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per se prudent or per se imprudent. . . . An investment reasonably de-
signed”as part of the portfolio”to further the purposes of the plan, and
that is made upon appropriate consideration of the surrounding facts and
circumstances, should not be deemed to be imprudent merely because the in-
vestment, standing alone, would have . . . a relatively high degree of risk.”1

Preamble to Final DOL Reg § 2550.404a-1, reprinted in Preambles to Pension
and Bene¬t Regulations, 80,352 and 80,354 RIA (1992).


Speci¬cally, the prudence of any investment can be determined only by
its place in the portfolio. This was a revolutionary concept, as the old com-
mon law held that each individual investment should be prudent of and by
itself. There are a great many individual investments in investment funds
today”such as start-up venture capital”that might not be prudent of and
by themselves but, in combination with other portfolio investments, con-
tribute valuable strength to the overall investment program.
4. The standard of prudence is de¬ned as “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.” This is of-
ten referred to as the “prudent expert” rule and strikes me as an appropri-
ate standard. Everyone involved in decision making for the fund should be
held to this standard. This does not mean that committee members should
be experts. But they should be relying on experts.2
That said, I fear that the words “¬duciary” and “prudence” have all
too often been impediments to investment performance because of the
scary emotional overtones those terms arouse. Such emotions lead to a
mentality such as “It™s okay to lose money on IBM stock but don™t dare
lose money on some little known stock.” Neither should be more nor less
okay than the other.
Prudence should be based on the soundness of the logic and process sup-
porting the hiring and retention of an investment manager, and on an a priori
basis”not on the basis of Monday morning quarterbacking. According to
the Center for Fiduciary Studies, “Fiduciary liability is not determined by in-
vestment performance, but rather by whether prudent investment practices
were followed.”3

With respect to charitable trusts and charitable corporations, the Uniform Man-
agement of Institutional Funds Act issued in 1972 by the National Conference of
Commissioners on Uniform State Laws (NCCUSL) includes provisions that are
generally consistent with the above standards. For a discussion of that Act and the
states that have adopted it, see John Train and Thomas A. Melfe, Investing and
Managing Trusts Under the New Prudent Investor Rule (Boston: Harvard Business
School Press, 1999), pp. 128“131 and 173“182. With respect to personal trusts, see
discussion of standards (also generally consistent) promulgated by the American
Law Institute in 1992 and the NCCUSL in 1994, ibid., pp. 24“34.
Donald B. Trone, Mark A. Rickloff, J. Richard Lynch, and Andrews T. Rommeyer,
Prudent Investment Practices: A Handbook for Investment Fiduciaries (Center for
Fiduciary Studies, 2004), p. 8.
Committee Organization and Functions

Another aspect of my concern is that the terms “prudence” and “¬du-
ciary” all too often motivate decision makers to look at what other funds
are doing and strive to do likewise on the assumption that this must be the
way to go. An underlying theme of this book is that this is not necessarily
the way to go. As ¬duciaries, we should do our own independent thinking
and apply our own good sense of logic.
Everything comes down to facts and logic. Do we have all relevant
facts we can reasonably obtain? Are the facts accurate? What are the un-
derlying assumptions? We should ask questions, ad nauseam if necessary.
Does a proposal make sense to us? If not, challenge it. And we should
work hard to articulate our reasons.


Well, who should be on this all-important ¬duciary committee? A com-
mittee may consist of outside investment professionals, as is often the
case with some of the members of endowment committees of large uni-
versities, or the committee may be composed of a group of members of
the sponsoring organization (perhaps including certain members of the
board of directors), none of whom may have any special expertise in in-
vesting. All should meet the criteria listed on page xiv of the Introduction
to this book.
What does the ¬duciary committee do, and how should it function?
Initially, the committee may adopt a written Operating Policy that ad-
dresses such things as committee membership, meeting structure and atten-
dance, and committee communications. As part of this Operating Policy, it
should specify the adviser on whom the committee will rely, so selecting
the adviser is the committee™s ¬rst job. A sample Operating Policy is in-
cluded at the end of this chapter as Appendix 1.
Then the committee should adopt a written statement of Investment
Policies, such as those described in Chapter 3, including the fund™s Policy
Asset Allocation. These are clearly the committee™s most important func-
tions”ones that will have more impact on the fund™s future performance
than anything else the committee does. After that, the committee must de-
cide whom to hire and retain as investment managers. All of these matters
are a big responsibility, and the committee will need to rely heavily on its
adviser for help.

Selecting an Adviser
The Uniform Prudent Investor Act empowers ¬duciaries to “delegate in-
vestment and management functions that a prudent trustee of comparable
skills could properly delegate under the circumstances.” Jay Yoder, writing
for the Association of Governing Boards of Universities and Colleges, adds
that “because investing an endowment or any large pool of money is a
complex and specialized task requiring full-time professional attention, I
would argue that ¬duciaries may even be required to delegate responsibili-
Yoder argues forcefully for a strong investment of¬ce: “Endowments
of $150 million and larger can and should create an investment of¬ce
and hire a strong chief investment of¬cer. . . . Hiring a consultant is no
substitute for employing a strong investment of¬ce.” A ¬rst-rate internal
staff “can be expected to produce a stronger, more advanced investment
policy . . . much better implementation of that policy; early adoption of
new asset classes and strategies; greater due diligence and monitoring of
managers; and, most important, better, more timely decision making.”5
Many investment funds are too small to afford a ¬rst-rate internal staff
to recommend the asset classes in which they should invest and then select
the best investment managers in those asset classes. Those funds therefore
need to hire an outside consultant who understands the bene¬ts of diversi-
¬cation and who specializes in trying to ¬nd the best managers in each as-
set class.
Such a consultant could be our local bank. Some banks have devel-
oped expertise in mutual funds, but most would rather guide us into in-
vestment programs managed by their own trust departments, very few of
which rank among the better investment managers. And few banks have
cutting-edge competence in asset allocation.
Many brokers and insurance company representatives offer mutual
fund expertise. But can we expect totally unbiased advice from them when
they are motivated to gravitate to the range of investment managers that
compensate them? Many such consultants are paid through front-loaded
mutual funds”those that charge an extra 3% to 8% “load” (read “selling
commission”)”or those that charge an annual 0.25% through a so-called
12(b)(1) deduction from assets (read “another form of selling commis-

Jay A. Yoder, Endowment Management: A Practical Guide (Association of Gov-
erning Boards of Universities and Colleges, 2004), p. 13.
Ibid., pp. 54 and 46.
Committee Organization and Functions

sion”)”or those that charge a back load when we sell the mutual fund, or
get compensated in some other way.
A consultant™s advice is more likely to be unbiased if the ¬rm™s only
source of compensation is the fees that it charges its investor clients. Its di-
rect fees will be higher, of course. But we will know fully what the consul-
tant is costing us because none of its compensation will be coming through
the back door.
If such a consultant recommends mutual funds to us, he will typically
steer us toward no-load mutual funds that do not charge 12(b)(1) fees.
Many world-class mutual funds ¬t this category. On occasion, the con-
sultant might steer us toward a load fund or one with 12(b)(1) fees. If so,
the consultant™s only motivation should be that he believes future returns
of that mutual fund, net of all fees, will still be the best in its particular
asset class.
I suggest that an investment fund, in hiring a consultant, require the

1. The consultant should acknowledge in writing that it is a ¬duciary of
the pension plan (or the foundation or endowment fund).
2. The consultant should make a written representation annually that ei-
a. It receives no income, either directly or indirectly, from investment
management ¬rms, or
b. If it does receive such income, the names of all investment managers
from whom it has received such income during the prior 12
months, and in each case, the approximate amount of income and
the services provided.
3. The consultant af¬rms it is prepared to provide to the fund all the ser-
vices included in this book as expected from a fund™s adviser.

It is easier to draw up the criteria for selecting such a consultant than
to ¬nd and hire one. Some members of the committee may, in their regular
businesses, have contact with investment consultants for whom they have
high regard. But we shouldn™t necessarily stop there. We can look in con-
sulting directories, such as that provided by the A.S.A.P. Investment Con-
sulting Directory, whose web site lists 74 consultants and whose volume
titled Investment Consultant Directory lists 380 consultants.
How should we decide among alternative consultants? If we as com-
mittee members have ¬rst gained some perspective by reading a book such

as this one, we will be better prepared to send prospective consultants a
questionnaire, to place a consultant™s response and presentation in perspec-
tive, and to ask meaningful questions.
Our selection should be based on the consultant™s track record with
other institutional funds, and on the predictive value we feel we can at-
tribute to that track record when we evaluate all the subjective factors”in-
cluding breadth of diversi¬cation in his approach, and continuity of staff.

Role of Committee Members
Once the committee decides on its adviser, the committee must expect to
approve most of the adviser™s recommendations. And if the committee has
lost con¬dence in its adviser, it must make a change and get an adviser in
whom it can place its con¬dence.
Does that mean that once the committee has an adviser in whom it
has con¬dence, it should essentially turn all decisions over to him? No,
decisions on investment objectives are not readily delegated. They
should be developed in the context of the needs and ¬nancial circum-
stances of that particular plan sponsor. Authority to hire and ¬re invest-
ment managers may be delegated to an adviser who is registered with
the SEC as an “investment adviser,” but even then the committee has the
responsibility to monitor results. The committee™s written Operating
Policies should specify which actions the adviser is authorized to take
upon his own judgment, and which actions must ¬rst be approved by
the committee.
What, then, should we as committee members do? We should ensure
that the fund™s objectives are consistent with the ¬nancial condition of the
plan sponsor, and we should ensure that the fund™s investment policies are
consistent with the plan™s objectives. Then we should review each of the
adviser™s recommendations from the following standpoints:

First and foremost, is the recommendation consistent with the fund™s

objectives and policies? If not, should the committee consider modify-
ing its objectives and policies, or is the recommendation therefore in-
Is the recommendation consistent with the committee™s Policy Asset

Allocation? If not, should the committee consider modifying its Policy
Asset Allocation?
Is the recommendation internally consistent?
Committee Organization and Functions

Has the adviser researched all of the right questions relative to things

such as:
“ Character and integrity of the recommended investment manager,
“ Assessment of the predictive value of the manager™s track record,
“ Nature of the asset class itself,
“ Credentials of the manager™s key decision makers,
“ Depth of the manager™s staff,
“ The manager™s decision-making processes and internal controls.
What alternatives did the adviser consider?

Have adequate constraints and controls been established, especially

with respect to derivatives that a manager may be authorized to use?
Does the fee structure seem appropriate?

Is the recommendation consistent with all applicable law?

Does this sound like a heavy-duty demand on investment sophistica-
tion? Although investment sophistication helps, it™s not among the criteria
for committee members as I™ve listed them in the Introduction to this book.
Should a committee strive to include at least some investment profes-
sionals among its members? In many cases, investment professionals con-
tribute valuable experience to the committee. They can sometimes suggest
particular managers for the adviser to consider and perhaps open doors
that might otherwise be closed.
But investment professionals should be conscious of any con¬‚icts of
interest. And if their experience is focused on particular investment areas,
they may be less comfortable considering recommendations about other
investment areas. Do they understand their limitations? To be successful
committee members, they must become generalists, not specialists. Unless
they can make this transition, their investment experience can actually be
a drawback.
“What is the difference between competent and incompetent boards?”
write Ambachtsheer and Ezra in their book Pension Fund Excellence.6
“Competent boards have a preponderance of people of character who are
comfortable doing their organizational thinking in multiyear time frames.
These people understand ambiguity and uncertainty, and are still prepared

Keith P. Ambachtsheer and D. Don Ezra, Pension Fund Excellence (New York:
John Wiley & Sons, Inc., 1998), p. 90.

to go ahead and make the required judgments and decisions. They know
what they don™t know. They are prepared to hire a competent CEO7 and
delegate management and operational authority, and are prepared to sup-
port a compensation philosophy that ties reward to results.”
Committee procedures usually call for decisions to be decided by a
majority vote. In practice, it is best if most decisions are arrived at by con-
sensus. That doesn™t mean that everyone must agree that a decision is the
best possible, but everyone should ultimately agree that it is at least a
good decision.

Number of Committee Members
How many members should compose the investment committee? This is
not a committee that needs to be representative of the different constituen-
cies that may compose the sponsor. This committee has a technical pur-
pose, not an organizational policy purpose.
I favor a smaller committee of members who will take their responsi-
bility seriously and will attend meetings regularly. A committee of ¬ve
might be optimal for purposes of generating good discussion, giving each
member a feeling he is important to the committee, and”not inconsequen-
tially”the ease of assembling the committee for a meeting.
It is for the last reason that I am wary of including out-of-town mem-
bers on an investment committee. Out-of-town members can bring special
quali¬cations, but they must commit to attending regularly scheduled
meetings in person, if possible. They must also be ready to participate in
meetings called on relatively short notice to address a special investment
opportunity or an unexpected problem. Conference calls, in combination
with e-mails and overnight delivery of advance information, can facilitate
full participation in such special meetings. Conference calls, however,
should ideally be kept to half an hour.

Role of Adviser
The adviser and his people must be the source of expertise and the ones
who do the work. But they should always remember that the investment

The pension fund™s Chief Executive Of¬cer (or Chief Investment Of¬cer). For ex-
ample, the staff™s director of pension investments. For our purposes, we might sub-
stitute the term adviser.
Committee Organization and Functions

committee is the one deciding on the objectives and policies, making the
actual investment decisions, and shouldering the ¬nal responsibility. The
adviser cannot be moving in one direction and the committee in another.
This fact leads to what I believe is the number-one responsibility of the
adviser: to provide continuing education to the committee members. Few
committee members start out with a broad grasp of the issues that ¬ll the
pages of this book. It is up to the adviser to teach them. Such education”
including the setting of realistic expectations for return and volatility”
should be provided on a continuing basis. Each decision opportunity
should be related to the fund™s investment policies.
What can the adviser do routinely for committee education? The fol-
lowing may be helpful if done regularly, whether times are good or bad:

Demonstrate the need for a long-term orientation and the futility of

short-term thinking.
Illustrate how the various security indexes have compared with one

another at different times over the last 30 years.
Compare the price/earnings ratio, dividend yield, and earnings-per-

share growth rate of today™s stock market with their historic norms.
Show a matrix of future total returns of the stock market as a factor of

future P/Es and EPS growth rates.
Carry out Ef¬cient Frontier studies, using as many asset classes as pos-

sible and, if feasible, using Monte Carlo probability methods.
When analyzing a recommended or existing investment manager,

show how the manager performed relative to his benchmark (or
benchmarks) over a variety of different intervals, not just intervals to
the latest date.
If possible, arrange an occasional off-site conference and bring a range

of noted investment thinkers”not necessarily the fund™s investment
managers”to discuss in an informal and extemporaneous way the
fund™s current investment strategy and other questions related to in-
vestment philosophy.

Advisers at times have come upon a highly attractive but offbeat in-
vestment opportunity but have not considered recommending it to the
committee for fear they would be laughed out of the room. To the extent
this is true, it is a sorry re¬‚ection on the openmindedness of the commit-
tee, a re¬‚ection on the inadequate education given the committee by the
adviser, or both. Offbeat opportunities may require much greater due

diligence and more careful explanation to committees than more tradi-
tional opportunities. But offbeat opportunities, if they pass this test, can
add valuable diversi¬cation to a fund™s overall portfolio.

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