The Handbook for
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The Handbook for
How to Make Prudent Investments
for Your Organization
RUSSELL L. OLSON
John Wiley & Sons, Inc.
Copyright Ā© 2005 by Russell L. Olson. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Olson, Russell L., 1933ā“
The handbook for investment committee members : how to make prudent
investments for your organization / Russell L. Olson.
p. cm.ā”(Wiley ļ¬nance series)
Includes bibliographical references and index.
ISBN 0-471-71978-1 (CLOTH)
1. Institutional investmentsā”Handbooks, manuals, etc. 2.
Investmentsā”Handbooks, manuals, etc. 3. Pension trustsā”Investments. 4.
Endowmentsā”Finance. I. Title. II. Series.
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
and my best friend
Organization of this Book xiv
The Investment Committee 1
Standards to Meet 1
Committee Organization and Functions 3
Interaction of Committee and Adviser 10
Social Investing 15
In Short 17
Example of an Investment Committeeā™s
Operating Policies 17
Risk, Return, and Correlation 21
Risk-Adjusted Returns 32
Derivativesā”A Boon or a Different Four-Letter Word? 34
In Short 38
Setting Investment Policies 39
Time Horizon, Risk, and Return 40
Policy Asset Allocation 42
Preparing a Statement of Investment Policies 47
In Short 52
Asset Allocation 53
Characteristics of an Asset Class 54
Asset Classes 58
Putting It All Together 70
In Short 79
Alternative Asset Classes 81
Liquid Alternative Assets 81
Illiquid Investments 91
Private Asset Classes 93
In Short 102
Selecting and Monitoring Investment Managers 103
Three Basic Approaches 103
Criteria for Hiring and Retaining Managers 107
Hiring Managers 111
Retaining Managers 118
In Short 122
The Custodian 123
Custodial Reporting 124
Management Information 125
In Short 126
Evaluating an Investment Fundā™s Organization 127
Investment Objectives 127
Asset Allocation 128
The Fiduciary Committee 128
The Adviser 129
Investment Managers 130
Structure of an Endowment Fund 131
The Total Return, or Imputed Income, Approach 131
āOwnersā of the Endowment Fund 134
In Short 136
The Total Return or Imputed Income Method 137
Whatā™s Different about Pension Funds? 139
Pension Plan Liabilities 140
Investment Implications 141
In Short 142
Once Again 143
About the Author 160
his book is a much easier readā”geared speciļ¬cally for committee mem-
T bersā”than my two prior books, Investing in Pension Funds and Endow-
ments: Tools and Guidelines for the New Independent Fiduciary, published
in 2003 by McGraw-Hill, and The Independent Fiduciary: Investing for
Pension Funds and Endowment Funds, published in 1999 by John Wiley &
Sons. Those books would be appropriate for a student or anyone who
serves as an adviser to an investment fund. This book, for committee mem-
bers, has been materially strengthened by input from several persons.
One is Joe Grills, former chief investment ofļ¬cer of the IBM retire-
ment funds and currently serving on various investment organizations,
such as the investment advisory committees of the state funds in New York
and Virginia, and the boards of directors of the Duke University Manage-
ment Company and selected Merrill Lynch mutual funds. Joe also is vice-
chairman of the Montpelier Foundation and serves on the investment
committees of two other endowment funds with assets between $120 and
Another is Katherine Noftz Nagel of Masterwork Consulting Services.
Kat has never served on an investment committee. Kat reviewed the manu-
script from the standpoint of someone appointed to an investment commit-
tee for the ļ¬rst time, and she provided helpful suggestions as to what would
make this handbook more helpful to someone who suddenly was asked to
be a ļ¬duciary.
Additional valuable input has come from Mike Manning, president of
New England Pension Consultants, and two persons who happen to be at-
torneysā”Jordan Sprechman, vice president and wealth advisor at J. P.
Morgan Private Bank, and Edward Siedle, president of the Center for In-
vestment Manager Investigations at Benchmark Financial Services, Inc.
Russell L. Olson
etā™s say I am a member of the investment committee of an endowment
L fundā”for a college, hospital, museum, local Boy or Girl Scouts council, or
my church or synagogueā”or a member of the investment committee of a pen-
sion fund or foundation. Whether theyā™ve told me or not, I am a āļ¬duciaryā
for that organization. As such, what is my job? What is expected of me?
Thatā™s what this book is about.
Our job as a ļ¬duciary is to act solely in the interests of our organiza-
tion and, according to one deļ¬nition, āto act with the care, skill, prudence,
and diligence under the circumstances then prevailing that a prudent man
acting in a like capacity and familiar with such matters would use in the
conduct of an enterprise of a like character and with like aims.ā1 That
What qualiļ¬cations are we expected to bring to this responsibility?
It is helpful if we are familiar with investmentsā”to the extent that we
participate in our employerā™s 401(k) plan, have an IRA account (Individual
Retirement Account), or have other investments in stocks or bonds. We
may even be a professional manager of common stock or bond invest-
ments, but that is certainly not necessary (and could, under some circum-
stances, be a drawback). Although investment sophistication helps, it is not
a requirement for a committee member.
Neither we nor our fellow committee members are expected to be ex-
perts. One of the ļ¬rst responsibilities of a committee is to ļ¬nd an expert to
rely on. If we have a very large fund, we may have a professional invest-
ment staff of sufļ¬cient competence on whom we can rely. If not, we should
ļ¬nd a broad-gauged investment consultant on whom we can rely. If our
fund is too small to afford a broadly knowledgeable consultant, we will
need to rely on a member of our committee who has this experience and
who would be competent and willing to serve in this capacity on a volun-
teer basis. Relying on an expert in whom we have conļ¬dence is a sine qua
From ERISA (The Employee Retirement Income Security Act of 1974).
non, because we must recognize that we and our fellow committee mem-
bers canā™t do it ourselves. And if we lose conļ¬dence in the expert we are re-
lying on, we must get another.
If not investment expertise, then what criteria should a committee
member meet? Here are some of the most important:
High moral character, ready to avoid even the perception of a conļ¬‚ict
Knowledge of how the fund relates to the ļ¬nancial situation of the
A healthy dose of common senseā”the ability to reason in a logical
manner, to apply abstract principles to speciļ¬c situations, and to relate
questions at hand to everything else we know.
A ļ¬‚exible mind, willing and able to consider, weigh, and apply new
concepts and ideas, and to challenge previously held concepts, includ-
ing oneā™s own.
A willingness to accept a level of risk high enough to gain the invest-
ment return advantage of a long time horizon.
A willingness to learnā”about the kinds of concepts discussed in this
book and about individual investment opportunities.
An ability and willingness to attend all meetings of the investment
committee and to do the homework before each meetingā”to be pre-
pared to discuss the subjects and proposals to be addressed at the
The purpose of this book is not to make anyone an investment ex-
pertā”thatā™s not necessary, or even realistic. The purpose is to help us un-
derstand information presented at committee meetings, to ask meaningful
and productive questions, to evaluate the responses we receive, and to vote
on recommendations knowledgeably.
ORGANIZATION OF THIS BOOK
We start in Chapter 1 with the functioning of our investment committee. In
Chapter 2 we provide a primer on risk, return, and correlationā”basic con-
cepts in investing. Chapter 3 discusses the statement of Investment Policies
that every investment committee should establish at the outset, and Chap-
ter 4 covers how to put together a portfolio of asset classes. Chapter 5
serves as a reference about alternative asset classes. Then Chapter 6 deals
with how to select and to monitor the investment managers or mutual
funds that actually invest our assets. The importance of a competent custo-
dian is covered in Chapter 7. Chapter 8 provides the kind of questions we
might ask in evaluating the investment organization of an endowment
fund, foundation, or pension fund.
Chapter 9 covers the structure of an endowment fund, the handling of
restricted money in the fund, and the importance of using the Imputed In-
come method to calculate annual payments to the fundā™s sponsor. And
Chapter 10 brieļ¬‚y summarizes whatā™s different about a pension fund.
Chapter 11 provides a brief summary of the book.
I have tried to make this book appropriate for both sophisticated in-
vestors and relative neophytes. One way I have done this is to place some
of the more advanced concepts in boxes or in footnotes. This should allow
someone with little investment background to comprehend the main infor-
mation without reading them, while the more experienced investor may
ļ¬nd interest there.
To make this book easier to read, I have taken four shortcuts you
should be aware of:
Shortcut 1. All of this book applies to endowment funds and founda-
tions as well as to pension funds. There are innumerable instances where I
have referred to our āendowment fund, foundation, or pension fund,ā but
instead of using those words, I have simply said our investment fund or
simply our fund. Whenever you see these words in italics you should inter-
pret their meaning as our āendowment fund, foundation, or pension
fund.ā The similarities in managing all three are overwhelming.
Shortcut 2. I have already stressed that one of the ļ¬rst responsibil-
ities of a committee is to ļ¬nd an expert to rely on. We must rely on a
professional investment staff, or else a consultant, or if the fund is too
small to afford either of these, then a member of our committee who is a
professional in the investment of endowment or pension funds. There
are innumerable instances in this book where I refer to our āstaff, con-
sultant, or other source of investment expertise.ā This phrase is entirely
too cumbersome, so I have substituted the term adviser, and the italics
denote that this term stands for our āstaff, consultant, or other source of
Shortcut 3. Unless our fund manages its investments in-house, which
in most case is inadvisable, it needs to hire investment managers or invest
in commingled funds such as mutual funds. There are innumerable in-
stances in this book where I refer to our āinvestment managers or commin-
gled funds such as mutual funds.ā This phrase also is entirely too
cumbersome, so I have substituted the term investment manager or simply
manager, and again the italics denote that this term stands for āinvestment
manager or commingled fund such as a mutual fund.ā
If the word āmanagerā is not in italics, then we are referring to the
particular person who manages a separate account or commingled fund.
Shortcut 4. Throughout this book, in referring to investment man-
agers, advisers, or committee members, I shall for convenienceā™s sake use
the masculine pronoun. In all such cases, the āheā is used in the classical
sense as a shorthand to designate āhe or she.ā In the current age, this may
open me to criticism, and Iā™m sorry if it does. Clearly, investing is every bit
as much a womanā™s world as a manā™s world.
The Investment Committee
ho is responsible for the investment of our investment fund? Ulti-
W mately, the board of directors of the fundā™s sponsor is responsible. But
it is not practical for boards of directors to make investment decisions for
the fund, so the board almost always appoints an investment committee to
take on this responsibility.
STANDARDS TO MEET
Members of the investment committee are ļ¬duciaries. What does this mean?
State laws differ in the precise way they deļ¬ne the term. Many funds look to
the federal law for private pension plansā”ERISA (the Employees Retire-
ment Income Security Act of 1974)ā”for guidance, even though the law does
not in any way apply to public pension plans or endowment funds. Key
standards of ERISA, as adapted for an endowment fund, would be:
1. All decisions should be made solely in the interest of the sponsoring
2. The investment portfolio should be broadly diversiļ¬edā”āby diversi-
fying the investments of the plan so as to minimize the risk of large losses,
unless under the circumstances it is clearly prudent not to do so.ā
3. āThe risk level of an investment does not alone make the investment