The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.
This is the first in a series about the most common mistakes non-profit organizations make when considering their investment portfolio. Not being aware of one or more of these missteps could have costly consequences.To read part two in this series, click here.
However, in order to capture the performance results of the entire portfolio, details from each manager and custodian must be captured, reconciled for cash flows, analyzed using a single point in time and submitted to the client soon after the relevant reporting period.
If an organization is not provided timely, comprehensive reports about its total investment portfolio performance, it is virtually impossible for fiduciaries (management and the board) to understand how the entire portfolio contributes to the support of the mission. This is akin to making investment decisions in isolation, without regard to the correlations to existing holdings or possible overlap ─ multiple investments in the same strategy or security.
Timely, comprehensive reports should provide relevant information in sufficient detail to allow for manager critique and actionable conclusions by the investment committee. Typical reports include an economic and asset class commentary and market outlook. It is important to tie these reports with actual or future investment decisions for the portfolio.
Most importantly, the report should include a performance review, holdings summary, historical holdings analysis, asset class performance, individual manager performance, risk analysis and an investment policy compliance review. Common reports also will include a litany of benchmarks. Benchmarking is a critical component of performance reporting. It defines "the market" and in doing so provides insight for investors in the form of relative performance. After all, beating the market is the primary goal of institutional investors. Defining and beating the market, however, is relevant only if the entire portfolio is included in the performance calculation.
Investment manager reviews come in many forms: gross or net return (i.e., net of fees), absolute or relative return (relative to peers or to a relevant benchmark). The availability of benchmark performance data, especially peer reviews, may constrain the frequency ─ or timeliness ─ of reporting. And the existence of illiquid alternative investments may also impact or delay reporting.
Greater frequency of reporting provides additional insight into contributors of the actual return. For example, was a star manager the greatest contributor to performance or was it a passive allocation to a unique asset class? Does the cash allocation continue to be a drag on performance? Greater frequency of reporting increases the number of data points and enhances the relevance of the analysis.
Fiduciaries should also be concerned about qualitative manager reviews. Although performance tends to drive engagement and retention of investment managers, there are a number of issues that should be monitored on a continuous basis that do not appear on a performance report. For example, was benchmark performance exceeded because of investment policy violations? Did the U.S. equity manager allocate to emerging markets equities to beat the U.S. equity benchmark? Has the manager's strategy drifted from its original mandate?
Fiduciaries should also be concerned with organizational changes of the investment managers, including personnel and legal issues. These issues should be policy driven and regularly reviewed by fiduciaries.
Leaving portfolio rebalancing to the discretion of the investment committee sounds good, but at its worst it is a form of market timing. That's because an investment committee may find it difficult to reduce holdings in an outperforming asset class and add to holdings in an underperforming asset class. Surely, such moves seem counter-intuitive. Selling a "winner" is simple enough, but buying more of a "loser" is very difficult. It is important to maintain the proper perspective, though. For example, the "loser" may be doing well by its mandate, but not relative to the "market."
The difficulty in rebalancing generally comes from an emotional response, which may lead to actions driven by emotion and not by logic or discipline. Indeed, the combination of major market swings and infrequent investment committee discussions creates an emotional environment at committee meetings. A disciplined approach, however, will offset the emotional distraction. Adherence to a formal, relevant investment policy should remove the emotional component of investment portfolio oversight, encouraging a disciplined approach by the committee.
At a minimum, fiduciaries should implement a policy that includes mandatory annual rebalancing of the investment portfolio, which can be done in conjunction with the annual review of the investment policy statement. An annual rebalancing policy will also lead to lower transaction costs versus a more frequent rebalancing policy.
How then does the organization recognize the risk of a down market and an increasing liability? The first step is to properly define "the market" as portfolio liabilities, which necessitates the need to customize the portfolio holdings to increase the probability of achieving the goal of beating "the market."
Regrettably, many non-profits have been placed in model portfolios giving them identical or nearly identical portfolios as other unrelated organizations. Some portfolios might even look more like an Individual Retirement Account than a multi-million dollar institutional portfolio. Most firms use model portfolios to manage their client's assets because they are the most efficient way for the investment advisor to maximize profitability as they reduce expenses. This approach leaves little room for a non-profit organization to have any input as to how its portfolio is managed. This might be acceptable for an IRA, where there is no current need for funds and the account can grow for a few more years before any withdrawals begin. However, a non-profit portfolio with current liabilities must work to mitigate portfolio volatility and generate more consistent year-to-year returns in order to satisfy those liabilities ─ today and in the future. Focusing on returns without considering volatility can result in a misalignment of the investment portfolio's goals.
Non-profit boards are asked to perform many tasks, including operational and financial review, development, management support and investment oversight. As an organizational representative in the community, fiduciaries should enhance their knowledge of the mission by helping to define the goals and understanding how best to achieve those goals as a unique entity with a unique purpose. Doing so makes it easier for the board member to represent their organization to all of their constituents: management, donors and other involved parties.
To read the continuation of this article, click here.
William M. Courson is the president of Lancaster Pollard Investment Advisory Group in Columbus. He may be reached at wcourson@lancasterpollard.com.
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This is the first in a series about the most common mistakes non-profit organizations make when considering their investment portfolio. Not being aware of one or more of these missteps could have costly consequences.To read part two in this series, click here.
Mistake #1: Not tracking total investment portfolio performance
It is not uncommon for non-profit organizations to use multiple investment managers and multiple custodians, such as banks and brokers. This may be the result of a desire to encourage participation of local providers or the introduction of a unique asset or strategy. Indeed, the investment process and the use of local providers by some non-profit organizations may exist because of a long-term local relationship, a source of local donations, or both.However, in order to capture the performance results of the entire portfolio, details from each manager and custodian must be captured, reconciled for cash flows, analyzed using a single point in time and submitted to the client soon after the relevant reporting period.
If an organization is not provided timely, comprehensive reports about its total investment portfolio performance, it is virtually impossible for fiduciaries (management and the board) to understand how the entire portfolio contributes to the support of the mission. This is akin to making investment decisions in isolation, without regard to the correlations to existing holdings or possible overlap ─ multiple investments in the same strategy or security.
Timely, comprehensive reports should provide relevant information in sufficient detail to allow for manager critique and actionable conclusions by the investment committee. Typical reports include an economic and asset class commentary and market outlook. It is important to tie these reports with actual or future investment decisions for the portfolio.
Most importantly, the report should include a performance review, holdings summary, historical holdings analysis, asset class performance, individual manager performance, risk analysis and an investment policy compliance review. Common reports also will include a litany of benchmarks. Benchmarking is a critical component of performance reporting. It defines "the market" and in doing so provides insight for investors in the form of relative performance. After all, beating the market is the primary goal of institutional investors. Defining and beating the market, however, is relevant only if the entire portfolio is included in the performance calculation.
Mistake #2: Infrequent investment manager review
Investment manager performance varies over time and should be evaluated frequently ─ at least quarterly. As a fiduciary, you are charged with the important task of oversight. Oversight does not mean to actively manage the investments, but to ensure that the policies are being followed by those hired to manage.Investment manager reviews come in many forms: gross or net return (i.e., net of fees), absolute or relative return (relative to peers or to a relevant benchmark). The availability of benchmark performance data, especially peer reviews, may constrain the frequency ─ or timeliness ─ of reporting. And the existence of illiquid alternative investments may also impact or delay reporting.
Greater frequency of reporting provides additional insight into contributors of the actual return. For example, was a star manager the greatest contributor to performance or was it a passive allocation to a unique asset class? Does the cash allocation continue to be a drag on performance? Greater frequency of reporting increases the number of data points and enhances the relevance of the analysis.
Fiduciaries should also be concerned about qualitative manager reviews. Although performance tends to drive engagement and retention of investment managers, there are a number of issues that should be monitored on a continuous basis that do not appear on a performance report. For example, was benchmark performance exceeded because of investment policy violations? Did the U.S. equity manager allocate to emerging markets equities to beat the U.S. equity benchmark? Has the manager's strategy drifted from its original mandate?
Fiduciaries should also be concerned with organizational changes of the investment managers, including personnel and legal issues. These issues should be policy driven and regularly reviewed by fiduciaries.
Mistake #3: Undisciplined portfolio rebalancing
The primary purpose of diversification is to reduce risk. Portfolios of a single asset tend to be more risky than portfolios of multiple assets. Changes in the allocation of individual assets within a portfolio changes the risk within the portfolio. Asset allocation can change due to market movements, leaving the portfolio in a different risk position than when it was originally developed. Unless the risk profile of the organization changes, such as a change in the size or structure of the liabilities of the organization, the investment committee should develop and maintain a disciplined approach to addressing portfolio risk through rebalancing.Leaving portfolio rebalancing to the discretion of the investment committee sounds good, but at its worst it is a form of market timing. That's because an investment committee may find it difficult to reduce holdings in an outperforming asset class and add to holdings in an underperforming asset class. Surely, such moves seem counter-intuitive. Selling a "winner" is simple enough, but buying more of a "loser" is very difficult. It is important to maintain the proper perspective, though. For example, the "loser" may be doing well by its mandate, but not relative to the "market."
The difficulty in rebalancing generally comes from an emotional response, which may lead to actions driven by emotion and not by logic or discipline. Indeed, the combination of major market swings and infrequent investment committee discussions creates an emotional environment at committee meetings. A disciplined approach, however, will offset the emotional distraction. Adherence to a formal, relevant investment policy should remove the emotional component of investment portfolio oversight, encouraging a disciplined approach by the committee.
At a minimum, fiduciaries should implement a policy that includes mandatory annual rebalancing of the investment portfolio, which can be done in conjunction with the annual review of the investment policy statement. An annual rebalancing policy will also lead to lower transaction costs versus a more frequent rebalancing policy.
Mistake #4: Focusing on returns without considering volatility
The goal of most investors is to "beat the market." Unfortunately, many non-profit organizations invest without first defining the market. For investors with a total return mandate, "the market" might be defined as an index, such as the Russell 3000, a combination of indexes or even inflation plus 5 percent. For many non-profit organizations, the market is not an index, per se, but the liabilities of the portfolio. For example, the liabilities of a foundation or endowment portfolio are defined by the spending policy. Even though the value of an index may move up and down, the liabilities of a foundation or endowment portfolio tend to move in just one direction…up.How then does the organization recognize the risk of a down market and an increasing liability? The first step is to properly define "the market" as portfolio liabilities, which necessitates the need to customize the portfolio holdings to increase the probability of achieving the goal of beating "the market."
Regrettably, many non-profits have been placed in model portfolios giving them identical or nearly identical portfolios as other unrelated organizations. Some portfolios might even look more like an Individual Retirement Account than a multi-million dollar institutional portfolio. Most firms use model portfolios to manage their client's assets because they are the most efficient way for the investment advisor to maximize profitability as they reduce expenses. This approach leaves little room for a non-profit organization to have any input as to how its portfolio is managed. This might be acceptable for an IRA, where there is no current need for funds and the account can grow for a few more years before any withdrawals begin. However, a non-profit portfolio with current liabilities must work to mitigate portfolio volatility and generate more consistent year-to-year returns in order to satisfy those liabilities ─ today and in the future. Focusing on returns without considering volatility can result in a misalignment of the investment portfolio's goals.
Non-profit boards are asked to perform many tasks, including operational and financial review, development, management support and investment oversight. As an organizational representative in the community, fiduciaries should enhance their knowledge of the mission by helping to define the goals and understanding how best to achieve those goals as a unique entity with a unique purpose. Doing so makes it easier for the board member to represent their organization to all of their constituents: management, donors and other involved parties.
To read the continuation of this article, click here.
William M. Courson is the president of Lancaster Pollard Investment Advisory Group in Columbus. He may be reached at wcourson@lancasterpollard.com.
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