiduciary (or other person) acted reasonablyand in good faith or it is reasonable to expect that the fiduciary (or otherperson) cannot restore losses to the plan without severe financial hardshipunless the waiver is grantedThe IRS also can impose an excise tax on anyfiduciary duty breach that constitutes a prohibited transaction The initialtax is 15 of the amount involved If the transaction is not corrected afternotice from the IRS an additional tax of 100 of the amount involvedcould be imposed Finally criminal penalties also may be imposed on indi-viduals or companies for ldquowillfulrdquo violations of ERISA Under the recentlyenacted Sarbanes-Oxley legislation Congress substantially increased themaximum criminal penalty for such violationsmdashconviction may result infines of up to $100000 or 10 years in prison for individuals and fines of upto $500000 for companies

bull Removal In cases involving serious breaches of trust courts may exercisetheir equitable powers and order the removal of a fiduciary and prevent thefiduciary from ever again acting as an ERISA fiduciary or as a serviceprovider to an ERISA plan One notable recent example is the Enron situ-ation where as part of a proposed settlement with the DOL the membersof the Enron board of directors were barred for five years from acting as fi-duciaries of any ERISA plan unless they receive DOL permission

If there is an actual or potential breach of fiduciary duties there are severalavailable remedial options including requesting guidance from the DOL in theform of an individual prohibited transaction exemption (which can even be ob-tained after the fact) Also to the extent the fiduciary breach involves a prohibitedtransaction IRS Form 5330 will need to be completed to report the prohibitedtransaction and pay the associated excise tax

The DOL has provided a correction program for certain fiduciary breachescalled the Voluntary Fiduciary Correction (VFC) program The VFC program allowsfiduciaries to avoid potential civil actions brought by the DOL under ERISA and

the assessment of civil penalties by the DOL The purpose of the VFC and thecorresponding class exemption is to encourage the ldquovoluntary and timely correc-tion of possible fiduciary breachesrdquo under ERISA

In general a person who has violated certain ERISA requirements may takeadvantage of the VFC by ldquocorrectingrdquo the ERISA violation and completing aVFC filing with the DOL The VFC is limited to certain specified transactionsAs noted in the Preamble to the VFC the DOL believes that the transactionsspecified under the VFC are uniform enough that general rules of correction canbe stated with respect to them

A person who satisfies the VFC requirement may also avoid excise taxes underCode Section 4975 with respect to a limited number of prohibited transactionsProhibited Transaction Class Exemption (PTCE) 2002-51 sets forth the require-ments that must be satisfied to avoid excise taxes The program covers 15 trans-actions including failure to timely remit participant contributions and someprohibited transactions with parties-in-interest The program includes a descrip-tion of how to apply as well as acceptable methods for correcting violations Inaddition the DOL gives applicants immediate relief from payment of excise taxesunder a class exemption

prudent procedures to limit fiduciary liability

The following describes several steps prudent fiduciaries can take to manage fi-duciary risk

bull Hold Regular Meetings and Document Findings One way fiduciaries candemonstrate that they have carried out their responsibilities properly is bydocumenting the processes used to carry out their fiduciary responsibilitiesIn carrying out their duties plan fiduciaries must review all relevant factsand circumstances (ldquosubstantive prudencerdquo) and make their decisions in ac-cordance with proper procedures (ldquoprocedural prudencerdquo) It is essential todocument the procedures followed in making any fiduciary decision (egcommittee minutes)Plan fiduciaries are not responsible per se for the out-come of fiduciary decisions however they are responsible for maintaining aproper fiduciary decision-making process that is protective of plan partici-pantsrsquo interests

bull Establish an Investment Policy With respect to plan investments an invest-ment policy should be maintained for each plan The investment policyshould cover the following topics (1) the role and responsibilities of the fi-duciary (and possibly other fiduciaries involved in plan investments such as

prudent procedures to limit fiduciary liability 233

the trust manager and the trustee) (2) the overall investment objective ofthe plan (3) the asset allocationinvestment funds of the plan (4) investmentobjectives and guidelines for each investment fund (or portion of the planrsquosportfolio) (5) performance standards (6) selection procedures (7) reviewprocedures and (8) at least in general terms termination criteria An in-vestment policy should be reviewed periodically and modified as necessarySee Chapter 7 for a further discussion of written policy statements

bull Give Participants Investment Responsibility Some plans such as most 401(k)403(b)or profit-sharing plans can be set up to give participants control overthe investments in their accountsFor participants to have control they mustbe given the opportunity to choose from a broad range of investment alter-natives Under DOL regulations there must be at least three different in-vestment options so that employees can diversify investments within aninvestment category such as through a mutual fund and diversify among theinvestment alternatives offered In addition participants must be given suf-ficient information to make informed decisions about the options offeredunder the plan Participants also must be allowed to give investment in-structions at least once a quarter and perhaps more often if the investmentoption is extremely volatile If an employer sets up their plan in this manner[a so-called ldquo404(c)rdquoplan] a fiduciaryrsquos liability is limited for the investmentdecisions made by participantsHowever a fiduciary retains the responsibil-ity for selecting the providers of the investment options and the optionsthemselves and monitoring their performance

bull Hire (and Monitor) an Outside Expert A fiduciary can also hire a serviceprovider or providers to handle fiduciary functions entering into an agree-ment so that the service provider assumes responsibility for those functionsselected If an employer appoints an investment manager that is a bank in-surance company or registered investment adviser the employer is respon-sible for the selection of the manager but is not liable for the individualinvestment decisions of that manager However an employer is required tomonitor the manager periodically to assure that it is handling the planrsquos in-vestments prudently Note that hiring a service provider is in and of itself afiduciary functionWhen considering prospective service providers plan fi-duciaries should provide each of them with complete and identical infor-mation about the plan and the desired services so as to permit a meaningfulcomparison Some items a fiduciary needs to consider when selecting aservice provider include

bull Information about the firm itself financial condition and experiencewith retirement plans of similar size and complexity

bull Information about the quality of the firmrsquos services the identity experi-ence and qualifications of professionals who will be handling the planrsquosaccount any recent litigation or enforcement action that has been takenagainst the firm and the firmrsquos experience or performance record

bull A description of business practices how plan assets will be invested if thefirm will manage plan investments or how participant investment direc-tions will be handled the proposed fee structure and whether the firmhas fiduciary liability insuranceAn employer should document its selection (and monitoring) process

andwhen using an internal administrative committee should educate com-mittee members on their roles and responsibilities

In addition the employer must monitor the service provider establishingand following a formal review process at reasonable intervals to decide if itwants to continue using the current service providers or look for replace-mentsWhen monitoring service providers actions to ensure they are per-forming the agreed-upon services includebull Reviewing the service providersrsquo performancebull Reading any reports they providebull Checking actual fees chargedbull Asking about policies and practices (such as trading investment

turnover and proxy voting)bull Following up on participant complaints

bull Monitor Fees Fees are just one of several factors fiduciaries need to considerin deciding on service providers and plan investmentsWhen the fees forservices are paid out of plan assets fiduciaries must understand the fees andexpenses charged and the services provided Although the law does notspecify a permissible level of fees it does require that fees charged to a planbe ldquoreasonablerdquo In comparing estimates from prospective service providersplan fiduciaries should ask which services are covered for the estimated fees and which are notThis is important because some providers offer anumber of services for one fee (sometimes referred to as a ldquobundledrdquo serv-ices arrangement) while other service providers charge separately for indi-vidual services Plan fiduciaries need to compare all services to be providedwith the total cost for each provider and consider whether the estimate in-cludes any unnecessary or unwanted services

Plan fiduciaries should also be aware that all services have costs so even ifa service is advertised as ldquofreerdquoor without chargeplan participants likely arepaying for the services indirectly For instance some service providers mayreceive additional fees from investment vehicles such as mutual funds thatmay be offered under an employerrsquos plan For example mutual funds often

charge fees to pay brokers and other salespersons for promoting the fundand providing other services There also may be sales and other relatedcharges for investments offered by a service providerAs a result plan fidu-ciaries should ask prospective providers for a detailed explanation of all feesassociated with their investment options

Once fiduciaries have properly identified the plan expenses those ex-penses may be paid by the employer the plan (if the plan so provides) orboth In addition for expenses paid by the plan they may be allocated toparticipantsrsquo accounts in a variety of ways pursuant to DOL guidance Inany case the plan document should specify how fees are paid

Finally after carefully evaluating fees during the initial selection processplan fiduciaries should make sure to monitor the planrsquos fees and expenses todetermine whether they continue to be reasonable

department of labor tips to helpfiduciaries understand theirresponsibilities

Finallybecause understanding fiduciary responsibilities is important for the secu-rity of a retirement plan and for compliance with the law the DOL has providedsome tips (slightly modified below) as a helpful starting point for employers andplan fiduciaries

bull Have you identified your plan fiduciaries and are those fiduciaries clearabout the extent of their fiduciary responsibilities Are all of the plan docu-ments (ie the plan the trust the investment manager agreements etc)consistent on the identification and roles of various fiduciaries

bull If participants make their own investment decisions have you provided suf-ficient information for them to exercise control in making those decisionsand have you notified participants that the plan is a so-called ldquo404(c)rdquo plandesigned to limit the fiduciariesrsquo liability for the investment decisions madeby participants

bull Are you aware of the schedule to deposit participantsrsquo contributions in theplan and have you made sure it complies with the law

bull If you are hiring third-party service providers have you looked at a numberof providers given each potential provider the same information and con-sidered whether the fees are reasonable for the services provided Have youdocumented the hiring process Are you prepared to monitor your planrsquosservice providers

bull Have you identified parties-in-interest to the plan and taken steps to mon-itor transactions with them Are you aware of the major exemptions underERISA that permit transactions with parties-in-interest especially those keyfor plan operations (such as hiring service providers and making plan loansto participants)

bull Have you reviewed your plan document in light of current plan operationsand made necessary updates After amending the plan have you providedparticipants with an updated summary plan description (SPD) or summaryof material modifications (SMM)

bull Are all individuals handling plan funds or other plan property covered by afidelity bond

department of labor tips 237

chapter 20

Final Thoughts

By now we hope you feel that you have a handle on the oversight of yournot-for-profit investment portfolio

summary

We have explored

bull Challenges that will be faced by nonprofit organizations in the 21st centuryincreasing demand for your services reduced funding lower investment re-turn expectations and increased fiduciary scrutiny

bull Special Issues Facing Hospitals including retirement plan considerations andthe increasing importance of endowment funds

bull Considerations for Religious InstitutionsThe decline in the numbers of youngpeople choosing to enter religious life and cash flow problems

bull The Total Return Approach as a superior spending methodology

bull Investment StyleThe key determinant of manager performance

bull Newer Asset Classes including real estate investment trusts (REITs) high-yield bonds non-US fixed-income and inflation indexed bonds (Treasuryinflation protection securities or TIPS) and how these assets can increaseyour opportunity for diversification

bull Alternative Investments including hedge fundsprivate real estate timberlandprivate equity structured products and managed futures and some of theirbenefits and drawbacks and why you may need to use them

bull Socially Responsible Investing Creating you own screens or using prescreened

funds and managers to match your investment portfolio to your core values

bull Selecting Other Vendors How to find custodians trustees record keepers andbrokers

bull Hiring Investment Management Consultants How to tell if you need onehowto identify the real thing (as opposed to the many salespeople disguised asldquoadvisersrdquo) and how to select a consultant who fits your needs

bull Behavioral Finance A new financial world-viewmdashidentifying the mental er-rors that humans make can help avoid ldquoshooting ourselves in the footrdquo

bull Legal requirements for endowments and other donor funds A brief overview ofprudent procedures for fund fiduciaries

bull Employee Retirement Income Security Act (ERISA) Legal requirements for re-tirement plan sponsors

bull Fees How to establish investment programs that are cost effective and howto negotiate with vendors to help reduce fees

the prudent steward

There are six steps involved in the effective management of your investmentfundThese six steps are followed by virtually all of the largest most successfulnon-profits

1 Set goals

2 Allocate assets

3 Develop a written investment and spending policy statement

4 Select managers

5 Implement a rebalancing strategy

6 Monitor performance

take aways

If you take away only two ideas from this book they should be

bull Asset allocation is far and away the most important decision you make It ac-counts for over 90 of your investment results Get this right and you aremiles ahead of the gameThe new probabilistic models avoid some of thedrawbacks inherent in traditional mean variance optimization and can helpyou create an ldquoall-weatherrdquo portfolio

240 chapter 20 final thoughts

bull If you donrsquot have the time or expertise to follow the steps outlined in thisbookhire someone who doesGood investment consultants should be ableto pay for themselves several times over (If they canrsquot find someone else)

conclusion

Your role in overseeing nonprofit investments is both noble and material Likemost fiduciaries you do what you do to try to make a differenceMaybe yoursquore avolunteer board member or a donor who has created a private foundation In anycase you recognize you have a responsibility and you are likely reading this bookbecause you care deeply about your missionYou want to give your organizationevery opportunity to succeed

Hopefully the information in this book will help you to reach that worthy goal

conclusion 241

appendix A

Sample InvestmentPolicy Statement1

introduction

The Investment Policy for the ABC Hospital Fund (ldquoFundrdquo) has been estab-lished to facilitate a clear understanding of the investment policy guidelines andobjectives between the committee and its investment managers including thosefunds held for anticipated disbursementsThe Policy also sets forth the guidelinesand restrictions to be followed by the investment managers It is the intention ofthis Policy to be sufficiently specific to be both meaningful and flexible enoughto be practical

purpose

The ABC Hospital Fund exists to provide funding for the growth and mainte-nance of the ABC Hospital as it strives to be a quality provider of healthcare serv-icesABC Hospital is a nonprofit institution established in 1946 to provide highquality healthcare services and research to its members and surrounding com-munity The Fund will be utilized to establish or maintain programs that are con-sistent with the aims of the ABC Hospital and the Spending Policy found in thenext sectionThose aims may include but are not limited to providing funds for

1The following investment policy statement has been adopted by the ABC Hospital Fund and may beamended as necessary from time to time

21 schneider A 22505 940 AM Page 243

specific research projects approved by the boardproviding clinical support to staffdoctors and providing funds for resident and internship programs

spending policy

The ABC Hospital Fund will spend 45 of its assets each yearThese funds willbe spent on programs submitted to and approved by the board of trusteesTheSpending Policy shall be implemented with the intent not only to provide fundsfor the Hospitalrsquos immediate aims but also to preserve and grow assets to meet fu-ture spending needs

investment policy

The Fund shall be invested to provide for total return The Fund shall be investedin a diversified portfolio consisting primarily of common stocks bonds cashequivalents and other investmentswhich may reflect varying rates of return Theoverall rate of return objective of the portfolio is a reasonable ldquorealrdquo rate consis-tent with the risk levels established by the Finance Committee (ldquoCommitteerdquo)The minimum acceptable rate of return over a full market cycle (3 to 5 years) isthat which equals or exceeds the assumed spending rateplus the rate of inflationThe Committee has also established a target return objective which may bechanged from time to timebut is currently 80net of fees assuming a 31 in-flation rate (an assumption which may be adjusted from time to time and whoseforecast is based on long-term historical rates of inflation)

investment objectives

Return

The total return objective measured over a full market cycle (3 to 5 years)shall be to outperformnet of fees the custom indexmade up of 30 Standard ampPoorrsquos 500 15 Russell 2000 30 Lehman Brothers Aggregate Bond 15Europe Australia and the Far East (EAFE) and 10 Wilshire Real Estate Index

The Plan should experience less risk (volatility and variability of return) than thatof a custom index made up of the following indices 30 Standard amp Poorrsquos 500

244 appendix a sample investment policy statement

15 Russell 2000 30 Lehman Brothers Aggregate Bond 15 EuropeAustralia and the Far East (EAFE) and 10 Wilshire Real Estate Index

asset allocation

The target asset allocation for the investment portfolio is determined by theCommittee to facilitate the achievement of the Fundrsquos long-term investment ob-jectives within the established risk parametersDue to the fact that the allocationof funds between asset classes may be the single most important determinant ofthe investment performance over the long run the Planrsquos assets shall be dividedinto five major asset classes as follows

Maximum Minimum TargetClass Percent Percent Percent

Fixed Income 400 200 300

Large-Cap Domestic Equities 400 200 300

Small-Cap Domestic Equities 220 80 150

International Equities 220 80 150

Real Estate 100 50 100

Cash 390 00 00

The actual asset allocation which will fluctuate with market conditions willreceive the regular scrutiny of the CommitteeThe Committee bears the respon-sibility for making adjustments in order to maintain target ranges and for any per-manent changes to policy

cash flowsrebalancing

The Committee shall allocate net cash flows (contributions) to investment man-agersAs a general rule new cash will first be used to rebalance the total fund inaccordance with target asset allocation policy If one asset class reaches the maxi-mum or minimum limit the entire portfolio will be rebalanced to long-termasset allocation targets The purpose of rebalancing is to maintain the riskreward relationship implied by the stated long-term asset allocation targetsThisprocess may result in withdrawing assets from investment managers who haveperformed well in the latest year or adding assets to managers who have lagged inthe most recent period This policy may necessitate the purchase andor sale ofsecurities which may create transaction costs to the account and the recognitionof capital losses

cash flowsrebalancing 245

transaction guidelines

All transactions should be entered into on the basis of best price and executionAll fees commissions and other transaction costs shall be reported as requestedby the Committee

selection of investment fundsmanagers

In selecting the funds or managers the Committee will examine the following

A Firm Quality and Depth Investment companies should have a history of re-liability and a sound financial background

B History of Adherence to Investment Objective andor Approach Portfolio man-agers should consistently invest according to the investment objectivesstated in their prospectus and investment policy statement

C Performance Measured against an Appropriate Benchmark Based on the invest-ment objectiveholdings investment style and market capitalization an ap-propriate benchmark should be used for relative investment performanceevaluation

D Diversification Portfolio managers will employ investment strategies thatshow sufficient diversification

E Performance and Risk Investment performance should be competitive on along-term basis and on a risk-adjusted basis within each appropriate assetclass

F Fees Selected fundsmanagers should have reasonable fees competitivewith those of similar offerings

performance monitoring

All guidelines and objectives shall be in force until modified in writing If at anytime investment managers believe that a specific guideline or restriction is im-peding the ability to implement their process or meet the performance objectivethey should present this fact to the Committee

Each investment managerrsquos performance will be reviewed quarterly by theCommittee Investment managers (when requested) will report portfolio hold-ings and quarterly performance Additionally the managers should provide awritten update concerning current investment strategy and market outlook atleast every quarter Managers are required to inform the Committee of any

change in firm ownership organizational structure professional personnel ac-counts under management or fundamental investment philosophy within threemonths of such event

termination of managers

Managers will be reviewed by the Committee for possible termination if over arolling three year period they fail to outperform at least three of the five bench-marks enumerated in the attached appendices In addition managers may be ter-minated at any time at the discretion of the Committee Events that may triggersuch termination include but are not limited to

bull Illegal or unethical behavior on the part of the manager

bull Failure to follow the guidelines established in this investment policy state-ment

bull Change of key management personnel

bull Style drift

bull Insufficiency of managerrsquos infrastructure to keep pace with asset growth

bull Any other event which might prevent the manager from effectively carry-ing out their duties

proxy voting policy

Separately managed accounts will be voted in accordance with the procedures es-tablished in their respective Investment Policy Statements

Mutual fund accounts will be voted in accordance with established proceduresin place at their respective mutual fund families

responsibilities of the investment consultant

The investment consultant will provide performance measurement and evalua-tion reporting for each investment manager andor fund as well as for the totalfund(s) Performance will be evaluated relative to stated policy objectives appro-priate benchmarks and a universe of investment returns appropriate to the in-vestment manager or fund evaluatedPerformance will be evaluated over differenttime periods including the latest quarter as well as latest one- three- and five-

responsibilities of the investment consultant 247

year periods In addition to performance the consultant will provide reportingand evaluation regarding the level of risk associated with a managerrsquos perform-ance as well as the managerrsquos consistency and adherence to the specific stylewhich they were hired to implement

The investment consultant will also report to the Committee with the dataavailable on the compliance of a manager or fund to the guidelines of these policies

meeting schedule

Performance reviews will be held on a quarterly basisThis document is adopted as the Investment Policy for the ABC Hospital

abc hospital fund

Name ____________________________

Title ____________________________

Date __________________

managersrsquo investmentobjectives and guidelines

Dated May 2002

general guidelines for all managers

The investment managers shall have complete discretion in the management ofthe assets subject to the guidelines set forth herein

Mutual funds or commingled funds may be used in any category of investmentmanagementWhen one is selected however it is expected that the fund(s) willin general comply with the guidelines set forth herein No fund may be usedwithout approval of the Committee Any exceptions to these Guidelines shall belisted in the following Investment Manager Objectives section

Cash equivalents may be held in any managerrsquos portfolio at the managerrsquos dis-cretion so long as the securities used comply with the guidelines established forfixed-income managersManagers will be evaluatedhoweverbased on their per-

formance relative to the appropriate index benchmark regardless of the amountof cash equivalents held during any performance-measuring period

Investment managers shall be required to provide quarterly reports Perform-ance shall be reviewed each quarter with emphasis on mid- to long-term objec-tives generally defined as three and five years respectively

specific guidelines

Guidelines are included in the attached investment policy statements for eachmanager Mutual fund benchmarks are listed in the Investment ManagerObjectives section

Implementation

The portfolio will be reviewed on a quarterly basis to assure compliance withthe guidelines

investment manager objectivesevaluation benchmarks of selectedmanagers

Over a rolling three- to five-year period each managerrsquos performance is expectedto exceed at least two of the three established benchmarks

1 ABC Fixed Income Manager

a Appropriate Universe Benchmark (Return) MedianIntermediate Fixed Income

b Appropriate Index BenchmarkLehman Aggregate Bond Index

c Appropriate Risk-Adjusted Performance Positiveversus the Policy annualized

alpha2 ABC Domestic Equity Manager

a Appropriate Universe Benchmark (Return) MedianLarge-Cap Core

b Appropriate Index BenchmarkSampP 500 Index

investment manager objectives 249

alpha3 ABC International Equity Manager

a Appropriate Universe Benchmark (Return) MedianInternational Equity

b Appropriate Index BenchmarkMSCI EAFE Index

appendix B

Investment Manager Questionnaire

1 Firm Name ____________________________________

Address ________________________________________

2 Primary Contact ________________________________

3 Telephone Number ______________________________

Fax Number ____________________________________

Web Site amp Password (if applicable) __________________

Email address __________________________________

Organization

1 When was the firm formed Month ____________

Year ______________

2 Please provide the requested information regarding your firmrsquos assets undermanagement

Domestic International Fixed TotalEquity Equity Income Assets

of of of UnderPeriod Accts Assets Accts Assets Accts Assets Mgt

22 schneider B 22505 940 AM Page 251

3 Provide the name relationship and percentage ownership ofa each parent organizationb other affiliated organizations

4 Please provide a brief history of your organization Be sure to include theownership structure and a list of all offices (along with the number of invest-ment professionals at each location)

5 Please provide a detail (including the percentage ownership) of current own-ers of the firm Include the titles of employee owners

6 Does your firm have a succession plan If so please outline in fewer than 150words

7 Does the firm have errors and omissions insurance Please indicate the extentof coverage

8 Does the firm have fiduciary liability insurance Please indicate the coverage

9 In the past 10 yearshas the firm its parentor another subsidiary been subjectto any litigation or censure by a regulatory body If yes please explain

10 Has the firm or any of its employees ever been the subject of any sanction ordisciplinary action by any state or federal regulatory body Are there any SECor other legal inquiries pending against the firm If so explain

11 Please detail all relationships for which the firm or its employees receivecompensation or pay for referrals

12 Provide a copy of the firmrsquos Form ADV Parts I amp II

Assets Under Management

1 Please provide a breakdown of the firmrsquos assets under management as of themost recent quarter

Total Assets ____________________________________

Total Tax-Exempt Assets __________________________

2 Identify any area of the firmrsquos business that is receiving additional marketingemphasis at this time

3 What are the goals for growth of assets under management for the organiza-tion Please discuss total assets total accounts addition of staff and new prod-ucts

4 Is there a dollar amount of assets under management in any product whereyou expect to close to new investors (Please list product and dollar amount)

5 Please provide the names of all accounts with over $1 million in assets thatwere lost in the past three years and list the reason

252 appendix b investment manager questionnaire

Client NameAccount Size Reason for Loss

Professional Staff

1 Please provide the total number of employees of the firm

2 Please provide the number of investment professionals by function

Total number Number ofof Professionals Professionals(Firm) (Product)

Equity portfolio managers

Fixed-income portfolio managers

Equity research analysts

Fixed-income research analysts

Marketing and client service

Chief investment officers

Economists

Equity traders

Fixed-income traders

Administration

Other (explain)

3 Provide biographies on your key portfolio managers and analysts

4 Describe the compensation package available to your professional staff in-cluding any incentive bonuses (ie performance or asset based) stock op-tions and equity participation

5 Describe and explain any departures or additions in investment personnelthat have taken place during the past three years If changes in staff have oc-curred please indicate the functional titles (eg portfolio manager) of eachand describe the changes

6 What is the average number of accounts per portfolio manager Please indi-cate whether your firm has an established maximum number of accounts permanager and if so what that maximum is

appendix b investment management questionnaire 253

7 List the average years at the firm and in the industry for both your analystsand portfolio managers

8 Is the research analyst position a career path for future portfolio managers oris it considered a career path by itself Have any research analysts been hiredas portfolio managers

9 Who is responsible for relationship management activities Describe howclient servicing responsibilities are divided between portfolio managers andclient servicingmarketing personnel

Investment PhilosophyStrategy

1 Strategy ___________________________________________________

2 Date of first actual account ____________________________________

3 Total product assets (in Millions) ________________________________

4 Total product accounts _______________________________________

5 Please provide the following information for this product

Product Accounts AccountsTotals Gained Lost

of of ofAccts Assets ($) Accts Assets($) Accts Assets ($)

6 Minimum account size for separately managed ____________________

7 Minimum fee for separately managed ____________________________

8 Fee schedule for separately managed accounts

of Basis Points Amount of Assets

_____________ On the first $ ____________________

_____________ On the next $ ___________________

9 Minimum account size for pooledcommingled ___________________

10 Minimum fee for pooledcommingled accounts

_____________ On the first $ ____________________

_____________ On the next $ ___________________

11 Will you negotiate fees on this product yes___ no___

12 Do you currently have any accounts using performance-based fees with thisproduct yes___ no___ If yes how many accounts__________________

13 Please describe in detail your firmrsquos investment philosophy and strategy

14 Explain your buy discipline including economic analysis initial screening ofsecurities screening steps and criteria number of securities followed etc

15 Does your firm use an equity investment committee to select specific securi-ties If so indicate the members of the committee frequency of meetingsand the implementation process of committee decisions If not describe thedecision-making process employed by your firm

16 Provide the names of all investment professionals associated with this prod-uct (include the name title years with the firm and years in the industry)

17 What is the number of industries covered per analyst (or portfolio manager)

18 How often do investment professionals meet with companies

19 Please describe your equity research capabilities and the extent to which yourely on external sources for research

20 Describe your sell discipline (price targets market cap restrictions portfoliopercentage guidelines individual holding restrictions etc)What events typ-ically trigger a sell signal

21 How are portfolios constructed Please discuss the sector industry and indi-vidual security weighting process Also include the benchmark that sectorexposure is measured against

22 What are the normal minimum and maximum percentages of a total port-folio that would be invested in any one sector industry and stock (absoluteor relative to the benchmark) Has this philosophy been altered over the pastfive years Can the portfolio manager override any of the guidelines If sohow often has this happened

23 Do you use a model portfolio If so who is responsible for maintaining andupdating the model portfolio

24 Do you have liquidity screens for smaller cap stocks

25 Please provide the following portfolio characteristics

062004 122003 062003 122002 062002 122001 062001 122000

DebtEquity

3 Year EPS Growth Rate

in Top 10 Holdings

Medium Market Capitalization

of Securities

Foreign

26 Do you use derivative financial instruments IPOsor ADRs in the portfolioIf leverage is used discuss in detail the use and methodology behind thestrategies employed

27 Please provide sector distributions for the past eight quarters

28 What do you consider to be the most appropriate benchmark for this strat-egy

29 What is the annual turnover range in a typical portfolio

30 Over a market cycle what is the typical cash range in this product

31 What is the minimum and maximum market cap of an individual security forthis product

32 At what level would you close this product to new assets

33 What factors differentiate this product from others with a similar style (pleaselimit your response to 150 words)

Trading

1 How many full-time traders does the firm employ

2 What level of input do traders have in the investment decision-makingprocess How much discretion do traders enjoy when implementing a buyor sell decision

3 Does the firm or an affiliate underwrite securities

4 Does the firm or an affiliate purchase securities for client accounts on a prin-cipal basis

ComplianceRisk Controls

1 Does your firm have a separate compliance department

2 How are accounts monitored for compliance with strategy targets modelportfolios approved list holdings restrictions etc

3 What tools are used to automate the compliance process

Performance

1 Please provide AIMR compliant quarterly performance data in an attachedMicrosoft Excel spreadsheet in the following format

1 Date Return

2 122003 343

3 92003 234

Also include all AIMR disclosures

2 Please provide the following information regarding the composite

CompositePeriod Number of as a ofEnding Accounts Total Assets High Low

3 What is the size of the smallest and largest account in the composite

Dispersion Range

4 How is dispersion monitored and controlled

5 Does the composite comply with AIMR performance presentation stan-dards If yes since what date

6 Are results actual or simulated Please provide the dates from which actual re-sults begin

7 Does the firm monitor historical performance attribution What system isused

8 Do you manage or subadvise mutual funds in the same style as this productIf so how does the fund differ from the product provided above

Questionnaire completed by

Title __________________________________________

Date __________________________________________

appendix C

Sample SearchInvestment Analysis

definition of key statistics

bull ReturnTime-weighted average annual returns for the time period indicated

bull Standard DeviationStandard deviation is a statistical measure of the range of performancewithin which the total returns of a fund fallWhen a fund has a high stan-dard deviation the range of performance is very widemeaning that there isa greater volatilityApproximately 68 of the time the total return of anygiven fund will differ from the average total return by no more than plus orminus the standard deviation figure Ninety-five percent of the time afundrsquos total return will be within a range of plus or minus two times thestandard deviation from the average total return If the quarterly or monthlyreturns are all the same the standard deviation will be zeroThe more theyvary from one another the higher the standard deviation Standard devia-tion can be misleading as a risk indicator for funds with high total returnsbecause large positive deviations will increase the standard deviation with-out a corresponding increase in the risk of the fundWhile positive volatil-ity is welcome negative is not

bull R-SquaredThis reflects the percentage of a fundrsquos movements that are explained bymovements in its benchmark index An R-squared of 100 means that allmovements of a fund are completely explained by movements in the indexConversely a low R-squared indicates that very few of the fundrsquos move-

23 schneider C 22505 941 AM Page 259

ments are explained by movements in the benchmark indexR-squared canalso be used to ascertain the significance of a particular beta Generally ahigher R-squared will indicate a more reliable beta figure If the R-squaredis lower then the beta is less relevant to the fundrsquos performanceA measureof diversification R-squared indicates the extent to which fluctuations in portfolio returns are explained by marketAn R-squared = 070 impliesthat 70 of the fluctuation in a portfolios return is explained by the fluctu-ation in the market In this instance overweighting or underweighting ofindustry groups or individual securities is responsible for 30 of the fundsmovement

bull BetaThis is a measure of a fundrsquos market riskThe beta of the market is 100Accordingly a fund with a 110 beta is expected to perform 10 better thanthe market in up markets and 10 worse than the market in down marketsIt is important to note however that a low fund beta does not imply thatthe fund has a low level of volatility rather a low beta means only that thefundrsquos market-related risk is low Because beta analyzes the market risk of afund by showing how responsive the fund is to the market its usefulness de-pends on the degree to which the markets determine the funds total risk(indicated by R-squared )

bull Sharpe RatioThe Sharpe ratio is the excess return per unit of total risk as measured bystandard deviation Higher numbers are better indicating more return forthe level of risk experiencedThe ratio is a funds return minus the risk-freerate of return (30-day T-Bill rate) divided by the fundrsquos standard deviationThe higher the Sharpe ratio the more reward you are receiving per unit oftotal risk This measure can be used to rank the performance of mutualfunds or other portfolios

bull AlphaThe alpha is the nonsystematic return or the return that canrsquot be attributedto the market It can be thought of as how the manager performed if the marketrsquos return was zero A positive alpha implies the manager addedvalue to the return of the portfolio over that of the marketA negative alphaimplies the manager did not contribute any value over the performance ofthe market

bull Information Ratio The information ratio is a measure of the consistency of excess returnThisvalue is determined by taking the annualized excess return over a bench-

260 appendix c sample search investment analysis

mark (style benchmark by default) and dividing it by the standard deviationof excess return

bull Tracking ErrorTracking error measures the volatility of the difference in annual returns be-tween the manager and the indexThis value is calculated by measuring thestandard deviation of the difference between the manager and index re-turns For example a tracking error of plusmn5 would mean there is about a 68chance (1 standard deviation event) that the managers returns will fallwithin plusmn5 of the benchmarks annual return

large company value search thescreening process

The search began with a database of 2242 large capitalization fundsmanagersThe following screens were applied

bull Assets of greater than or equal to $50 million

bull Median market capitalization of $8 billion or greater

bull Foreign stock of less than 20

bull Cash holdings of less than 15

bull Bond holdings of less than 5

bull Manager tenure greater than or equal to 2 years

bull Fund inception date of 3 years ago or longer (may consider funds withshorter history under special circumstances)

bull Expense ratio less than the Morningstar category group average

bull Consistent style emphasis

bull Consistent and clearly defined investment process

bull Organization stability of personnelinfrastructure

bull Ability to have loadssales charges waived

bull Manageable growth in assets

bull Quantitative analysis includes ranking of the following riskreturn scores 13 5 rolling year total return 3 5 year standard deviation 3 5 year Sharperatio 3 year Morningstar risk score

bull Additional screens may have been applied for administrative capabilities

large company value search 261

large c

y valu

r a lo

entrsquo

rsquosth

0ndash

trsquol

large-c

ndash3

+ndash

ndash5

ndash2

+ndash

Zephyr

Schneid

ssocia

Manager S

1999 -

Russell

1000 V

ussell

1000 G

Russell

2000 V

ussell

2000 G

all-101

e Valu

erican F

unds W

Dodge amp

ussell

Generic C

1999 -

-month

ell 1000 V

ell 1000 G

ell 2000 V

ell 2000 G

Dodge amp

Manager

le12-Q

1999 -

Russell

1000 V

ussell

1000 G

Russell

2000 V

ussell

2000 G

all-101

e Valu

erican F

unds W

Dodge amp

ussell

Generic C

ance A

ttributio

1999 -

d to S

Benchm

erican F

unds W

Dodge amp

ithZephyr

anagerre

Zephyr

Schneid

ssocia

Manager

2001 -

Return

Dodge amp

1000 V

Manager

1999 -

Return

Dodge amp

1000 V

-month

2001 -

Upside

Dodge amp

1000 V

1999 -

Upside

Dodge amp

1000 V

anager re

ffron E

ar Inc

Zephyr

Manager

rn thro

d if le

Zephyr

ingsta

Return

101520

Dodge amp

1000 V

entile to M

n to 7

entile

Manager

lpha thro

less t

Zephyr

ingsta

Alpha -11

Dodge amp

1000 V

entile to M

n to 7

entile

Manager

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

Manager

lpha R

ank thro

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

anager re

ffron E

ar Inc

Zephyr

Schneid

ssocia

Manager

less t

Zephyr

ingsta

Sharpe Ratio -040

Dodge amp

1000 V

entile to M

n to 7

entile

Manager

less t

Zephyr

ingsta

Information Ratio

-4-3-2-101

Dodge amp

1000 V

entile to M

n to 7

entile

Manager vs U

Rank thro

mber 2004

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

Manager

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

anager re

ffron E

ar Inc

appendix D

zzz eVestment Alliance LLC eAUS Equity Sample Product

24 schneider D 22505 941 AM Page 271

on amp

d Tamp

alTamp

appendix d zzz evestment alliance llc 273

ldquoMos

ionrdquo

274 appendix d zzz evestment alliance llc

ldquoBal

atrdquo

mdashA

8mdash

Investment Strategy

eVestment Alliancersquos (eArsquos) process is primarily bottom up in which they interrelate price withearnings momentum Their strategy uses a present valuation model in which the current price ofthe stock is related to the risk-adjusted present value of the companyrsquos future earnings stream

Screening Process

The Investment Policy Group works as a team by using a bottom-up selection process

The identification of appropriate stocks for consideration begins with screening a database of9000 common equity securities for market capitalization of at least $3 billion a minimum 10historical earnings growth rate and a proprietary quality evaluation The resultant universe of ap-proximately 500 common stocks is then subject to our proprietary earnings and valuation mod-els Analyst judgment based on qualitative factors and strong financial characteristics furthernarrow the universe to a select list of approximately 150 names

Analysts follow these stocks closely regularly evaluating their valuation and relative earningsgrowth We typically initiate a position in a stock that is trading at a discount (normally 10ndash25)to our estimate of its intrinsic value This value is computed using a modified present value modelthat incorporates our analystsrsquo assumptions for normalized earnings secular earnings growthrate (minimum 10 maximum 20) dividend payout ratio and a stock-specific risk-adjusteddiscount rate

The discount rate is determined by our proprietary 11 factor financial scoring process which re-flects a companyrsquos historical long-term growth earnings quality balance sheet strength andprofitability This score combined with earnings variability net worth and trading volume de-termines a companyrsquos relative place within a range of discount rates The base rate is the current10-year Treasury yield We then assign a suitable equity risk premium that may range from 050 up to 400 above the 10-year Treasury yield depending upon the quality of the companyThe valuation model is a dynamic process in which the earnings base is adjusted each quarterIn addition the fundamental attributes that contribute to the risk-adjusted discount rate arereevaluated annually for each security and more frequently if market industry or specific com-pany issues so demand Our valuation model is updated daily and published every two weeks

We consider above median relative earnings growth to be the catalyst driving share price appre-ciation This measure is determined by comparing estimated and historical six-month annualizedearnings growth to a benchmark and subsequently ranking companies by decile

Analyst judgment based on fundamental analysis that includes thorough due diligence of com-pany and industry fundamentals is the final arbiter in determining candidates to be presented tothe IPG for investment consideration and potential inclusion in the growth model portfolio of 30to 40 issues

Portfolio Construction Methodology

Portfolio risk is primarily controlled by eArsquos purchase of high-quality companies with strong bal-ance sheets management and earnings momentum the Firmrsquos emphasis on price their diver-sification guidelines the conservative growth assumptions used when valuing companies andtheir sell discipline Risk is controlled through the continuous evaluation of the Model Portfoliowhich is implemented across all fully discretionary accounts and by monitoring the dispersionof portfolio characteristics relative to the target benchmark eA does not use derivatives to controlportfolio or security risk

The Firmrsquos diversification guidelines include a maximum 7 exposure to any one security al-though a position will rarely exceed 5 Their sector allocation may range from 0 up to no morethan 25times the weighting of any given sector in the SampP 500 subject to a 40 cap Typically initialsecurity purchases will be 2 to 3 of the market value of the portfolio Some holdings may com-prise as little as 1 They buy US domiciled companies US registered ADRs and foreign com-panies listed on US stock exchanges

(For client and consultant relationships comparing eA to the Russell 1000 Growth index eA uti-lizes the SampP 500 index in sector allocation because they believe it to be a better indication ofthe broad market whereas the R1000G index can become overweighted at times in individualsectors This helps to insure that eArsquos guidelines monitor the diversification of their portfolio atthe broadest level possible)

BuySell Discipline

eArsquos IPG is the catalyst in their decision-making process Portfolio policy and stock selection arereviewed at IPG meetings held at least twice weekly Specific decisions regarding purchases andsales and the percentage of the portfolio any security is to represent are based on consensus re-sulting from these meetings and are implemented across all accounts unless there are specificclient restrictions In fully discretionary accounts with no client restrictions the portfolio man-agers have no discretion to enact trades that are not approved by the IPG

Sell Discipline If a companyrsquos results remain consistent with eArsquos forecast they could hold theposition for a number of years On average their holdings tend to make the maximum move inprice with a two-year period However if a security becomes excessively valued before that timeor if they foresee a slowdown in earnings momentum they would take profits eA would also re-duce a position when it exceeds 5 of the equity portion of a portfolio Their average annualturnover is normally 30 to 40

A holding will be reviewed for probable sale when it reaches eArsquos target price ratio which is nor-mally 120 of their determination of its fair value Trimming the position rather than total salemight be the decision in the case of a big-growth company with rapidly compounding earningsStocks are also sold when experiencing weakening earnings momentum or underperformingthe market

Any significant earnings disappointment will trigger an immediate review of the holdings and adecision to ldquoadd or sellrdquo Since eArsquos investment policy centers on positive earnings momentumwithin a six-month period ldquoadd or sellrdquo decisions are made within that framework This timeframe may be extended for one quarter out to nine months in order to capture exceptionally goodvalue occurring just prior to restored earnings momentum Unless they discern visible earningsgrowth for the next six to nine months and the valuation is attractive enough to justify adding po-sitions they will sell on earnings disappointments

TradingExecution Strategy

Once the decision to buy or sell a security is approved eArsquos trading department determines(based on the percent position of a portfolio and the securityrsquos price) the total number of sharesto be allocated a group of larger fully discretionary institutional portfolios that have no restric-tions Trading then forwards via e-mail the optimization sheet for the security to all portfolio man-agers and portfolio assistants Trading is able to begin the execution process with the group ofaccounts for which it has optimized and then merges orders submitted by the managers as theycome into trading for which the block execution process has begun The trade orders are preparedby the assistants and checked by the portfolio managers for compliance with the directives of the

IPG and the clientrsquos guidelines Orders are imported into the Longview 2000 Order ManagementSystem from the AXYS Portfolio Accounting System

The broker selection for a trade is of paramount importance The traders take the actualexecution reports from brokers and compare those with time and sales monitored from the quotesystem

eA focuses on getting total participation across all portfolios in order to avoid opportunity costsIn the process they try to limit price variation as much as possible Their traders maintain closecommunication with the chief investment officer the portfolio managers and analysts relayingtrends in the market that may affect the buy or sell program

Normally fully discretionary accounts are traded before directed trades Generally eA will exe-cute nondirected brokerage orders in securities before directed orders in order to minimize mar-ket movement in the substantial positions of securities held in client accounts The sequence oftrades of securities with directed brokers is varied so that all directed brokerage accounts overtime are treated fairly Because of the length of time required for numerous brokers to completethe trades some directed brokerage accounts for securities may obtain either higher or lowerprices that were obtained for the completed nondirected trades

Although eA will follow its clientsrsquo instructions regarding directed trades they strongly suggestthat clients direct no more than 25 to 30 of the commission business They recommend thatin directed accounts the directed trades be used in an initial buy-in or in cash flows They do notrecommend directed brokerage when they are executing programs across all accounts

Additional Comments

This is test language

ndash40

35times

34times

99times

0ndash

timesCu

23times

gt $50

15ndash

smdash

5ndash15

15ndash

ndash1

ndash75

lt $40

)mdash

mdashCo

mdashEn

smdash

mdashH

dsmdash

mdashIn

mdashM

mdashTe

mdashU

temdash

ndash7

72ndash

1ndash

6ndash

ndash5

61ndash

mdash6

60ndash

ndash11

ndash2

ndash3

74ndash

mdash9

ndash27

ndash20

ndash22

ndash9

66ndash

5ndash

4ndash

ndash3

67mdash

ndash2

95ndash

3ndash

onmdash

mdashmdash

9mdash

mdashmdash

mdashA

hamdash

mdashmdash

ndash8

70ndash

mdashmdash

ormdash

mdashmdash

3mdash

mdashmdash

mdashIn

mdashmdash

mdashndash

ndash0

12mdash

mdashmdash

mdashS

mdashmdash

mdashndash

ndash0

60ndash

mdashmdash

ISAmdash

mdashmdash

mdash29

ndash1

kmdash

mdashmdash

ndash27

ndash20

ndash22

mdashmdash

mdash57

ndash31

mdashmdash

ormdash

mdashmdash

mdashIn

mdashmdash

omdash

mdashmdash

AmdashG

mdashmdash

ndash2

38mdash

kmdash

mdashmdash

mdashndash

2ndash

3mdash

smdash

mdashmdash

mdash17

1mdash

mdashmdash

ormdash

mdashmdash

mdashIn

mdashmdash

omdash

mdashmdash

undmdash

mdashmdash

mdash12

ndash12

ndash14

mdashmdash

mdashndash

9ndash

2ndash

smdash

mdashmdash

45ndash

onmdash

mdashmdash

mdashA

hamdash

mdashmdash

mdashTr

mdashmdash

omdash

mdashmdash

mdashS

mdashmdash

tymdash

mdashCo

mdash12

mdash6

MPI Stylus Charts for zzz eVestment Alliance LLC eA US Equity Sample Product

Analysis As of Date 062004Data frequency Quarterly

Style Map Total Period Asset Allocation Total Period

Return Index Total Period Jan 86ndashJun 04 Total Period Jan 86ndashJun 04

Cumulative Performance Total Period Batting Average (Annualized Periods)

Total Period Jan 86ndashJun 04 Total Period Jan 86ndashJun 04

This analysis is created using MPI Stylus performance-based style regression software and drawsupon information sources believed to be reliable eA does not guarantee or warrant the accuracytimeliness or completeness of the information provided or the analysis generated and is not re-sponsible for any errors or omissions Performance and subsequent performance analysis maybe provided with additional disclosures available on eA systems and other important considera-tions such as appropriateness of the style regression parameters may be applicable

ndash10

1ndash

0ndash

ndash10

ndash50

0ndash

mdashA

03mdash

mdashmdash

ion) U

mdashEx

rsmdash

emdash

mdashD

mdashmdash

19mdash

mdashFu

smdash

palamp

Firm Background

eVestment Alliance was founded 4 years ago by the following individuals Matt Crisp HeathWilson Jim Minnick and Karen Minnick They later made an outstanding acquisition of MattRobison eA continues to build clients and enhance products

Joint VenturesAffiliations

Sample Capital is affiliated with ZZZ capital

Prior or Pending Ownership Changes

In April 1994 Montag amp Caldwell signed a merger agreement with Alleghany Corporation of NewYork a New York Stock Exchangendashlisted company to become a member of the Alleghany family ofcompanies The merger was completed July 29 1994 On October 19 2000 Montag amp Caldwellentered into an intent agreement whereby Alleghany Asset Managementmdashincluding Montag ampCaldwell Incmdashwould be acquired by a subsidiary of ABN AMRO ABN AMRO Bank is headquar-tered in the Netherlands and has operations in over 50 countries The parent companyrsquos shares(ADRs) are listed on the New York Stock Exchange (Symbol ABN) On February 1 2001 the mergerwas consummated

ABN AMRO fully understands the investment management business providing an excellent fitwith Montag amp Caldwell As a separate subsidiary of ABN AMRO we operate under our own nameand with our own corporate officers and staff Montag amp Caldwell will continue to exercise com-plete independence in its investment counseling activities

Prior or Pending Litigation

Additional Comments

No additional comments

appendix E

Request for Proposal for HedgeFund-of-Funds Management

A Organizational and Regulatory Considerations

1 Please provide the name title address e-mail address and phone num-ber of the person completing this RFP and the date of its completion

2 Provide the name and address of your firm

3 Is your firm a registered investment adviser If so e-mail a PDF copyof the firmrsquos Form ADV Parts I and II

4 What regulatory authority(s) is your firm registered with and whatwas the date of the last inspection

5 Does your firm have a compliance officer on staff If soplease providetheir name contact information and CV

6 E-mail a copy of the offering memorandum in a PDF

7 Does your firm serve as a stated ldquoERISA fiduciaryrdquoand do you possessan ERISA bond

8 Does the firm have errors and omissions and fiduciary liability insur-ance

9 Please describe any litigation that your firm has ever been a party toAlso is there any pending or imminent litigation

10 Has there ever been a criminal civil or administrative proceedingagainst your firmrsquos principals If so please summarize the situation(s)

11 Provide a short history of your firm with important milestones

12 Please describe your firmrsquos growth objectives

25 schneider E 22505 941 AM Page 293

13 Does your firm have business activities outside of asset management inalternative strategies If so please explain them

14 Discuss the firmrsquos capacity constraints

15 Please provide the name and contact information of the namedfund(s)rsquos external legal counsel audit firm custodian and administra-tor

16 Discuss the due diligence process you employed to select a custodianand administrator

17 What disaster recovery plans or other emergency procedures are inplace

18 Describe the ownership structure of your firm Please summarize anyownership changes that have occurred over the past 10 years or are an-ticipated to occur in the future

19 What percentage of the firm is owned by active employees Pleasesummarize the ownership stake of each employee-owner

20 How many people are currently employed with your firm Pleasebreak them down into the following categoriesbull Key decision makersinvestment committee membersbull Additional investment professionalsbull Sales staffbull Administrative staff

21 Clearly summarize the decision-making authority for the firm froman operating standpoint For example does a single person a board ofdirectors a committee of people etc make decisions Please providethe names and titles of applicable people

22 Provide an organization chart for your firm in a Word or PDF file asan attachment to the response of this RFP

B Product Summary

23 What are the legal structures of all of your products For all productsclearly state where the product is domiciled

Product Legal Structure

Product Name Legal Structure Where Domiciled

XYZ Fund Offshore Bermuda

24 Summarize the allowable contribution and distribution (and requirednotice) frequency for all named product(s)

25 Summarize any initial lock-up period if applicable for all named prod-uct(s)

294 appendix e request for proposal

C Assets Under Management

26 What are your firmrsquos total assets under management as of the RFP date

27 Summarize how your total firm assets are divided by investor type ac-cording to number of clients and assets by filling in the following tables

Number of Clients

Investor 2004 2003 2002 2001 2000

All clientsFirm employeesCorporate pension (ERISA)Public pension fundsTaft HartleyEndowmentfoundationsTaxable institutionsTax-exempt high-net-worth investorsTaxable high-net-worth investorsNon-US institutionalNon-US high-net-worthOther investors

Number of Clients

Investor 2004 2003 2002 2001 2000

28 Summarize the investor type for your largest five clients what percent-age of your total firm assets they represent individually and whichproducts they are invested in respectively

29 Summarize the growth history of the firmrsquos assets under management forthe last ten years (or since inception)

appendix e request for proposal 295

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets(in millions)

D Allocation of Assets Among Strategies

30 Outline your product allocation as of the RFP date and product in-ception dates for the named and non-named products Please use thefollowing template as your guide

Allocation Allocation InceptionProduct Name ($) () Date

All Named ProductsNamed Product 1 $X X XXX19XXAll Non-Named ProductsNon-Named Product A $A A XXX19XX

31 What type of investor is each product above designed to serve basedon its legal structure For examplepensions endowmentswealthy in-dividuals etc Also are there any restrictions regarding ERISA assetsfor any of the above products

32 Provide the growth history of the named productrsquos assets under manage-ment for the past 10 years (or since inception)Please use the followingtemplate as your guide

Named Product 1mdashName

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets(in millions)

33Provide the growth history of the non-named productrsquos assets under manage-ment for the past 10 years (or since inception) Please use the following tem-plate as your guide

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets(in millions)

(Other non-named products if applicable)

E Product Investment Strategies

34 What are the named product(s)rsquos targeted return volatility and corre-lation (to SampP 500 amp Lehman Aggregate Bond index)

35 List all of the underlying investment strategies employed by managersin the named product(s)

36 Clearly summarize the source of investment returns for each underlyingstrategy used in the named fund(s) and use examples if necessary

Strategy

(eg) Merger Arbitrage Merger arbitrage sometimes called risk arbi-trage involves investment in corporate events mergers and hostiletakeovers Managers typically purchase stocks of the company beingacquired and sell short the stocks of the acquiring company in orderto profit off the inevitable decline in spread Example Long PeopleSoft amp Short Oracle

37 Clearly summarize the sources of risk (and uses of leverage) for each ofthe above strategies (feel free to use examples)

Strategy

(eg) Merger Arbitrage The main risk of this strategy is that the mergerwill fall through or the spread between the long and short positionswidens (hurting the long and short positions) Leverage which is fre-quently employed can magnify the magnitude of losses

38 Summarize the number of managers being used in the named prod-uct(s) as of the date of this RFP Also what is the current largest allo-cation to a single manager

F Investment Philosophy

39 Describe your overall investment philosophy (core investment beliefs)and principles

40 What investment strategies if any do you avoid and why

41 Have there been any changes in the investment philosophy adopted byyour firm over the past five years If yes please specify

42 What percentage of the named fund(s) will be held in cash at anytime

G Investment Process

43 Summarize your overall investment process for the named product(s)

H Key Investment Professionals

44 List all of your key investment professionals (eg investment commit-tee members or decision-makers) and their tenure with the firm andtheir job functionAlso list all key investment professionals that havedeparted the firm in the past 10 years and the date they departed andtheir job function

45 For each of the people listed (both current and departed) supply a CVshowing their qualifications and what they did prior to their currentresponsibilities

46 Please list all of your research professionals (not designated above askey investment professionals) and their tenures with the firmAlso listall research professionals that have departed the firm in the past fiveyears the date they departed and a description of their job function

47 Are your investment professionals required to invest in your funds Ifso to what extent List the total amount of assets invested in the firmrsquosfunds by employees

48 Are investment professionals allowed to invest in the underlying man-agers outside the firmrsquos funds If so describe to what extent Howmuch of employee assets are invested in the underlying firms outsidethe firmrsquos funds

49 Please disclose any potential conflicts of interest (real or perceived) thatmay exist for the firm or any of the firmrsquos key investment professionals

50 Please describe the compensation structure for all of the firmrsquos professionals

I AssetStrategy Allocation Process

51 Describe the firmrsquos assetstrategy allocation process for the namedproduct(s)

52 What percentage of your value added as a manager would you say isassetstrategy allocation vs manager selection

53 Discuss how you go about defining and changing the assetstrategy al-location for your funds Does traditional Markowitz optimizationguide your diversification principles or are there other competingmodels or methodologies that drive the portfolio optimizationprocess

54 Define your firmrsquos main competitive advantage(s) in the assetstrategyallocation of your hedge fund of funds

55 What aspect of your asset allocation approach do you think distin-guishes your firm from other hedge fund of fund managers

56 Do you employ a tactical assetstrategy allocation strategy or a strate-gic assetstrategy allocation policy

57 If you employ a strategic long-term assetstrategy allocation policyhow often do you review the policy and how often have you madechanges

58 If you employ a tactical assetstrategy allocation how frequently andto what extent have you made tactical shifts to the allocation Pleasefeel free to provide specific examples

59 Clearly summarize the investment decision-making authority for thefirm from an assetstrategy allocation perspectivebull Does a single person a group of people a committee of people etc

make decisions bull Does a committee of people vote decisions with certain committee

members getting double votesbull Do decisions have to be unanimousbull Does any committee member have veto power

J Manager Evaluation and Due Diligence

60 What process do you have in place to identify potential new man-agers Do you employ the services of any external agents

61 Do you have any guidelines regarding when in the life cycle of thehedge fund you will invest (ie new talent vs more established hedgefund managers)

62 Describe in detail the firmrsquos due diligence process clearly stating whois responsible for carrying out each stage and for decision makingPlease outline the qualitative and quantitative selection criteria used inthis process including any screens on managers you will invest withE-mail a PDF version of a manager report you generated internally

63 How do you gather assess and utilize the following information onhedge fundsbull Background and integrity of personnelbull Legal structurebull Incentive structurebull Investment decision and portfolio management processbull Internal controlsbull Risk managementbull Managersrsquo personal investments in fundbull Security of credit bull Custody arrangements

64 Do you have any absolute standards regarding liquidity use of primebrokers transparency or the fee structure of hedge funds that youwould invest in

65 How do you measure risk at the individual hedge fund level (includereview of any analytical tools software and quantitative methods usedand state the specific measures used)

66 What attribution software (or processes) do you employ to determinethe source of manager performance and whether it is as a result of skill(active component of management process) or luck (returns resultfrom external factors not inherent in managerrsquos stated objective)

67 In assessing risk at the individual manager levelwhat tools do you useto detect changes in the managerrsquos behavior (eg style drifts increasein leverage fraud increase in risk)

68 How long do you expect due diligence to take and how much timewould you expect to spend with each manager during the due dili-gence process

69 On average how many new managers do you research per year

70 Do you have an approved list of managers If so how many managersare currently on it and what is their aggregate capacity What is the ca-pacity by investment strategy

71 Describe the ongoing monitoring process

72 Describe your manager termination disciplineprocess

73 How has the number of managers in your portfolio(s) changed overtime Complete the following table for the named product(s)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Managers

74 How many managers have been terminated per year over the past 10years Complete the following table for the named product(s)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Managers

75 How many new managers have been hired per year over the past 10years Complete the following table for the named product(s)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Managers

76 What is the reason for the growth or decline in the number of man-agers over the past few years

77 How does your process deal with multistrategy managers What is themost you would allocate to multistrategy managers How much doyou currently have allocated to multistrategy managers

78 Does your firm currently possess an ownership stake in any of the un-derlying managers in any of your portfolios If so please provide thenumber of current managers in your portfolios that your firm has anownership interest in

79 Has your firm ever possessed an ownership stake in any underlyingmanagers in your portfolio If so please explain when and how theywere divested or to what extent any ownership position still existsDisclose the number of current managers in your portfolios that yourfirm has ever had an ownership interest in

80 Have you ever received finderrsquos fees or ldquokick-backsrdquo for investing witha manager If so please explain how you used or allocated this finderfee(s)

81 What is the aggregate additional capacity of your managers What isthe additional capacity of your managers by investment category

82 Have you ever told a manager that you were going to terminate themif they refused to provide you with additional capacity If so how fre-quently have such things occurred

83 Does your firm have unique access to certain managers that might beclosed to new investors but have reserved capacity for your firm If soplease explain

K Level of Transparency

84 Describe the level of transparency you receive from your underlying man-agers Please include a discussion of (at least) following issuesbull Ownership structurebull Funds managed and strategies employedbull Accounting leveragebull Implied (use of derivatives) leveragebull Individual holdingsbull Firm assets under managementbull Staffingbull Investment decision making processbull Division of responsibility of investment professionals and key oper-

ational professionalsbull Detailed biographies of key investment and operational professionals

85 Please describe the level of transparency you are willing to provide your

clients about the underlying managers Please include a discussion of (atleast) the following issuesbull Manager name location and strategybull Ownership structurebull Funds managed and strategies employedbull Accounting leveragebull Implied (use of derivatives) leveragebull Individual holdingsbull Firm assets under managementbull Staffingbull Investment decision making processbull Division of responsibility of investment professionals and key oper-

86 For the named product(s) list the name of all your managers their cityof location date of your first investment with their firm and the strat-egy they employ If you are unwilling to share please explain why

Named Product(s)Firm Name Firm City Date of First Investment Strategy

L Leverage at the Portfolio LevelPlease note any differences between the named product(s) for the following leveragequestions

87 Summarize the current level of accounting leverage for the named prod-ucts (accounting leverage defined as [long + shorts] [equity capital])

88 Summarize the current level of implicit leverage for the named products(implicit leverage defined as leverage caused by use of options swapsfutures andor other derivative instruments)

89 Summarize the total (accounting + implicit) leverage for the namedproducts

90 What limits or caps to portfolio leverage (accounting + implicit)would you apply for the named products

91 What were the aggregate longshort positions over the past five yearsfor the named product(s) Please use the following template

1999 2000 2001 2002 2003 2004

Gross LongGross ShortNet Long

M Leverage at the Manager Level

92 What limits to leverage (accounting + implicit) do you allow at themanager level If this leverage limit (or cap) varies based on the invest-ment strategy summarize how for each underlying strategy

93 Do you periodically employ additional leverage at the portfolio levelto enhance returns or reduce risk If so explain how and why

N Risk Management

94 Describe your risk management procedures and philosophy both atthe FOF level and at the manager levelFeel free to include discussionsof the following in your responsebull Organizational riskbull Model riskbull Liquidity riskbull Value-at-risk (VaR)bull Sensitivity analysisbull Factor push analysisbull Scenario analysisbull Event riskbull Herd riskbull Equity riskbull Exchange rate riskbull Interest rate riskbull Yield spread riskbull Commodity risk

95 Do you have a written risk management policy If so would you bewilling to provide it if asked

96 What internal VaR target (95 andor 99) have you set for each ofthe named portfolios (please express in terms instead of dollarterms) Please summarize your methodology for calculating VaR(Variance-Covariance Method Monte Carlo Simulation ScenarioAnalysis etc)

97 How do you manage any liquidity mismatch between the hedge fundsin which you invest and the level of liquidity you offer to your clientsWould you be willing to borrow funds to pay out redeeming investors(causing leverage)

O Fees

98 Summarize your fee schedule for each named product(s)

99 What fees if any are not fully covered by the above fee schedule (other

than underlying manager fee structures and trading costs by each ofthe underlying managers)For exampledo you charge travel expensesresearch expenses audit expenses trust-custody expenses etc to theportfolio If so summarize (in basis point terms) how much these feeshave averaged on an annual basis over the past 5 years and whetherthey are reflected in your performance numbers

P Investment Performance

100 Provide the monthly returns for the named products dating back toproduct inception in an Excel spreadsheet If linked performance isused between products clearly state how

101 Describe the benchmark that you think is the best proxy for evaluatingyour portfolio and why

102 Provide the monthly returns of this benchmark (specified above) in anExcel spreadsheet

103 Provide monthly returns of each of your strategies (eg event drivenconvertible arbitrage distressed debt etc) in an Excel spreadsheet Inother words provide the underlying strategy returns that can be com-bined to generate the named productrsquos total return

104 Are these performance numbers gross or net of all fees Please specifyany fee that is not factored into the monthly performance numbers

105 With what frequency are the asset management performance basedandor additional fees charge to the portfolios

106 How often is NAV calculated for each named product

107 What entity is responsible for calculating returns If returns are calcu-lated internally what external entity is responsible for auditing the re-turns

108 How often are performance reports provided to clients How longafter the month or quarter does it take for the performance reports togo out

109 Provide an electronic version of a periodic (monthly or quarterly) per-formance report

appendix F

Request for Proposal Record-Keeping Services Firm Background

1 Please state the name title address telephone number and e-mail address ofthe person we may contact with questions about the responses to this re-quest for proposal

2 Please provide the following information about your firmbull Date foundedbull Total employees in the organizationbull Total employees in the defined contribution services segmentbull Number of firm locationsbull Number of defined contribution services locations (specify the locations

and what functions are performed at each site)bull Describe any parentsubsidiaryaffiliate relationshipsbull Firmrsquos financial condition

3 Please provide the following information about your defined contributionbusinessbull Number of years providing defined contribution record-keeping servicesbull Number of years providing daily valuation defined contribution record-

keeping servicesbull Total number of defined contribution participants for which you record-

keepbull Number of daily valued defined contribution plans your company cur-

rently provides full-service capabilities for in the following size groups

26 schneider F 22505 942 AM Page 305

Number of DailyValue Defined

Plan Size Contribution Total Number(by participants) Plans Total Assets of Participants

Under 100

100ndash999

1000ndash4999

5000ndash9999

Over 10000

4 Please state the total number of full-service defined contribution relation-ships for your firm during the following periods

2001 2002 2003 2004

Total Full Service DC Plans

5 How many new full-service defined contribution relationships were addedover the following periods (based on plan size)

Plan Size(by participants) 2001 2002 2003 2004

Under 100

100ndash999

1000ndash4999

5000ndash9999

Over 10000

6 What is the size of your largest and smallest record-keeping account bynumber of participants and assets

7 Please provide the following as of the most recent period availablebull Total assets under managementbull Defined contribution assets under managementbull Defined contribution assets under your firmrsquos administration but man-

aged by allianceoutside firms

8 What are your firmrsquos various sources of revenue What percentage doesrecord-keeping services provide What source produces the greatest per-centage of revenues

306 appendix f request for proposal firm background

9 Please state your firmrsquos target market for defined contribution services byparticipant size total assets andor average balance per participant

10 What was your firmrsquos capital investment made to the defined contributionbusiness in 2003 and 2004 What capital investments are budgeted for 2005

11 Describe your firmrsquos organizational structure

12 What benefit outsourcing services does your firm provide other than de-fined contribution services

plan sponsor services

1 Describe your organizational philosophyapproach to client services

2 From what geographic location will this account be serviced

3 What is the ratio of clients to client service managers If this differs based onplan size what is the ratio of clients to client service managers for a plan ofthis size

4 What is the average annual personnel turnover in your defined contributionunit

5 How are client service managers compensated What is their performancebased on

6 Describe the typical employment and educational background of a clientservice manager

7 What is the average firm tenure for client service managers

8 How many new employees were added to the defined contribution unit in2002 2003 and 2004

9 Please specify the methods used by your organization to monitor client sat-isfaction and with what frequency

10 Do you conduct client conferences or organize client advisory councils Ifso please describe

11 Identify the client service structureteam responsible for this relationshipand their primary rolesfunctions

12 Are your service levels audited or surveyed by any outside firms Please de-scribe

13 Can your firm provide the client Internet access to plan level information Ifyes do they have the ability to generate customized reports Does this in-clude the ability to make correction changes

14 How often will your firm conduct on-site meetings with the client to re-view your services and the plan

plan sponsor services 307

15 How many daily valued record-keeping clients has your firm lost in the pastthree years for reasons other than a merger or acquisition Please provide thename of three former clients that can be contacted (Please notewhile we re-quire you to provide references they will not be contacted unless your firmis selected as a finalist)

16 Important Please provide three references for current clients with similar demographics (contact name title telephone number company namecompany size length of record-keeping relationship types of services pro-vided any other relevant information) (please notewhile we require you toprovide references they will not be contacted unless your firm is selected asa finalist)

administrationrecord keeping

1 Is record-keepingadministration performed internally If not please pro-vide details on the organization providing these services

2 What softwaresystem is used to provide record-keeping services

3 Please describe your disaster recovery systems and insurance for your record-keeping and 800 number systems

4 How often are your disaster recovery systems tested

5 What is the ldquocutoff rdquo time for investment transfers to be made the same dayDoes this differ for proprietary alliance and nonallianceoutside funds If soplease describe

6 What is the ldquocutoff rdquo time for contribution wires to post to participantsrsquo ac-counts the same day

7 Please specify which of the following transactions cannot be performed pa-perlessbull Enrollmentbull Designation of beneficiarybull Deferralsbull Fund transfersbull Fund electionsbull Loansbull Contribution changesbull Distributionsbull Hardship withdrawalsbull Address changes

8 If paperwork is required can it be returned to your firm for processing

9 With what transactions will the plan sponsor need to remain involved

10 Once proper information is received how much time is required to issue adistribution or withdrawal check for payment

11 Please indicate which of the following compliance testing you will provideand at what costs Please specify frequency of tests (annual semi-annualetc)bull ADPACP bull Annual addition limitation - 415(c )bull HCE determination

12 Will your firm supply a signature-ready 5500 form At what cost

participant services

1 How soon after the end of a quarter will you provide participant statementsIs this guaranteed Can they be sent to participantsrsquo homes Please supply asample statement

2 Is your firm able to supply statements on demand for periods other thanquarter end

3 Does your firm calculate a ldquopersonalized rate of returnrdquo for each participantIs this information available on the statement On the Internet

4 Do you offer 24-hour voice response service Please provide the 800 num-ber and a sample ID for demonstration purposes (if available)

5 Is your interactive voice response system fully integrated with your record-keeping system

6 How often and for how long has the voice response system been down inthe past 24 months

7 Are live representatives available What timesdays

8 Please describe the typical experience and training of telephone representa-tives Are they required to be licensed (Series 6 7 etc)

9 Do you offer Internet access to participants Inquiries only or transactionsPlease describe

10 Please provide your retirement plan services Internet address for both partic-ipants and Plan Sponsors along with a sample ID for demonstration purposes

11 Is your Internet site fully integrated with your record-keeping system

12 Can the Internet site be customized Briefly describe

participant services 309

13 What services are available through your voice response system and Internet

Voice Response Internet

Enrollment

On-demand statements

Up-to-date statements

Most recent quarter-end statement

Balance inquiries

Rebalancing feature

Contribution changes stops restarts

Contribution inquiries

Change future and existing contributions

Loan modeling

Loan payoff balances

Termination options

Fund objectives

Investment performance

Initiate and request paperwork for

Withdrawals

Termination distributions

Change in beneficiary

14 Please provide the following statistics for 2004bull Average total number of voice response system calls per daybull Average total number of retirement service site Internet contacts per daybull Average number of rep-assisted calls per daybull Average speed of answer for rep-assisted callsbull Average call-handling time

15 Would the client have an exclusive 800 number or dedicated telephone rep-resentatives

16 Do telephone representatives have electronic access to plan provisions whena participant calls

17 Do telephone representatives have electronic access that allows them to trackformsdocuments mailed to and from participants

communication and education services

1 Identify the standard education meetings and materials included in yourpricing

2 How many initial enrollment meetings are included in your pricing If additional meetings are needed what are the costs Are travel expenses included

3 How many annual ongoing education meetings are included in your pric-ing If additional meetings are needed what are the costs Are travel ex-penses included

4 Which of the following educationcommunication materials will you pro-vide and at what cost

Service Provided (Yes or No) Cost

Enrollment meetings

Ongoing meetings

Enrollment kits

Videotapes (off-the-shelf)

Videotapes (customized)

Retirement planning software (Internet-based)

Retirement planning software (customized)

Payroll stuffers

Posters

Quarterly newsletters

Personal projection letters

Internet access

5 Can education materials be customized To what extent and at what cost

6 Please provide details of any work that is outsourcedThis includes mailingseducation meetings materials etc

communication and education services 311

7 Does your firm allocate an annual education budget to clients If so howmuch would be allocated annually to this client

8 Do you provide basic and advanced level meetings for different participantgroups If so please describe

9 Do you have a dedicated education meeting team If so how many individ-uals make up that department

10 Does your organization provide financial planning services If so please de-scribe At what cost

11 Does your organization provide retirement planning software If so pleasedescribe At what cost

12 Describe in detail how your firm would provide education meetings at var-ious client locations throughout the country

13 Please provide a sample calendar demonstrating education efforts for a sim-ilar client

14 What quarterly educationcommunication material will you provide Pleasedescribe Are there extra costs

investments

1 Which of the existing funds if any can you accommodate

2 How many proprietary funds do you offer for defined contribution plans

3 Do you require clients to use your proprietary funds If so to what extentPlease be precise as to the percentage of assets or number of funds that mustbe with proprietary funds

4 Do you offer alliance (nonproprietary) funds within your program If sohow many Please provide a complete listing of the alliance funds available

5 Do you limit the number of alliance funds that can be used

6 Are there any additional asset-based fees on alliance funds

7 Can you accommodate nonproprietary funds outside of your alliance fundofferings

8 If you permit outside (nonalliance) funds are there any additional asset-basedfees

9 Are all trades processed on a true daily basis including the use of nonpropri-etaryalliance funds (egbuy and sell on the same day) If notplease describe

10 How many investment options are included in your pricing What are thecosts for additional investment options beyond this number

11 Please complete the request for information in Appendix I by identifying one pro-prietary and one allianceoutside fund you propose to offer within each ofthe following categoriesbull Money marketbull Stable valuebull Intermediate-term bondbull Balancedbull Large company valuebull SampP 500 indexbull Large cap growthbull Small company valuebull Small company growthbull Internationalbull Real estatebull Lifestyleasset allocation funds

trustee services

1 Will you act as or provide trustee services If not who will provide trustservices

2 Please indicate where your trust company or trust alliance partner is located

3 Will you act as trustee on outside funds

4 Is your trust accounting system integrated with your record-keeping system

5 How often are trust statements reconciled with the record-keeping state-ments

6 Describe the controls and lines of communications between the record-keeping function and the trustee function

mutual fund trading practices

1 Has your firm or any of its affiliates received a subpoena or similar requestfrom any governmental entity seeking information regarding its mutual fundtrading practices

2 If the answer to the above question is ldquoyesrdquoplease detail the scope of the ex-amination and any specific funds and professionals (current or former)named in the request for information

3 Please provide all press releases or other public statements in response to theallegations

mutual fund trading practices 313

4 Provide a copy of the firmrsquos policies and procedures regarding trading in itsmutual funds by clients and employees

5 Has the firmrsquos system of internal controls detected any violations of the poli-cies and procedures If so detail the nature of the violation and the actiontaken to rectify the situation

6 Has the firm launched an internal inquiry into market timing or late daytrading Detail the scope of the examination and the results thus far Also listthe beginning and end date of the inquiry

7 Has the firm terminated any employee in connection with the trading prac-tice investigations Please provide information

8 What is the firmrsquos policy regarding after hours trading Are there any situa-tion where an investor can purchase shares after 4 PM Eastern Timeor afterthe fundrsquos shares have priced and receive that dayrsquos closing price

9 Are brokers and retirement plan record keeps permitted to place order after4 PM Eastern Timeprovided those orders are received before 4 PM EasternTime How does the firm verify the original order was received before 4PM Eastern Time

10 Does the firm employ fair market value pricing Please describe

11 Does the firm permit hedge funds to invest in the mutual funds Please de-scribe how hedge fund investors may be treated differently from other in-vestors How is the firm compensated for working with hedge funds

12 Please list the Board of Directors that oversees the firmrsquos mutual fundsPleaseprovide biographical informationAre any changes to the structure of theBoard of Directors forthcoming or anticipated

3 What has been the average increase in your organizations fees over the pastthree years

4 What would cause any of the fee quotes provided to change significantly

5 Please describe any costs or penalties incurred for terminating the agreementat contract expiration Prior to contract expiration

6 What is the minimum term of agreement required to avoid any plan termi-nationconversion penalties or fees

7 Clearly describe how investment management fees can offset record-keeping and other administrative fees

8 Will you provide an accounting of 12b-1 subaccounting revenue sharingor other fees received from fund companies and provide any credit or reim-bursement of such fees

9 Can a decrease in fees as assets increase clause be built into the contract

10 Please provide an estimate of overall first year fees including any conversionandor set-up fees

12 Provide a detailed estimate of fees and please include all assumptions

One-Time Plan Sponsor Fees

Conversion

Flat fee

Per employee

Loan conversion

Rollout communicationeducation

Number of on-site meeting days

Travel expenses

Annual Ongoing Plan Sponsor Fees

Record-keepingadministration

Trustee

Compliance testing

Contribution processing

Signature-ready 5500 form

Employee education services

Cost per additional day

Travel expenses

Internet services

Voice response system

Quarterly statements

fees 315

Mailing postage and handling

Miscellaneous Plan Sponsor Fees

QDRO processing (each)

Additional fee

Subsequent changes to VRUInternet

Subsequent changes to investments

New fund agreement set-up charge

Additional fund options

Quarterly newsletter

Self-directed brokerage costs

Plan sponsor fee (annual)

Miscellaneous Participant Fees

Participant fee (annual)

Asset-based fee

Commissions

Miscellaneous fee

Initiation fee

Annual maintenance fee

Distributions (per check)

Periodic distributions

Initial

Processing fee (per check)

13 Other (please include and explain all other relevant costs omitted from thismatrix here)

conversions

1 When would your firm need to be notified by for a January 1 2006 conver-sion

2 Please briefly describe the conversion process

3 Are the individuals who oversee the conversion process the same for ongo-ing administration or are separate teams utilized

4 What is a reasonable blackout period for a plan this size and structure

5 How much advance warning will participants receive regarding the black-out period

Please respond as requested in order to receive full consideration Feel free tocontact John Smith at (555) 555-5555 should you have any questions Thankyou

conversions 317

Fund N

appendix G

Resources

Morningstar Inc225 West Wacker DriveChicago IL 60606Tel (312) 696-6000wwwmorningstarcomMorningstar Inc is a leading provider of independent investment researchThecompany offers an extensive line of Internet software and print-based productsfor individual investors financial advisors and institutional clients

InvestorForce Inc1400 Liberty Ridge Drive Suite 107Wayne PA 19087Tel (877) 417-1240Tel (610) 408-3700Fax (610) 408-3710wwwinvestorforcecomInvestorForce provides technology solutions to the institutional investment com-munityThey offer an integrated platform of traditional asset class products andhedge fund products InvestorForce also offers an online database of active hedgefund products and active traditional investment managers

eVestment Alliance501-E Johnson Ferry Road NESuite 250Marietta GA 30068

27 schneider G 22505 942 AM Page 319

Tel (678) 560-3036wwwevestmentalliancecomeVestment Alliance is an investment manager database and analytics providerservicing the institutional investment industry

Plan Sponsor NetworkInforma Investment Solutions Inc4 Gannett Drive White Plains NY 10604Tel (914) 640-0200Fax (914) 694-6728wwwinformaiscomInforma Investment Solutions provides separate account information portfolioaccounting and performance measurement systems analytical tools and consult-ing support to pension funds investment consultantsbrokerage firms and moneymanagers

analytical software

PPCAmdashStokTribRon Surz78 MarbellaSan Clemente CA 92673Tel (949) 488-8339wwwppca-inccomPPCA is an investment consulting firm specializing in innovative analytical toolsfor the discriminating investor StokTrib is a holdings-based style analysis andperformance attribution software system

VestekThomson Financial195 Broadway 6th FloorNew York NY 10007Tel (646) 822-3000Fax (646) 822-6450wwwvestekcomVestek provides software to help investment professionals make more informeddecisionsVestek offers an array of products for portfolio analysis and construc-tion and holdings-based attribution analysis

320 appendix g resources

BaselineThomson Financial195 Broadway 6th FloorNew York NY 10007Tel (646) 822-2130wwwbaselinecomBaseline is a provider of information products and services to the investmentcommunity Their products include an equity analytic tool for the institutionalinvestors that aids in stock selection portfolio evaluation and communication

Ibbotson Associates225 North Michigan AvenueSuite 700Chicago IL 60601Tel (312) 616-1620Fax (312) 616-0404wwwibbotsoncomIbbotson sells historical financial data as well as a number of analytical softwarepackages including both meanmdashvariance and probabilistic asset allocation mod-els Descriptions of several products include

bull ldquoIbbotson EnCorrreg software combines the latest in financial theory andpractice for robust performance and analytics Utilizing the multiple com-ponents of the EnCorr Investment Analysis software program you can buildoptimal asset allocation recommendations Our flexible investment analysistools enable you to analyze historical performance datadevelop and imple-ment your asset allocation policy with managers or mutual funds and eval-uate and monitor managerfund style and performancerdquo

bull ldquoPortfolio Strategistreg Ibbotsonrsquos Investment Planning software helps youcreate better portfolios for your clients and determine the asset mix that of-fers the best chance of achieving the highest return for a given level of riskChanging client needs and objectives unique constraints and a variety ofrisk tolerancesmdashall these factors must be considered when you are design-ing implementing and monitoring asset allocation strategies for yourclients Portfolio Strategist can help you face the ongoing challenge of tai-loring asset allocation recommendations to fit your clientsrsquo needsrdquo

bull ldquoIbbotsonrsquos Presentation Materials allow you to illustrate the benefits oflong-term investing and effectively demonstrate time-tested investmentconceptsAll of our NASD-reviewed materials will assist you in educating

analytical software 321

your clients on the importance of asset allocationCharts and graphs can bepersonalized with your firmrsquos logo to increase visibility or we can work withyou to customize any existing graph to your specification or create an en-tirely new onerdquo

CheckFree Investment Services Mobius4819 Emperor Boulevard Suite 300Durham NC 27703Tel (914) 941-2600Fax (919) 9417018wwwcheckfreeinvsvcscomCheckFree Investment Services (CIS) provides a broad range of investment man-agement services to thousands of financial institutions through M-Solutions soft-ware applicationsThey are particularly known for their performance analysissoftware and data

Zephyr Associates IncPO Box 12368Zephyr Cove NV 89448Tel (755) 588-0654Tel (800) 789-8423Fax (775) 588-8423wwwstyleadvisorcomZephyr Associates is a leader in performance and returns-based style analysis soft-ware Zephyrrsquos StyleADVISORreg and AllocationADVISORtrade are used by in-vestment professionals throughout the world to analyze investment managersmutual funds financial markets and investment portfolios

New Frontier Advisors LLC 184 High Street Floor 5 Boston MA 02110 Tel (617) 482-1433Fax (617) 482-1434wwwnewfrontieradvisorscomNew Frontier Advisors is a developer and seller of patented probabilistic portfo-lio optimization and rebalancing applications

other resources

The Investment Management ConsultantsrsquoAssociation (IMCA)5619 DTC Parkway Suite 500Greenwood Village CO 80111Tel (303) 770-3377Fax (303) 770-1812wwwimcaorgIMCA is an important resource for the investment consulting world on develop-ments in investment strategies legal and regulatory issues economic news andmarketing techniquesThe mission at IMCA is to ensure quality service to thepublic by developing and encouraging high standards in the investment consult-ing profession

CFA Institute 560 Ray C Hunt DrCharlottesvilleVA 22903-2981Tel 1-800-247-8132 (US amp Canada)Tel 1-434-951-5499 (Outside US amp Canada)wwwcfainstituteorgCFA Institute is an international nonprofit organization which includes thesponsorship of the Chartered Financial Analyst (CFA) designationThey estab-lished the widely accepted AIMR-PPS ethical standards used primarily by in-vestment managers in the United States and Canada for creating performancepresentations that ensure fair representation and full disclosure

Commonfund15 Old Danbury RoadPO Box 812Wilton CT 06897-0812Tel 888-TCF-MAINTel (203) 563-5000wwwcommonfundorgThe Commonfund is an investment firm that understands the specific needs ofnon-profit institutions

other resources 323

12b-1 Fees A fee used to defray distribu-tion and marketing costs 12b-1 fee infor-mation is disclosed in a fundrsquos prospectusand is included in the stated expense ratio

3(c)1 Fund Fund limited to no more than99 accredited investors

3(c)7 Fund Fund limited to 499 qualifiedpurchasers who have a minimum of $5million in investment assets

401(k) Employer-sponsored retirementplan in which eligible employees maymake salary deferral contributions on apre-tax basisEarnings accrue on a tax-de-ferred basis

403(b) Retirement plan for certain em-ployees of public schools churches andother tax-exempt organizationsVery sim-ilar in structure to a 401(k) plan

Absolute Return Strategies Strategies thatseek positive returns regardless of marketdirections

Arbitrage Pricing Theory (APT) An alter-native asset pricing model to the CapitalAsset Pricing Model Unlike the CapitalAsset Pricing Model which specifies re-turns as a linear function of only system-atic risk Arbitrage Pricing Theory mayspecify returns as a linear function of morethan a single factor

Accredited Investor Securities and Ex-change Commission criteria consists ofthe following

ldquo-Any natural person whose individualnet worth or joint net worth with

spouse exceeds $1000000 at time ofpurchase of 325 with spouse of$300000 for the last 2 years and hasreasonable expectations of reaching thesame income in current year-A trust with total assets of $5000000not formed specifically for the purposeof acquiring assets offered Directed bya person with the knowledge and ex-perience to make such investmentrdquo

Accrued Income Refers to interest that isowed by the issuer but has not been paid

Active Management Is an investment ap-proach that uses available information andforecasting techniques to seek better per-formance than a specified index

Alpha A coefficient measuring the risk-ad-justed performance considering the riskdue to the specific security rather than theoverall market

Alternative Investments Category of in-vestments outside of traditional stocksbonds and cash instrumentsThis categoryincludes hedge funds real estate timber-land private equity structured productsand commodities

Arbitrage Attempting to profit by exploit-ing price differences in identical or similarfinancial investments

Arithmetic Average Returns Average re-turns that do not factor in the effects ofcompounding For example a return inyear one is +50 and in year two is -50Annual Arithmetic Average Return =(+50 + (-50)) 2 = 0

Glossary

28 schneider gloss 22505 942 AM Page 325

Asset Allocation The strategic diversifica-tion of a portfolio

Basis Point One hundredth of a percent-age point (01) One hundred basispoints equal 1

Behavioral Finance A theory stating thatimportant psychological and behavioralvariables effect investorsrsquo actions

Beta A quantitative measure of the volatil-ity of a given stock mutual fund or port-folio relative to a market proxy A betaabove 1 is more volatile than the marketproxy while a beta below 1 is less volatile

Biased Expectations The tendency of in-vestors to discount any information thatdoesnrsquot support their opinions

Bottom-up Investment strategy in whichcompanies are considered on their ownmerit without regard for sector or eco-nomic conditions

Breakpoint (fees) Asset-based fees that de-cline (on a percentage basis) above certainasset levels

BrokerDealer A firm in the business ofbuying and selling securities as an agentfor clients as well as for their own accountBrokerDealers are regulated by TheNational Association of Securities Dealers(NASD) and the SEC

Bundled Recordkeeper Provides record-keeping compliance and regulatory re-porting servicing and investmentmanagement all in one product

Call Option An option contract that givesthe holder the right to buy a certain quan-tity of an underlying security at a specifiedprice (the strike price) up to a specifieddate (the expiration date)

Capital Asset Pricing Model (CAPM) Aneconomic model for valuing investmentsby relating risk (beta) and expected returnbased on the idea that investors demandadditional expected return if asked to ac-cept additional risk

Capital Gain The amount by which anassetrsquos selling price exceeds its initial pur-chase price

Carve Out Investment strategy of consider-

326 glossary

ing a particular investment on its ownmerit or apart from the total portfolio assetallocation

Central Bank The generic name given to acountryrsquos primary monetary authoritysuch as the Federal Reserve System in theUS Usually has responsibility for issuingcurrency administering monetary policyholding member banksrsquodeposits and facil-itating the nationrsquos banking industry

Certificate of Deposit Financial instru-ment with a stated interest rate and matu-rity issued by a bank

Commingled Trusts Unregistered invest-ment products that combine some of thebenefits of mutual funds with the cost effi-ciencies of separate accounts Similar to amutual fund investors in a commingledtrust pool their assets with other investorsand the holdings are ldquounitizedrdquo into indi-vidual shares

Commodity Physical substances such asfoods grains and metals that are inter-changeable with other products of thesame type and that investors buy or sellusually through futures contracts

Commodity Trading Advisors (CTAs) Anindividual or firm that advises othersabout buying and selling futures andorfutures options

Community Development Bank Federallyinsured banks that provide loans as well assavings and checking accounts in low-in-come areas

Community Development Credit UnionFederally-insured institutions that offermany of the same services as traditionalcredit unions but serve low-income areas

Community Development Loan FundPooled capital provided by individuals andinstitutions to provide loans at below mar-ket rates to fund small business affordablehousing and community services

Community Development Venture CapitalFund Pooled funds that invest in smallbusinesses with strong growth potential inlow-income areas

Community Investing Directing capital todisadvantaged communities

glossary 327

Default Risk The possibility that a bond is-suer will default or fail to pay interest andprincipal in a timely manner

Defined Benefit Pension Plan Employer-sponsored retirement plan in which a for-mula determines the exact benefits eachretiree is entitled to Payouts are typicallydetermined by salary history and employ-ment tenure

Defined Contribution Retirement Plan Aretirement plan in which a certain amountof money is set aside each year for thebenefit of the employee The actual bene-fit is dependent on the amount con-tributed and the investment return onthose contributions

Derivative Instruments A collective termfor securities whose prices are based onthe prices of another (underlying) invest-mentThe most common of these are fu-tures options and swaps

Deterministic Describes an algorithm inwhich the correct next step depends onlyon the current stateThis contrasts with analgorithm where at each point there maybe several possible actions and no way tochoose among them except by trying eachand backtracking if it fails

Directional Strategy A strategy which isdependent on market movement to gen-erate positive returns For example a longstrategy is dependent on a rising market

Dispersion Range of returns

Dividend Yield Ratio of annual incomepaid as dividends to share price

Dollar-Weighted Return This methodmeasures rate of growth of initial capitaland subsequent cash flowsSize and timingof cash flows have an impactAlso knownas internal rate of return (IRR)

Efficient Frontier The curve on a risk-rewardgraph comprising all efficient portfolios

Efficient Market Hypothesis The theorythat all market participants receive and acton all of the relevant information as soonas it becomes available causing all securi-ties to be fairly priced at any given mo-ment in time Under this theory superior

Consumer Price Index (CPI) An inflationindicator that measures the change in thecost of a fixed basket of products and serv-ices including housing electricity foodand transportation

Contrarian Rebalancing Rebalances aportfolio in opposition to the prevailingwisdom for example rebalancing back tostocks during a bear market when othersare pessimistic and rebalancing back tobonds during bull markets when theyrsquoreoptimistic

Corporate Dialogue Correspondence toeffect change in corporate policies andpractices

Correlation The degree to which the priceor market value of two assets moves together

Counterparty Risk The risk that the otherparty in a financial agreement will default

Credit Analysis The process of evaluatingany entityrsquos debt issue in order to deter-mine the likelihood that the borrower willlive up to its obligations

Credit Risk The possibility that a bond is-suer will default by failing to repay princi-pal and interest in a timely manner

Credit Spreads The difference in yield be-tween a low quality and high quality fixedincome instrument

Currency Risk The risk that an asset de-nominated in a foreign currency decreasesrelative to the local currency because ofexchange rate fluctuations

Currency Swaps An arrangement in whichtwo parties exchange a series of cash flowsdenominated in one currency for a seriesof cash flows in another currency atagreed intervals over an agreed period

Custodian A financial institution that hasthe legal responsibility for a customerrsquos securities

Custody Costs The fee a bank charges tohold assetsThese may include asset-basedfees transaction fees income collectionfees foreign exchange fees etc

Daily Valuation Process by which invest-ments in a retirement plan are priced on adaily basis

investment performance is a result of luckrather than skill

Emerging Market Debt Sovereign and cor-porate debt of a developing country

Equity-Linked Notes A debt instrumentwhose return on investment is tied to theequity markets The return on equity-linked notes may be determined by a stockindex a basket of stocks or a single stock

ERISA Employee Retirement IncomeSecurity Act of 1974 The federal lawwhich established legal guidelines for pri-vate pension plan administration and in-vestment practices

Euro The name for the composite mone-tary unit that has replaced national curren-cies in several European countries

Eurozone The collective group of coun-tries which use the Euro as their commoncurrency

Expected Return Midpoint of all possibleoutcomes

Expense Ratios The percentage of a fundrsquosassets that are spent to run a mutual fundThis includes management and advisoryfees overhead costs 12b-1 fees adminis-trative fees and all other asset-based costsincurred by the fund The expense ratiodoes not include brokerage costs for trad-ing

Fallen Angel A bond which was invest-ment-grade when issued but which is nowof lower quality

Fiduciary An individual that has a specialduty and responsibility in oversight of oth-ersrsquo assets

Form 5500 A form which all qualified re-tirement plans (excluding SEPs and SIM-PLE IRAs) must file annually with theIRS

Frontier Engineertrade A Proprietary proba-bilistic optimization algorithm developedby DiMeo Schneider amp Associates LLC

Futures Contracts A standardized transfer-able exchange-traded contract that re-quires delivery of a commodity bondcurrency or stock index at a specifiedprice on a specified future date Unlike

328 glossary

options futures convey an obligation tobuy

General Partner A partner with unlimitedlegal responsibility for the debts and liabil-ities of a partnership

Geometric Average Returns Average re-turns that factor in the effects of com-pounding For example a return in yearone is +50 and in year two is -50Average Annualized geometric return =[(1+05)(1-05)]^(12) - 1= -134

Global Custody Capability Ability to holdsecurities traded on foreign exchanges

Hedge Fund of Fund (HFoF) Fund that in-vests in several separate hedge funds withdifferent strategies

Hedge Funds Broad term used for privateinvestment pools typically falling outsidethe regulation of the Investment Com-pany Act These funds typically are de-signed for wealthy or accredited investorsThe manager has broad discretion to tradebuy sell short securities options and de-rivatives

Herd Mentality ldquoGo Alongrdquo attitude thatleads investors to bypass a due diligenceprocess and blindly follow others

Heuristics Human mental shortcuts de-signed to deal with the complexities of ex-istence

High Water Mark Previous high valueachieved by the fund prior to a lossThisdefined value must be surpassed before themanager can again charge any incentivefees

High Yield Bonds Non-investment-gradebondsusually rated BB or loweroften re-ferred to as ldquoJunk Bondsrdquo

Hurdle Rate of Return A minimum returnthat must be achieved before a managercan change an incentive fee

Incentive Fees An additional fee paid tothe manager or general partner of a fundbased on a percentage of profits

Incubator Fund A start-up fund seeded bythe manager and that does not yet allowoutside investors

Inflation Risk Premium A risk premium

glossary 329

built into nominal bonds that provides theinvestor with compensation for the threatof unanticipated inflation

Inflation-Adjusted Return Real return ad-justed for inflation

Inflation-Indexed Bonds Fixed incomesecurities whose principal and couponpayments are adjusted for inflation

Interest Rate Risk The possibility of a re-duction in the value of a security espe-cially a bond based on changes in interestrates

Internal Rate of Return (IRR) Measuresrate of growth of initial capital and subse-quent cash flows Size and timing of cashflows have an impactAlso known as dol-lar-weighted return

Investment Company Act A set of Federallaws that regulate the registration and ac-tivities of investment companies enforcedby the Securities and ExchangeCommission

Investment Flexibility The ability of a re-tirement plan to offer a wide variety ofmutual funds from different fund families

Investment Policy Statement (IPS)Document that outlines investment objec-tives guidelines performance measures aswell as responsibilities of parties involved

Kurtosis A statistical term that refers togreater frequency andor magnitude ex-treme observations or ldquofat tailsrdquo than whatis expected based on the normal distribu-tion

Leverage The use of borrowed money toamplify investment performance

Limited Partners Partners who enjoyrights to the partnershiprsquos cash flowbut arenot liable for partnership obligations be-yond their initial contribution

Limited Partnership A business organiza-tion with one or more general partnerswho manage the business and assume legalliability for debts and obligations and oneor more limited partners who are liableonly to the extent of their investments

Liquidity The ability to sell an asset quicklyand without any price discount

Market Capitalization (Market Cap)Market value of a company as determinedby the number of shares outstanding mul-tiplied by the current stock price

Market Portfolio A concept used inModern Portfolio Theory which refers toa hypothetical portfolio containing everysecurity available to investors in a givenmarket in amounts proportional to itsmarket value

Master Trust Administration Ability toprovide recordkeeping on numerous ac-counts in which the investments are com-mingled

Maximum Drawdown Maximum reduc-tion in value over any given time period

Mean-Variance Optimization Mathematicalgorithm that generates the efficient fron-tier

Mezzanine Financing Late-stage venturecapital financingusually the final round offinancing prior to an initial public offer-ing

Money Market Account Investment in apool of short-term interest-bearing secu-rities

Monte Carlo Simulation A probabilityanalysis technique in which a large num-ber of simulations are generated using ran-dom quantities for uncertain variablesThe name comes from the city of MonteCarlo which is known for its casinos

Most Favored Nations A clause in thecontract with an investment managementfirm that states that your organizationrsquosfees will be at least as low as those of anysimilar clients of the manager

Mutual Funds Registered investment pro-ducts They are pools of money that aremanaged by an investment company andregulated by the Investment Company Actof 1940

NCREIF National Council of Real EstateInvestment Fiduciaries

Nominal Not adjusted for inflation

Nominal Return Return not adjusted forinflation

Normal Distribution A probability distri-

bution shaped like a bell often found instatistical samplesThe distribution of thecurve implies that for a large population ofindependent random numbers the major-ity of the population often clusters near acentral value and the frequency of higherand lower values taper off smoothly

Overconfidence Believing onersquos expecta-tions are more likely to be realized thanthose of others

Pass-Through Entity Trust established toallow the pooled income from investmentsto be distributed directly to shareholdersof the trust

Passive Management An investment ap-proach that seeks to merely replicate theperformance of a specified indexThis isthe least expensive approach and is oftenused for assets classes that are efficient Apassive strategy assumes that the market-place will reflect all available informationin the price paid for securities and there-fore does not attempt to find mis-pricedsecurities

PriceEarnings Ratio (PE) Ratio of earn-ings per share to share priceused to meas-ure relative cost of shares

Private Equity Equity capital invested in acompany that is not publicly traded

Probabilistic Relating to or governed byprobabilityThe behavior of a probabilisticsystem cannot be predicted exactly but theprobability of certain behaviors is knownSuch systems may be simulated usingpseudo-random numbers

Probabilistic Optimization Models Port-folio optimization models that developtheir output based on the assumption thatmarket returns cannot be predicted ex-actly but the probability of certain out-comes is known

Proxy A written authorization given by ashareholder for someone else usually thecompanyrsquos management to cast hishervote at a shareholder meeting or at an-other time

Proxy Voting Voting on resolutions andother matters by shareholders

330 glossary

Real Return Return adjusted for inflation

Recordkeeper A firm that administers re-tirement plans andor charitable trustsThey report on individual accounts andprocess transactions and distributions

Regression Analysis A statistical tech-nique used to find relationships betweenvariables for the purpose of predicting fu-ture values

REIT Real Estate Investment Trust A cor-poration or trust that uses the pooled cap-ital of many investors to purchase andmanage income property (equity REIT)andor mortgage loans (mortgage REIT)

Returns Decomposition Method A meth-od for estimating an assetrsquos expected returnthat involves breaking a return stream intoits various components which may in-clude income and capital gains

RFP Request for ProposalAn invitation tobid

Risk Premium The reward for holding arisky investment rather than a risk-freeone

Risk-Free Rate A theoretical interest ratethat would be returned on an investmentwhich was completely free of riskThe 3-month Treasury Bill is a close approxima-tion since it is virtually risk-free

R-Squared A measurement of the portionof an investmentrsquos return stream that canbe explained by the market proxy orindex Values for r-squared range from 0 to1 where 0 indicates no linear relationshipand 1 indicates a perfect linear relationship(perfect positive or negative correlation)

Securities Lending The temporary lend-ing of securities to brokers in exchange forincome

Sell Short Borrowing a security (or com-modity futures contract) from a brokerand selling it with the understanding thatit must later be bought back (hopefully ata lower price) and returned to the brokerShort selling (or ldquoselling shortrdquo) is a tech-nique used by investors who try to profitfrom the falling price of a stock

glossary 331

Semi-Bundled Recordkeeper Record-keeping and some investment manage-ment may be provided howevercompliance testing some investment man-agement and regulatory reporting may beoutsourced to other firms

Separate Accounts Individually managedaccounts for institutions or high-net-worth persons or institutionsThey hold aportfolio of individual stocks or bondsThese accounts are each specific to oneindividual or holder

Settlement Date The day a trade settles(when the cash or securities are actuallytransferred) Typically this occurs 3 daysafter the trade date

Shareholder Advocacy Active ownershipmethods to effect change in corporatepolicies and practices

Shareholder Resolution A formal requestmade to a company seeking action on aspecific issue

Sharpe Ratio A risk-adjustment measuredeveloped by William F Sharpe ( returnminus risk-free rate divided by standarddeviation) It determines reward per unitof risk The higher the Sharpe ratio thebetter the investmentrsquos historical risk-adjusted performance

Short Squeeze Term used to describe asituation where a securities price rises andinvestors who have sold the security shortare forced to buy back at higher prices

Skewness A distribution table that hasmore observations in one tail

Socially Responsible Investing (SRI)Investing based on social moral or ethicalguidelines

Sovereign Debt A debt instrument guar-anteed by a government

Stable Value Fund A fund designed tomaintain a stable net asset value Stablevalue funds invest in a pool of guaranteedinsurance contracts and fixed income se-curities

Standard Deviation Measures volatilityaround the mean

Stop Loss A sell stop order for which thespecified price is below the current marketprice It is designed to limit losses to a spe-cific percentage

Stop Order A market order to buy or sell acertain security if a specified price isreached or passed

Style Sorting securities by characteristicssuch as priceearnings ratio price-to-book ratio or earnings growth Investmentapproaches can be broadly labeled asgrowth or value styles large mid andsmall-cap

Survivorship Bias The tendency for failedcompanies or mutual funds to be excludedfrom performance studies (since they nolonger exist) Survivorship bias causes theresults of some studies to skew higher be-cause only companies or mutual fundswhich were successful enough to surviveuntil the end of the period are included

Systematic Risk Risk which is commonto an entire class of assets and cannot bediversified away Sometimes called marketrisk

The Consumer Price Index (CPI) A meas-ure of the average price level of a fixedbasket of goods and services purchased byconsumers Monthly changes in the CPIrepresent the rate of inflation

Third Party Administrator (TPA) A firmthat specializes in providing unbundledrecordkeeping services

Time-Weighted Return A performancemethod measurement that calculatesgrowth of a portfolio between each cashtransaction and links those results togetherto create longer-term results It eliminatesthe impact of cash flows

Treasury Inflation Protection Securities(TIPS) A bond issued by the USTreasury whose principal and couponpayments are adjusted to eliminate the ef-fects of inflation

Total Return Concept Having no prefer-ence for income over capital gains

TPI Timber Performance Index

Trade Date The day a trade occurs as op-posed to settlement date

Transparency The ability to audit all trans-actions and positions of a fund or manager

Treynor Ratio A risk-adjusted performancemeasure developed by Jack TreynorThis isa measure of a portfoliorsquos excess return perunit of risk equal to the portfoliorsquos rate ofreturn minus the risk-free rate of returndivided by the portfoliorsquos beta This is asimilar ratio to the Sharpe ratio exceptthat the portfoliorsquos beta is considered themeasure of risk as opposed to the varianceof portfolio returns

Trustee An individual or firm that holdsandor manages assets for the benefit ofothers

332 glossary

Unbundled Recordkeeper Provides record-keeping onlyCompliance testing and reg-ulatory reporting performed by otherfirms

Venture Capital (VC) Capital made avail-able for startup firms and small businessesManagerial and technical expertise areoften also providedVC is also called riskcapital

Wrap-Fee Product An investment programthat charges a single fee for a suite of serv-ices such as brokerage advisory custodyand management

Zero-Sum Game Situation in which oneinvestorrsquos gain results only from anotherrsquosequivalent loss

3(c)1 fund 3253(c)7 fund 32512b-1 fees 325reduction 5401(k) 179 186 234 325case study 17ndash18403(b) 14 179 186 234 325401(k) contrast 12ndash13case study 17ndash18404(c) plan 234 236

Absolute returns 35strategies 120ndash121 325

Academic research 93ndash97Account

composite 281turnover 266 272 289types 115ndash116

Accredited investor 120 325Accrued income 325calculations 153 See also Fixed-income

investmentsActive management 325Adams Greg 177Administration performance 308ndash309Administrative compatibility 113ADV See Form ADVAIMR-PPS

compliance 104standards 112

Alpha 110 152 260 325 See also Negative alphaPositive alpha

derivation 163evidence 107generators 132measurement 163

Alternative investments 119 239 325Analytical software resources 320ndash322Anchors 210Annual returns

average 40impact 100

Annualized standard deviation 145Annuities 13ndash15 See also Gift annuitiesArbitrage 325Arbitrage Pricing Theory (APT) 56 207 325Arbitrary rebalancing 141ndash142Arithmetic average returns 325Arms production reduction 171Asset allocation 30 46 51 245 326 See also Hedge

funds of fundsanalysis 92fluctuation 144methodologies 62performance monitoring 31rebalancing 30

Asset management 107ndash108breakdown 252

Asset-based retainer 204Assets

classes 53 69 83 239high-yield bonds correlation 75management See Hedge funds of fundsregion classification 288segregation 209type classification 266 272 287ndash288vehicle type 266 272 288

Attribution analysis 160

Back-end loads 15Bank of England 83Bank of Japan 83

29 schneider index 22505 946 AM Page 333

Barker Report 23ndash24Baseline 160 321Basis point 108 326Bauer Rob 177Behavioral finance 207 240 326Benchmarks 110 153ndash155 See also Investment

Managers Multiple benchmarks Stylecomparison See Performanceevaluation See Managersusage 154

Bernstein Wealth Management study 124Beta 54 177 260 326

adjustment 152derivation 163performance expectation 260

Biased expectations 326overconfidence 208ndash209

Bid-ask spread 122Blow-up situation 122ndash123Board-created endowment fund 220Bonding requirement 231Bonds

funds maturity 4investment 35recovery 5ndash6timberland correlation 129yields inflation risk component 89

Bottom-up investment strategy 326Breakpoint (fees) 326Bright Craig B 23Broad-based indexes 155Brokerdealer 179 326Brokers 102 104 194Bundled recordkeeper 326Bundled services arrangement 235Buyout funds 131Buysell discipline 277

Call option 326Capital

campaigns 11gains 88 326inflow 128markets 5ndash6 53ndash54 82

Capital Asset Pricing Model (CAPM) 207 326case study 54regression analysis 55 57ndash58

Capitalization 155Cap-weighted index 155Care duty 229Carve out 120 326CaryWilliam L 23Cash flows 127

rebalancing 245

Catholic institutions money management 19ndash20Central bank 326Cents-per-share rate 113Certificate of deposit (CD) 13 326CFA Institute 323Charitable endowment funds legal aspects 215CheckFree Investment Services 160 322Citigroup indexes 86 156COBRA See Consolidated Omnibus Budget

Reconciliation ActCofiduciaries duty 231Cognitive dissonance 210Commingled accounts investment guidelines 48Commingled funds 176Commingled trusts 116 326Committee member questionnaire 103Committee questionnaire sample 43Commodity 326Commodity Trading Advisors (CTAs) 136 326

leverage 137study 138

Commonfund 114ndash115 323Commonfund International 114Communication

impact See Retirement plansservices 311ndash312

Community developmentbank 326credit union 326loan fund 326venture capital fund 326

Community investing 170 174ndash175 326Compensatory damages 231ndash232Completeness fund 97

analysis 98Compliance See ManagersComposite figures usage 112Composite hedge performance 137Composite information See US equityConsolidated Omnibus Budget Reconciliation Act

(COBRA) 18Consultant See Investment consultant

agreement 203fees 204interview questions 203need 197on-site visit 203reference questionnaire 201usage 204

Consumer Price Index (CPI) 37 153ndash154 327changes 88 89

Contrarian rebalancing 327Contributions 4 18ndash19Convexity usage 109

334 index

Corporate dialogue 170 327Corporate responsibility encouragement 171Correlation 53ndash54 83 327 See also Standard amp

Poors 500coefficient 53ndash54 83

Counterparty risk 134 327Credit analysis 327Credit risk 80 327Credit spread 327

risk 109Cumulative annualized returns 146Currency risk 327

hedging 84ndash86Currency swaps 327Currency swings 84Custodian 327Custody

costs 327fees 185services 183ndash184

Daily valuation 327DALBAR Inc 162Damages See Compensatory damagesData

collection 123ndash124manipulation 105ndash106presentation 157resources 319ndash320

Databases usage 112Deal-killers 200Debt instruments 88Default losses 59Default risk 73 109 327Deferral rates 16Defined benefit (DB) pension plan 190 327

administration 180Defined benefit (DB) plans 4 190ndash191Defined contribution (DC)

plan 15ndash17retirement plan 327

Derivative instruments 134 327Derivatives usage 135 280Deterministic 327

sense 53DiMeo Schneider amp Associates See Frontier

EngineerDirectional strategy 120 327Discretionary investment strategy 136Dispersion 327Diversification 90ndash92 See also PlanTimberland

benefits 80 137examination 246increase 25ndash26

Dividend yield 177 327Document

compliance duty See Plan documentsfindings 233

Dollar-weighted basis 152Dollar-weighted method 152ndash153Dollar-weighted return 327Donor funds

legal aspects 215legal requirements 240

Donor-created endowment funds 217Donor-created restricted funds 217Donor-created restricted gifts 217Donors confidence 6ndash7Dow Jones Industrial Average (DJIA) 154Downgrade risk 109Downside risk control 137Due diligence See Hedge funds of fundsDuration 108

Early-round venture capital 132Earnings multiples 3

eASE Database 112Economic justice pursuit 171Education

Efficient frontier 51ndash52 72 77 91 327 See alsoTwo-asset efficient frontier

Efficient Market Hypothesis 207 327ndash328Embedded optionality 109Emerging market debt 328Employee Benefits Security Administration

(EBSA) 226Employee Retirement Income Security Act of

1974 (ERISA) 24 225ndash227 240 328fees gross 282ndash283funds See Non-ERISA fundsimpact 8 15 99responsibility 151

EnCorr (Ibbotson) 321Endowed funds management 23Endowment funds 18 220 See also Board-created

endowment fund Donor-createdendowment funds

investing advice 217ndash218legal requirements 240nature 216

Endowmentsboard creation 216ndash217current status 22ndash23history 21ndash22

Environment protection 171Equal-weighted index 155

index 335

Equitable relief 231ndash232Equity See Private equity Structured equity

analysis See Large-cap equity analysissample product See US equity

Equity-linked notes 328ERISA See Employee Retirement Income

Security Act of 1974Ethical investing 169Euro 328Europe Australia and the Far East (EAFE) index

244ndash245European Central Bank 83Eurozone 328

countries 82Evaluation benchmarks See ManagerseVestment Alliance 112 160 319ndash320Exclusive benefit rule 229Execution strategy 277ndash278Exemptions identification 231Expected return 53 328

assumptions development 54ndash60Expense ratio 108 328

Fallen angel 328Familiarity 211Fat tails See KurtosisFeedback loop 213Fees 240 See also Firm

calculation table 274disclosure 274examination 246gross 281ndash283 See also Gross-of-fee

comparisonsinformation 266 273monitoring 235ndash236negotiation See Mutual fundsnet usage See Net of fees

Festinger Leon 210Fiduciary 328 See also Functional fiduciary

breaches penalties 231ndash233identification 227ndash229issues See Retirement fundsliability (limit) prudent procedures 233ndash236responsibilities 99 236ndash237short-term decisions 25stewardship 196

Finances control 3ndash4Financial Accounting Standards Board (FASB) 99Financial counselors 104Financial information problem 100Firm

background 292 305business 126conversion 317fees 314ndash316

information 287investments 312ndash313ownership structure 289qualitydepth examination 246

Fitch credit rating agency 109Fixed dollar amount designation 36Fixed percentage band methodology 142Fixed retainer fees 204Fixed-income instruments 153Fixed-income investments 69 71

accured income calculations 153Fixed-income investors risk 108ndash109Fixed-income portfolios 108Fixed-payment bond 73Ford Foundation 23ndash24 114Foreign bonds

fund 84market 81

Foreign corporate debt 80ndash83Foreign exchange fees 86Foreign fixed-income markets experience

(importance) 87Form 5500 328Form ADV 104 109Frank Russell Company indexes 156Frontier Engineer (DiMeo Schneider amp

Associates) 65 328Functional fiduciary 227Fundraising

challenge 6initiatives 37

Fundsbalances decrease 37benefits 34fiduciaries caution 26

Funds of funds 121ndash122 See also Hedge funds offunds

search 125ndash126Futures contracts 328

General contractor hiring 196ndash204General partners 328Geometric average returns 328Gift annuities 191ndash194Gifting strategies 6Global bond market government share 81Global corporate bond issuance 82Global custody capability 328Global macro bets 122Global problems 2ndash3Globalization increase 2Goal setting See Investment

exercise 29ndash30inflation impact 41process 45

336 index

Gross-of-fee comparisons 153Growth

managers 155ndash156 162Guerard Jr John B 177Gultekin Mustafa N 177

Harvard College vArmory 22 218Health Insurance Portability and Accountability

Act (HIPAA) 18Hedge funds 120ndash121 328

indexes 124strategies types 121

Hedge funds of funds (Hfof) 121ndash122 328asset allocation 296 298ndash299assets management 295ndash296benefits 124ndash125due diligence 299ndash301fees 123 303ndash304investment 297ndash298 304leverage 302 303management RFP 293ndash304manager evaluation 299ndash301organizational considerations 293ndash294product 294ndash295 297regulatory considerations 293ndash294risk management 303strategy allocation process 298ndash299transparency level 301ndash302

Hedged foreign bondstock indexes 156Hedging costs 87Herd mentality 209 328 See also ManagersHeuristics 208 328Hfof See Hedge funds of fundsHigh water mark 123 328Higher education price index (HEPI) 37High-risk assets returns 67High-yield bonds (junk bonds) 69 73ndash78 156

328comparison 76correlation See Assetshistory 73ndash76portfolio construction benefits 76statistical properties 76ndash78

High-yield mutual funds 76HIPAA See Health Insurance Portability and

Accountability ActHistoric dollar value 222Historical analysis 59Historical portfolios observations 145Historical returns 90statistical properties See Real estate investment

trustsHoldings-based analysis 105Holdings-based style analysis 94ndash95Hospital problems 11

Human lifedignity promotion 171Hurdle return rate 328

Ibbotson Roger 93Ibbotson Associates 321ndash322 See also EnCorr

Portfolio StrategistPresentation Materials 321ndash322IBM decision 202Iconoclastic position 98Impartiality 196Incentive fees 328Income

gains 88recipient 23usage 21

Income only approach 25Incubator fund 328Index selection 156Industry-specific indexes 156Inflation

band example 38ndash39effects 41impact See Goal settingincrease 70risk premium 89 328ndash329

Inflation protection bond (IPB) 87 90Inflation-indexed bonds 69 87 89ndash90 329Informa Investment Solutions Inc 320Information ratio 110 260ndash261Inputs precision 62Institutional mutual fund fees (net) 284Institutional Shareholder Services study 173Institutions aging 20Interest rate

country average 85decrease 78environments 83ndash84fluctuations 59risk 108 329

Interfaith Center on Corporate Responsibility(ICCR) 172ndash173

Internal rate of return (IRR) 152 329International bonds 78ndash86

opportunity set 80International stocks 114Investing legal aspects 215Investment See Alternative investments Firm

analysis 259ndash269 See also Large companyapproach adherence (history) 246benchmarks 49diversification See Planflexibility 329funds selection 246goal setting 29ndash30 33guidelines 48 See also Managers

index 337

Investment (continued)management consultant hiring 195 240managers 246 251ndash258menu proposal 318objectives 244ndash246 See also Managersoptions number 17passive approach 139philosophy 110 254ndash256 See also Hedge funds

of fundsportfolio construction 29process 110 126 See also Hedge funds of fundsprofessionals characteristics 275program construction 29responsibility 234strategy 6ndash7 37 136 276 254ndash256 See also

Discretionary investment strategy Systematicinvestment strategy

styles 93 155ndash156 239Investment Company Act 329registration exemption 48Investment consultant

advice 200ndash201hiring 196ndash204identification 198interview 201ndash202responsibilities 247ndash248verification 202

Investment Management Consultants Association(IMCA) 197 323

Code of Professional Responsibility 198Investment policy 30 45

content 46establishment 233ndash234implementationmaintenance 48importance 45ndash46socially responsible investing incorporation

178Investment policy statement (IPS) 45 247 329

language 48purpose 243ndash244sample 46ndash47 243SRI approach 178

Investment-grade bonds 209returns 76value decrease 75

Investor See Process-oriented investor Structuredinvestor Unstructured investor Suspiciousinvestor

Investor personality types 211ndash212Investor Responsibility Research Center (IRRC)

172InvestorForce Inc 160 319IPB See Inflation protection bondIrrational exuberance 149

January effect 207Joint ventures 292JP Morgan Emerging Markets 82

Kees Koedijk 177Kurtosis (fat tails) 64 73 329

excess 76 78

Land value increase 128Land-based funding source 21Large company

growth search 107value 261ndash269

Large-cap allocation decrease 63Large-cap core manager 111Large-cap domestic equities 147Large-cap equity analysis 264ndash265Large-cap stocks 76 108 152ndash154

allocation 64returns expectations 62

Large-cap US stocks long run calculation 64ndash65Late trading abuses 5Lehman Brothers indexes 156ndash157 244ndash245Leverage 123 329

levels See Hedge funds of fundsrisk 137ndash138 See also Private equityusage 123

Limited partners 329Limited partnership 329Liquidity

absence 122ndash123 See alsoTimberlanddefinition 329risk 73 See also Private equity

Long-term capital objectives 37Long-term equity returns 60Long-term objectives 34 45Long-term timberland returnsvolatility 129Loyalty duty 229Lumber value appreciation 127

Managed futures 136Management

consultant hiring See Investmentcontrast See Passive managementRFP See Hedge funds of funds

Managers See GrowthValueanalysis 106benchmarks evaluation 249ndash250compliance 257criteria minimum 104 106ndash109evaluation 154 See also Hedge funds of fundsfees 138ndash139herd mentality 100ndash101interview 105 110ndash111

338 index

investment objectivesguidelines 248ndash250objectives comparison 158performance 101 257ndash258professional staff examination 253ndash254qualitative analysis 105 109ndash110quantitative screens 104ndash106selection 30 46 99 102ndash111 See also

Investmentskill analysis 161star system avoidance 101ndash102style 96 163StyleAdvisor analysis 267ndash269termination 46 166ndash167 247universe comparison 159

Marked to market 153Market

bubbles 212ndash213capitalization 329 See also Stockscycle evaluation 157indexes 155inefficiencies 119portfolio 54 329sensitivity 152timing abuses 5

Marketing contact sample 287Market-neutral stance 120Markowitz Harry 22 51 60 213Markowitz algorithm 51 62

usage 52Markowitz portfolio optimization process 65Master trust administration 329Maximum drawdown 329Mean variance optimization (MVO) 60 329

disadvantages 62ndash64model usage 78

Mean-reverting markets 26Meeting schedule 248Mental accounting 209Merrill Lynch indexes 156Mezzanine financing 131 329Mid-cap stocks 108Mid-cap value fund 102Ministerial functions 228Mission defining 33 34Mistrust environment 4ndash5MLM index fund 139Mobius Group 160 322Modern Portfolio Theory (MPT) 22ndash24 60ndash62 73

impact 76 162 212 223Money managers 102Money market account 329Monte Carlo simulation 66 329Moodys Investors Service credit rating agency

109 156

Moral anchor 210Morgan Stanley indexes 156Morningstar Inc 319

large-cap growth fund identification 105rating 101ndash102

Most favored nations 329MPT See Modern Portfolio TheoryMultifactor riskreturn model 106 107Multiple benchmarks 157Multistrategy fund 120Mutual funds 15ndash16 115ndash116 329 See also High-

yield mutual fundscontrast See Separate accountsfees negotiation 116ndash117fees (net) See Institutional mutual fundinvestment guidelines 48selection 86ndash87trading practices 313ndash314

MVO See Mean variance optimization

Narrow-based index 155National Conference of Commissioners on

Uniform State Laws 24 218National Council of Real Estate Investment

Fiduciaries (NCREIF) 127 329Timberland Index 130

Natural disasters SeeTimberlandNegative alpha 260Negative skew 71Nelsons Consultants Directory 197Net asset value (NAV) 122Net of fees usage 153New Frontier Advisors LLC 322Nominal 329Nominal bonds 89Nominal return 329Noncash gifts 6Non-ERISA funds 18Non-for-profit organization capital control 132Nonprofit organization need (identification)

195ndash196Non-US bonds 69 80

managers requirements 86Non-US corporate debt 81Normal distribution 329ndash330Normal portfolio 164Not-for-profit funds

management 116relationship SeeTreasury inflation protection

securitiestrustees 111

Not-for-profit health care system threat 19Not-for-profit organizations perfect storm

35ndash36

index 339

ODeanTerence 207One-off reporting 13On-site visit See ConsultantOperating funds 18Opportunity set See International bondsOrganization

examination 109information 251ndash252purpose 34

Otten Roger 177Outside expert hiringmonitoring 234ndash235Overconfidence 330 See also Biased expectationsOwnership changes 292

Participant services 309ndash311Participation rates 16Passive investable index 139Passive management 330

active management contrast 111ndash112Pass-through entity 330Peer group comparison 157Pension Benefit Guaranty Corporation (PBGC)

226Pensions

plan liabilities cost 11problem 4underfunding 11ndash12

Percentage band methodologies 142Performance See Managers

attribution 155benchmark comparison 246calculations 152ndash153evaluation 46examination 110impact See Socially responsible investingmeasurementevaluation 151monitoring 246ndash247 See also Asset allocation

Timberlandrecords 100reporting 166risk relationship 246

Personnel consistency 108Plan

documents compliance duty 230fiduciaries 235investments diversification (duty) 230size 306ndash307sponsor services 307ndash308

Plan Sponsor Network 160 320PODS See Portfolio opportunity distribution setsPonzi schemes occurrence 212ndash213Popular index PODS (PIPODS) 166Portfolio See Normal portfolio

analysis 160annual return expectation 36

composition 108data 101developments 164ndash166drift degree 144input 147ndash149losses snakebites 208models construction 147ndash149rebalancing 141risk 208volatility 60

Portfolio construction 53ndash54benefits See High-yield bondsexamination 110methodology 276ndash277rules 164

Portfolio engineerapproach 143ndash147difference 144ndash147disclaimer 147premise 144radius calculator 148

Portfolio opportunity distribution sets (PODS)164ndash166 See also Popular index PODS

Portfolio Strategist (Ibbotson) 321Positive alpha 260PPCAmdashStokTrib 320Priceearnings ratio (PE) 330

reflection 3Pricing differences See Security positionsPride seeking 211Principal preservation 21Private equity 131ndash134 330

fees 132leverage risk 133ndash134liquidity risk 133performance index See US private equity

performance indexreporting issues 134returns calculation 132ndash133risks 133ndash134special situations 131

Private foundationrestrictions 215rules 222ndash223

Privately owned real estate role 126ndash127Probabilistic 330

sense 53Probabilistic optimization models 65ndash67 330Procedural prudence 233Process-oriented investor 212Product team description 274Professional turnover 275 290ndash291Prohibited Transaction Class Exemption (PTCE)

233Project basis fees 204

340 index

Property outright sales 20Proxy 330

appointment 115Proxy voting 46 115 170 330 See also Socially

responsible investingpolicy 247

Prudent expert rule 18 229Prudent Investor Act See Uniform Model Prudent

Investor ActPrudent Investor Rule See Restatement of Trusts

of Prudent Investor RulePrudent investor standard 24Prudent man rule 215 218Prudent person rule 229ndash230Prudent steward 29 240Putnam Samuel 22

Qualified purchasers 120Qualitative analysis See ManagersQuantitative Analysis of Investor Behavior (QAIB)

162Quantitative anchor 210Quantitative screens See Managers

Rational investor 207Real estate

control 20role See Privately owned real estatesaleleaseback 20values appraisal 127

Real estate investment trusts (REITs) 56 69ndash71239 330

benefits 126ndash127historical returns statistical properties 71ndash73long-term investment performance 70returns distribution (Wilshire) 74returnsrisks 70share price premiums 71usage 126ndash127

Real return 330Rebalancing 46 86 See also ArbitrageAsset

allocation Cash flow Contrarian rebalancingPortfolio

efforts facilitation 26ndash27frequency 147methods 141ndash143overlay 143strategy 141triggering 146

Recordkeepers 330 See also Semi-bundledrecordkeeper Unbundled recordkeeper

usage 186ndash188Record-keepingperformance 308ndash309requirements 13

RFP work plan 187Regression analysis 54 330Regret fear 211REITs See Real estate investment trustsReligious institutions considerations 19ndash20 239Remainderman 23Removal SeeTrustReporting issues See Private equityRepresentativeness 211Request For Proposal (RFP) 180ndash184 199ndash200

305 See also Hedge fund-of-fundsmanagement

modification 193work plan See Record-keeping

Resources 319Restatement of Trusts of Prudent Investor Rule

219Restricted fundslegal aspects 215

nature 216Retirement funds fiduciary issues 225Retirement plans 15

educationcommunication impact 16ndash18problems 11

Returns 259 See also Cumulative annualizedreturns Expected returnTimberland

calculation See Private equitydecomposition method 59ndash60 330events contrast 79linkage frequency 153objective SeeTotal return objectiverate See Rate of returnrequirement 33 37ndash41risk relationship 76 78spread 94standard deviations 53strategies See Absolute returnsvolatility 162

Returns-based analysis 97 105Returns-based style analysis 94ndash97Returns-based technology ancillary uses 97RFP See Request For ProposalRisk 137ndash139 See also Private equity

analysis 162ndash163controls 257experience 244ndash245factors 92indicators 259level 41management See Hedge funds of fundsperception 41premium 56ndash59 330 See also Small-cap equity

risk premiumreduction 52relationship See Performance

index 341

Risk (continued)tolerance understanding 33 41ndash42types 122ndash124

Risk-adjusted return 101 209 212Risk-free rate 54 330Risk-seeking behavior 212R-squared 56 259ndash260 330

derivation 163Russell indexes 70 155ndash156 178 244ndash245

Saleleaseback See Real estateSarbanes-Oxley legislation 232Screening process 276Sector-specific indexes 156Securities and Exchange Commission (SEC)

focus 5ndash6registration 104regulations 133 172reporting requirements 116

Securities lending 330Security positions pricing differences 153Semibundled plan 186Semi-bundled recordkeeper 331Senate Finance Committee review 5Separate accounts 116 331

investment guidelines 48management 175mutual funds contrast 175ndash176selection 86ndash87

Settlement date 331reporting contrast SeeTrade date

Settlor functions 227Shareholders

advocacy 172ndash173 331resolution 170 331

SharpeWilliam 54 93 207quadratic algorithm 105

Sharpe ratio 106 110 260 331measurement 163

Shefrin Hersh 207Short selling 330Short squeeze 331Short-term risk 42Short-term spending needs 37Skewness 64 331Slope coefficient 54Small-cap equity risk premium 59Small-cap product assets 108Small-cap stocks 69ndash70 76 108Small-cap value funds 102Social investing 113ndash114Social Investment Forum 169Social screening 280Socially responsible investing (SRI) 169 239ndash240

history 169ndash170incorporation See Investmentperformance impact 176ndash177proxy voting 173ndash174screening 170ndash172strategies 170ndash175

Soft dollar payments usage 6Software usage 147ndash149South Sea Company shares (purchase) 22Sovereign debt 80 87 331Spending

approaches 37methods 36ndash37policy 33ndash37 46 244

Stable value fund 331Standard amp Poors 500 (SampP 500) 134 244

correlation 138index 3 42 56 137 151 157monthly returns histogram 65

Standard amp Poors (SampP)Barra Value 178credit rating agency 109 156

Standard deviation 53 259 331 See alsoAnnualized standard deviation ReturnsTimehorizon

measurement 163methodology 142 143

Statistics 259ndash261Statutory penalties 232Stocks

investment 35long run calculation See Large-cap US stocksmarket capitalization 108recovery 5ndash6returns 35 40timberland correlation 129transactions commissions 113

StokTrib 160 See also PPCAmdashStokTribStone Bernell K 177Stop loss 137 331Stop order 331Stops usage 137Structured equity 134ndash135Structured investor 212 See also Unstructured

investorStyle 154 331 See also Investment

advisor 163 165analysis 160ndash162benchmark 97drift 94 95reliability 155

Style-neutral portfolio 97Style-neutral posture 102Style-specific managers current state 98Style-specific market 154

342 index

Style-specific peer groupuniverse 49Subcontractors hiring 30Substantive prudence 233Summary of material modifications (SMM) 237Summary plan description (SPD) 237Surrender charge 13Survivorship bias 120 159 331

risk 138Surz Ronald J 164Suspicious investor 211ndash212Systematic investment strategy 136Systematic risk 331

Table limits 64Tactical rebalancing 142Target allocation 30

percentage change relationship 142Tax-qualified investors 69Team description 290 See also Product team

descriptionThaler Richard 207 210Third-party administrator (TPA) 331Third-party service providers 236Timberland

active management 130ndash131addition 127ndash131benefits 126ndash128competitive returns 127ndash128considerations 130ndash131correlation See Bonds Stocksdiversification 128geographic diversification 130government intervention 130liquidity absence 128ndash129natural disasters impact 129performance monitoring 130price fluctuations 129ndash130risks 128ndash130volatility 128 See also Long-term timberland

returnsvolatilityTimberland investment management organizations

(TIMOs) 130Timberland Performance Index (TPI) 130

331Time horizon 64

designation 33 42standard deviation 59

Time-dependent rebalancing 142Time-weighted basis 152Time-weighted return definition 331Total return

concept 88 331objective 244

Total return approach 21 26 239disadvantages 26

landmarks 27reasons 25ndash27

Tracking error 110 261Trade date 332

valuation settlement date reporting (contrast)153

Trade execution 113Trading

costs reduction 5ndash6policy 256ndash257 277ndash278

Transaction-based fees 86Transaction-based values 127Transaction-related fees 191Transactions

guidelines 246prohibition (avoidance) duty 230ndash231weighting 153

Transparency 332absence 122

Treasury inflation protection securities (TIPS)87ndash92 239 331

Treesgrowth 128value appreciation 127

Treynor ratio 332measurement 163

Trust (breaches) removal 232Trustee 332

fees 185services 183ndash184 313

Turnover 125 See also Account Professionalturnover

Two-asset efficient frontier 61

Unbundled recordkeeper 186 332Unhedged foreign stockbond indexes 156Uniform Management of Institutional Funds Act

(UMIFA) 24 215 220ndash222application 220appreciation appropriation 222delegationstandards 221ndash222investment authority 221ndash222

Uniform Model Prudent Investor Act 218ndash220Uniform Principal and Income Act 215Uniform Prudent Investor Act 215Universe comparisons 157ndash160 See also ManagersUnstructured investor 212US assets category 288US equity

allocations 280ndash281characteristics 279composite information 285sample product 272stylus charts 286

US private equity performance index 133

index 343

Valueinvestment analysis See Large companymanagers 155ndash156

Value expressive investor 211Values-based investing 169Vendors

provider ratings 189reference questions 192ndash193search needs assessment 181selection 179ndash185 188ndash190 240

Venture capital (VC) 131 332 See also Early-round venture capital

fund See Community developmentVenture Economics US Private Equity

Performance index 133

Vestek 160 320Volatility 42 82 See also Portfolio ReturnsVoluntary Fiduciary Correction (VFC) program

232ndash233

Wilshire indexes 244ndash245Wrap fee 13

product 104 332

Yield spread changes 59

Zephyr Associates Inc 160 322Zero-sum game 136 332

344 index

The Practical Guide to Managing Nonprofit Assets

About the Authors

About the Contributors

Contents

Chapter 1 Introduction

A Crying Need

Shocks to the System

Finances

Contributions

The Pension Problem

Environment of Mistrust

The Good News

The Fund-Raising Challenge

Gifting Strategies

Investment Strategy

Expect to Find

How to Use This Book

Who Should Use This Book

Chapter 2 Special Issues

Hospitals mdash The Retirement Plan Mess

Underfunded Pensions

403(b) Versus 401(k)

Annuities

Mutual Funds

Education and Communication

Case Study

Endowment and Operating Funds

Contributions

Considerations for Religious Institutions

Summary

Chapter 3The Total Return Approach

Early History

The Modern Era

The Legal Challenge

The Barker Report

Umifa Rrisa Upia and the Prudent Investor Standard

The Case for the Total Return Approach

Potential Negatives

Summary

Chapter 4 The Prudent Steward

Build a House Build an Investment Program

Set Goals The Blueprint

Allocate Assets

Manager Selection Hire the Subcontractors

Rebalance

Monitor Performance

Chapter 5 Set Goals

Introduction

Define the Mission

Determine a Spending Policy

Establish the Required Return

Understand Your Risk Tolerance

Designate the Time Horizon

Summary

Chapter 6 Investment Policy

Overview

Why Is It Important

Content

Sample Investment Policy Statement

Implementation and Maintenance

Sspecific Investment Guidelines

Investment Benchmarks

Summary

Chapter 7 Asset Allocation

The Efficient Frontier

Capital Market Assumptions The Building Blocks of Portfolio Construction

Developing Expected Return Assumptions

Case Study

Modern Portfolio Theory

Shortcoming of Traditional Mean Variance Optimization

The Long Run

Probabilistic Optimization Models

Summary

Chapter 8 New Asset Classes

Real Estate Investment Trusts

The Statistical Properties of Historical Reit Returns

HighYield Bonds

International Bonds

Mutual Fund or Separate Account

Experience Counts

Summary


Risk Factors

Conclusion

Chapter 9 Investment Style

Academic Research

Ancillary Uses

The Current State

Summary

Chapter 10 Manager Selection

Overview

Herd Mentality

Avoiding the Star System

Where to Begin

Manager Selection

Passive Versus Active Management

Databases

Administrative Compatibility

Trade Execution

Social Investing

The Commonfund

Proxy Voting

Account Types

Negotiate Fees

Chapter 11 Alternative Investments

Hedge Funds (Absolute Return Strategies)

Funds of Funds

Risks

Benefits

Fund-Of-Funds Search

Real Estate

Timberland

Private Equity

Structured Equity

Managed Futures

An Investment Strategy

Benefits of Diversification

Risks

Conclusion

Chapter 12 Portfolio Rebalancing

Traditional Rebalancing Methods

A New Approach

Building Your Own Model

Conclusion

Chapter 13 Performance Measurement and Evaluation

Performance Calculations

Benchmarks

Market Indexes

Style

Picking the Right Index

Multiple Benchmarks

Presenting the Data

Universe Comparisons

Portfolio Analysis

Style Analysis

Risk Analysis

Recent Developments

Performance Reporting

Terminating a Manager

Chapter 14 Socially Responsible Investing

History

Socially Responsible Investing Strategies

Separate Accounts Versus Mutual Funds

Performance Impact of Socially Responsible Investing

Incorporating Socially Responsible Investing Into Investment Policy

Chapter 15 Selecting Other Vendors

Step One

Step Two

Step Three

Step Four

Record Keepers

Narrow the Field

Final Steps

Defined Benefit Plans

Gift Annuities

Brokers

Chapter 16 Hiring an Investment Management Consultant

Identifying the Need A Tale of the Typical Nonprofit Organization

The General Contractor mdash AKA the Investment Consultant

Effective Use of a Consultant

Summary

Chapter 17 Behavioral Finance

Trying to Break Even

Snake Bitten

Biased Expectations and Overconfidence

Herd Mentality

Asset Segregation or Mental Accounting

Cognitive Dissonance

Anchors

Fear of Regret and Seeking Pride

Representativeness

Familiarity

Investor Personality Types

Risk-Seeking Behavior

Naturally Occurring Ponzi Schemes and Market Bubbles

Conclusion

Chapter 18 Legal Aspects of Investing Charitable Endowment Restricted and Other Donor Funds

Overview

The Nature Of Endowment Or Restricted Funds

Endowments Created By the Board

Donor-Created Endowment Funds

Donor-Created Restricted Gifts Or Funds

General Statement About Investing Endowment and Other Funds

The Prudent Man Rule

The Prudent Investor Act

Uniform Management of Institutional Funds Act

Private Foundation Rules

Summary

Chapter 19 Fiduciary Issues mdash Retirement Funds

Erisa

Who is a Fiduciary

Fiduciary Requirements

Penalties for Fiduciary Breaches

Prudent Procedures to Limit Fiduciary Liability

Department of Labor Tips to Help Fiduciaries Understand Their Responsibilities

Chapter 20 Final Thoughts

Summary

The Prudent Steward

Take Aways

Conclusion

Appendix A Sample Investment Policy Statement1

Introduction

Purpose

Spending Policy

Investment Policy

Investment Objectives

Asset Allocation

Cash FlowsRebalancing

Transaction Guidelines

Selection of Investment FundsManagers

Performance Monitoring

Termination of Managers

Proxy Voting Policy

Responsibilities of the Investment Consultant

Meeting Schedule

ABC Hospital Fund

Managersrsquo Investment Objectives and Guidelines

General Guidelines For All Managers

Specific Guidelines

Investment Manager Objectives Evaluation Benchmarks of Selected Managers

Appendix B Investment Manager Questionnaire

Appendix C Sample Search Investment Analysis

Definition of Key Statistics

Large Company alue Search The Screening Process

Large Company Value Investment Analysis

Large-Cap Value Equity Analysis

Appendix D zzz eVestment Alliance LLC eA US Equity Sample Product

Appendix E Request for Proposal for Hedge Fund-of-Funds Management

Appendix F Request for Proposal Record-Keeping Services Firm Background

Plan Sponsor Services

AdministrationRecord Keeping

Participant Services

Communication and Education Services

Investments

Trustee Services

Mutual Fund Trading Practices

Fees

Conversions

Appendix G Resources

Data

Analytical Software

Other Resources

Glossary

Index

William A Schneider

Robert A DiMeo

ISBN-13 978-0-471-69233-1ISBN-10 0-471-69233-6

10 9 8 7 6 5 4 3 2 1

William A Schneider

Bob DiMeo

Mike Benoit

Doug Balsam

Matt Porter

Matt Rice

Jackie Rondini

Steve Spencer

Trina Sweet

About the Authors

Contents

XII contents

contents XIII

XIV contents

contents XV

Glossary 325

Index 333

XVI contents

chapter 1

Introduction

a crying need

finances

finances 3

contributions

the pension problem

the good news

the good news 5

gifting strategies

investment strategy

expect to find

expect to find 7

bull Be committed

bull Be consistent

bull Be quick

bull Be personal

bull Be known

bull Be meticulous

bull Be there

bull Be honest

bull Goal setting

bull Cost control

chapter 2

Special Issues

annuities

annuities 13

ndash20

onndashV

mutual funds

mutual funds 15

403(b) 401(k)

2224 403(b)

401(k)

50403020100

case study

contributions

Aging Institutions

summary

chapter 3

early history

the modern era

the legal challenge

the barker report

potential negatives

summary

summary 27

Early history

Modern era

chapter 4

The Prudent Steward

allocate assets

rebalance

monitor performance

chapter 5

Set Goals

introduction

define the mission

Stocks

The Perfect Storm

$11000

$10000

New Approaches

0001926ndash2003 1980s 1990s

Stocks

10301190

17501820

2 Inflation $9056807921

35 Inflation $14033968520

5 Inflation $21609711870

$0 $50000000 $100000000 $150000000 $200000000 $250000000 $300000000

Introduction

summary

chapter 6

Investment Policy

overview

why is it important

content

bull Purpose

bull Rebalancing

bull Proxy voting

I Purpose

II Spending policy

IV Asset allocation

summary

summary 49

chapter 7

Asset Allocation

00 2 4 6 8 10 12 14 16

Risk (Std Dev)

MIX C MIX A

Market Timing2

Asset Allocation94

Security Selection4

Expected Return

Standard Deviation

Correlation

Rf = Risk-free rate

β = 110

ndash20

Russell2000

Risk-free rate = 30

ndash20

Wilshire REITIndex

ndash20

GDP = GDP growth

456789

Expected Return

the long run

(1978ndash2004)

SampP 500

ndash22

ndash20

ndash18

ndash16

ndash15

ndash13

ndash11

ndash9

ndash8

ndash6 ndash4

SampP 500

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

summary

summary 67

Bond 46 63 20 00 92

chapter 8

New Asset Classes

Large-cap 139 155

Small-cap 143 196

REIT 145 145

-40ndash364

ndash88

102 90

ndash196

ndash10

Return

high-yield bonds

History

high-yield bonds 73

050520

ndash22

ndash16

ndash14

ndash13

ndash11

ndash10

ndash9

ndash7

ndash6

ndash4

ndash3

ndash1

30 25 20 15 10 5 0

high-yield bonds 75

Large-cap 133 155

Small-cap 123 193

ndash10

Return

international bonds

Large-cap 1

High-yield bond (B) 048 097 017 078 1

High-yield bond (C) 036 086 001 066 084 1

Large-cap 124 145

40 35 30 25 20 15 10 5 0

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

40 35 30 25 20 15 10 5 0

8ndash3

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

40 35 30 25 20 15 10 5 0

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

8ndash3

ndash32

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

Opportunity Set

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

0 3 0 Taiwan

0 5 0 Austral ia

060India

1530Japan

020South Africa

3000 EMU Europe

ilar f

Index 2003 2002 2001 2000 1999 1998

experience counts

summary

Nominal Bonds

Nominal BondsYield

Real Return

Inflation

Yield Components

Yield Real Return

Inflation

Yield Components

Diversification

Large-cap 78 171

Small-cap 100 217

TIPS 77 51

ndash10

Return

risk factors

conclusion

chapter 9

Investment Style

academic research

rvalue rgrowth

r2 growth

Sample Manager

ndash1

rvalue rgrowth

r2 growth

Sample Manager

ndash1

r2 value

ancillary uses

ancillary uses 97

Out-of-sample

the current state

summary

rvalue rgrowth

r2 growth

Completion Fund

Resultant Portfolio

SampP 500

ndash1

r2 value

chapter 10

Manager Selection

overview

herd mentality

$21589250$19671514

$46609571

$38696844

10 years 20 years

where to begin

where to begin 103

___________________________________________________________________________

Completed by___________________________________________________________________________

___________________________________________________________________________

manager selection

2 Minimum criteria

4 The interview

Minimum Criteria

Final Candidate

Interview

Weighting 10 10 10 20 30 10 10

databases

trade execution

social investing

the commonfund

proxy voting

account types

account types 115

negotiate fees

negotiate fees 117

chapter 11

funds of funds

funds of funds 121

risks 123

Gross return 120

Base fee 1 ndash10

Net return 88

benefits

Index 2002 2001 2000 1999 1998

Fund of funds

Market neutral

CSFBTremont 74 93 150 153 133

Global Macro

HRFI macro 74 69 20 176 62

Distressed

real estate

timberland

timberland 127

Risks of Timberland

timberland 129

Return SD

Conclusion

private equity

private equity 131

Calculating Returns

private equity 133

VC venture capital

structured equity

managed futures

Leverage

risks 137

Survivorship Bias

Passive Approach

conclusion

conclusion 139

Natural gas

MeatsLive cattle

chapter 12

allocation)

Considerations

a new approach

a new approach 143

Underlying Premise

The Key Difference

a new approach 145

88 90 92 94 96 98 100 102 104 106

00 02 04 06 08 10

9700 02 04 06 08 10

Disclaimer

Rebalance

ldquoove

Return

bullTa

conclusion

chapter 13

benchmarks

benchmarks 153

broad large cap

SampP 500 index

market indexes

style 155

multiple benchmarks

presenting the data

Fund SampP 500

CPI+74 105

Quarter Ending

Return

SampP 500

Return

Universe

5th -tile

25th -tile

50th -tile

75th -tile

95th -tile

portfolio analysis

style analysis

tfolio

risk analysis

rvalue rgrowth

r2value r2growth

Value -1 0 1 Growth

risk analysis 163

recent developments

Manager

1999 -

June 2

Return

Citi g

ance A

ttribution

d to B

Russell 1

r vs U

d if le

-6-505

Manager A

Russell 1

entile

n to 7

entile

Manager

atio thro

(not annualiz

ed if le

ss than 1

Russell 1

entile

n to 7

entile

er amp

chapter 14

history

Screening

Proxy Voting

Community Investing

chapter 15

step one

step two

step two 181

_____________________________________________________________________________

step three

step three 183

Accounting Systems

Reports

(continued)

Disbursements

step four

ndash$

times12

) times25

er amp

record keepers

record keepers 187

Indicates meeting

narrow the field

Organization ____ _____ _____ _____ _____

bull Capability

Client service ____ _____ _____ _____ _____

bull Technology

bull Efficiencies

People ____ _____ _____ _____ _____

Investments ____ _____ _____ _____ _____

bull Quality

bull Quantity

bull Other

Cost ____ _____ _____ _____ _____

bull Initial

bull Ongoing

final steps

gift annuities

gift annuities 191

gift annuities 193

D Communications

E Investments

F Overall

A Internet services

B Phone services

C Statements

D Communications

E Investments

41 Notes

brokers

chapter 16

bull Negotiate fees

(continued)

Useful Hints

IV References

V Fee Schedule

The Interview

bull Manager search

bull Pricing

Verification

The On-Site Visit

The Agreement

summary

summary 205

chapter 17

Behavioral Finance

snake bitten

herd mentality

anchors

representativeness

familiarity

conclusion

conclusion 213

chapter 18

overview

Application

summary

summary 223

chapter 19

who is a fiduciary

chapter 20

Final Thoughts

summary

We have explored

the prudent steward

1 Set goals

2 Allocate assets

4 Select managers

take aways

conclusion

conclusion 241

appendix A

introduction

purpose

spending policy

investment policy

Return

asset allocation

Cash 390 00 00

bull Style drift

proxy voting policy

meeting schedule

abc hospital fund

Name ____________________________

Title ____________________________

Date __________________

Dated May 2002

specific guidelines

Implementation

appendix B

1 Firm Name ____________________________________

Address ________________________________________

2 Primary Contact ________________________________

Fax Number ____________________________________

Email address __________________________________

Organization

Year ______________

Total Assets ____________________________________

Professional Staff

Economists

Equity traders

Administration

Other (explain)

1 Strategy ___________________________________________________

_____________ On the first $ ____________________

_____________ On the next $ ___________________

_____________ On the first $ ____________________

_____________ On the next $ ___________________

062004 122003 062003 122002 062002 122001 062001 122000

DebtEquity

in Top 10 Holdings

of Securities

Foreign

Trading

Performance

1 Date Return

2 122003 343

3 92003 234

Dispersion Range

Title __________________________________________

Date __________________________________________

appendix C

large c

y valu

r a lo

entrsquo

rsquosth

0ndash

trsquol

large-c

ndash3

+ndash

ndash5

ndash2

+ndash

Zephyr

Schneid

ssocia

Manager S

1999 -

Russell

1000 V

ussell

1000 G

Russell

2000 V

ussell

2000 G

all-101

e Valu

erican F

unds W

Dodge amp

ussell

Generic C

1999 -

-month

ell 1000 V

ell 1000 G

ell 2000 V

ell 2000 G

Dodge amp

Manager

le12-Q

1999 -

Russell

1000 V

ussell

1000 G

Russell

2000 V

ussell

2000 G

all-101

e Valu

erican F

unds W

Dodge amp

ussell

Generic C

ance A

ttributio

1999 -

d to S

Benchm

erican F

unds W

Dodge amp

ithZephyr

anagerre

Zephyr

Schneid

ssocia

Manager

2001 -

Return

Dodge amp

1000 V

Manager

1999 -

Return

Dodge amp

1000 V

-month

2001 -

Upside

Dodge amp

1000 V

1999 -

Upside

Dodge amp

1000 V

anager re

ffron E

ar Inc

Zephyr

Manager

rn thro

d if le

Zephyr

ingsta

Return

101520

Dodge amp

1000 V

entile to M

n to 7

entile

Manager

lpha thro

less t

Zephyr

ingsta

Alpha -11

Dodge amp

1000 V

entile to M

n to 7

entile

Manager

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

Manager

lpha R

ank thro

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

anager re

ffron E

ar Inc

Zephyr

Schneid

ssocia

Manager

less t

Zephyr

ingsta

Sharpe Ratio -040

Dodge amp

1000 V

entile to M

n to 7

entile

Manager

less t

Zephyr

ingsta

Information Ratio

-4-3-2-101

Dodge amp

1000 V

entile to M

n to 7

entile

Manager vs U

Rank thro

mber 2004

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

Manager

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

anager re

ffron E

ar Inc

appendix D

on amp

d Tamp

alTamp

ldquoMos

ionrdquo

ldquoBal

atrdquo

mdashA

8mdash

Investment Strategy

Screening Process

BuySell Discipline

Additional Comments

ndash40

35times

34times

99times

0ndash

timesCu

23times

gt $50

15ndash

smdash

5ndash15

15ndash

ndash1

ndash75

lt $40

)mdash

mdashCo

mdashEn

smdash

mdashH

dsmdash

mdashIn

mdashM

mdashTe

mdashU

temdash

ndash7

72ndash

1ndash

6ndash

ndash5

61ndash

mdash6

60ndash

ndash11

ndash2

ndash3

74ndash

mdash9

ndash27

ndash20

ndash22

ndash9

66ndash

5ndash

4ndash

ndash3

67mdash

ndash2

95ndash

3ndash

onmdash

mdashmdash

9mdash

mdashmdash

mdashA

hamdash

mdashmdash

ndash8

70ndash

mdashmdash

ormdash

mdashmdash

3mdash

mdashmdash

mdashIn

mdashmdash

mdashndash

ndash0

12mdash

mdashmdash

mdashS

mdashmdash

mdashndash

ndash0

60ndash

mdashmdash

ISAmdash

mdashmdash

mdash29

ndash1

kmdash

mdashmdash

ndash27

ndash20

ndash22

mdashmdash

mdash57

ndash31

mdashmdash

ormdash

mdashmdash

mdashIn

mdashmdash

omdash

mdashmdash

AmdashG

mdashmdash

ndash2

38mdash

kmdash

mdashmdash

mdashndash

2ndash

3mdash

smdash

mdashmdash

mdash17

1mdash

mdashmdash

ormdash

mdashmdash

mdashIn

mdashmdash

omdash

mdashmdash

undmdash

mdashmdash

mdash12

ndash12

ndash14

mdashmdash

mdashndash

9ndash

2ndash

smdash

mdashmdash

45ndash

onmdash

mdashmdash

mdashA

hamdash

mdashmdash

mdashTr

mdashmdash

omdash

mdashmdash

mdashS

mdashmdash

tymdash

mdashCo

mdash12

mdash6

ndash10

1ndash

0ndash

ndash10

ndash50

0ndash

mdashA

03mdash

mdashmdash

ion) U

mdashEx

rsmdash

emdash

mdashD

mdashmdash

19mdash

mdashFu

smdash

palamp

Firm Background

Additional Comments

appendix E

B Product Summary

Number of Clients

Investor 2004 2003 2002 2001 2000

Number of Clients

Investor 2004 2003 2002 2001 2000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets(in millions)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets(in millions)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets(in millions)

Strategy

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Managers

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Managers

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Managers

1999 2000 2001 2002 2003 2004

N Risk Management

O Fees

appendix F

Under 100

100ndash999

1000ndash4999

5000ndash9999

Over 10000

2001 2002 2003 2004

Under 100

100ndash999

1000ndash4999

5000ndash9999

Over 10000

Enrollment

Balance inquiries

Rebalancing feature

Loan modeling

Termination options

Fund objectives

Withdrawals

Enrollment meetings

Ongoing meetings

Enrollment kits

Payroll stuffers

Posters

Internet access

investments

trustee services

Conversion

Flat fee

Per employee

Loan conversion

Travel expenses

Trustee

Compliance testing

Travel expenses

Internet services

fees 315

Additional fee

Asset-based fee

Commissions

Miscellaneous fee

Initiation fee

Initial

conversions

conversions 317

Fund N

appendix G

Resources

analytical software

other resources

other resources 323

Glossary

326 glossary

glossary 327

328 glossary

glossary 329

330 glossary

glossary 331

332 glossary

rebalancing 245

334 index

index 335

fund 84market 81

336 index

index 337

excess 76 78

338 index

109 156

35ndash36

index 339

226Pensions

340 index

index 341

342 index

331Time horizon 64

index 343

232ndash233

product 104 332

344 index

About the Authors


Contents


A Crying Need


Finances

Contributions

The Pension Problem


The Good News


Gifting Strategies

Investment Strategy

Expect to Find







Annuities

Mutual Funds


Case Study


Contributions


Summary


Early History

The Modern Era

The Legal Challenge

The Barker Report



Potential Negatives

Summary




Allocate Assets


Rebalance

Monitor Performance

Chapter 5 Set Goals

Introduction

Define the Mission





Summary


Overview

Why Is It Important

Content





Summary





Case Study



The Long Run


Summary




HighYield Bonds

International Bonds


Experience Counts

Summary


Risk Factors

Conclusion


Academic Research

Ancillary Uses

The Current State

Summary


Overview

Herd Mentality


Where to Begin

Manager Selection


Databases


Trade Execution

Social Investing

The Commonfund

Proxy Voting

Account Types

Negotiate Fees



Funds of Funds

Risks

Benefits


Real Estate

Timberland

Private Equity

Structured Equity

Managed Futures



Risks

Conclusion



A New Approach


Conclusion



Benchmarks

Market Indexes

Style


Multiple Benchmarks

Presenting the Data


Portfolio Analysis

Style Analysis

Risk Analysis

Recent Developments




History






Step One

Step Two

Step Three

Step Four

Record Keepers

Narrow the Field

Final Steps


Gift Annuities

Brokers





Summary



Snake Bitten


Herd Mentality



Anchors


Representativeness

Familiarity




Conclusion


Overview










Summary


Erisa

Who is a Fiduciary






Summary

The Prudent Steward

Take Aways

Conclusion


Introduction

Purpose

Spending Policy

Investment Policy


Asset Allocation






Proxy Voting Policy


Meeting Schedule

ABC Hospital Fund



Specific Guidelines















Investments

Trustee Services


Fees

Conversions


Data

Analytical Software

Other Resources

Glossary

Index

William A Schneider

Robert A DiMeo

ISBN-13 978-0-471-69233-1ISBN-10 0-471-69233-6

10 9 8 7 6 5 4 3 2 1

William A Schneider

Bob DiMeo

Mike Benoit

Doug Balsam

Matt Porter

Matt Rice

Jackie Rondini

Steve Spencer

Trina Sweet

About the Authors

Contents

XII contents

contents XIII

XIV contents

contents XV

Glossary 325

Index 333

XVI contents

chapter 1

Introduction

a crying need

finances

finances 3

contributions

the pension problem

the good news

the good news 5

gifting strategies

investment strategy

expect to find

expect to find 7

bull Be committed

bull Be consistent

bull Be quick

bull Be personal

bull Be known

bull Be meticulous

bull Be there

bull Be honest

bull Goal setting

bull Cost control

chapter 2

Special Issues

annuities

annuities 13

ndash20

onndashV

mutual funds

mutual funds 15

403(b) 401(k)

2224 403(b)

401(k)

50403020100

case study

contributions

Aging Institutions

summary

chapter 3

early history

the modern era

the legal challenge

the barker report

potential negatives

summary

summary 27

Early history

Modern era

chapter 4

The Prudent Steward

allocate assets

rebalance

monitor performance

chapter 5

Set Goals

introduction

define the mission

Stocks

The Perfect Storm

$11000

$10000

New Approaches

0001926ndash2003 1980s 1990s

Stocks

10301190

17501820

2 Inflation $9056807921

35 Inflation $14033968520

5 Inflation $21609711870

$0 $50000000 $100000000 $150000000 $200000000 $250000000 $300000000

Introduction

summary

chapter 6

Investment Policy

overview

why is it important

content

bull Purpose

bull Rebalancing

bull Proxy voting

I Purpose

II Spending policy

IV Asset allocation

summary

summary 49

chapter 7

Asset Allocation

00 2 4 6 8 10 12 14 16

Risk (Std Dev)

MIX C MIX A

Market Timing2

Asset Allocation94

Security Selection4

Expected Return

Standard Deviation

Correlation

Rf = Risk-free rate

β = 110

ndash20

Russell2000

Risk-free rate = 30

ndash20

Wilshire REITIndex

ndash20

GDP = GDP growth

456789

Expected Return

the long run

(1978ndash2004)

SampP 500

ndash22

ndash20

ndash18

ndash16

ndash15

ndash13

ndash11

ndash9

ndash8

ndash6 ndash4

SampP 500

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

summary

summary 67

Bond 46 63 20 00 92

chapter 8

New Asset Classes

Large-cap 139 155

Small-cap 143 196

REIT 145 145

-40ndash364

ndash88

102 90

ndash196

ndash10

Return

high-yield bonds

History

high-yield bonds 73

050520

ndash22

ndash16

ndash14

ndash13

ndash11

ndash10

ndash9

ndash7

ndash6

ndash4

ndash3

ndash1

30 25 20 15 10 5 0

high-yield bonds 75

Large-cap 133 155

Small-cap 123 193

ndash10

Return

international bonds

Large-cap 1

High-yield bond (B) 048 097 017 078 1

High-yield bond (C) 036 086 001 066 084 1

Large-cap 124 145

40 35 30 25 20 15 10 5 0

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

40 35 30 25 20 15 10 5 0

8ndash3

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

40 35 30 25 20 15 10 5 0

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

8ndash3

ndash32

ndash109

ndash92

ndash76

ndash59

ndash43

ndash27

ndash10

Opportunity Set

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

0 3 0 Taiwan

0 5 0 Austral ia

060India

1530Japan

020South Africa

3000 EMU Europe

ilar f

Index 2003 2002 2001 2000 1999 1998

experience counts

summary

Nominal Bonds

Nominal BondsYield

Real Return

Inflation

Yield Components

Yield Real Return

Inflation

Yield Components

Diversification

Large-cap 78 171

Small-cap 100 217

TIPS 77 51

ndash10

Return

risk factors

conclusion

chapter 9

Investment Style

academic research

rvalue rgrowth

r2 growth

Sample Manager

ndash1

rvalue rgrowth

r2 growth

Sample Manager

ndash1

r2 value

ancillary uses

ancillary uses 97

Out-of-sample

the current state

summary

rvalue rgrowth

r2 growth

Completion Fund

Resultant Portfolio

SampP 500

ndash1

r2 value

chapter 10

Manager Selection

overview

herd mentality

$21589250$19671514

$46609571

$38696844

10 years 20 years

where to begin

where to begin 103

___________________________________________________________________________

Completed by___________________________________________________________________________

___________________________________________________________________________

manager selection

2 Minimum criteria

4 The interview

Minimum Criteria

Final Candidate

Interview

Weighting 10 10 10 20 30 10 10

databases

trade execution

social investing

the commonfund

proxy voting

account types

account types 115

negotiate fees

negotiate fees 117

chapter 11

funds of funds

funds of funds 121

risks 123

Gross return 120

Base fee 1 ndash10

Net return 88

benefits

Index 2002 2001 2000 1999 1998

Fund of funds

Market neutral

CSFBTremont 74 93 150 153 133

Global Macro

HRFI macro 74 69 20 176 62

Distressed

real estate

timberland

timberland 127

Risks of Timberland

timberland 129

Return SD

Conclusion

private equity

private equity 131

Calculating Returns

private equity 133

VC venture capital

structured equity

managed futures

Leverage

risks 137

Survivorship Bias

Passive Approach

conclusion

conclusion 139

Natural gas

MeatsLive cattle

chapter 12

allocation)

Considerations

a new approach

a new approach 143

Underlying Premise

The Key Difference

a new approach 145

88 90 92 94 96 98 100 102 104 106

00 02 04 06 08 10

9700 02 04 06 08 10

Disclaimer

Rebalance

ldquoove

Return

bullTa

conclusion

chapter 13

benchmarks

benchmarks 153

broad large cap

SampP 500 index

market indexes

style 155

multiple benchmarks

presenting the data

Fund SampP 500

CPI+74 105

Quarter Ending

Return

SampP 500

Return

Universe

5th -tile

25th -tile

50th -tile

75th -tile

95th -tile

portfolio analysis

style analysis

tfolio

risk analysis

rvalue rgrowth

r2value r2growth

Value -1 0 1 Growth

risk analysis 163

recent developments

Manager

1999 -

June 2

Return

Citi g

ance A

ttribution

d to B

Russell 1

r vs U

d if le

-6-505

Manager A

Russell 1

entile

n to 7

entile

Manager

atio thro

(not annualiz

ed if le

ss than 1

Russell 1

entile

n to 7

entile

er amp

chapter 14

history

Screening

Proxy Voting

Community Investing

chapter 15

step one

step two

step two 181

_____________________________________________________________________________

step three

step three 183

Accounting Systems

Reports

(continued)

Disbursements

step four

ndash$

times12

) times25

er amp

record keepers

record keepers 187

Indicates meeting

narrow the field

Organization ____ _____ _____ _____ _____

bull Capability

Client service ____ _____ _____ _____ _____

bull Technology

bull Efficiencies

People ____ _____ _____ _____ _____

Investments ____ _____ _____ _____ _____

bull Quality

bull Quantity

bull Other

Cost ____ _____ _____ _____ _____

bull Initial

bull Ongoing

final steps

gift annuities

gift annuities 191

gift annuities 193

D Communications

E Investments

F Overall

A Internet services

B Phone services

C Statements

D Communications

E Investments

41 Notes

brokers

chapter 16

bull Negotiate fees

(continued)

Useful Hints

IV References

V Fee Schedule

The Interview

bull Manager search

bull Pricing

Verification

The On-Site Visit

The Agreement

summary

summary 205

chapter 17

Behavioral Finance

snake bitten

herd mentality

anchors

representativeness

familiarity

conclusion

conclusion 213

chapter 18

overview

Application

summary

summary 223

chapter 19

who is a fiduciary

chapter 20

Final Thoughts

summary

We have explored

the prudent steward

1 Set goals

2 Allocate assets

4 Select managers

take aways

conclusion

conclusion 241

appendix A

introduction

purpose

spending policy

investment policy

Return

asset allocation

Cash 390 00 00

bull Style drift

proxy voting policy

meeting schedule

abc hospital fund

Name ____________________________

Title ____________________________

Date __________________

Dated May 2002

specific guidelines

Implementation

appendix B

1 Firm Name ____________________________________

Address ________________________________________

2 Primary Contact ________________________________

Fax Number ____________________________________

Email address __________________________________

Organization

Year ______________

Total Assets ____________________________________

Professional Staff

Economists

Equity traders

Administration

Other (explain)

1 Strategy ___________________________________________________

_____________ On the first $ ____________________

_____________ On the next $ ___________________

_____________ On the first $ ____________________

_____________ On the next $ ___________________

062004 122003 062003 122002 062002 122001 062001 122000

DebtEquity

in Top 10 Holdings

of Securities

Foreign

Trading

Performance

1 Date Return

2 122003 343

3 92003 234

Dispersion Range

Title __________________________________________

Date __________________________________________

appendix C

large c

y valu

r a lo

entrsquo

rsquosth

0ndash

trsquol

large-c

ndash3

+ndash

ndash5

ndash2

+ndash

Zephyr

Schneid

ssocia

Manager S

1999 -

Russell

1000 V

ussell

1000 G

Russell

2000 V

ussell

2000 G

all-101

e Valu

erican F

unds W

Dodge amp

ussell

Generic C

1999 -

-month

ell 1000 V

ell 1000 G

ell 2000 V

ell 2000 G

Dodge amp

Manager

le12-Q

1999 -

Russell

1000 V

ussell

1000 G

Russell

2000 V

ussell

2000 G

all-101

e Valu

erican F

unds W

Dodge amp

ussell

Generic C

ance A

ttributio

1999 -

d to S

Benchm

erican F

unds W

Dodge amp

ithZephyr

anagerre

Zephyr

Schneid

ssocia

Manager

2001 -

Return

Dodge amp

1000 V

Manager

1999 -

Return

Dodge amp

1000 V

-month

2001 -

Upside

Dodge amp

1000 V

1999 -

Upside

Dodge amp

1000 V

anager re

ffron E

ar Inc

Zephyr

Manager

rn thro

d if le

Zephyr

ingsta

Return

101520

Dodge amp

1000 V

entile to M

n to 7

entile

Manager

lpha thro

less t

Zephyr

ingsta

Alpha -11

Dodge amp

1000 V

entile to M

n to 7

entile

Manager

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

Manager

lpha R

ank thro

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

anager re

ffron E

ar Inc

Zephyr

Schneid

ssocia

Manager

less t

Zephyr

ingsta

Sharpe Ratio -040

Dodge amp

1000 V

entile to M

n to 7

entile

Manager

less t

Zephyr

ingsta

Information Ratio

-4-3-2-101

Dodge amp

1000 V

entile to M

n to 7

entile

Manager vs U

Rank thro

mber 2004

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

Manager

(not a

nnualiz

than 1

Zephyr

ingsta

tility

Dodge amp

1000 V

anager re

ffron E

ar Inc

appendix D

on amp

d Tamp

alTamp

ldquoMos

ionrdquo

ldquoBal

atrdquo

mdashA

8mdash

Investment Strategy

Screening Process

BuySell Discipline

Additional Comments

ndash40

35times

34times

99times

0ndash

timesCu

23times

gt $50

15ndash

smdash

5ndash15

15ndash

ndash1

ndash75

lt $40

)mdash

mdashCo

mdashEn

smdash

mdashH

dsmdash

mdashIn

mdashM

mdashTe

mdashU

temdash

ndash7

72ndash

1ndash

6ndash

ndash5

61ndash

mdash6

60ndash

ndash11

ndash2

ndash3

74ndash

mdash9

ndash27

ndash20

ndash22

ndash9

66ndash

5ndash

4ndash

ndash3

67mdash

ndash2

95ndash

3ndash

onmdash

mdashmdash

9mdash

mdashmdash

mdashA

hamdash

mdashmdash

ndash8

70ndash

mdashmdash

ormdash

mdashmdash

3mdash

mdashmdash

mdashIn

mdashmdash

mdashndash

ndash0

12mdash

mdashmdash

mdashS

mdashmdash

mdashndash

ndash0

60ndash

mdashmdash

ISAmdash

mdashmdash

mdash29

ndash1

kmdash

mdashmdash

ndash27

ndash20

ndash22

mdashmdash

mdash57

ndash31

mdashmdash

ormdash

mdashmdash

mdashIn

mdashmdash

omdash

mdashmdash

AmdashG

mdashmdash

ndash2

38mdash

kmdash

mdashmdash

mdashndash

2ndash

3mdash

smdash

mdashmdash

mdash17

1mdash

mdashmdash

ormdash

mdashmdash

mdashIn

mdashmdash

omdash

mdashmdash

undmdash

mdashmdash

mdash12

ndash12

ndash14

mdashmdash

mdashndash

9ndash

2ndash

smdash

mdashmdash

45ndash

onmdash

mdashmdash

mdashA

hamdash

mdashmdash

mdashTr

mdashmdash

omdash

mdashmdash

mdashS

mdashmdash

tymdash

mdashCo

mdash12

mdash6

ndash10

1ndash

0ndash

ndash10

ndash50

0ndash

mdashA

03mdash

mdashmdash

ion) U

mdashEx

rsmdash

emdash

mdashD

mdashmdash

19mdash

mdashFu

smdash

palamp

Firm Background

Additional Comments

appendix E

B Product Summary

Number of Clients

Investor 2004 2003 2002 2001 2000

Number of Clients

Investor 2004 2003 2002 2001 2000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets(in millions)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets(in millions)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets(in millions)

Strategy

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Managers

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Managers

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Managers

1999 2000 2001 2002 2003 2004

N Risk Management

O Fees

appendix F

Under 100

100ndash999

1000ndash4999

5000ndash9999

Over 10000

2001 2002 2003 2004

Under 100

100ndash999

1000ndash4999

5000ndash9999

Over 10000

Enrollment

Balance inquiries

Rebalancing feature

Loan modeling

Termination options

Fund objectives

Withdrawals

Enrollment meetings

Ongoing meetings

Enrollment kits

Payroll stuffers

Posters

Internet access

investments

trustee services

Conversion

Flat fee

Per employee

Loan conversion

Travel expenses

Trustee

Compliance testing

Travel expenses

Internet services

fees 315

Additional fee

Asset-based fee

Commissions

Miscellaneous fee

Initiation fee

Initial

conversions

conversions 317

Fund N

appendix G

Resources

analytical software

other resources

other resources 323

Glossary

326 glossary

glossary 327

328 glossary

glossary 329

330 glossary

glossary 331

332 glossary

rebalancing 245

334 index

index 335

fund 84market 81

336 index

index 337

excess 76 78

338 index

109 156

35ndash36

index 339

226Pensions

340 index

index 341

342 index

331Time horizon 64

index 343

232ndash233

product 104 332

344 index

About the Authors


Contents


A Crying Need


Finances

Contributions

The Pension Problem


The Good News


Gifting Strategies

Investment Strategy

Expect to Find







Annuities

Mutual Funds


Case Study


Contributions


Summary


Early History

The Modern Era

The Legal Challenge

The Barker Report



Potential Negatives

Summary




Allocate Assets


Rebalance

Monitor Performance

Chapter 5 Set Goals

Introduction

Define the Mission





Summary


Overview

Why Is It Important

Content





Summary





Case Study



The Long Run


Summary




HighYield Bonds

International Bonds


Experience Counts

Summary


Risk Factors

Conclusion


Academic Research

Ancillary Uses

The Current State

Summary


Overview

Herd Mentality


Where to Begin

Manager Selection


Databases


Trade Execution

Social Investing

The Commonfund

Proxy Voting

Account Types

Negotiate Fees



Funds of Funds

Risks

Benefits


Real Estate

Timberland

Private Equity

Structured Equity

Managed Futures



Risks

Conclusion



A New Approach


Conclusion



Benchmarks

Market Indexes

Style


Multiple Benchmarks

Presenting the Data


Portfolio Analysis

Style Analysis

Risk Analysis

Recent Developments




History






Step One

Step Two

Step Three

Step Four

Record Keepers

Narrow the Field

Final Steps


Gift Annuities

Brokers





Summary



Snake Bitten


Herd Mentality



Anchors


Representativeness

Familiarity




Conclusion


Overview










Summary


Erisa

Who is a Fiduciary






Summary

The Prudent Steward

Take Aways

Conclusion


Introduction

Purpose

Spending Policy

Investment Policy


Asset Allocation






Proxy Voting Policy


Meeting Schedule

ABC Hospital Fund



Specific Guidelines















Investments

Trustee Services


Fees

Conversions


Data

Analytical Software

Other Resources

Glossary

Index