Good governance by investment committees is the best and only reliable way to achieve superior long-term results for endowments and pension funds. Far more care should be given to investment committee design, membership, and leadership. Serving on the investment committees of Yale, Exeter, Singapore's GIC, the New Zealand Future Fund, and King Abdullah University in Saudi Arabia (one of the five largest endowments in the world) and several others, the importance of good governance has been made clear to me. Unfortunately, all too many institutions and families do not enjoy the benefits they could have had with more attention to organizing for good governance.
Thoughtful observers are increasingly in agreement that endowment and pension investment committees have important governance responsibilities in assuring the successful management of the pensions and endowments supporting the retirement security of workers in states, municipalities, and corporations as well as of many of our nation's most treasured educational, cultural, and philanthropic institutions.
While the full board of trustees has the ultimate institutional responsibility, the center of active good governance is the investment committee. The available evidence indicates that our nation's institutional funds (while assuming generous returns—usually by assuming they can and will outperform the markets in which they invest) are falling short of the market averages. Some will argue over the data, some will blame consultants, and some will blame the managers. All will be able to find examples that confirm their concerns about institutional investment management.
I share their concerns with management but believe there are comparably serious problems with governance. Unless the systematic failure of governance is overcome, any improvements in fund management will be dominated by the larger, more insidious problems of governance. Since spendable income from endowments is the crucial factor in institutional excellence for our leading universities, schools, museums, hospitals, and scientific research organizations, we all have a significant interest in the long-term investment success of their endowments. Endowment success, in turn, depends on two functions working well together—skillful investment management and good governance—assuring the investing program is right for the particular institution. Investment committees cannot hope to succeed in operational management in today's fast-paced market, but they can add “House of Lords” wisdom and guidance by focusing on good governance, the focus of modern Best Practices investment committees.
Who should serve on a Best Practice investment committee? In investing, as in most professions, experience is not only the best teacher, it's the only good teacher. That's why investment committees need thoughtful and informed members ready and able to make good judgments based on the kind of wisdom that can only come from experience in investing. At least a strong a majority of each investment committee should have substantial experience as investors. (Note: Stockbrokers and bankers seldom are also experienced as investors.) A minority of committee members may be chosen for other reasons: executive positions, experience as business leaders, political stature and knowledge, expertise and understanding of a philanthropic institution and its finances or demonstrated philanthropic generosity.
The most effective committees range in size from 5 to 9 members—large enough to have diverse experience, expertise, and opinions and small enough so everyone gets heard and understood.
A senior organizational leader should always serve on or meet regularly with the committee to assure two-way communications and understanding by the investment committee of the financial management challenges and appreciation of the sponsoring corporation's or state's or municipality's resources or a charitable institution's long-term program strategy and its plans for fundraising. And, vice versa, financial managers setting the plans and budgets need to understand the unpredictable, market-driven realities of investment management and the long-term limits on an endowment's ability to produce spendable annual “income.” As in any superior relationship, success depends on good two-way communication.
Endowment governance should be both coordinated with and integrated into overall governance of the institution's operating budgets, its capital and programmatic strategies, and its fundraising. Wise and effective integration of endowment investing, institutional finance, and fundraising is, of course, the central responsibility of the full board of trustees, but this important “macro” strategy work can be best initiated and even led by the investment committee.
Clearly separating the work of management from the work of governance, the Best Practice investment committees understand that good governance provides the long-term policy framework and assures the working environment that enables operating managers to do their work both efficiently and effectively. As Peter Drucker famously explained, “Efficiency is doing things the right way; effectiveness is doing the right things.”
Investment committees, usually meeting four or six times each year, have two reasons for concentrating on governance and for not attempting management. The first reason is a non-negative: In today's intensely managed, fast-changing capital markets, committees meeting quarterly are ill-designed and ill-timed for taking up operational decisions. They know they can't do it well.
The second reason for concentrating on good governance is positive: Even the best-organized and best-led committees will find themselves fully challenged by the responsibilities of good governance: setting appropriate limits on risk, setting optimal investment policies and objectives, agreeing on portfolio structure, assuring wise selection of investment managers, staying on a steady course during periods of market euphoria or despair, formulating sensible spending rules, and coordinating with the finance committee and the full board on overall governance so the fund's investment management organization performs its full and appropriate role in the context of the overall fiscal governance.
The best investment committees make sure investment managers are skillful, diligent, and cost-effective in investment management operations, but their primary focus and responsibility are on getting it really right on organizational governance and investment policy. In setting long-term investment objectives, Best Practice investment committees know that risk controls come first, long-term strategic portfolio and rate of return second, and spending policy third. Every organization is unique and each deserves its own custom-tailored set of governance policies on all three dimensions. Best Practice investment committees search continuously and diligently for the right balance between risk and reward. For them, boldly cautious is no oxymoron. Separately, Best Practice investment committees will make sure that external managers' compensation incentives are reasonably aligned with achieving the long-term investment results the pension fund or endowment looks for.
While risk management is the investment committee's first priority, this most definitely does not mean overly conservative “caution.” As Robert Barker's committee famously reported to the Ford Foundation for endowments long ago, the opportunity cost of excessive caution can be very great. Over the past 50 years, public and private pension funds have also been too cautious and all too conventionally over-invested in bonds. The sad history of failures and shortfalls in endowment investing has more examples of too little courage than of too much boldness in asset allocation. Best Practice investment committees will insist on taking and managing sensible short-term market risks and insist on avoiding unnecessary long-term risks of real loss due to either over-reaching or through the silent opportunity cost of not really striving.
Where should investment committees turn for advice? First, every committee member should read the wisest and most useful book on institutional investing, David Swensen's Pioneering Portfolio Management. This thoughtful and explicit explanation of the reasoning behind each aspect of Yale's endowment management invites every institution to develop its own answers to each of the core questions: What is our strategic portfolio structure and why? What is our time horizon for investing and why? How do we select investment managers and why? What is our Spending Rule or rate of return assumption and why? What are our investment committee's particular governance functions and responsibilities and why?
Best Practice investment committees make certain that they secure the defensive perimeter via “active reconnaissance” with specific individuals responsible for keeping well informed about each investment manager's organization, its professional capacities, and its business commitments; actively engaging in “scuttlebutt” networks; rebalancing regularly; and regularly revisiting each manager at his office to watch for changes that might be early warning signals.
Best Practice investment committees revisit and reevaluate their central beliefs and the resulting policy guidelines in a rigorous “back to basics” way on a regular basis. This work is best done at a dedicated annual meeting for which all participants are expected to specify their best questions well in advance. If staff work will be required to gather data, ample lead time is assured. Best Practice committees will also evaluate their own performance to determine whether or not they have added value.
Risk evaluations by Best Practice investment committees will have three dimensions: income risk, asset risk, and liquidity risk. Assuring a predictable flow of income to support the institution's budget is usually the highest priority. The financial crisis showed many endowments how important liquidity can suddenly be.
The central governance decision will be deciding the degree of emphasis on equity investment and the need for portfolio liquidity. For long-term returns, the equity emphasis should be substantial and balanced with a discipline that recognizes both long-term investing advantages and short-term problems of market fluctuations. This is not easy disciplining, but it is vital for good governance.
Investment committees can make a major contribution to good governance by assuring the establishment of clear policies on the selection of managers. This does not mean that the committees will actually select or terminate managers. In fact, the best evidence of a committee confusing governance versus management—if it has an internal management—is that the committee hires and fires investment managers. But governing committees can and should require explicit statements of the policies and practices that will be used in selecting or terminating investment managers to be sure the management process is well thought out. For example …
Good governance centers on assuring that investment operations are within the skill set and risk capacity of the managers. The easiest investment operation uses index funds. If active management is considered, Best Practice committees will start with a rigorous review of long-term results—over at least the past ten years. (Such a review will show that most managers fail to match, let alone beat, the market and that the average shortfall is larger than the average value added.) Committees should also examine objectively the probability that their organization will be able to select managers who will outperform the index in the future, knowing that while many have tried, most have not succeeded. A sensible humility is an invaluable characteristic of good governance in investment management but pulling back from responsibility imperatives is certainly not.
If active managers are to be used, most small and midsize funds should consider using one manager with many different demonstrated skills. By concentrating its assets with one multi-capability firm, even a small fund makes itself an important client. This will justify the manager giving it “blue ribbon” attention and the benefit of the manager's best investment counsel and make it easy to rebalance or change portfolio structure if and when appropriate.
Investment committees that want to be Best Practitioners will benefit from careful self-study to see if any of these signs of trouble are part of their problem:
Having many managers may be a virtual necessity for the largest funds when they also specialize in using small specialist managers. But smaller funds—$2 billion or less—should seriously consider working with just one or two major managers that have developed strong capabilities in advising on optimal asset mix and have demonstrated superior professional competence in each of the major asset classes. (Rarely is a manager skilled at both investing in conventional asset classes and in “alternatives,” such as private equity, real estate, hedge funds, etc., so those committees that want both types of investing will usually need both types of managers.)
While there are potential benefits in diversifying managers and having experts in each asset class or specialty, history teaches that the benefits of “diversification” by having multiple managers with the same basic mandate are maddeningly modest, particularly in the long run. After all, most equity managers already diversify portfolios across 60–80 different stocks.
With numerous managers, the committee will never develop with its managers the deep shared understanding that is needed to develop superb trust-based and open communications and relationships that enable client and manager to work well together to add value. With a dozen or more managers, at least one will be “on watch” or “in the penalty box,” so the committee's limited time will get focused on solving problems rather than adding positive value. Not really knowing each manager well enough to weather stormy passages, committees will be sorely tempted to “bury mistakes” and “throw the bums out,” incurring the cost of changing managers and repeating the sad cycle again—and again. It's easy for committees that meet only periodically, to get caught in “groupthink” and terminate managers that have recently performed poorly and hire managers who have recently performed well.
The expected duration of each manager relationship is long—ideally forever—because the cost of changing managers can be far greater than the 3–5% transaction costs usually cited. The all-in cost includes the cost of hiring “hot” managers high and firing “failed” disappointing managers low. Quickly chosen managers all too often disappoint.
Add to these visible costs the hidden costs of distracting the management away from working more rigorously on developing superb, long-term working relationships with their best managers. Candidly, there's far too much “dating” and not enough “marital” relationships in endowment and pension management. While committees typically blame the turnover on the investment managers, the real culprits are usually the committees who tolerate a “transactional” approach. The worst offenders are committees that hire impatiently—often on only one-hour “speed-dating” presentations—and then, because the main consideration is “good performance” rather than a well-developed, shared understanding with each manager, they repeat the costly in-and-out, in-and-out transactional sequence.
Some regular turnover is good and helps keep the committee and its discussions fresh. But if members come on and go off too quickly, they will not learn how best to listen carefully to each other and will miss the privilege of learning how best to work together and the group will lose the stabilizing benefits of institutional memory. Nor should committee members stay too long. They'll get stale and will stop listening closely to each other. Tenure on Best Practice committees will average six or seven years because for all sorts of working groups, this proves to be optimal.
Service on committees should be staggered and planned so no one member or small group of members will ever be “essential.” Terms of five or six years—renewable once or even twice—help committees quietly remove those who are not effective or are not enjoying service. Members should differ in background, age, and skills.
The chairs of Best Practice investment committees are servant-leaders who take as their top priority facilitating the collective contributions of all committee members. This facilitation begins with selecting members who “play well with others” and have expertise to contribute. It extends through thoughtful preparation of the agenda and ample documentation—ideally from several different perspectives—so important policy issues are given time for full and open discussion and rigorous resolution. And it includes attending to the climate of meetings so they are interesting, enjoyable, give everyone the chance to be heard, and operate at “due deliberate speed.”
The best investment consultants have earned fine reputations for being helpful. Still, investment consulting is a business, particularly for the larger consulting organizations. The business strategy of many of these firms often involves guiding clients into extensive asset class diversification which leads directly to having so many different investment managers—none of which are really well known to the committee—that the committee becomes inevitably dependent on the consultant for monitoring and managing the managers. Instead of concentrating on long-term investment policy and other dimensions of good governance, available time at meetings gets taken up with the interesting and entertaining, but eventually fruitless business of firing the “poor performers” and hiring promising “winners” in a repetitive cycle that, at its worst, could only please a Las Vegas marriage parlor. Consultants' performance should be evaluated regularly.
Of course, if you did hire Top Quartile managers, your investment experience would be highly favorable, but the recorded data are overwhelming: Almost nobody has done it and nobody has done it for very long. The mean irony is that those committee members who harbor such aspirations are deluding themselves and sooner or later, damage their funds. The “Icarus irony” is that pressing to have the “best” managers all too often leads to hiring “hot” managers at the peak of their performance records and then getting sub-par results as peaks are followed by troughs.
Good governance will avoid trying too hard to increase returns; will assure that only “all-weather” managers with strong professional cultures are selected; and will set long-term return expectations that can be sustained indefinitely. Achieving strong long-term rates of return will require being “bold, but not too bold” and “modern, but not too modern.” Investment professionals learn through painful experience not to follow the crowd, particularly when a crowd is enamored of the view out the rearview window of recent experience with the recent past projected as easy glories still to come or as an inalienable right by those who join the parade late in the day.
Having too many managers is costly. The obvious cost is that when your total fund is divided into many small accounts, your fund gets charged the high end of the managers' fee structures. Other costs are hidden, but far more consequential. They include not knowing each manager well enough to establish a strong “shared understanding” relationship; not knowing how to interpret intermediate-term investment results; not understanding managers well enough to stay the course when performance falters; and not being well understood by the investment managers.
The Best Practitioners have an average tenure or duration of manager relationship of more than ten years. While an average relationship duration of less than ten years can be “acceptable,” an average of only five years is not. The Best Practitioners will focus on selecting and working with managers so well that their average tenure will be more than 15 years.
One exception to staying the course with managers is clear: When one of your managers brings the “good” news that they have joined forces with—code for sold out to—a major organization (usually a giant bank or insurance company, often domiciled in a different country) who will somehow provide all the resources they need to do great things, do not wait or seek to understand. Terminate immediately.
If this view seems too categorical, offer to stay in touch during the next two or three years and, if you are thrilled by the results of the combination—sure to be a great rarity—consider rehiring the previously terminated manager. But when first told, do not compromise or hesitate. (By the way, you will surely receive a brilliantly articulate and often quite moving explication of all the benefits and advantages to come, but the long history of such acquisitions is not at all encouraging. So be guided by history not friendship and terminate promptly.)
A second exception requires particular vigilance: When a manager changes his tune—moving away from the investment philosophy and decision-making process by which he earned the mandate to manage your fund or when it outgrows the asset size he had declared was its “sweet spot” or maximum assets aspiration, beware! Experience says that that manager has probably shifted his real focus from professional investing to the asset gathering business. Such a shift can be remarkably profitable for the managers, but all too costly for the clients.
Best Practice committees know to interpret performance data over time and in the context of reasonable expectations. They use annual and quarterly comparisons to peers primarily to encourage the manager to explain the real reasons for results that differ from expectation. Of course, any major difference from expectation may signal a major problem. If so, Best Practice committees will address it directly and rigorously. (Managers or custodians or investment consultants can provide the relevant data as part of their standard service.)
Pension or endowment management is a calling—a way of making a life, not just making a living—and depends on a strong understanding of the often subtle realities of the particular institution and its leadership. This takes care and time and they both require long-term continuity. Long-serving capable staff can make important contributions to good investment results and Best Practice committees make sure they have able, committed staff and make sure the staff are “career.”
Diversification is the one “free lunch” for investors and diversification across economies and markets makes sense. However, most funds in most countries are over-concentrated in their “home” market.
The obvious advantage of indexing is lower costs, but that's not as important over the long run as the better investment results. And that's not nearly as important as this: indexing keeps the committee focused on what really matters, getting it right on the strategic asset mix.
The ideal set of investment policies—in writing—could be given to a group of “competent strangers” with confidence that they could follow the stated policies faithfully and return the portfolio in good condition with fine interim results ten years later.
For pension funds, a central policy is the chosen rate of return assumption. Best Practices committees will not accept a rate of return that is not well documented as expected returns future and rigorously ask why for each asset class. If “active management” is expected for any class or for the overall fund, document why.
While all investment committees are, of course, interested in good long-term rates of return, the Best Practitioners know that their first priority must always be—particularly in buoyant times when risks are easily overlooked—managing risk. (Of course, taking astute risks in a disciplined way is the key to earning superior returns over the longer run.) The short-term risk of market fluctuations can be reduced through an appropriate smoothing or spending rule to avoid disruptions in support provided to the institution's mission.
Wise spending and wise investing are “two hands clapping” in support of well-governed, well-managed institutions. Note that actuarial return and spending rules should conform to and be determined by investment results, not the other way around. Committees should never let spending wishes or “needs” influence, let alone determine, investment objectives. Making sure of this fiscal sequence is clearly the governance responsibility of the investment committee.
Best Practice committees evaluate their own members and their own operation as a committee. What are we doing right? Where can we improve? What should we add to our agenda? Where can we cut? Some Best Practice committees also evaluate each member, usually annually, using scale ratings on half a dozen agreed-upon key criteria—such as comes well prepared, stays focused on topic, adds value on substance, adds value on process, inspires confidence in judgment, speaks briefly and to the point, etc.—survey results can then be reported to each member by the Chair in comparison to the group's high-median-low scores.
Best Practice committees focus on policies. Similarly, the Spending Rule is the principal connection between an endowment and the budget of the institution it helps support. Deciding how much to draw from an endowment for current expenses and how much to continue investing for the future—and future spending—is one of the most important decision responsibilities of any investment committee. Most institutions' payouts cluster around 4.5–5% of assets.
While a variety of choices continues to be used at different institutions, Best Practice increasingly centers on the work of Yale's Nobel economist James Tobin, who formulated a sophisticated process to achieve what he wisely called “intergenerational equity.”1 Tobin described this objective eloquently:
Committees should be careful of three temptations. One is to believe that the current budgetary priorities are so urgent that it's OK to make an exception and increase spending above the long-term norm “on this watch.” Another is to become so optimistic after a long, favorable market with high returns as to say, “this time, it's different” and ramp up assumptions or spending to what may prove to be an unsustainably high level that will be painful to bring down.
The third temptation is to decide during a long bear market that the needs of the present are so strong that heavy drains on the fund—selling low in a seriously adverse market—have somehow become an imperative. Note that the best time to prevent this problem is to retard endowment spending or return assumptions for pensions when markets have been favorable and the idea of increasing the expected returns seems easiest and most tempting.
As J.P. Morgan famously warned, “Markets fluctuate” and so do endowments. That's why investment committees and trustees need to have a long-term focus when making decisions on the self-discipline of their actuarial rate of return assumption or spending rule. These rules only really matter when they are accepted as binding even when that discipline is most difficult to accept.
Many investment committees have been advised to make major commitments to “alternative” investments in hedge funds of various types, styles and kinds; private equity; real estate; venture capital; etc.2 For leading endowments, the “endowment model” brought a truly marvelous record of strong rates of return over the very long term, but it would be a shame if this great work were misunderstood or misinterpreted and converted into a simplistic “anyone can do it” proposition that could lead some investment committees into unwise practices. As might be expected, the past record seems compelling, but wise committees will be alert to four different factors:
It's at least possible that some consultants' enthusiasm for replication is influenced, if not driven, by their firms' own economic interest in making the process of supervising numerous different kinds of managers so complex that committees will cede effective control of quarterly meetings and the overall investment process to the consultants. While committee members come and go, shrewd consultants will make themselves “permanent party.”
Profit-centered consulting firms compensate their individual consultants for not losing their clients and keep raising the fees as more and more managers and more and more services are used. Once the substantial costs of research are covered, the incremental costs to deliver reports or manager recommendations to additional clients are very small, so the incremental profits can be truly compelling. So again, caveat emptor.
In 2008, investors saw the worst market disruption in a very long time. Two obvious questions came to everyone's mind. First, what should be done? Second, what enduring lessons could be drawn from that dreadful experience?
The realistic and sensible answers to the first question come in two parts. First, if any inappropriate risks were being taken—bank balances over the FDIC insured $100,000 being a simple and familiar illustration—those bank balances should be divided among more banks. Similarly, securities should not be left in Street name with stockbrokerage firms.
The second part of the answer to the first question is for most investment committees both more useful and more important. As we all now know, black swans—unexpected “outlier” events—do occur. And bell-shaped probability curves do have “fat tails,” meaning that the least probable events occur more frequently and with far greater impact than a perfectly normal distribution of probabilities would indicate.
The enduring lessons to be drawn from experience are clear. Just as precision is not the same as accuracy and risk is not the same as uncertainty, wise investment committee members will not go “too close to the edge.” That's why Ben Graham and David Dodd never invest without having an adequate “margin of safety” or capacity to absorb error. In investing, if precise calculation is required, a commitment is not an investment, it's a speculation. Staying power—particularly the staying power of the investment committee—is crucial to deciding how much market risk can be taken. Long-Term Capital Management's computer models did prove to be correct—in the long run—but the firm went bankrupt in the short run anyway.
The Endowment Model—originated by institutions with over 300 years of institutional history—is a long-term model. Institutions and investment committees that are not well prepared to maintain a very long-term perspective on short-term experience will be wise to study the endowment model carefully and adopt the model only to the extent that they have the necessary staff capabilities, financial disciplines, and internal understanding.
A final word: Serving on an investment committee should be interesting, enjoyable, and fulfilling. Best Practice committees are designed to be successful on all three dimensions. If your committee does not measure up on all three criteria, change it. There's no reason not to be a Best Practice investment committee that concentrates on excelling in governance. Sure, it takes thoughtful determination and strong leadership, but it's also more fun—and for more personally and professionally rewarding.
Source: Association of Governing Boards, 2016.