Before selecting a manager, we should ´¬ürst decide whether to use an index
fund or active management for that asset class.
Our adviser should recommend individual managers, but we committee
members should learn the criteria for hiring and retaining managers and be
prepared to question our adviser on the basis of those criteria.
We should know at least as much about our existing managers as about a
manager we are considering to hire, and every year we should ask our ad-
viser if each of our existing managers is still the best we can get for that
particular asset class.
If we have a broadly diversi´¬üed portfolio, as we should, we will have some
risky investments. If one of those risky investments should turn sour, what
protection do we have against charges of imprudence? We should do two
1. I canÔÇ™t overemphasize: Avoid even the perception of con´¬‚ict of interest.
2. Maintain good records about:
a. Why each investment decision was made, including a copy of the
full presentation made to the committee, and
b. The periodic review of our investment managers and why the re-
tention of each manager was appropriate.
Prudence is not a matter of what happened to an investment with 20/20
hindsight. ItÔÇ™s the process and rationale that went into the decision and the
subsequent monitoring. Because the prudence of an investment is not to be
determined in isolation but in the context of the overall portfolio, I believe
good recordkeeping can provide a committeeÔÇ™s strongest defense. I suspect
many committees, however, are not as careful about this as they should be.
We have talked continually about the importance of having an adviser.
But what should cause us to lose con´¬üdence in our adviser? There are two
basic things an adviser should do for us:
1. Help us develop our Investment Policy and our Policy Asset Allocation
(including our Benchmark Portfolio).
2. Recommend whom to hire as investment managers and when to termi-
nate a manager.
The second function is easiest to quantify. If over a period of three to
´¬üve years our actual returns have not equaled or exceeded our Benchmark
Portfolio, that would be evidence that the adviserÔÇ™s recommendations of
managers have not been particularly good.
The ´¬ürst function is harder to quantify except in the long term. If our
adviser has led us to a widely diversi´¬üed portfolio, our Benchmark Portfo-
lio might underperform more conventional portfolios during intervals
when conventional asset classes such as large U.S. stocks and investment
grade bonds have outperformed most other asset classes. This, however,
would probably not be a time to switch advisers.
On the other hand, if we have not approved most of our adviserÔÇ™s rec-
ommendations, how can we hold our adviser accountable? Perhaps it is
our own committeeÔÇ™s approach that we should be modifying.
Finally, a number one function of any adviser, in my opinion, is to give
us continuing investment education. If the adviser is not doing that, or if
we cannot achieve a rapport with our adviser, perhaps it is time to consider
Italicized words, as used in this book:
adviser Investment staff, consultant, or other source of investment expertise
to an investment committee.
fund Investment fund.
investment fund Our endowment fund, foundation, or pension fund.
investment manager Investment manager or commingled fund such as a
manager Investment manager.
12(b)(1) fees Fees charged by a mutual fund to cover advertising and promotional
401(k) plan A de´¬üned-contribution pension plan offered by many corporations.
aggregate volatility The volatility of a total portfolio, as opposed to the volatility
of individual securities, individual managers, or individual asset classes.
alpha Technically, the risk-adjusted return on a security or a portfolio in excess of
its benchmark. In common parlance, the simple difference between a portfo-
lioÔÇ™s return and that of its benchmark.
alternative asset classes Asset classes other than traditional asset classes such as
stocks and bonds.
arbitrage programs Programs that are both long and short, such as long security A
and short security B, so that results depend entirely on the difference in return
between securities A and B.
asset class A category of assets, such as large U.S. stocks, or high-yield bonds, or
asset/liability studies Studies based on (a) assumptions about the future perfor-
mance of speci´¬üc asset classes and (b) projected liabilities of a pension fund, to
determine an optimal asset allocation.
back-loaded mutual funds Mutual funds that charge a fee when an investor sells
the mutual fund.
bell curve A normal frequency curve, a distribution curve that is symmetrical on
both sides of the median.
benchmark A basis of comparison for the investment return of an investment
manager or for an overall portfolio.
benchmark portfolio A portfolio of asset classes (with a benchmark, usually an
index, identi´¬üed for each asset class) whose theoretical return serves as the
benchmark for an investment fund.
benchmark risk The risk that an investment manager or a fund may deviate mate-
rially from its benchmark.
beta A measure of the volatility or a stock or a portfolio relative to a benchmark
index (such as the S&P 500). A beta of more than 1 means more volatile than
an index, a beta of less than 1 means less volatile.
board-designated endowment Money designated by an organizationÔÇ™s board of
directors (rather than the donor) to be treated as endowment.
book value The price that was paid for an investment.
buy-in funds Private investment funds that invest directly in private shares of an
buy-out funds Private investment funds that purchase all outstanding shares of a
capitalization of a stock The number of a companyÔÇ™s shares outstanding (or avail-
able for trading) times the price of its stock.
capitalization-weighted index A securities index that weights each security in di-
rect proportion to its capitalization.
CEO (chief executive of´¬ücer) of a fund The chief of´¬ücer heading the staff of an in-
certi´¬ücate of deposit A deposit with a bank of a speci´¬üc amount of money for a
speci´¬üc time at a speci´¬üc rate of interest.
commingled fund A fund in which two or more clients invest. Mutual funds,
group trusts, and most limited partnerships are common examples.
commodity future For example, a contract to buy an amount of corn by a speci´¬üc
date at a speci´¬üc price. There are 22 or more listed commodity futures, includ-
ing grains, foreign exchange, and petroleum products.
convertible arbitrage A program that buys convertible securities and sells short
the stocks into which those securities are convertible.
correlation A statistical term measuring the amount of similarity between the
volatilities of any two indexes, individual securities, or investment portfolios.
custodian The organization that holds and reports on the assets of an investment
de´¬üned-bene´¬üt pension plan A pension plan where the bene´¬üt is not impacted by
whether investment returns are good or bad.
de´¬üned-contribution pension plan A pension plan, such as a 401(k) plan, where
the employee bears the entire risk or opportunity of investment results.
derivative A security such as a convertible bond or futures contract whose market
value is derived all or partly from a different security. Examples of derivatives
are listed on pages 28ÔÇ“29.
distressed securities Securities of a company that is in or heading toward bank-
diversi´¬ücation Assembling a portfolio of securities that ´¬‚uctuate in value differ-
ently from one another.
diversi´¬üable risk Volatility that can be eliminated through diversi´¬ücation.
diversi´¬ücation bene´¬üt The reduction in volatility or increase in return that can be
gained through the diversi´¬ücation of a portfolio.
dividend yield A stockÔÇ™s dividend as a percent of its market value.
dollar-weighted return Internal rate of return, the average percent return on every
dollar that was invested over an interval of time.
donor-designated endowment Money designated by its donor to be treated as en-
duration Duration is a measure of the average amount of time until we re-
ceive our returns on an investment, including both interest and principal
ef´¬ücient frontier Given assumptions for the return, volatility, and correlation of
each asset class, the Ef´¬ücient Frontier is a graph showing the highest return
that can be achieved at every level of portfolio volatility.
emerging markets Stock and bond markets of the less developed countries of the
EPS (earnings per share) The net earnings of a company divided by the number of
its outstanding shares.
ERISA (the Employee Retirement Income Security Act) The U.S. law that governs
all private pension plans in the country.
´¬üduciary A person in a special position of trust and responsibility for an invest-
´¬üxed income Bonds and cash equivalents, whose principal and interest payments
foreign exchange risk The risk of losing money because of the reduced value of
forward (forward contract) An agreement to buy (or sell) a security at some fu-
ture date at a price agreed upon today.
front-loaded mutual fund A mutual fund that deducts a sales charge from a pur-
chase of that fund.
funding ratio The ratio of (a) the market value of a pension fund to (b) the pre-
sent value of the liabilities of that pension fund.
future (future contract) An agreement to pay or receive, until some future date,
the change in price of a particular security or an index.
FX (foreign exchange) Foreign currencies.
GDP/GNP Gross Domestic Product and Gross National Product are two mea-
sures of the size of a nationÔÇ™s economy.
growth stocks Stocks with higher growth rates in earnings per share.
hedge An investment that reduces the risk of another investment.
hedge funds A term designating a broad range of funds that make both long and
short investments, sometimes using a variety of derivatives.
high-grade bonds Bonds with high quality ratings.
high-yield bonds Bonds with lower quality ratings, once known as ÔÇťjunk bonds.ÔÇŁ
illiquid assets Assets that cannot be readily sold or otherwise converted to cash,
usually for at least a year and perhaps for many years.
Imputed Income method A method for determining the amount of income to be
paid annually by an endowment fund to its sponsor. Also called the Total Re-
index (a securities index) A measure of the investment return on an asset class.
index funds An investment fund that is designed to replicate as closely as possible
the return on a particular index; for example, an S&P 500 index fund.
in´¬‚ation-linked bonds Bonds whose interest rate is stated in real termsÔÇ”in per-
centage points exceeding the in´¬‚ation rate.
in-house management Management of all or a portion of a fundÔÇ™s investments by
its internal staff.
interest rate arbitrage Buying a ´¬üxed income security and selling short a different
´¬üxed income security.
internal rate of return (IRR) The average percent return on every dollar that was
invested over an interval of time; a dollar-weighted rate of return.
investment-grade bonds Bonds with high quality ratings, usually BBB and above.
Investment Policies An organizationÔÇ™s written policies relative to the investment of
IRA (Individual Retirement Account) An individualÔÇ™s personal taxfree investment
LBO (leveraged buyout) The purchase of an entire company through the signi´¬ü-
cant use of borrowed money.
leverage Investing with the use of borrowed money or credit.
liabilities of a pension fund The value of promises made to the participants in a
pension plan, usually the present value of those promises.
LIBOR The London interbank offered rate, generally used as the interest rate as-
sumed implicitly in the pricing of futures.
liquid assets Assets that can be sold or otherwise can be converted to cash in less
than a year.
long/short investments Investments that are both long and short, such as buying
security A (long) and borrowing and selling security B (short), so that results
depend entirely on the difference in return between securities A and B.
market-neutral investments Investments whose volatility has a very low correla-
tion with the volatility of the stock and bond markets.
market value The price at which an investment could be sold at any given time.
maverick risk The perceived risk in making investments that are different from
those of oneÔÇ™s peers.
median The midpoint of a distribution, with half above and half below.
merger & acquisition (M&A) arbitrage The purchase of stock in a company that
is expected to be acquired and the short sale of stock in the acquiring company.
micro stocks The smallest stocks, such as (in the U.S.) stocks smaller than those
included in the Russell 2000 index.
mid-cap stocks Mid-size stocks, such as (in the U.S.) stocks larger than those in-
cluded in the Russell 2000 index, but excluding the largest stocks.
money market mutual funds Mutual funds that invest in ´¬üxed income securities
shorter than one year in maturity, funds whose price is not expected to ´¬‚uctuate.
Monte Carlo probability methods Random number generators whose output is
intended to ´¬üt a normal probability curve.
net returns Investment returns that are net of all fees and expenses.
no-load mutual funds Mutual funds that do not make a sales charge when the in-
vestor buys or sells its shares.
opportunity cost The return that a fund could have made if it had made an invest-
ment that it didnÔÇ™t make.
Operating Policies An organizationÔÇ™s written policies relative to the operation of
its investment committee.
options The right, but not the obligation, to buy a security from (or sell a security
to) a particular party at a given price by a given date.
PBGC (Pension Bene´¬üt Guarantee Corporation) A U.S. government agency that
insures the payment of pension bene´¬üts up to a certain bene´¬üt level in the event
that a private pension plan is terminated and canÔÇ™t come up with the money to
meet its promises.
Policy Asset Allocation The target asset allocation that an organization has estab-
lished in its Investment Policies.
portable alpha Investing in an index fund through index futures , and then investing
the cash that isnÔÇ™t used for collateral in a market-neutral investment program.
portfolio All of the securities held by an investment fund.
predictive value The extent a managerÔÇ™s past performance may provide some indi-
cation of that managerÔÇ™s future performance. See pages 107ÔÇ“110.
price/earnings ratio The ratio of a stockÔÇ™s price to its earnings per share.
private investments Investments that are not sold publicly.
proxy The voting on issues to be decided at a stockholderÔÇ™s meeting.
quantitative managers Managers who develop and rely on mathematical algorithms
to determine the transactions to be made in managing an investment portfolio.
quartile One-quarter of a distribution, for example the top 25% or the bottom
real return Investment return in excess of in´¬‚ation.
realized capital gain The change in price of an investment from the time it was
purchased to the time it was sold.
rebalancing Transactions that bring a portfolioÔÇ™s asset allocation closer to the in-
vestment fundÔÇ™s Policy Asset Allocation.
reinvested dividends Dividends paid by a stock that are used to buy more shares
of that stock. For example, a total return index assumes that all dividends are
REITs (real estate investment trusts) Common stocks of companies that invest in
real estate, but whichÔÇ”instead of paying corporate income taxÔÇ”pass their in-
come tax liability on to their shareholders.
restricted endowment Endowment money that the donor restricted for a special
risk The probability of losing money, or that the value of our investment will go
down. For a portfolio of investments, risk is often de´¬üned as volatility, which
over long intervals tends to encompass most individual risks.
risk-adjusted return Return-on-investment adjusted for its volatility over time,
with a volatile investment requiring a higher return and vice versa.
securities Evidence of ownership or debt, such as stocks or bonds.
separate accounts A portfolio that is held for only one investor. (Insurance com-
panies, however, use ÔÇťseparate accountsÔÇŁ to denote a portfolio held for one or
more investors that is valued for those investors at market value.)
Sharpe Ratio A measure of risk-adjusted return: speci´¬ücally, an investmentÔÇ™s rate of
return in excess of the T-bill rate, divided by the investmentÔÇ™s standard deviation.
short selling Borrowing a security and then selling it.
short-term investment fund (STIF) A money market fund provided by a bank for
investment clients for whom the bank serves as custodian.
small stocks Stocks with relatively low capitalization, sometimes measured by the
Russell 2000 index.
social investing Overlaying a fundÔÇ™s investment objectives with a set of social
goals that constrain the fund from investing in certain kinds of companies or
that encourage it to invest in certain other kinds of companies.
standard deviation A measure of volatility of the return on a security or a
structured note A private ´¬ünancial agreement between two parties relating to the
style The manner in which a manager invests, such as in small, medium, or large
stocks, or in growth stocks or value stocks.
swap An agreement between two parties to pay or receive, until some future time,
the difference in return between one partyÔÇ™s portfolio (or an index) and the
counterpartyÔÇ™s portfolio (or an index).
systematic risk The portion of a securityÔÇ™s volatility that is highly correlated with
all or a portion of the market; for example, the portion of a stockÔÇ™s volatility
that is highly correlated with the overall stock market or with other stocks in
its own industry.
tactical asset allocation A strategy of moving investments between different asset
classes (such as between stocks and bonds), depending on which seems more at-
tractive at the time. Such strategies are typically driven by quantitative models.
Target Asset Allocation See Policy Asset Allocation.
time diversi´¬ücation Purchasing investments in an asset class in multiple different
time horizon The time between when one makes an investment and when one will
need to use the money for other purposes.
time-weighted return The compound annual growth rate of a dollar that was in a
portfolio from the beginning of an interval to the end of that interval. The
portfolioÔÇ™s performance in each unit of time is given equal weight.
TIPS (Treasury In´¬‚ation-Protected Securities) In´¬‚ation-linked bonds issued by the
total return The investment return on a security or a portfolio that includes in-
come (such as dividends and interest) and capital gains (whether realized or
not), net of all fees and expenses.
total return index A securities index that assumes that all dividends are reinvested
in the issuing companyÔÇ™s stock.
Total Return method See Imputed Income method.
track record The historical investment performance of a manager.
transaction costs The total costs involved in buying or selling a security, including
both brokerage commissions and market impact costs.
Treasury bill (T-bill) A short-term loan to the U.S. government.
TSE 300 The leading index of Canadian stocks.
unrealized capital gain The change in price of an investment from the time it was
purchased to its present market value.
value stocks Stocks with lower price-to-book-value ratios.
venture capital Private corporate investments, especially in start-up companies.
volatility Fluctuation in the market value of a security or a portfolio.
wealth The total market value of a portfolio at any given time.
withdrawal from a fund The cash payment by an investment fund to its sponsor
or to its plan participants.
Wilshire 500 index A capitalization-weighted index of virtually all stocks traded
in the U.S., including foreign stocks listed on U.S. exchanges.
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