Examinable 1 - Primer for Investment Trustees 2017 - Introduction (pages 1-10) PDF

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A PRIMER FOR INVESTMENT TRUSTEES Understanding Investment Committee Responsibilities

Jeffery V. Bailey, CFA, and Thomas M. Richards, CFA

A PRIMER FOR INVESTMENT TRUSTEES Understanding Investment Committee Responsibilities

Second Edition

Jeffery V. Bailey, CFA, and Thomas M. Richards, CFA

Statement of Purpose The CFA Institute Research Foundation is a not-for-profit organization established to promote the development and dissemination of relevant research for investment practitioners worldwide. Neither the Research Foundation, CFA Institute, nor the publication’s editorial staff is responsible for facts and opinions presented in this publication. This publication reflects the views of the author(s) and does not represent the official views of the CFA Institute Research Foundation.

The CFA Institute Research Foundation and the Research Foundation logo are trademarks owned by the CFA Institute Research Foundation. CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for the Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. © 2017 The CFA Institute Research Foundation. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Cover Image Photo Credit: istocksdaily/Getty Images ISBN 978-1-944960-29-2

Dedication In memory of my mother, Joyce Keller JVB To Diane TMR

© 2017 CFA Institute Research Foundation. All rights reserved.

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Biographies Jeffery V. Bailey, CFA, previously served as senior director, Benefits, at Target Corporation, where he supervised the investment programs and administration of the company’s defined-benefit and defined-contribution plans, nonqualified retirement plans, and health and welfare plans. Formerly, Mr. Bailey was a managing partner of Richards & Tierney, a Chicago-based pension consulting firm specializing in quantitative risk control techniques. Prior to that position, he was assistant executive director of the Minnesota State Board of Investment, which manages the pension assets of Minnesota public employees. Mr. Bailey has published numerous articles about pension management. He co-authored the textbooks Investments and Fundamentals of Investments with William F. Sharpe and Gordon J. Alexander and coauthored the Research Foundation of CFA Institute publication Controlling Misfit Risk in Multiple-Manager Investment Programs with David E. Tierney. Mr. Bailey received a BA in economics from Oakland University and an MA in economics and MBA in finance from the University of Minnesota. Thomas M. Richards, CFA, is co-founder of Richards & Tierney, an investment consulting firm that provided investment analytical services to institutional investment organizations. In 2007, Nuveen Investments acquired Richards & Tierney. During his investment career, Mr. Richards has published a variety of papers in the investment finance literature and has been a frequent speaker at investment conferences and seminars. He is a co-author of the chapter on performance evaluation published in the textbooks Managing Investment Portfolios and Investment Performance Measurement. Mr. Richards has been a trustee of the Research Foundation of CFA Institute and served as chair from 2009 to 2012. He earned a BS in mathematics from Bucknell University and an MS in finance from the Pennsylvania State University.

© 2017 CFA Institute Research Foundation. All rights reserved.

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Contents Acknowledgments ................................................................................. Foreword ................................................................................................

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Introduction ........................................................................................... Our Target Audience ...................................................................... Organization of the Book ............................................................... Takeaways ...................................................................................... Session 1. Governance Structure ............................................................ Governance Basics ......................................................................... Roles and Responsibilities.............................................................. Lines of Authority .......................................................................... Accountability Standards ............................................................... Fiduciary Duty................................................................................ More on the Trustees ..................................................................... Takeaways ...................................................................................... Questions Molly Should Ask .......................................................... Session 2. Investment Policy................................................................... The Importance of Investment Policy ............................................ Defining Investment Policy ............................................................ Policy Asset Mix: Selection and Rebalancing ................................. Investment Policy as a Stabilizer .................................................... Reviewing Investment Policy ......................................................... The Investment Policy Statement .................................................. Takeaways ...................................................................................... Questions Molly Should Ask .......................................................... Session 3. The Fund’s Mission................................................................. The Fundamental Conflict ............................................................. Liabilities ........................................................................................ Contributions ................................................................................. Takeaways ...................................................................................... Questions Molly Should Ask .......................................................... Session 4. Investment Objectives ........................................................... Criteria for Effective Investment Objectives................................... Examples of Investment Objectives............................................... Takeaways ...................................................................................... Questions Molly Should Ask .......................................................... Session 5. Investment Risk Tolerance .....................................................

1 1 3 9 11 11 13 19 21 22 24 25 26 30 30 30 32 33 34 35 37 38 40 41 44 45 47 47 49 49 52 54 54 56

© 2017 CFA Institute Research Foundation. All rights reserved.

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A Primer for Investment Trustees

Returns Are Only Half the Story .................................................... Types of Investment Risk................................................................ Measuring Risk ............................................................................... Relationship between Risk and Expected Return .......................... Managing Risk through Diversification.......................................... Risk Budgeting ............................................................................... Investment Risk Tolerance ............................................................. Takeaways ...................................................................................... Questions Molly Should Ask .......................................................... Session 6. Investment Assets .................................................................. Types of Investment Assets............................................................ Diversifying across Asset Classes ................................................... Market Indexes............................................................................... External and Internal Investment Management ............................ Active and Passive Management ................................................... Separate Accounts and Commingled Funds.................................. Alternative Investments ................................................................. Fees and Expenses ......................................................................... Takeaways ...................................................................................... Questions Molly Should Ask .......................................................... Session 7. Defined-Contribution Plans ................................................... Investment Policy for the DC Plan.................................................. The Fund’s Mission for the DC Plan................................................ Investment Assets in the DC Plan .................................................. Takeaways ...................................................................................... Questions Molly Should Ask .......................................................... Session 8. Performance Evaluation......................................................... The Importance of Performance Evaluation .................................. Performance Measurement ........................................................... Performance Benchmarks ............................................................. Performance Attribution................................................................ Performance Appraisal .................................................................. Putting It All Together.................................................................... Takeaways ...................................................................................... Questions Molly Should Ask .......................................................... Session 9. Ethics in Investing .................................................................. Recognized Principles of Trustee Ethical Conduct ......................... Creating a Culture of Ethical Behavior ........................................... Takeaways ...................................................................................... Questions Molly Should Ask .......................................................... viii

56 57 58 60 61 62 63 65 66 68 68 69 69 72 73 75 76 78 80 81 84 85 87 87 89 89 91 91 92 94 95 97 99 100 101 103 103 104 106 106

© 2017 CFA Institute Research Foundation. All rights reserved.

Appendix A. Lurinberg University Endowment Fund Governance Policy Statement ................................................................................ Investment Committee .................................................................. Investment Staff ............................................................................. Investment Consultant(s) ............................................................... Investment Managers .................................................................... Custodian Bank .............................................................................. Appendix B. Lurinberg University Defined-Benefit Plan Investment Policy Statement ............................................................ Background.................................................................................... The Fund’s Mission......................................................................... Roles and Responsibilities.............................................................. Risk Tolerance ................................................................................ Investment Objectives ................................................................... Policy Asset Mix ............................................................................. Rebalancing the Policy Asset Mix .................................................. Asset Class Targets ......................................................................... Investment Manager Structure ...................................................... Performance Evaluation................................................................. Fee Policy ....................................................................................... Additional Investment Policy Issues............................................... Appendix C. Lurinberg University Defined-Contribution Plan Investment Policy Statement ............................................................ Background.................................................................................... The Fund’s Mission......................................................................... Roles and Responsibilities.............................................................. Investment Options ....................................................................... Selection of Investment Managers ................................................ Performance Evaluation................................................................. Additional Investment Guidelines ................................................. Fee Policy ....................................................................................... Glossary of Investment Terms ................................................................ Further Reading...................................................................................... Must-Reads .................................................................................... Further Education .......................................................................... Resources for Investment Committees .......................................... Ethical and Professional Standards ................................................ Textbooks and Articles ..................................................................

109 109 111 111 112 113 115 115 115 116 117 117 118 120 120 120 122 123 124 126 126 126 127 127 129 130 130 131 133 141 141 141 142 142 143

This publication qualifies for 5 CE credits under the guidelines of the CFA Institute Continuing Education Program.

Acknowledgments Since the first edition of A Primer for Investment Trustees (the Primer) was published, in 2011, we have participated in numerous meetings and seminars with investment committee members from all types of funds and others who work directly or indirectly with investment trustees. We have discussed the Primer and received positive feedback that confirmed our belief in the need for and value of investment trustee education. In the process, we enhanced our understanding of the perspectives, circumstances, and constraints that investment trustees face. Those insights led us to believe that additional material should be added to the Primer, including addressing the needs of smaller fund sponsors and the unique issues faced by trustees of defined-contribution retirement plans. We agreed that a second edition of the Primer would be a worthwhile effort. We would first like to again thank all those who provided invaluable assistance in completing the first edition, including Beth Dubberley, Bruce Duncan, John Freeman, Doug Gorence, Scott Kennedy, Ed Kunzman, John Mulligan, John Nagorniak, and Dave Tierney. In particular, we would like to thank Jesse Phillips, who was a co-author of the first edition and whose contributions are greatly appreciated. This time around, we benefited from the comments, research, and reviews provided to us by a variety of interested individuals and organizations. For their assistance and support, we thank Ann Posey, Callan Associates; John Griswold, Commonfund; Matt Fleishman, COPIC Insurance; Gary Brinson, the Brinson Foundation; Bob Seng, Dorsey & Whitney; Henrik Sterin, Zibetto Espresso; and Larry Siegel, the CFA Institute Research Foundation.

© 2017 CFA Institute Research Foundation. All rights reserved.

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Foreword Approximately six years ago, I was asked to write the foreword for A Primer for Investment Trustees (the Primer). It was a monograph directed at investment trustees—in particular, those individuals who sit on investment committees and are responsible for the investment policy and strategy decisions of funds that have been set aside for the benefit of others. Such funds include retirement funds, endowments, and foundations. I agreed to write the foreword for two primary reasons. First, for more than 40 years, I have had a strong commitment to support the CFA Institute Research Foundation. I believe their work in producing indepth, high-quality discussions of topical investment issues is of great value to the investment community. Second, I believe that investment trustees are a very important but underserved constituency in the investment community. Most investment trustees have had successful careers—but not necessarily in the investment field. In their capacities as trustees, they are not responsible for the day-to-day decision making of the funds they serve, but they do bear responsibility for setting investment and governance policy, understanding the fund’s mission, establishing objectives, and assessing performance. Very few publications discuss these responsibilities, and there is a dearth of education programs available for interested trustees. The Primer is a powerful text that provides a comprehensive discussion of investment issues relevant to investment trustees. It examines these issues from the perspective of the investment trustee and avoids the use of complex investment terminology. The Primer is an “easy read,” which is particularly helpful to trustees who probably have other full-time jobs. Although the Primer’s main audience is investment trustees, it also can be beneficial to investment professionals and other parties who work directly or indirectly with investment trustees. For example, the fund’s staff, outside consultants, professional investment managers, actuaries, accountants, custodian banks, lawyers, and others who interact with fund trustees can benefit by understanding the investment trustee’s perspective, circumstances, and responsibilities. Such an understanding will facilitate communications and allow all parties to work together more effectively. Since the Primer was first published, in 2011, it has become one of the most popular monographs the CFA Institute Research Foundation has published. That popularity does not mean, however, that it cannot be improved. New investment products are created. New investment issues arise. And new insights are developed. In this second edition of the Primer, the authors © 2017 CFA Institute Research Foundation. All rights reserved.

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address these types of developments together with other issues identified by interested readers. Such issues include the needs of smaller funds with spending constraints and funds in which the beneficiaries bear the investment risk. In addition, this edition contains an expanded discussion of governance, investment risk tolerance, and investment assets. As I did with the first edition, I wholeheartedly recommend the Primer. I believe it can be of great value to all investment trustees, to investment professionals who work with trustees, and to those who have an interest in understanding the role and responsibilities of a very import...