Anyone charged with the responsibility for managing the investment of assets needs to have a basic understanding of investment principles and concepts.  An investment trustee has a fiduciary duty to manage assets prudently.  In practice, that means that the trustee must understand certain features of the fund, such as fund governance, its investment assets, and its investment performance.  But perhaps the most important feature of a fund -- and an area ripe with litigation risk for trustees -- is a fund’s investment policy.  Let’s discuss why that is the case.

            Investment policy, more formally recorded as an “Investment Policy Statement”, is the “blue print” for how the fund should be managed.  Thus, an Investment Policy Statement (“IPS”) should address, for example: the fund’s “mission”; the “policy asset mix”; the investment objectives; the investment risk tolerance that the fund is willing and able to bear; and the performance evaluation. 

First, any fund’s “mission” is to seek to have sufficient assets to pay all promised or expected benefits when due.  But that mission can be complicated, and it often involves recognizing and balancing the competing interests of all the stakeholders to the fund.  Consider the competing interests that are involved in a defined-benefit plan, an endowment or a foundation.  In each instance there are stakeholders with different interests: some are providing the benefits, others are making the contributions, and still others are receiving the benefits. 

Second, the “policy asset mix” is a long term strategic asset allocation plan, with provisions for selecting, monitoring and rebalancing those assets.  Trustees first need to understand the underlying risk and expected return characteristics of those asset classes.  They also must understand what the fund can and will accept in terms of volatility in performance.  Equally important, they must have a sense of the consequences to the fund should there be early losses (as opposed to early gains) in the fund.

Third, the investment objectives of the fund should meet certain criteria.  Apart from meeting the fund’s mission, they should be unambiguous, measurable, specified in advance and for a given period of time, and attainable.  In addition, investment objectives should be quantifiable, and should be expressed relative to a benchmark (such as a market index).  Finally, it is prudent to specify investment objectives as a range of desirable outcomes as opposed to a single number.

Fourth, risk tolerance.  This inquiry determines the risk that the fund not only is able but also is willing to bear.  Whereas fund performance is an after-the-fact concept, risk tolerance is a before-the-fact concept, and the management of risk is an ongoing process.  Benjamin Graham, the father of security analysis, once said, “The essence of investment management entails the management of risk, not the management of returns.”  Whereas a trustee cannot control a fund’s return, a trustee can -- and has a fiduciary duty to -- manage risk.  A fund’s primary risks are capital market risk (such as in the stock and bond markets), active management risk (in that active managers will take on risk different than a passive, market index) and liquidity risk (the inability to quickly convert investments to cash).  Standard deviation is a widely available and popular risk measure that can measure both capital market risk and active management risk, but not liquidity risk.  Witness the debacle in the auction rate securities market.  In all instances, prudent trustees will take advantage of diversification by seeking to select various assets and asset classes for which correlation (the degree to which their price / value moves in the same direction) is low or zero.

Fifth, performance evaluation.  This too is a necessary component of prudent investment management, but it is not as simple as determining if the fund made money or not.  The reason is that it is important not just to review the investment results; it is equally if not more important to review the results relative to the established investment objectives, and to determine the sources of that relative performance.  That exercise will reveal strengths and weaknesses in the fund’s portfolio, and it will provide evidence as to whether the fund is being managed properly.  There are two measures of rate of return that widely are used: time weighted rate of return and money weighted rate of return.  Whereas time weighted rate of return is not sensitive to money flows into and out of the fund, money weighted rate of return is sensitive to those money flows.  Both are helpful measurements that trustees should be implement in their performance evaluation process.

As one can see, there is quite a process involved in prudently managing the assets of a fund, and trustees need to be aware of and implement that process.  They owe, after all, the highest (fiduciary) duty to the fund that they serve!