This is the time for special care. It is so easy, being unfamiliar with writing a governance document, to simply get someone else’s and copy. The thinking is that if it is good enough for them, it must be good enough for us. Trying to fit your organization into someone else’s iron frame is a big mistake, and can make all the difference between success and failure. This document is uniquely yours, your governance, your goals, your risks, and your process. The effort to think through and write a unique document is the main reason for the governance plan. A secondary reason is to memorialize the development process results so that your investment committee and board will hold to the plan rather than ad hoc decisions. The governance document also exists to inform and educate new members as they come along so that the plan has legs and remains long-term. This is not to say it can’t be changed, but changes should come infrequently, and not as an emotional reaction to every stress point.

Writing this governance document and investment policy statement after thought and discussion gives it weight and understanding, while pulling out someone else’s means that the document and its contents are not all that important and are there just to paper the file. Not having one or having one of little importance means that at each juncture decisions are made with emotion rather than deliberate and unhurried care.

The investment policy statement or governance document is an integral component of the investment program because it lays the groundwork for the investment program and provides clear instructions and guidelines for implementation. An investment policy statement also articulates what roles and responsibilities each party will have within the investment program. An effective investment policy will cover the major elements of philosophy and process; truly a plan for governance.

Return Objectives

Best practices indicate that an institution should articulate the primary goal or goals of the organization’s investable assets, and what types of returns are needed to achieve those goals. Additionally, the board should determine what the appropriate time horizon is to achieve those goals, as well as how they plan to measure and monitor progress.

In many standard boilerplate investment policy statements, there is a tendency to create return goals that are relative in nature, whether to other funds, markets, inflation or, most commonly, to some sort of “policy” index. While it’s nice to know that you beat your rival, or are better than average, you cannot spend relatives. The problem is that the fund is supposed to provide some cash money. That’s the way checks are written—for grants, for budget support or to pay retirement benefits. Therefore, your return objective should be an absolute number.

Many funds are perpetual in nature; so, should your investment horizon be “forever?” We’d like to think our fund will last into perpetuity, but need to be realistic “forever” is just not going to happen.. More commonly we hear a three- to five-year time horizon, but is that realistic? I believe the best approach is the one used in both the pension and insurance industries, where the time horizon is based on your expenditure needs (liabilities). This would mean you have multiple and rolling horizons. For example, one organization had a short-term need for a return of 9% to support their budget during a long-term construction effort. But they also wanted to have as much in their fund at the end of the construction plus two years, (for a total of 14 years) as they had at the beginning, which meant a long-term return of 11%. They used a rolling three-year return of 9% and a fixed time that ended 14 years in the future as their goals.

Risk Tolerance

The organization needs to define risk and its own appetite for taking risk in order to accomplish its goals. Contrary to the belief of almost every academic or consultant, risk is not a standard deviation. Risk is the danger of not meeting your financial and non-financial goals. We will discuss risk in much more detail in a later chapter, but for now, note that it is the chance (probability) of some bad thing happening. Defining risk is defining that bad thing—loss of capital, a return below some number, not having enough for a construction project—and the probability associated with failing.

For example, one institution defined risk as a minimum percentage of return on average as an absolute, plus a second (higher and less absolute) return number that would allow a particular construction project. Once risk is defined, the organization can establish the appropriate risk metrics to measure such risk—is it volatility, probability of loss, drawdown, or purchasing power loss?

Asset Allocation

While asset allocation is best left to your investment officer, those organizations that have chosen not to use one will need to determine which asset classes the investment program will include and exclude. Asset classes that can be considered are: equities (U.S., emerging markets, global, MLPs, REITs, commodities international); fixed income (treasuries, corporates, high yield, distressed debt, mezzanine, emerging markets, mortgage-backed securities, CLOs, collateral debt obligations, collateral mortgage-backed securities, residential mortgage-backed securities); and alternatives (long/short equity, multi-strategy hedge funds, fund of funds, venture capital, growth equity, levered buyouts, commodity trading advisors, managed futures, macro hedge funds, and the list goes on). As the list of financial products continues to grow, an organization should only venture into those asset classes for which they have the necessary expertise to understand the risks and benefits.

It is common and traditional (if 30 years can be called a tradition) to set a target allocation and then create ranges around those targets. The questions to ask are why those asset classes were chosen, and where the target allocation numbers and the ranges around them came from. Did they come in a dream, or do they simply feel good? Are you using someone else’s? Why a certain percentage for domestic equity and not another? The most common approach is to just use someone else’s, but, that is a big mistake. For example, a well-known university uses 10% as a target allocation for six different classes, and 40% for hedge funds. Come on really? Can they find that many really good hedge funds? Aside: they rank in the bottom few universities and their investment committee has some of the best resumes in the country. There is an old saw about what you step in if you are following the herd. We’ll revisit asset allocation in a separate chapter.

Rebalancing Protocol

Portfolio rebalancing is a component of the portfolio management process, and again should be delegated to the investment officer. For those boards that choose to do it themselves, the rebalancing policy should describe how they plan to rebalance the portfolio, including methodology and rationale. There are a number of rebalancing techniques for organizations, but the most common are calendar, corridor ranges, and tactical asset allocation. Calendar rebalancing is as simple as it sounds—every so many months, quarters or other pre-determined time interval, the portfolio is adjusted back to the original target allocation. Corridor ranges allow asset classes to trade within a band, and the portfolio will be rebalanced back to the original allocation only after an asset class breaches the asset allocation range. These asset allocation ranges are set based on several things including (unfortunately) how the board or investment committee feels. Tactical asset allocation allows for more flexibility, but skeptics believe it’s a strategy designed to “time” the market. Specifically, tactical asset allocation allows an institution to take advantage of asset classes that are perceived to be undervalued relative to other opportunities, or, in some iterations, what’s hot. Some institutions use systematic tactical asset allocation strategies, where a quantitative investment model (black box) is used to systematically exploit inefficiencies or temporary imbalances among different asset classes.

Portfolio Evaluation – Benchmarking

Whatever benchmark you write down will become the goal that the investment committee, the consultant and the investment officer will manage to—in order to exceed and win—win congratulations, commissions or bonuses. If you pay your yard guy by the hour, the work will take all day; if instead you pay by the job, don’t blink or you’ll miss him.

A successful investment policy will establish the definition of success—success for you, not someone else. Then, through metrics designed to measure progress to that goal, real measurement and subsequent evaluation can take place. In advance of making a particular investment, an appropriate benchmark should be determined so that the underlying investment can be monitored and evaluated over the life of the investment.

A portfolio benchmark, in the form of an absolute return and not a customized benchmark (policy index), should be established after portfolio goals have been defined. The investment policy statement should also elaborate on which time periods will weigh more heavily for evaluation purposes, harking back to the investment horizons already established. Frequent review will permit the discovery of rapidly developing issues and the large amount of data will permit identification of slower trends. A well-thought-out portfolio evaluation process can protect investors from some of the irrational behavior that plagues both institutional and retail investors—namely, overreaction during large market downturns.