effective endowment management

Effective Endowment Management

CAIS / NYSAIS

Business Affairs Conference

May 4-6, 2005

2Jay Yoder, CIO ~ Tuckerbrook Alternative Investments ~ jyoder@tuckerbrook.com

Topic 1: Writing a strong, effective investment policy

• Fiduciary responsibility demands it

• Written guidelines protect your endowment from market-driven departures from sound long-term policy

• It serves to educate and inform all parties involved

Characteristics of a well-written policy

Detailed and specific

Includes sound rationales in the form of explicit answers to “Why?” questions

Individual components are logically consistent

Seven necessary components

Return objectives Relevant risks Asset allocation guidelines Asset class rationales Rebalancing Benchmarks Indexing

Return objectives

Financial

• The overall financial goal of the endowment is to maintain its inflation-adjusted market value while contributing approximately 5% per year to the college’s operating budget (i.e. CPI + 5%)

Investment

• Earn a total return matching or exceeding the portfolio’s composite benchmark

• Earn a total return matching or exceeding your peer group

Relevant risks

Volatility Decline in real value of endowment Peer risk Headline risk Inflation Deflation Failing to achieve your policy objectives

Rebalancing

Importance

• Failure to do so increases risk and reduces return

• Difficult to implement

• Counterintuitive

• Doesn’t work until trend reverses

Conclusions

• An automatic rebalancing rule is extremely important

• The method of rebalancing is less important than enshrining the decision in the investment policy and implementing it rigorously

Benchmarks

Definition: The standard or index against which performance is measured

Examples at the portfolio level:• CPI + 5%• Composite benchmark (sum of asset class benchmarks x

policy weights)• Peer performance

Extremely important because:• Poor benchmarking leads to poor (i.e. misleading) analysis• Poor analysis leads to poor decision-making

Facts about indexing

Logic dictates that the average manager underperforms

Historical evidence proves that the average manager underperforms

History shows that past performance does not predict future performance

No one benefits from indexing—except the investor!

Past performance is not predictive

1996-99 2000-03 1996-99 2000-03

Source: Frank Russell Company

Top Quartile

Second Quartile

Third Quartile

Bottom Quartile

Where did most top quartile managers come from?

Where did most top quartile managers go?

Views on indexing

How will you beat the odds?

• Smart people?

• Contrarian decision-making?

A policy on indexing is crucial to avoid jumping back and forth between active management and indexing

Is your investment policy strong and effective? A quick test.

Does your policy meet fiduciary standards by addressing all the issues a prudent expert would address?

Has the policy achieved its goals in the past? If new, is it likely to do so in the future (based on reasonable assumptions)?

Is the policy specific enough and clear enough that a stranger could properly manage your endowment based solely on the policy document?

Topic 2: Good governance and policy implementation

Roles & responsibilities• Board, investment committee, staff, & consultant

Committee structure• Size, tenure, & composition

Policy implementation Solutions Conflicts of interest Frequency of meetings Reporting

Roles and responsibilities

Fiduciary Level

PolicyReturn objectives

Define risk

Asset allocation

Strategy

Sub-asset classes

Manager structure

ManagementPolicy

implementation Manager hiring &

firing

Execution

Security selection

ControlReviews results vs. guidelines

& objectives

Board of Trustees

Formally approves Oversees

Reviews committee decisions

Investment Committee

Determines Formally approves Oversees Reviews CIO decisions

Chief Investment Officer

Recommends Determines Determines Oversees Reviews money managers

Money Managers Determines

Complies with guidelines

Committee structure & role

Size of Investment Committee

10-15 members 5-7 members

Committee Role

Makes all final decisions.

Very hands-on.

Delegates much. Focused largely on big-picture/policy

issues.

CIO Role

Filled by committee/consultant

/treasurer

Strong role, filled by individual with authority to

implement policy.

Roles, Committee tenure, composition, & conflicts of

interestUndefined Well-defined

Traditional Best Practices

Problems with traditional structure…

Lack of expertise, experience, resources, education and/or time

Diffusion of responsibility

Group decision-making

…lead to common mistakes

Common mistakes…

Favoring asset classes, strategies, and managers that have enjoyed recent success

Substituting one’s own (shorter) time horizon for that of the perpetual time horizon of endowment

Overconfidence in the ability to market-time and select managers that will outperform in the future

Selecting managers for all the wrong reasons

…lead to poor implementation and value lost

Policy implementation

Two components

• Manager selection

• Market-timing (all departures from policy)

Determine success of policy implementation by calculating the value-added or lost—in dollar terms over a long period of time.

Present results to the Board and the Committee

XXXXX College endowmentHistorical performance

-5% 0% 5% 10% 15%

ActualPerformance

Manager Selection

Departure fromPolicy Asset Alloc

Policy Portfolio

11 Years ending June 30, xxxx

Annualized Return

Expected endowment market value: $1.01 billion

Value lost through market timing: $6 million

Value lost through manager selection: $100 million

Actual endowment market value: $907 million

Effect on Market Value

Solutions to poor policy implementation

Revise governance structure How? If endowment exceeds $100 million:

• Institute or revise written guidelines that impose best practices on committee structure (size, tenure, composition)

• Hire an experienced CIO and create a strong investment office

• Delegate significant authority to the CIO

• Employ specialized consultants or advisors

Solutions to poor policy implementation

If endowment is less than $100 million:

• Create a strong investment policy

• Resist all attempts to improve or tweak this new policy for several years

• Institute or revise written guidelines that impose best practices on committee structure (size, tenure, composition)

• Delegate policy implementation to an individual

• Index large percentage of traditional asset classes

Consultant roles

Proper (because they usually succeed):

• Assisting Board, Committee, and CIO in performing their respective tasks

• Serving as an independent voice

• Functioning as an extension of staff

Improper (because they often fail):

• Choosing managers

• Substituting for a strong CIO

Conflicts of interest

Disclose

Recuse

Address in formal written policy• Require full disclosure of any conflicts, potential conflicts, or

appearance of conflicts

• No investing in firms related to committee members

• May invest with firms represented by board members, but board members may not promote firm to staff or committee members

Frequency of committee meetings

Four times a year is most typical

Twice a year is enough if the committee is properly focused on major policy issues

Monthly is probably necessary if committee insists on filling CIO role

Reporting

Traditional: 50 pages of detail that provide very little useful or actionable information

Best practices:

• Where do we stand? (Asset allocation)

• How have we done? (Performance)

• vs. financial objective (CPI + 5%)

• vs. policy (composite benchmark)

• vs. peers

Topic 3:Alternative Investments

What are they?

Informal definition:

• Any investment or asset class that is unusual, unfamiliar, or causes discomfort

among those responsible for investing.

Formal definition:

• Investments with unique risk and return properties that are not generally obtainable from traditional asset classes.

Alternative investments —marketable or liquid

Hedge funds

• Distressed debt

• Long/short

• Market neutral

• Managed futures

• Arbitrage strategies

• Convertible

• Fixed income

• Merger

• Capital structure

Alternative investments —non-marketable or illiquid

Real Assets

• Energy

• Real Estate

• Timber

• Commodities

Private equity

• Venture capital

• Buyouts

Rationale for alternatives

Higher returns Greater diversification Non-correlated returns Reduced volatility Can fulfill certain policy objectives better than

traditional investments

Challenges of alternative investments

Require greater expertise Lack of transparency Benchmarking Too much money chasing too few good

managers Expensive

Low correlation – and stock market soars Committee panics and retreats at exactly the

wrong time Manager risk Career or headline risk

Manager risk

Ten-year Performance DataThrough 2002

Top Bottom

Quartile Quartile Difference

U.S. Bonds 7.9 % 7.1 % 0.8 %

U.S. Stocks 12.5 % 8.8 % 3.7 %

Int’l Stocks 7.8 % 4.7 % 3.1 %

Hedge Funds 14.3 % 8.5 % 5.8 %

Buyouts 38.3 % 12.9 % 25.4 %

Venture Cap 39.0 % 10.6 % 28.4 %

Risk mitigators

Ensure that all decisions are driven by sound policy

Perform strong due diligence

Use a fund-of-funds

Key investment policy questions:

Does your investment policy address the seven key components?

What types of risk are most relevant to your endowment? Are these risks codified and reflected in the policy? Does rebalancing regularly and automatically take place? Are all benchmarks appropriate and effective ones? Has your institution added value by selecting active

managers? Has your institution added value by market timing? Does your policy pass the three-part test from the prior

slide?

Key governance/policy implementation questions:

Has your policy implementation—market timing and manager selection—added to or detracted from endowment returns?

What has been the resulting impact to the market value of your endowment?

Is your investment committee focused largely on broad policy and strategic issues?

Do you have written guidelines governing the structure of your committee?

If your endowment exceeds $100 million, do you have a strong CIO to whom you have delegated significant authority?

If your endowment is less than $100 million, have you considered the five steps to success?

Key questions on alternative investments:

Can your endowment benefit from alternatives?

Why are you interested in alternatives?

Are you willing to make a significant, long-term, policy-driven commitment to alternatives?

Are you willing to incur the challenges and risks of alternative investments?

How will you access the expertise necessary to invest in alternatives?

Helpful Resources for the Business Officer

Pioneering Portfolio Management, by David Swensen

Winning the Loser’s Game, by Charles Ellis

Endowment Management: A Practical Guide, by Jay Yoder (available from www.agb.org)

effective endowment management

consistentjay yoder

rigorouslyjay yoder

policy objectivesjay

peer groupjay yoder

poor decisionmakingjay

parties involvedjay

poor benchmarking

total return matching

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