Principles and Objectives: The Common Fund Perspective

Endowm

ent Managem

entTheCommonFund

d

2 Asset Allocation and

Spending Policy Recommendations

7 Asset Class Overview

10 Manager Selection

12 Risk Management

14 Common Fund Programs and Services

Published for trustees and investment officers of independent schools, colleges and universities byThe Common FundInvestment Management for EducationalEndowment and Operating Funds

Contents

Principles of EndowmentManagement

• Establish an asset allocation and spending policy that are compatible.

• Understand the components of risk and decide on acceptable parameters.

• Maintain, over time, the highest possible equity exposure compatible with an acceptablerisk level.

• Diversify among asset classes and investmentmanagers to increase return and reduce overallportfolio risk.

• Access quality portfolio managers and monitorthem on a regular basis for compliance withguidelines and performance measurement.

• Conduct periodic asset allocation review.

• Minimize costs.

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1

“The Common Fund offers this publication fortrustees and investment officers who must writethe future today.”

A M

essage from the President

It has been said that the true task of senior management is to make sounddecisions with imperfect or less than complete information.

This dictum is universal — it applies to the largest multinationalcorporations and the tiniest start-ups; to the White House and to town hall;and to the nonprofit sector, from museums to hospitals. It applies as well tothe decisions of educational institutions’ trustees and investment officers.

Indeed, it may impact the choices and commitments made by theinvestment committees of independent schools, colleges and universities witheven greater force because, although their decisions can have significantimpact on near-term spending, they are largely long term. The challenge liesin the fact that the outcome of decisions made today may not be known for 5, 10 or even 20 years.

The Common Fund offers this publication for trustees and investmentofficers who must write the future today. Our primary objective is to summa-rize the guiding principles that determine an endowment’s fortunes over thelong term. Secondarily, it is our desire to increase awareness of The CommonFund because our investment and cash management programs and broadrange of services are focused 100% on helping educational institutions meetthe challenges of an uncertain tomorrow. Moreover, as a nonprofit member-ship organization, we believe our approach offers definite advantages thattrustees and investment officers should know about and consider.

We hope you find this information useful, and want to let you knowthat The Common Fund stands ready to assist you in any way possible. If you have questions or would like assistance with the development and/orimplementation of investment and spending policies and procedures, pleasecontact your Common Fund Member Services representative.

Robert L. BovinettePresident

2

Asset A

llocation and Spending Policy Recom

mendations

Keys to Successful Endowment ManagementEstablishing an asset allocation policy and a spending policy that is consistentwith the chosen asset mix are, perhaps, the most important decisions aninvestment committee makes. Both these decisions should take into considera-tion an acceptable risk level.

Asset allocation is so vital because it is the major factor determining port-folio returns. Numerous studies confirm that asset allocation (in tandem withspending decisions) far outweighs the contribution that investment managersmake through securities selection. Two landmark studies have confirmed this.

• 93% of long-term portfolio return is the result of asset allocation(Gary P. Brinson, et al).*

• 90% of equity portfolio return is the result of equity style (Growth,Value) selection (William F. Sharpe).†

The Task for Trustees: Generational NeutralityThe objective of an endowment — and, hence, the objective of asset allocation decisions — is “generational neutrality.” In other words, trusteesand investment officers should seek to manage the endowment to provide at least the same level of support to future generations as the current bene-ficiaries receive. That means the annual transfer from the endowment to theoperating budget — i.e., spending — must remain stable on a real (net ofinflation) basis and not erode the real corpus of the endowment.

The need to maintain generational neutrality should lead trustees to aspecific investment objective, which is to earn a total return equal to the sumof inflation plus the spending rate (and the costs associated with investing).Stated another way, a sustainable spending rate is total investment returnminus inflation. Because asset allocation is the chief determinant of totalreturn, asset allocation and spending are inexorably linked.

Stocks, Bonds, Cash Equivalents and Inflation Average Annual Compound Returns

1935-95 1975-95 1985-95(60 Years) (20 Years) (10 Years)

Nominal ReturnsStocks 11.6% 13.6% 14.7%Bonds 5.0 10.1 12.2Cash 4.0 7.3 5.7

Inflation 4.1% 5.4% 3.6%

Real Returns(Nominal Returns Adjusted For Inflation)

Stocks 7.3% 7.8% 10.7%Bonds 0.9 4.5 8.4Cash -0.1 1.8 2.0Stocks = S&P 500 Index; Bonds = U.S. Long Term Gov’t. Bonds; Cash = U.S. 30-day T-Bill; Inflation = CPI

Source: Ibbotson Associates

* Brinson, Gary P.; Hood, Randolph L.; and Beebower, Gilbert L., “Determinants of Portfolio Performance,” Financial Analysts Journal, July-August 1986.

† Sharpe, William F., “Asset Allocation: Management Style and Performance Measurement,” The Journal of Portfolio Management, Winter 1992.

3

Endowment Spending Rules

Spend a percentage of market valueSpend all or a percentage of current incomeDecide on an appropriate rate each yearIncrease prior year's spending by a prespecified percentageOther

64.6%8.6%

8.0%

12.8%

6.0%

Source: NACUBO 1995 National Endowment Study

Calculating Compatible Asset Mixes and Spending Rates

A quick calculation can help you match various asset mixes and spending levels:

• Total Return - Inflation = Real Return• Real Return = Spending• Assume Real Return on Stocks = 7.3% and on Bonds = 0.9%

In order to determine the asset mix consistent with a 5% spending rate, solve the followingequation: 7.3x + 0.9(1-x) = 5, where x equals the proportion invested in stocks and 1-x equalsthe proportion invested in bonds. Answer: 60% stocks/40% bonds.

How much can you spend without depleting the purchasing power of the endowment?

Equity/Fixed Income Asset Mix Spending

80%/20% 6.0%70%/30% 5.5%60%/40% 5.0%50%/50% 4.0%40%/60% 3.5%

Spending practices vary considerably among educational institutions.In the past, the approach was to spend dividends and interest only. Thisincome-only spending policy led to a dependence on securities with high cur-rent yield, principally bonds, and exposed the endowment to the ravages ofinflation. Thus, over the years, additional approaches have evolved. Examples are:

• Spending a percentage of the market value of the endowment• Increasing prior year’s spending by inflation • Spending a percentage of a moving average of the endowment’s

market value (such as 5% of the endowment’s average market value over the past three years)

The graph below summarizes the frequency with which the most common spending practices are utilized, as tracked by a recent NationalAssociation of College and University Business Officers (NACUBO) endowment study.

Asset allocation decisions are critical because of their powerful influenceon risk and return. Choosing a strategic asset mix that will generate thereturns necessary to support the agreed-upon spending policy at an acceptablelevel of risk is a challenging task, especially in light of the infinite number ofalternatives available. The table on page 4 provides some insight into averageasset allocations based on the NACUBO survey.

4

Endowment Asset AllocationJune 30, 1995

All Institutions Under $25 Over $400Average* Million* Million*

EquityU.S.† 48.3% 48.7% 46.7%International 11.1 5.6 12.4Private/Venture/Energy 5.4 0.2 8.0

64.8% 54.5% 67.1%

Real Estate 3.7% 0.8% 4.8%

Fixed IncomeU.S.◊ 22.8% 33.4% 19.8%International 2.5 1.7 2.8Cash 4.9 8.1 4.1Other 1.3 1.5 1.4

31.5% 44.7% 28.1%

Total 100.0% 100.0% 100.0%* Dollar-weighted average† Includes investment in hedge funds (2.6%) and event arbitrage (0.6%)◊ Includes investment in high-yield bonds (0.6%) and distressed securities (1.2%)

Source: NACUBO 1995 National Endowment Study

As time goes on, a portfolio will need to be rebalanced to maintain theoriginal asset allocation. There are two basic ways to rebalance a portfolio. Oneis time-based, that is, rebalancing at a given time interval, usually annually.The other is range-based, for example, allowing the proportion accounted forby an asset class to rise and fall within an upper and lower range. Rebalancingis triggered if either limit is exceeded.

Bringing the Future into FocusOne tool for making asset allocation decisions is computer-based simulationprograms. In cooperation with leading academic and investment experts, TheCommon Fund developed such an analytical tool, the Endowment PlanningModel (EPM), to help trustees and investment officers understand the long-term implications of decisions concerning asset allocation and spending. Themodel provides trustees and investment officers with the means to analyze therange of available options and to construct a portfolio that comes closest tomeeting the school’s long-term objectives. The EPM permits a simulation oftotal nominal and real (net of inflation) returns resulting from current and pro-posed asset allocation decisions. The model allows combinations of 10 differentasset classes to be analyzed, along with the impact of various spending levels.The results of each combination are simulated over a 20-year period using his-torical return data, with the option of looking at the results at interim periods.As there are thousands of possible combinations of each asset class under vary-ing levels of inflation, the model calculates 200 possible outcomes for each yearover 20 years, and then displays the range of results in tables and graphs.

Common Fund RecommendationsThe Common Fund recommends that an effective plan for the future bebased on a commitment to equity investing and to broad diversification withineach asset class, such as growth and value styles, U.S. and non-U.S. markets,and public and private investing. We have found (through Endowment

5

Planning Model simulations and other studies) that greater diversificationcombined with more emphasis on equities can produce higher long-termreturns with approximately the same level of risk as traditional approaches.

The following graphs show three alternative asset allocation policies(60% /40% equity/fixed income, 70%/30% and 80%/20%) using the samespending policy and the long-term implications of each.

This chart represents the Endowment Planning Model results from three asset allocationalternatives based on a beginning market value of $10 million and a spending policy of5% of a three-year moving average of market value. It shows graphically that by increasingthe endowment’s exposure to equities there is a greater probability of exceeding the origi-nal market value and experiencing real (net of inflation) growth in the endowment.

Three Asset Allocation Alternatives Mean Nominal Returns and Standard Deviations After 20 Years

Portfolio Mean Nominal Return: 11.3%Portfolio Standard Deviation: 8.5%

Portfolio Mean Nominal Return: 12.1%Portfolio Standard Deviation: 9.0%

Portfolio Mean Nominal Return: 13.0%Portfolio Standard Deviation: 10.4%

U.S. Global/InternationalEmerging Markets Private Capital Venture Capital Private Equity International Private Equity Energy Real Estate

60%/40% Policy 70%/30% Policy 80%/20% Policy

U.S. Global/International

Equity Fixed Income

32.5%

10.0%

2.5%5.0%

2.5%2.5%2.5%2.5%

30.0%

10.0%

30.0%

10.0%

5.0%5.0%

5.0%

10.0%

2.5% 2.5%

22.5%

7.5%

30.0%

15.0%

5.0%5.0%

5.0%

5.0%

5.0%

10.0%

15.0%

5.0%

Source: The Common Fund’s Endowment Planning Model

Endowment Planning Results from Three Asset Allocation Alternatives Real Market Value After 20 Years ($ millions)

$23.0

$25.4

$33.090th

75th

Median

25th

10th

24.7

16.6

11.5

7.1

20.3

14.5

9.9

6.8

17.4

13.0

8.4

6.0

Beginning Market Value of $10 Million

80%/20% Policy60%/40% Policy 70%/30% Policy

Source: The Common Fund’s Endowment Planning Model

Perc

entil

e

In terms of spending, we advocate as modest a rate of spending as possible. The following two graphs illustrate the effect of different spendingrates (5% and 6% of a three-year moving average market value) on the realmarket value of the endowment and annual dollars available for spending with an 80%/20% equity/fixed income asset mix.

These graphs show that spending a lower percentage of market value results in a higherdollar level of spending over the long term. After 20 years, schools spending 5% will beable to spend more than those spending 6%.

6

Median Expected Real Endowment Value Assuming 80%/20% Policy and Different Spending Rates($ millions)

5.0% 6.0%

Source: The Common Fund’s Endowment Planning Model

00 10 20 Years

4

8

12

$16

Median Expected Real Spending from Endowment Assuming 80%/20% Policy and Different Spending Rates($ millions)

5.0% 6.0%

Source: The Common Fund’s Endowment Planning Model

0

0.25

0.50

0.75

$1.00

100 20 Years

Asset C

lass Overview

7

In making their asset allocation decisions, trustees and investment officershave more choices than ever. The following briefly summarizes the attributesof the primary asset classes found in most educational endowment portfoliostoday. Each asset class should not be considered alone, but by the role it playsin a diversified portfolio.

To achieve the lowest risk for a given rate of return, trustees and invest-ment officers should seek to construct diversified portfolios. How asset classesrelate to each other is the key to making asset allocation decisions within thecontext of overall portfolio risk and return. Adding an asset class that may berisky by itself but has a low correlation with other asset classes in an endow-ment portfolio serves to lower overall portfolio risk.

For example, investing in asset classes that can be expected to move together (i.e., are highly correlated) produces little diversification benefit. How-ever, due to their relatively low correlation to U.S. equities, adding non-U.S.equities and/or U.S. real estate, for example, to a U.S.-only approach produces afar greater diversification benefit and can reduce overall portfolio volatility.

The table below shows one measure of diversification, the “correlationcoefficient.” A correlation of 1.0 is a “perfect” correlation; that is, two assetclasses that rise and fall together. A correlation of -1.0 is a “perfect negative”correlation; that is, if one is up 10% the other will be down 10%. A correla-tion of zero means that movement of one asset class cannot be predicted by the other.

Correlations Among Selected Asset Classes and Inflation

U.S. Inter- 1-Year 5-Year 20-Year Inter-S&P Small Venture national Real U.S. U.S. U.S. national500 Cap Capital Equity Estate Treasuries Treasuries Treasuries Bonds

S&P 500 1.00U.S. Small Cap .76 1.00Venture Capital .28 .22 1.00International Equity .55 .43 .19 1.00Real Estate -.24 -.20 -.04 -.12 1.001-Year U.S. Treasuries -.07 -.09 .02 -.01 .38 1.005-Year U.S. Treasuries .13 .12 .04 .06 -.23 -.14 1.0020-Year U.S. Treasuries .06 .06 .00 .01 -.25 -.32 .88 1.00International Bonds .09 .07 .05 .42 -.12 -.07 .51 .45 1.00Inflation -.32 -.26 -.07 -.19 .52 .42 -.06 -.02 -.05

Source: The Common Fund’s Endowment Planning Model

Common StocksCommon stocks offer enhanced real returns. Historically, they have producedreal returns of approximately 7% compared with about 1% for bonds. Thereturn for equities in any given year will vary widely, but the long-term per-spective of an endowment diminishes that risk significantly. For example, overthe past 50 years, holding stocks for one-year periods would have produced aloss more than 20% of the time, but never when stocks were held for 20 years.

8

BondsFixed income securities offer protection against deflation and higher currentincome than stocks. An actively managed bond portfolio offers the investor an opportunity to gain access to a variety of fixed income strategies, therebydiminishing the risk of losing value in a rising interest rate environment, andreduces the portfolio’s exposure to market defaults and call or prepaymentrisks. In recent years, high-yield bonds have produced premium returns suffi-cient to justify the default risk, and some distressed securities (bonds indefault) offer the potential for high returns when managed by experiencedinvestment professionals.

Global, International and Emerging MarketsInternational equity markets account for more than 65% of world stockmarket capitalization. International equity markets are attractive for poten-tially higher returns compared to the U.S. market because foreign economiesare expected to grow more rapidly in the future. In addition, their low cor-relation with the U.S. market enables them to serve as a diversifier. Typically,the highest growth rates may be found in emerging countries; moreover,because these countries’ stock markets are less efficient, experienced portfoliomanagers are often able to capture excess returns.

Similar to international equities, international bonds today account forapproximately 60% of the world’s fixed income markets. International bondscan provide a hedge against rising U.S. interest rates as well as coupon ratesthat are often higher than the U.S. fixed income market.

In contrast to international managers, which focus on markets outsidethe U.S., global equity and fixed income managers are free to seek the bestreturns in the world, no matter where they may be. Global equity managershave the broadest possible universe of stocks and industries to choose from,and they may make top-down judgments as to which countries, including the U.S., offer the most favorable market valuations and economic prospects.Global bond managers identify the most attractive bond and currency marketsworldwide by focusing on fundamental, top-down economic analysis. Managersevaluate many of the same key statistics driving the domestic market such asinflation rates, employment data and monetary and fiscal policies.

Portfolio Role of Individual Asset Classes

Asset Class Rationale

Total Return StrategiesU.S. Equities Enhance real returnNon-U.S. Equities Enhance real return and diversify portfolioEmerging Markets Equities Enhance real return and diversify portfolioOpportunistic Strategies: Enhance real return and diversify portfolio

Hedge FundDistressed Securities

Alternative Equities: Significantly enhance real return and Venture Capital diversify portfolioPrivate Equity

Source of Cash FlowReal Estate Hedge against high rates of inflationOil and Gas Hedge against high rates of inflationU.S. Bonds Hedge against deflationNon-U.S. Bonds Hedge against deflation and diversify portfolio

9

Real EstateReal estate generally offers good current income, the potential for highabsolute returns and a hedge against inflation. In addition, it has a lowcorrelation with publicly traded stocks and a negative correlation with thebond market. Although real estate is the oldest endowment asset class of all, today it accounts for a relatively low percentage of many endowments’assets. In part, this may be attributed to the fact that it is difficult for manyeducational endowments to invest in a fully diversified portfolio of investmentquality real estate. However, in today’s recovering real estate markets, several of the larger endowments have allocated 10% or more to real estate.

Private CapitalPrivate capital consists of several asset classes, principally venture capital,private equity (domestic and international) and energy. Partnerships may beformed to invest in a wide range of assets that are not available to the investorthrough the public markets. The primary reason for investing in these assetclasses is the potential to earn higher returns than those attainable throughthe public equity markets. Direct investment in a company offers greateropportunity for investors to affect the management, financing, operationsand, ultimately, the return on their investment. In keeping with the illiquid,long-term nature of private capital investing, investors in these markets seek to be rewarded with higher rates of return over time. For example, successfulventure capital funds, private equity partnerships and energy programs areexpected to earn net returns to investors from the mid-teens to about 20%over long periods of time.

Experienced private capital investors often commit at a level that ishigher than their target allocation to private capital. Experience shows thatinstitutions committing at 100% of their asset allocation target rarely achievetheir target investment level. It usually takes several years to draw down thecapital committed to a private capital partnership investment, and capital isfrequently returned from profitable investments starting around the midpointof the program.

Manager Selection

10

Once the appropriate asset allocation and spending policies are in place, thenext most important decision made by trustees and investment officers is thedevelopment of a coherent, well-reasoned investment manager structure forthe portfolio.

There are a number of issues to consider in hiring investment managers.

• Diversification. The portfolio should not only be diversified by assetclass, but by manager styles and strategies.

• Costs. Check management, trading and custody fees carefully; aninstitution may incur relatively high fees due to single investment or mini-mum investment hurdles.

• Performance analysis. Monitor manager results individually, thencombine for overall portfolio return. Measure a manager’s performance againstan appropriate benchmark and manager universe.

• Service. Be certain the managers you hire are prepared to meet yourneeds for information and periodic portfolio review on a timely basis.

• Expertise. Determine a manager’s ability to successfully implementits strategy.

• Fiduciary responsibility. Trustees and investment officers shareresponsibility for manager oversight. The full board of trustees is responsiblefor setting overall investment policy.

• Ongoing monitoring. Be certain you have in place the necessarycontrols and risk management procedures. This should include a periodicreview of all your internal policies and practices, as well as ongoing oversightof external investment managers to assure compliance with written guidelines.

• Operations capability. You will want to be able to report currentmarket values quickly and accurately, and you will need a custodian to pricethe securities in your portfolio.

Manager Selection at The Common FundThe decision to hire a manager involves qualitative and quantitative considera-tions. Although performance is one factor in evaluating a potential manager,we are also interested in the firm’s investment decision making process, seniormanagement, ownership structure, internal controls, reporting, asset growthand size (assets under management). In addition, we want to see experience indifferent investment climates, a clear investment philosophy and approach,and a commitment to that philosophy. We demand strong internal controlsand high-quality, timely reporting. We also seek reasonable fees.

Manager Selection, Fund Structure and Assessment of PerformanceManager Selection Fund Structure Assessment

• Gather Data • Member Needs • Performance Measurement• Build Universe • Multi-Manager Approach • Portfolio Characteristic• Screen Universe • Objective Comparisons• Meet Managers • Risk/Return Tradeoff • Manager Reviews• Select Manager • Portfolio Characteristics • Manager Contacts

• Manager/Strategy Rebalancing• Fee Structure

11

▼The Common Fund Staff

Presentation to:

Prospective Manager Universe

Manager Recommendation based on Staff Analysis

Committee Makes Final Selection

• Chief Investment Officer• Fund and Manager Supervisor• Portfolio Analysts

▼The Common Fund

Board of Trustees Investment Committee

Final Manager Presentation to:

Once a manager is identified as a potential candidate, we evaluate theeffect of its inclusion in the portfolio using statistical risk/return measures,including standard deviation, alpha, beta, correlation, Sharpe ratio andcomposite (simulated) returns to determine the appropriate policy weightof the potential manager. If the manager’s style is a good fit for the fund,we conduct on-site due diligence to review trading policies and risk manage-ment procedures.

On balance, we believe that too large a firm (in terms of assets andaccounts under management) can be a negative factor, especially in the smallercapitalization equity markets. Within our portfolios, we tend to overweightmanagers who have demonstrated a solid investment process with qualityresults over a full market cycle. We review managers’ weightings on at least amonthly basis and either rebalance to original allocations or make changesbased on the factors discussed above.

Decision Process

Risk M

anagement

12

Generally, risk management refers to assessing the potential for loss, as well asits magnitude, under any circumstance. For nearly three centuries, investorsconcerned themselves principally with credit risk. Over time, they began tofocus on investment performance and market risks. And while all investmentscome with varying degrees of risk, some investments clearly pose more riskthan others. How one defines risk and how great one’s tolerance of risk is,have major effects on how one manages it. One brief way to define risk is a“deviation from expectations.”

In terms of theory, the potential for added reward must justify added risk. An investor must fully understand the nature of the risk associated with eachinvestment, and feel comfortable with the anticipated return for a given levelor increment of risk.

In terms of practice, the risk management process is very much like theinvestment process. Investors should begin by establishing goals and objectivesfor the risk management process, taking into account their appetite for annualportfolio volatility. Second, the investor implements procedures to manage therisks and achieve the stated goals. Once implemented, managing risk requiresconstant monitoring, evaluation and prioritization — to control, limit and miti-gate risk — and it almost always includes the preparation of a contingency plan.

Over the past several years, the investment industry has seen the creationof complex new financial instruments, while the infrastructure charged withcontrolling them has not kept pace. In many cases, it is not the instrumentsthemselves that are at issue, but their misapplication. More recently, the scope ofconcern has broadened significantly to include internal controls, policies, proce-dures and practices related to the operational aspects of investment portfolios.

Why are operational risks receiving more attention today? Until recently,the investment community paid far more attention to portfolio or marketrisk. However, as discussed earlier, diversification has become a fundamentalmethod of reducing overall portfolio risk. With that in mind, the communityhas turned its attention to manager oversight, counterparty risk, investmentguideline enforcement and related areas. Operational risks include the failureto execute or executing improperly (not following guidelines and policies),delay (not implementing to schedule), lack of asset verification and fraud.

The fundamental tenets of operational risk management must be thesegregation of responsibilities; independent, third party checks; and randomaudits of internal policies and procedures with the basis for any risk manage-ment program being accurate, timely information.

Risk Management at The Common FundAt The Common Fund, we have developed an infrastructure to monitor andcontrol the risks associated with managing a full range of multi-manager funds.More than half of our professional staff — about 50 people in our Investmentand Operations Groups — are involved in some form of risk management.

The Common Fund has pursued an active program of risk managementover the years. Among the main features of the program are:

• Policies for the Investment and Operations Groups• Rules and guidelines for external portfolio managers• On-site portfolio manager visits to review internal controls or measure

market and operational risks• Independent audit• A primary custodian for the aggregation of most information in a

central place

The Common Fund has intensified its risk management efforts bydeveloping and implementing a number of initiatives. Working with ourcustodian, Mellon Trust, we are participating in the development of acomputer-based portfolio control system, called Investment Monitor, whichprovides a daily comparison of a manager’s portfolio against The CommonFund’s established guidelines and alerts us of any violations so that appro-priate actions may be taken.

We send our portfolio managers in-depth risk questionnaires requiringwritten responses, and members of our Investment and Operations Groupsconduct periodic on-site manager visits.

Another major step has been to create the position of IndependentRisk Oversight Officer (IROO) at the senior management level and staffthis position with a highly qualified, experienced professional. The IROOis responsible for the strength and coordination of risk management andmeasurement across the organization. This includes standards expected ofinvestment managers; ongoing review of investment managers, advisors andcustodians; assuring the implementation of a disciplined risk managementprocess; monitoring and controlling counterparty risk; and review of invest-ment manager risk/reward benefits in each fund. The IROO reports directlyto the President and to the Audit and Risk Management Committee of theBoard of Trustees.

This separate Audit and Risk Management Committee has beenestablished at the Board level. The Common Fund is governed by a Board of Trustees drawn from both the educational and investment communities.The Trustees dedicate a considerable amount of time and energy to their task,and bring yet another level of oversight to the task of risk management.

We also have an internal Risk Management Committee (consisting ofthe Chief Investment Officer, the Independent Risk Oversight Officer, theHead of Fund Operations and Legal Counsel). The RMC establishes policiesand procedures to be approved by the Board for monitoring all aspects ofinvestment risk, including manager oversight, portfolio risk and operationalrisk. The RMC draws upon individual expertise from internal and externalsources as required.

We continue to develop and refine our risk management policies, procedures and practices as an ongoing process. Moreover, we appreciate thecosts and complexity associated with enhanced risk management necessary toprotect our Members’ assets. Our goal is to be cost effective and thorough inour risk management program and, since it is a community issue, we will en-deavor to share what we learn with educational institutions and other investors.

13

Com

mon Fund Program

s and Services

14

Endowment ManagementDomestic Equity FundsThe Common Fund’s domestic equity program offers two multi-manager,multi-strategy funds and eight multi-manager, focused strategy funds. Themulti-strategy funds are the Equity Fund and the Domestic Equity Fund.The Equity Fund is designed to provide, in a single fund, all of the strategyand manager diversification that any endowment would normally require.The Domestic Equity Fund provides Members with a single domestic equityprogram that incorporates three strategies — core, value and growth — in adiversified, multi-manager portfolio.

The focused strategy funds are the Core Equity Fund, the Equity-IncomeFund, the Growth Equity Fund, the Small Cap Value Fund, the Small CapGrowth Fund, the Hedge Fund, the Absolute Return (Equitized) Fund, andthe Absolute Return Fund.

Global and International Equity FundsThe Common Fund offers global and international equity programs as well asan Emerging Markets Fund. Our global, international and emerging marketsequity programs are multi-strategy, multi-manager funds seeking to enhancereturns by providing Members the opportunity to seek the best investmentopportunities around the world, as well as to diversify away from a U.S.-onlyapproach. Global programs invest primarily in developed countries anywherein the world, including the United States, while international programs investprimarily in developed countries outside the U.S. The Emerging MarketsFund invests in equity securities in more than 40 lesser developed countries ofthe world.

The Global and International Equity Funds are offered in two currencyhedging versions: Less Hedged and More Hedged. In both the Less Hedgedand More Hedged versions, portfolio managers may hedge foreign currencyexposure opportunistically in addition to their country and stock selectionexpertise. Further, in the More Hedged version of the fund, currency overlayspecialists are utilized to hedge all foreign currency exposure except that whichis expected to add to return.

Domestic Fixed Income FundsThe Bond Fund is a multi-manager, multi-strategy fixed income investmentprogram which invests in the major segments of the broad fixed income mar-ket, including investment grade, global, high-yield, private and distressed debtissues. The primary objective of the fund is to add significant value above thereturn of the broad U.S. bond market, and produce a relatively high and sta-ble current yield.

The High Quality Bond Fund focuses on investment grade securities(Baa, BBB or better) and employs various strategies such as sector rotation,undervalued security selection and yield curve positioning to add value.

Global and International Fixed Income FundsThe Common Fund offers global and international fixed income investmentprograms. The Global Bond Fund and the International Bond Fund aremulti-manager, multi-strategy investment programs that provide Memberswith a diversified bond portfolio seeking to outperform a U.S.-only fixedincome approach over time.

15

Global programs invest anywhere in the world, including the UnitedStates, while international programs invest in countries outside the U.S. Theseprograms are offered in two currency hedging versions: Less Hedged, in whichthe portfolio managers may hedge foreign currency exposure opportunistically;and More Hedged, in which the portfolio managers are normally fully hedgedto the dollar, although they have the latitude to reduce hedges opportunisticallywhen they anticipate dollar weakness.

Index FundsThe Common Fund offers three index funds: Domestic Equity, InternationalEquity and Bond Index Funds. These funds are indexed against the S&P 500Index, the MSCI EAFE Index and the Lehman Aggregate Bond Index, respec-tively. Indexing a portion of an endowment’s core holdings allows it togain access to the broad market at a lower cost than active management. TheCommon Fund has developed these funds out of a desire to remain responsiveto its Members. We are able to add value by offering Members a lower-costalternative for index investing than is generally obtainable elsewhere.

Tactical Asset Allocation ProgramTactical Asset Allocation (TAA) is designed to make timely shifts betweenstocks, bonds and cash based on the relative attractiveness of each asset class.TAA is a systematic and disciplined approach which utilizes futures to varymarket exposure to stocks, bonds and cash to reflect current valuation levelsand market outlook. This overlay program is available on the Equity, Equity-Income, Bond and High Quality Bond Funds.

Cash ManagementCash management is a discipline that well-managed corporations utilize andthat educational institutions are rapidly integrating into their managementsystems. As a result, many Common Fund Member institutions have foundthey have much to gain by putting a cost-effective cash management programin place.

The purpose of a cash management program is to ensure that yourcash is working to earn income whenever it can during the cash flow pro-cess, thus increasing total return. In its simplest terms, cash management isthe discipline of effectively managing cash from the moment it is due untilit is received and deposited in an investment vehicle, and from the time it iswithdrawn from that investment instrument until it is ultimately disbursedand presented for payment.

The Common Fund’s cash management staff is available to meet withboth Member and nonmember educational institutions to recommend waysof developing and implementing an effective cash management program.

Cash Management ProgramMost educational institutions have three primary concerns when examiningalternatives for the investment of cash: safety, liquidity and optimum return. Inpursuit of these goals, there are many alternatives, from U.S. Treasuries andmoney market mutual funds to certificates of deposit and commercial paper.The Common Fund offers two vehicles for cash investments: the Short TermFund and the Intermediate Cash Fund.

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Short Term FundThe Short Term Fund has three fundamental objectives.

• Safety of participants’ assets. The fund is used by Members foroperational expenditures at their schools or for funds awaiting investment inother asset classes and, as such, cannot be subject to any principal risk.

• To provide liquidity, as these funds are required on a demand basis tomeet specific cash needs of our Members.

• To achieve a total return subject to meeting certain restrictions toallow liquidity and limit exposure to investment risk. The fund’s total returnvariability should be similar to that of three-month U.S. Treasury securities,while never exceeding the variability of one-year U.S. Treasury securities.

The fund is a bank common trust with CoreStates Bank, N.A. as trustee.Because it is a bank common trust, each Common Fund Member has a separatetrust account. The fund’s assets are segregated trust assets and, as such, cannotbe claimed by any creditor of CoreStates Bank, N.A. Each investment isreviewed before it is placed in the fund by CoreStates Bank, N.A., as TrusteeBank. The fund utilizes a multi-advisor, multi-strategy approach to investing.

A unique feature of the Short Term Fund is its Reserve Account. Toassure that the fund meets its objectives over the long term, it credits a por-tion of any excess return to a Reserve Account according to a smoothing formula. In periods of underperformance, the difference is drawn from theReserve Account so that the net credited return to participants is equal to the average yield on the 3-month U.S. Treasury bill. For a complete discussionof the operation of the Reserve Account, see “Information for Participants inThe Common Fund for Short Term Investments.”

Intermediate Cash FundThe Intermediate Cash Fund is a multi-strategy, multi-manager domesticfixed income program available for investment of core cash balances or otheroperating funds that are not expected to be needed for expenditure for a period of at least 12 months. The fund provides twice-a-month liquidity forMembers’ deposits and withdrawals, and principal may be subject to short-term market fluctuations.

The first objective of the Intermediate Cash Fund is to earn a total returnin excess of the Merrill Lynch 1-3 Year Treasury Index. Second, the fund shouldproduce a higher current yield than short-term money market funds. Third, thefund seeks to minimize the chances of a negative return over a 12-month period.

The fund is designed to allow Members to use it for operating reserves and,as such, a heavy reliance is placed on credit quality. No leverage is permitted.

Typical Cash Balance CycleThe goal is to invest both Core and Variable balances effectively.

Variable

Core

DJ F M A M J J A S O N

This is a graphical display of a typical spread sheet showing the monthly sum of a school’s checking and investment accounts. The line traces the monthly pattern over the course of a year – showing periods when the balances are high and periods when they are low. To identify your core balance, draw a line at the lowest point, as has been done in this chart. Everything below the line is core balance, and it either stands idle in your checking accounts month after month, earning no income, or is in a low income investment account. If that money is moved to your Short Term or Intermediate Cash Fund account it would generate more interest.

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Investment AdviceThe Common Fund advises educational institutions with respect to the struc-ture of endowment portfolios, analysis of spending policies and the investmentof endowment and cash assets.

Endowment Planning ModelA useful tool for endowment planning, The Common Fund’s EndowmentPlanning Model was developed to assist trustees and investment officers inmaking better decisions regarding investment management, particularly assetallocation and spending policy.

EducationThe Common Fund seeks to provide Members with informational andeducational programs that have the essential objective of improving overallinvestment performance by upgrading skills and knowledge of investmentofficers and trustees and sharing timely, useful information.

The Endowment InstituteThe Endowment Institute is an educational program developed by TheCommon Fund and designed exclusively for trustees and senior investmentofficers who seek to enhance their contributions to the educational institu-tions they serve. During a rigorous week-long program, participants have theopportunity to analyze investment theories and concepts and discuss theirpractical application to endowment management problem solving. They alsobenefit from association with their peers in an interactive setting that encour-ages a stimulating exchange of ideas and experiences.

Endowment Management SeminarsTo help with the continuing education, growth and development of trusteesand investment officers, The Common Fund sponsors endowment confer-ences throughout the year in various parts of the country. Recent meetingshave focused on general endowment management as well as international andprivate capital investing for educational institutions.

National Cash Management Conference and Regional Seminars The National Cash Management Conference is a three-day meeting, generallyheld every 18 months and hosted by a Member educational institution. Theconference features numerous expert speakers who address cash managementfrom the perspective of mid-sized to larger schools. In addition, The CommonFund’s Cash Management staff holds Regional Cash Management Seminarsthroughout the year.

Annual MeetingThe Common Fund holds its annual meeting every autumn in different sections of the country to make it convenient and cost-effective for Membersto attend. This meeting, which provides a review of our investment programsas well as the opportunity for Members to interact with each other, is held indifferent geographic areas.

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PublicationsThe Common Fund regularly publishes reports, topical papers and researchworks intended to be useful to Member trustees and investment officers.Subjects range from endowment planning and analysis of emerging assetclasses to effective cash management. In addition, The Common Fund pro-duces quarterly and annual reports to keep Members fully apprised of fundperformance and to report upon news, events and activities.

ServicesMember Services GroupThe Member Services Group consists of four regional teams: Northeast,Southern, Central and Western; the National Team, which serves largeendowment Members; and the Cash Management Team. A Member Servicesrepresentative is available on a daily basis to answer questions regarding ourinvestment programs and Members’ accounts and to process monthly trans-actions for all endowment and intermediate cash accounts. Member Servicesofficers are available to attend investment committee meetings and to meetwith the investment officers of Member institutions. High quality service toMembers is a cornerstone of the mission of The Common Fund.

Cash Management Services Among the cash management services offered by The Common Fund isTCF Access, an electronic information and transaction service for schoolsparticipating in the Short Term Fund (refer to page 16). TCF Access provides cash balance information instantly and executes repetitive with-drawals via electronic wire transfer and Automated Clearing House (ACH).Participants in the Short Term Fund may also take advantage of the LinkProgram, which provides an automatic sweep into and out of Short Termfund accounts, speeds collections, slows disbursements, protects your fundsagainst loss and allows money to remain longer in your Short Term Fundaccount to enhance its earning capacity.

Distribution Management ServiceThe Distribution Management Service (DMS), which is offered through The Common Fund’s companion organization, Endowment Advisers, Inc.,provides schools with a rewarding and efficient way to manage the in-kindsecurities distributions they receive from venture capital and private equityinvestments. Research indicates that active management of in-kind distribu-tions may provide greater returns than either “sell immediately” or “holdindefinitely” policies. The DMS’s objective is to maximize the value of thesein-kind distributions on behalf of participating schools and to provide theadministrative services associated with managing them. Each member of theDMS has a separate account with the investment manager and can customizeinvestment guidelines according to liquidity needs.

The Mission of The Common FundOur mission is to enhance substantially thefinancial resources of educational institutionsthrough superior fund management andinvestment advice. We provide the followingbenefits to our Members:• Focus. A nonprofit, membership organiza-tion dedicated to educational institutions• Diversification.

– Style. Multiple managers and strategies – Portfolio. Traditional and nontraditional

investments• Performance. Strong long-term results• Costs. Low fee structure• Service. Exclusive focus on educationalinstitutions

– Investment management– Investment advice– Education of trustees and investment

officers• Expertise. In-house with The Common Fund• Leadership. The Common Fund has helpedshape endowment management for more than25 years; several significant contributions tothe discipline of endowment managementinclude:

– Belief in the primacy of asset allocationdecisions

– Diversification into international and global markets

– Advocating the benefits of private capitalin a diversified portfolio

– Participation in alternative asset classes,such as hedge funds, and the develop-ment of opportunistic strategies

– Developing cash management as a value-added discipline

Board of Trustees

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Louis W. Moelchert, Jr., ChairVice President for Business & FinanceUniversity of Richmond

Paul J. AslanianVice President for Finance and PlanningSwarthmore College

Robert L. BovinettePresidentThe Common Fund

John B. CarrollPresidentGTE Investment Management Corporation

Mayree C. ClarkManaging Director, Global ResearchMorgan Stanley & Co., Inc.

Robert D. Flanigan, Jr.Vice President for Business and Financial Affairs & TreasurerSpelman College

Caspa L. Harris, Jr., Esq.Consultant and Attorney

Norman G. HerbertAssociate Vice President and TreasurerUniversity of Michigan

William C. HromadkaTreasurer and Associate Senior Vice PresidentUniversity of Southern California

David M. Lascell, Esq.PartnerHallenbeck, Lascell, Norris & Zorn, LLP

John T. LeathamTrusteeLawrence UniversityChairmanSecurity Health Managed Care

David J. MeagherVice President for Finance and TreasurerLoyola University Chicago

Robert D. PaveyGeneral PartnerMorgenthaler Ventures

André F. PeroldSylvan C. Coleman Professor of Financial ManagementHarvard University Graduate School of Business Administration

Robert S. Salomon, Jr.Principal and Founder STI Management LLC

William T. SpitzTreasurerVanderbilt University

ParadigmThe Common Fund

A single decision to investendowment funds or managecash through The Common Fundprovides colleges, universitiesand independent schools with everything required anddesired in a comprehensive, professionally managed organi-zation whose mission is to enhance substantially the finan-cial resources of educationalinstitutions through superiorfund management and invest-ment advice.

The Common Fund At a Glance• Largest pool of educational

endowment and operating funds in the world

• 1,300 Members• $17 billion in assets under

management • 100 portfolio managers• Nonprofit• Exclusive education focus• 25 years experience

“Wisdom outweighs any wealth.”Sophocles

Funds OfferedDomestic equitiesGlobal and international

equitiesDomestic fixed incomeGlobal and international

fixed incomeTactical asset allocationPrivate capital*Short term cash Intermediate term cash Services ProvidedManager SelectionFund objectives and structureManager universe analysisEvaluation of investment

philosophy and process

Board level approval of selected managers

Manager OversightInvestment strategyInvestment guidelinesRisk management

proceduresTracking and monitoringPortfolio AnalysisPerformance attributionPortfolio characteristicsPeer group standingsRisk analysis

* Through Endowment Advisers, Inc., a companion organization.

Investment AdviceAsset allocationSpending policyInvestment policy

developmentCash managementPerformance reportingEducationAnnual and Regional

MeetingsThe Endowment InstituteRegional Endowment

Management SeminarsNational Cash Management

Conference

Regional Cash Management Seminars

Special purpose investment meetings and seminars

PublicationsTopical papers on

investment issuesEndowment Management Books

Funds for the FuturePrinciples and Objectives:

The Common Fund PerspectiveAnnual and Quarterly Reports

Fund AccountingMonthly portfolio reconciliation

and performance measurementMonthly consolidated unitized

fund valuationOngoing review of managers’

operating proceduresOngoing management of

custodial relationships

Investment Management

Member Services

Operations

Participant AccountingMonthly and quarterly

account statementsMonthly transaction processingQuarterly income distribution

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