FIDUCIARY RESPONSIBILITIES OF INVESTMENT COMMITTEES

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1 FOCUS TOPIC B R I E F FIDUCIARY RESPONSIBILITIES OF INVESTMENT COMMITTEES C H R I S T O P H E R M. M E Y E R, C FA / Managing Principal / Chief Investment Officer To avoid implementation shortfall and remove the barriers to excellence, we believe that all fiduciary roles must be clearly defined. Investment committees face more and increasingly complex challenges today than they did even a decade or two ago. Twenty years ago, for example, many of our clients employed only a handful of managers in their portfolios. On average, our clients would have exposure to U.S. large cap equity, U.S. small cap equity, international equity, and fixed income. They may have had one or two managers for each mandate, but most would employ fewer than ten managers. Typically, our clients would conduct searches to hire the managers, interviewing the candidates before selecting the most appropriate manager for each particular mandate. Once the manager was hired, investment committees often would perform their own additional due diligence by meeting with the managers once every year or two. Over time we recommended further diversification, which increased the complexity of our clients portfolios. For instance, we recommended exposure to mid cap, emerging markets, international small cap, real estate investment trusts, high yield, and inflation protected bonds. Furthermore, we recommended hedge fund strategies and private capital strategies, such as venture capital, buyouts, distressed debt, timber, energy partnerships, and private real estate. This further diversification meant an increase in the number of managers, as demonstrated in the 2013 NACUBO-Commonfund Study of Endowments (NCSE), where the average number of investment managers per participating institution reached over 26. This increase in the number of managers is consistent with other types of institutions (e.g., community foundations, pension plans, etc.), as well as our experience with institutional investors. APPROVED FOR CLIENT USE. PAG E 1 O r i g i n a l l y p u b l i s h e d S e p t e m b e r 2 014

2 The increased complexity of institutional portfolios over the last two decades has definitely changed how committees approach their roles. With this changing dynamic, we summarize in this focus topic the challenges confronting committees, review oversight structures, and discuss the rationale for outsourcing portfolio implementation. Challenges Confronting Investment Committees BARRIERS TO EXCELLENCE In their book Pension Fund Excellence, Keith Ambachtsheer and Don Ezra identified barriers to excellence for pension funds. In a survey of 50 senior pension executives, 98% cited poor process (decision structure, communication, and inertia) as a major hurdle to achieving investment goals. Other factors cited were inadequate resources (cited by 48%), lack of focus on mission (43%), conservatism (35%), and insufficient skills (35%). Although focused on pension funds, its findings apply to other institutional investors. Many pension plan committees are staffed by employees who spend only a few days a year on investments, as they have other full-time responsibilities. This is not unlike endowment/ foundation committee members, who are volunteers, typically meeting four times a year. B A R R I E R S T O E XC E L L E N C E Barriers to Excellence 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 98% Poor Process 48% Inadequate Resources 43% Lack of focus on Mission 35% 35% Conservatism Source: Pension Fund Excellence, Keith P. Ambachtsheer and D. Don Ezra Data source: Pension Fund Excellence, Keith P. Ambachtsheer and D. Don Ezra Insufficient Skills COMMIT TEE PROCESS In our experience, the typical committee is comprised of 7-15 individuals with varying degrees of investment knowledge, who meet quarterly, seek consensus, and base their decisions on comfort. By meeting quarterly, committees may miss opportunities to act on investment opportunities, or on the other hand, believe they must act when action is not warranted. Because the committee members either work together (pension plans) or are volunteers (endowments and foundations), they are usually collegial and avoid confrontations. Rarely have we seen decisions reached on a contentious 5-4 vote. In fact, we rarely see 8-1 votes either, as a general consensus is usually reached before acting. With varying degrees of investment knowledge, a large group, and a desire to become comfortable with an investment strategy before proceeding, investment committees rarely are contrarian or invest in strategies before others. PAG E 2

3 By investing with the herd, committees seek to limit reputation risk. In order to achieve superior returns, however, an investment committee must be willing to invest differently than their peers. Once an investment strategy has become mainstream, the exceptional returns have been realized. In many cases the major hurdle to achieving superior performance is the committee process, which leads to implementation shortfall. Implementation shortfall includes delays in decisions due to lack of information, insufficient knowledge, failure to reach a consensus, inability to schedule a meeting, and lack of accountability (no one is solely accountable for performance). Additionally, with the proliferation of managers and new investment strategies, investment committees have been unable to spend as much time interviewing and performing ongoing due diligence on the managers. Thus, committees have had to rely more on staff, consultants, or fund of funds managers to perform this due diligence. Furthermore, some committee members are not as knowledgeable about a number of the non-traditional investment strategies, leading to less robust discussions about these strategies. Recognizing their limitations, boards and investment committees have focused more of their attention on governance, their fiduciary responsibilities, and the appropriate structure for their particular institutions. Oversight Structures LEVELS OF FIDUCIARY RESPONSIBILIT Y In their book Pension Fund Excellence, Keith Ambachtsheer and Don Ezra describe three levels of fiduciary responsibility: 1. Governing mission and objectives 2. Managing portfolio implementation 3. Operating administration and execution Understanding these responsibilities helps to define the roles of each fiduciary and ensure an effective governance structure. 3-TIER CAPTIVE For many larger institutions (assets over $1 billion), the board or investment committee serves as the governing fiduciary. They establish the mission and objectives, define the liquidity and risk tolerances for the plan/fund, and set the asset allocation and investment policies. The managing fiduciary is the chief investment officer (and staff), who determines the asset allocation within the policies established by the governing fiduciaries, selects the investment managers, and provides day-to-day supervision of the assets. The operating fiduciaries include the investment managers, who select securities and manage the portfolios, the custodians, who hold the assets and collect dividends and interest payments, as well as actuaries, administrators, and other vendors. PAG E 3

4 O V E R S I G H T S T R U C T U R E S 3-TIER CAPTIVE 2-TIER COMMITTEE DRIVEN 3-TIER OUTSOURCED Governing Fiduciaries Investment Committee Investment Committee, Staff, Investment Committee and Consultant - Supporting Managing Fiduciary CIO and Staff Fiduciary Staff and Outsourced CIO Operating Fiduciaries Investment Managers Custodian Actuaries Other Vendors Investment Managers Custodian Actuaries Other Vendors Investment Managers Custodian Actuaries Other Vendors 2-TIER COMMIT TEE DRIVEN For institutions unable to hire investment staff, a common structure is to combine the governing and managing fiduciary roles, with the investment committee serving both roles. Thus, they set policy and also implement decisions by hiring managers, determining the asset allocation within the policy parameters, deciding when to rebalance, and when to terminate managers. 3-TIER OUTSOURCED Some institutions unable to hire investment staff have moved to outsourcing the managing fiduciary role in order to overcome the challenges of the 2-tier committee driven approach. The advantages to this approach, versus the 2-tier committee driven structure, are: increased oversight of the assets more flexible decision making clear accountability for performance better allocation of the governing fiduciaries time INCREASED OVERSIGHT With the proliferation of investment managers in portfolios, most investment committees do not have the time to monitor all of the managers. Furthermore, with the increased allocations to hedge funds and private capital strategies, many investment committee members do not have the expertise to select and monitor these strategies. Outsourced advisory firms, on the other hand, can employ research staffs who conduct due diligence on hundreds, if not thousands, of managers. Thus, they can provide increased oversight serving in this managing fiduciary role. PAG E 4

5 INCREASED FLEXIBILIT Y In today s ever increasingly complex and changing investment world, an outsourced advisory firm is structured to provide more flexibility in the decision making process. Coupled with the increased oversight and daily monitoring of the asset mix and investment managers, outsourced advisory firms can exploit opportunities that would be difficult for committees to implement. For example, under the 2-tier approach, the committee would need to be informed (or identify) an opportunity, schedule a meeting or conference call, review the research, discuss the opportunity, reach a decision, and then implement the decision. An outsourced advisory firm, who is monitoring the markets and the portfolio on a daily basis, is better positioned to implement these opportunities. CLEAR ACCOUNTABILIT Y Under the 2-tier approach who is ultimately responsible for performance? The committee chair? Consultant? Staff? The entire committee? The committee chair runs the meetings and sets the agenda, but has only one vote. Consultants and staff may provide recommendations, but they are not always accepted. The entire committee ultimately is responsible, but as the governing fiduciaries, placed in the awkward position of assessing themselves as the managing fiduciaries. Thus, there is a lack of true accountability with the 2-tier structure. Outsourced investment advisory firms, on the other hand, accept this responsibility and are held accountable for performance. BET TER ALLOCATION OF TIME Finally, outsourcing leads to better allocation of the governing fiduciaries time. By delegating the managing fiduciary role, the board/committee can spend more time on the governing fiduciary role. Too often committees are involved in the details of the investment portfolio, such as selecting specific managers and rebalancing, and unable to spend the necessary time on the mission of the institution, defining the portfolio s risk tolerance and long-term strategy, and establishing the investment policies that will ultimately drive the long-term success of the portfolio. Conclusion Today s fiduciaries oversee portfolios more complex than ever before. What may have worked years ago, may not work as well today. Consequently, fiduciaries are assessing their governance structures and seeking to improve their processes. To avoid implementation shortfall and remove the barriers to excellence, we believe that all fiduciary roles must be clearly defined. The first step is to determine the appropriate oversight structure. For larger institutions, we are seeing many hire chief investment officers to serve in the managing fiduciary role. For those unable to hire investment staff, we are seeing an increased interest in outsourcing the managing fiduciary role. Even those who continue with the 2-tier committee driven structure are reviewing roles and governance, with several relying on sub-committees to more efficiently manage the process. PAG E 5

6 DISCLOSURES This report was prepared by Fund Evaluation Group, LLC (FEG), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non-discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directly to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202, Attention: Compliance Department. The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it. FEG, its affiliates, directors, officers, employees, employee benefit programs and client accounts may have a long position in any securities of issuers discussed in this report. Index performance results do not represent any managed portfolio returns. An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Neither the information nor any opinion expressed in this report constitutes an offer, or an invitation to make an offer, to buy or sell any securities. Any return expectations provided are not intended as, and must not be regarded as, a representation, warranty or predication that the investment will achieve any particular rate of return over any particular time period or that investors will not incur losses. Past performance is not indicative of future results. Investments in private funds are speculative, involve a high degree of risk, and are designed for sophisticated investors. This report is prepared for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report. All data is as of October 31, 2014 unless otherwise noted. PAG E 6