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place the assets in the account under the direction of a new manager.
If we have a manager of foreign exchange (FX) who is authorized to
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hedge all foreign currency exposure that is not otherwise hedged, our
trustee can provide our FX manager a daily list of the total unhedged
dollar exposure of our composite account to each foreign currency.
We can have all of our assets made available to a single securities-lending
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agent”the most convenient agent often being the master custodian itself.

Each of these management information services comes, of course, with
a price tag. Our adviser can help us select a custodian and also which man-
agement information services would seem worth subscribing to.


IN SHORT

Every investment fund should have a custodian, usually a bank.
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The custodian safeguards the assets and provides transaction reports
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and asset listings showing book values and market values.
The custodian can also be a valuable source of management informa-
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tion, such as performance measurement and portfolio composition.
8
CHAPTER

Evaluating an
Investment Fund™s Organization


f I were asked to evaluate the organization of an investment fund, how
I would I go about it?
I™d be interested in prior performance, of course, but that is only pro-
logue. Past performance, either absolute or relative to peers, is not by itself
a valid criterion. Good past performance might be the fortuitous result of a
poorly designed investment program, and poor past performance might be
the random result of a well-designed investment program.
The only thing that counts is the future. Hence, our evaluation should
be future oriented. We will want all the quantitative measures that are rele-
vant. But ultimately, an evaluation comes down to asking the right ques-
tions and concluding with qualitative judgments. What are some of the
right questions? My suggestions follow.



INVESTMENT OBJECTIVES

Does the fund have a written statement of Investment Policies? Are
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they well thought out?
Do all key decision makers buy into these policies, and do they under-
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stand their rami¬cations?
Do the Investment Policies de¬ne an overall risk constraint? Why and
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how was the measure of risk chosen?
Is the risk constraint appropriate for the fund sponsor™s ¬nancial
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situation?
Is the investment return objective de¬ned as the highest return that can
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be achieved within that risk constraint?



127
128 EVALUATING AN INVESTMENT FUND™S ORGANIZATION


How long have these objectives been in effect?
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Net of all costs, how well have these objectives been met?
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ASSET ALLOCATION

What is the Policy Asset Allocation?
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What was the rationale underlying this asset allocation?
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How close is the Policy Asset Allocation to an Ef¬cient Frontier?
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Were adequate sensitivity tests on risk, return, and correlation assump-
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tions carried out in Ef¬cient Frontier studies?
How many diverse asset classes were included in the Ef¬cient Frontier
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study?
How many asset classes is the adviser prepared competently to recom-
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mend and manage?
How close has the fund™s actual allocation been to its Policy Allocation?
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Does the plan diverge from its Policy Asset Allocation tactically? If so,
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who decides? With what results?
How does the fund go about rebalancing?
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THE FIDUCIARY COMMITTEE

Does the fund have a written statement of Operating Policies?
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Who are the members of the fund™s ¬duciary committee? What are the
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criteria for membership, and why?
How much experience do the members have in institutional portfo-
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lio investing, and how much time each year do they devote to this
function?
Is the ¬duciary committee suf¬ciently oriented to the long-term, or is it
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overly concerned with short-term performance?
What decisions does the committee reserve for itself, and what deci-
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sions does it delegate to its adviser? Why?
How much con¬dence does the committee have in its adviser?
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129
The Adviser


What constraints does the committee place on its adviser”either
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through limits on its openness to new ideas or the frequency of its
meetings?
How does the committee judge the effectiveness of its adviser?
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THE ADVISER

How experienced is the adviser? What is its size, its continuity, and its
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commitment to excellence?
How does it go about retaining good people?
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How able is it to advise on asset allocation? What are its processes
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for this?
How able is it to evaluate alternative investments such as those de-
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scribed in Chapter 5?
How well-researched and supported are its recommendations (or
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actions)?
How well does it communicate with the investment committee?
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How well does it do in the continuous education of committee members?
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How does the adviser monitor each of the fund™s managers and main-
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tain an up-to-date understanding of all the factors that impact the pre-
dictive value of that manager™s past performance?
What triggers a recommendation to terminate a manager?
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What is the rationale for retaining each of the fund™s current
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managers?
How does the adviser go about ¬nding out whether there are better
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managers available that it might be using?
How solid are the adviser™s administrative support services?
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What steps has it taken to mitigate manager risks? What are its au-
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dit procedures? How does it control managers™ use of derivatives?
How much possibility is there for a manager to penetrate the fund™s
deep pockets?
In each asset class, was an index fund considered? Why or why not
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was an index fund chosen?
What do the adviser™s other clients say about their experience with the
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adviser? What has been the adviser™s client turnover?
130 EVALUATING AN INVESTMENT FUND™S ORGANIZATION


INVESTMENT MANAGERS

In each asset class, net of all costs, how have the fund™s active man-
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agers”including terminated managers”performed relative to an in-
dex fund alternative? How have they performed relative to other
active managers?
Has the fund stayed within its overall risk constraint?
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If the fund™s historic risk has been materially below its overall risk con-
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straint, could performance have been improved by taking more risk,
closer to the fund™s overall risk constraint?
9
CHAPTER

Structure of an Endowment Fund


hat is the purpose of an endowment fund or foundation? Its purpose
W is to throw off a perpetual stream of income to support the operations
of the sponsoring organization. All endowment policies should ¬‚ow from
that purpose.
Key criteria for endowments:

For planning and budgeting purposes, the stream of income should be
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reasonably predictable.
For the health of the organization, the magnitude of that stream of in-
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come should, over the long term, maintain its buying power. “While
¬duciary principles generally specify only that the institution preserve
the nominal value of a gift, to provide true permanent support, institu-
tions must maintain the in¬‚ation-adjusted value of a gift,” writes
David Swensen of the Yale endowment fund.1




THE TOTAL RETURN, OR IMPUTED INCOME, APPROACH

If your organization is already using the Imputed Income approach to
determine the amount of money to transfer each year from the your en-
dowment fund to your sponsor™s operating account, you may care to skip
this section.
The traditional approach to income recognition by endowment funds is



1
David F. Swensen, Pioneering Portfolio Managment (The Free Press, 2000), p. 27.



131
132 STRUCTURE OF AN ENDOWMENT FUND


materially ¬‚awed. It de¬nes income by the accounting de¬nition of divi-
dends, interest, rent, and sometimes net realized capital gains as well. If an
investment approach is kept reasonably intact, the year-to-year stream of
dividends, interest, and rent is quite predictable. But the impact on income
is a key consideration if anyone suggests a major change in the endow-
ment™s investment approach. Moreover, if realized capital gains are in-
cluded in the de¬nition of income, that creates a wild card.
The trouble with income de¬ned as just dividends, interest, and rent
is that it impacts investment policy both seriously and detrimentally. To
provide a reasonable amount of income, the sponsor is motivated to in-
vest a major proportion of the endowment in bonds and stocks that pay
high interest or dividends. And if income is running short of what is
needed, the sponsor can adjust the investment portfolio to increase the
dividends and interest.
Such an approach dooms the second criterion, of maintaining the en-
dowment™s buying power over the long term. That™s because the market
value of bonds, for example, does nothing to maintain buying power (un-
less one considers relatively new in¬‚ation-linked bonds). There is no con-
cept of real return”investment return in excess of in¬‚ation.
Because the de¬nition of income has such a great impact on investment
policies, the de¬nition of income must be revised before we can consider
investment policy.
Fortunately, a concept has been developed that does a pretty good job
of meeting both of the above criteria, and it is widely used today. It is
known as the “Total Return” or “Imputed Income” approach.
The Total Return Approach begins with the concept that we should
recognize as income only an amount that might, long-term, be considered
real income”income in excess of in¬‚ation. So the ¬rst question is: How
much real return can we realistically aspire to earn on our endowment
fund over the long term?
That depends on how we invest the endowment fund. It™s obvious,
then, that the way to maximize the endowment™s real return over the long
term is to maximize its total return”the sum of accounting income plus
capital gains, both realized and unrealized. We go right back to Chapters 3
and 4, “Investment Objectives” and “Asset Allocation,” as they are the
starting point.
Let™s say we decide on an asset mix of 80% common stocks, 20% ¬xed
income, or 75/25, and after consulting historical returns of those asset
classes, we conclude that we can prudently expect a real return over the
133
The Total Return, or Imputed Income, Approach


long term of 5% per year. That says we can recognize 5% of market value
as “Imputed Income” each year.
But with this asset allocation the market value will ¬‚uctuate widely
from year to year, and if Imputed Income equals 5% of that ¬‚uctuating
value, then the ¬‚uctuations in annual income may be greater than our
sponsor can live with. Therefore, let™s de¬ne Imputed Income as 5% of a
moving average of market values. While there are many variations, we
have found that a sound de¬nition of Imputed Income is: X% of the aver-
age market value of the endowment fund over the last ¬ve year-ends (ad-
justed for new contributions and adjusted for withdrawals in excess of
Imputed Income, if any).
Appendix 9 at the end of this chapter describes how the Imputed In-
come method works. This approach includes the following advantages:

The sponsor gains a fairly predictable level of annual income, not sub-
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ject to large percentage changes from year to year.
The sponsor learns early in the year the amount of income it will with-
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draw from the endowment fund. This is a big help in budgeting.
Investment policy cannot be manipulated. The only way our sponsor
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can increase Imputed Income is by investing more successfully”by
achieving a higher rate of total return, long term.

What is the downside of the Total Return Approach? There may be in-
tervals when the fund™s market value declines for several years in a row,
and the dollar amount of Imputed Income may actually decline. There is
no way to avoid this possibility, since all markets are volatile. But markets,
over a great many years, have eventually bounced back each time. As they
do, the fund, under the Total Return Approach, should regain the buying
power that it lost”provided the rate of Imputed Income was established
responsibly in the ¬rst place.
Once the sponsor knows the amount of Imputed Income for the cur-
rent year, it can decide when during the year it will withdraw the money. A
withdrawal usually requires a sale of stocks or bonds (or mutual funds),
since cash should not generally be allowed to accumulate. Dividends and
interest should be reinvested promptly.
Warning: Members of the fund sponsor may agitate to raise the Im-
puted Income percentage, and clamor hardest at the wrong time. For ex-
ample, during the 20-year intervals ending in the late 1990s, investment
returns far exceeded the 5% real return assumption that formed the
134 STRUCTURE OF AN ENDOWMENT FUND


philosophical basis for the Imputed Income formula of many endow-
ment funds. At that time, members of certain fund sponsors agitated
successfully to raise the Imputed Income percentage to 51/2% or 6%”
just before the market plunged in 2000“2002. It is easy to forget that a
market debacle like that has occurred before and will occur sometime
again. The higher the market goes, the higher the probability that it will
occur. My advice, therefore is: Don™t make a change. If we have estab-
lished our Imputed Income formula soundly in the ¬rst place, let™s not
tinker with it.
David Swensen of the Yale endowment fund has articulated the danger
well: “Increases in spending soon become part of an institution™s perma-
nent expense base, reducing operational ¬‚exibility. If the rate of spending
rises in a boom, an institution facing a bust loses the bene¬t of a cushion
and gains the burden of a greater budgetary base.”2


“OWNERS” OF THE ENDOWMENT FUND

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