Investment Policy Statement PPT Northwest Planned Giving Roundtable Nov 13 2015

TemplateDesign:DaltonMaag

RSVP'ingtheUnknown(It’sComingAnyway): The Role of Investment Policy Statements in Creating Better Long-Term Outcomes

Chris Magaña November 2015

www.imscapital.com

We make investing decisions based on how we feel rather than what we know

Source:CarlRichards,AuthorTheBehaviorGap

The worst time to try to make a prudent decision will be when these issues are on the front page of the Wall Street Journal.

Assume that when it comes to investing your board, finance committee and investment manager will behave irrationally

Take away

“Stockmarketso?enmoveinresponsetomanyfactorsunrelatedtotruevalue”ShlomoBenartziUCLAAndersonSchoolofManagement

“Theevidencethat

investor

emoJonsareinfluencin

gpricesof

securiJesisbecom

ingoverwhelming”

KentDaniels

GraduateSchoolof

Business,ColumbiaUnive

rsity

“Behavioralfinanceholdsthatinv

estors

tendtofallintopredictablepaPerns

ofdestrucJvebehavior.Inother

words,theymakethesamemistakes

repeatedly”LibraryofCongre

ss,BehavorialPaPernsandPiTall

sofUS

InvestorsResearcher:Seth

Elan

“Theinvestor’schiefproblem–evenhisworstenemy–islikelytobehimself.”BenjaminGrahamWarrenBuffe*’smentorandformerstudent

“Howcouldeconomicsnotbebehavioral?Ifitisn’tbehavioral,whatthehellisit?”CharlieMungerBillionaireinvestor,authorandphilanthropist

“Oursocietyglorifiesfreedomandfreewill,butwecarrymanyprimiJveimpulsesbeneaththethinveneerofcivilizaJon.Wewanttojoingroupsforsafetyandbeledbystrongleaders.Thegreatertheuncertainty,thestrongerourwishtojoinandtofollow.”AlexanderElderMedicalDoctorandProfessionalInvestor

ElementsofanIPS

InvestmentStrategy

Exhibits

ObjecIves

Acknowledgements

DefiniIonof

DuIes

Monitoring,EvaluaIng&

ReviewProcess

Purpose&Scope

SpendingPolicy&Liquidity

Nonprofits need to be more focused on finding the right level of spending in the face of lower expected future returns

Currently: US 10 Year Treasury yield 2.34%

ThecurrentyieldgivesyouadecentindicaJonofwhatyoumightearnoverJme.Since1926,henotes,theentryyieldonthe10-yearTreasuryexplains92%oftheannualizedreturnaninvestorwouldhaveearnedoverthesubsequentdecade

JohnC.Bogle FounderVanguardGroup

Source:WallStreetJournal“HowToPredictTheNextDecade’sBondReturns”March3,2014

Currently: Barclays US Agg Bond Index 2.37%

TheentryyieldontheBarclaysU.S.AggregateBondindexexplains90%ofits10-yearreturnsfortheyears1976to2012

TonyCrescenziPIMCOMarketStrategist

Source:WallStreetJournal“HowToPredictTheNextDecade’sBondReturns”March3,2014

Since 1926 US stocks have delivered a positive annual return about 75% of the time…if that relationship remains true will it be enough???

TemplateDesign:DaltonMaag

What do the tea leaves say about the future for stock prices?

7-YearAssetClassRealReturnForecastsUSLargestocks -1.1%USSmallstocks -1.2%InternaIonallarge0.8%Emergingstocks 4.2%GMO,LLCAugust31,2015

USEquity8-YearExpectedReturnBreakdown Core

USLargeCap 4.7%USMidCap 0.7%USSmallCap -3.7%Total(AllCap) 4.1%

WilliamBlairDynamicAllocaIonStrategiesTeam

October31,2015

SmoothedMovingAverageFormula:SpendingisbasedonastatedporIonoftheporeoliovalueattheendoftheprioryear.AsmoothingcalculaIonisthenappliedusingtheaverageendingporeoliobalancesoveranumberofpreviousyearsorquarter.Notes:SpendinghaslessvariabilityfromyeartoyearandgenerallymiIgatesmildebbsandflowsofthestockandbondmarkets.

BandedInflaJonFormula:StartwithadollaramountofspendingthatistypicallyexpressedasapercentageoftheiniIalporeolioinyearone.ThespendingamountforeachsubsequentyearisthendeterminedbymulIplyingtheprioryear’sspendingbyaninflaIonfactorsuchasCPI.Notes:Stablespendingyeartoyear,butmakesnoadjustmentfordecreasingspendinginanextendeddecliningstockorbondmarket.

HybridApproachFormula:ThelevelofannualspendingisdeterminedbycombiningafixedpercentageusingthebandedinflaIonmodelandafixedpercentageusingamovingaverageformulawith3or5yearsmoothing.Asaresult,aporIonofthespendingvariesbasedonthemarkets(inflaIonformula)andaporIonismorepredictable(movingaverage).Notes:ThisstrategyismostcommonlydeployedbyeducaIonrelatedorganizaIonsandprivatefoundaIons.Manysmallernonprofitsfindtheapproachtobeoverkillfortheirneedsandburdensomefortheamountofdedicatedresourcestheyhaveavailable.

SpendingRatesSurvey

Source:SEIReport“TheCurrentLandscapeofNonprofitSpending”2013

3% 4% 5%

Overall

Community

CulturalorArts

EducaJon

Faith-Based

Environmental

Sample:UCLAFoundaIonSpendingPolicy

TwelvequarteraveragewilltypicallydoagoodjobsmoothingoutmarketfluctuaJons

ForecasJngthenextsixquartersusingexpectedreturnscanbetricky,ifnotimpossibletodoconsistently.

Source:hips://www.uclafoundaIon.org/finances.aspx?content=investmentpolicy

Spending Policy Take Away

AprudentSpendingPolicyisthehardestandmostimportantstepsindevelopingtheIPS

ANonprofitmustdeterminewhichSpendingmethodologyisappropriatefortheirorganizaIon

TheSpendingPolicyshouldaiempttoachieveBOTHthecurrentandfuturespendinggoals

ThemethodologychosenshouldbeunderstoodbytheNonprofit’skeystakeholders

Themethodologyshouldnotbemorecomplicatedthatnecessary

Themethodologychosenshouldconsider:•  Spendinggoals•  Liquidityrequirements•  VolaIlityinfunding

To achieve the Nonprofit’s long-term goals, not taking risk is often the biggest risk of all

MyindustryrouInelydefinesriskasvolaIlityandorperformingpoorlyrelaIvetoabenchmark.WhatdothesedefiniIonsofrisktellusaboutanorganizaIonachievingit’sshortandlongtermspendinggoals? ANSWER: Very Little

Take Away: Find an investment manager that translates those definitions of risk into a discussion of your organization’s spending goals.

How would you evaluate an investment manager without using performance?

q  Evidenceofcommitmenttotheinvestmentphilosophy

q  Howthefirm’sdecision-makingprocessworks

q  Philosophyonriskmanagementq  Whatinternalcontrolsdoesthefirm

deployq  Thequalityandpromptnessofits

reporIngsystem

q  Thesizeofthefirmintermsofstaffandassetsundermanagement

q  Howthefirmhaschargesclientsq  Ancillaryservices(lending,planned

givingresourcesetc.)q  Abilitytoentertainsponsorship

opportuniIesq  Thefirm’sownershipstructure

www.imscapital.com

IPSChecklist

PoreolioRebalancing PrioriIzeRiskPerformanceMonitoring

SpendingPolicy AssetAllocaIonRoles&ExpectaIons

Case - Improving Due Diligence Scenario:Nonprofitclientreceivedafinancialwindfallof$20mandhired4investmentmanagerstooverseethefunds.IPS:TheclienthasathoroughlywriienIPSthatwasdraped10yearsago.TheIPSmateriallylimitsinternaIonalinvesIngandtheuseofhighyieldbonds.SpendPolicy:3%oftheaveragemarketvalueofthelast8quarters.ThestakeholdersconsistentlyhaveconcernstheorganizaIonisn’tspendingenoughtoachievethecurrentfinancialgoals.Also,thereissomeconcernregardingthevolaIlityintheannualspending,especiallyduringthe2008/09recession.InvestmentManagerDueDiligence:Theinvestmentcommiieemeetswitheachinvestmentteamquarterlyforonehour(backtoback).InvestmentManagers:TwolocalRIA,onelargebanktrustdepartmentandonelocaltrustcompany.All4managersdeploymostlyacIveinvesIngstrategies.

Case-DueDiligence(Issues)IPS:TheIPSisdatedandtheorganizaIonshouldreviewitandopenthediscussionuptotheinvestmentmanagerforcommentsorsuggesIons.It’sagoodpracIcetoreviewandpotenIallyrevisetheIPSevery5yearsorwhenmaterialcircumstanceshavechangedtheorganizaIonsspendingandinvestmentgoals.ThereconInuestobeinnovaIonintheinvestmentbusiness(notallforthegood)buttheIPSmaynotadequatelyaddresstheuseofETF,PrivateREITs,MLPasthesehavebecomemuchmorepopular.SpendPolicy:Thespendingpolicydoesn’tmatchtheorganizaIonsincomeneeds.Also,nooneinternallywantstodotherolling8quartercalculaIons.TheorganizaIonshouldconsidermodifyingthespendingrateto4%or5%whichwouldhelpthemachievetheircurrentspendinggoals.TheorganizaIonshouldalsoconsiderusingthe“smoothingmethod”over3or5yearstomaketheannualspendingamountmorepredictable.InvestmentManagerDueDiligence:TheInvestmentCommiieeisrelaIvelydisengagedbythefourthinvestmentmanagermeeIng.TheorganizaIonbudgetsonehourpermanageranddoesthembacktoback.SomeImesonlystoppingforashortbreakorlunch.Bythelastinvestmentmanagertheyhavealreadyheardseveralrecapsofthebigeconomic,poliIcalandinvestmentnewsmulIpleImes.It’smyopinionbythelastinvestmentmanagerortwothequalityofporeolioduediligenceisgreatlydiminished.InvestmentManagers:Using4acIveinvestmentmanagerstheorganizaIonisessenIally“blankeIng”thestockandbondmarkets.Theaggregateresultslookalmostlikeaverybroadstockandbondindexstrategy(minusmuchhigherfeesthanamorepureindexapproach).TheorganizaIonwouldbemuchbeieroffreducingtheirinvestmentmanagersto1or2.ReducingtheinvestmentmanagerswouldimprovetheiracIvemanagerbetsandmateriallyreducefees(astheorgwouldhavepricingpowerwiththeremaininginvestmentmanagers).ReporJng/MeeJngCycle:Meetlessfrequentlywitheachmanager,butdoamuchdeeperduediligencedive(meetonceortwiceperyearwitheachinvestmentmanager).TheinvestmentporeolioispermanentcapitalsomeeIngwithallforinvestmentmanagersquarterlyisoverkillandaninefficientuseoforganizaIonshumancapital.

Benchmarks

AbenchmarkcomprisedoftheexpectedinflaIonrateplusthespendingpolicyrate

Asimplebenchmark(apassivemixofstocksandbonds,suchas60%equity/40%fixedincome)

Arelevantpeeruniversebenchmark,suchasusingthedataprovidedbyHewiiConsulIngorRVKforperformanceofcomparableinsItuIons

TypicalInvestmentMeeJngAgenda•  IntroducJonsandSmallTalk•  Approveminutes•  Reviewinvestmentperformancereport•  Discussanymanager/assetclasschanges•  Discuss“hottopics”intheeconomy/world

-WhenwilltheFedhikerates?-HowmuchwilltheChinaSlowdownimpactus?-What’sgoingtohappeninthenextelecJon?

•  TelltheboardtoexpectvolaJlity(thereisalwaysvolaJlity)•  CursoryreviewoftheSpendingPolicy,•  CursoryreviewoftheIncomegeneraJonandanyunexpectedcash

flows•  ClosethemeeJngwitha“Thankyouforyourbusiness”

KeyResponsibiliIesSpendingPolicyTheboardwithinputfromthefinance/investmentcommiiee

IPSoversightandtargetassetallocaJonThefinance/investmentcommiieeasauthorizedbytheboard

FrameworkforselecJng,sizing,andterminaJnginvestmentmanagersThefinance/investmentcommiieeasauthorizedbytheboard

InvestmentperformancemonitoringandreporJngandotherporTolioanalysisThefinance/investmentcommiiee

Odds and Ends

StockGips

Feeagreements

Stakeholdersfocusedonspendinggoals

AvoidBackTestedStrategies

ManagingRequestforProposals

SAMPLE:ConflictofInterestPolicyAnysituaIonwhichbringstomindthequesIonofapossibleconflictofinterestshouldbebroughttotheaienIonoftheInvestmentCommiiee;membersshouldbesensiIvetoeventheappearanceofimpropriety.Generally,aconflictofinterestexistswheneverliIgaIon,acontract,orotherrelaIonshipbeingenteredinto,reviewed,ormodifiedis:•  BetweenABCandthemember,ortheemployer,businesspartner,orimmediatefamilyofthe

member;or

•  BetweenABCandanorganizaIoninwhichthemember’semployer,businesspartner,orimmediatefamilyisdirector,officer,orlegalrepresentaIve,orhasamaterialfinancialinterest.

AconflictofinterestdoesnotarisesimplybecausedirectorsormembersoftheirfamiliesareincidentallybenefitedasmembersofaclassofpersonsenItledtobenefitfromatransacIon,policy,orprogramconsistentwithpurposesandaccomplishedingoodfaith.Forthesepurposes,“family”includesparents,siblings,children,grandchildren,andtheirspouses.ThispolicyisnotintendedtoprohibitinvesIngwithanyfirmsorinvestmentmanagerswithwhomaBoardMemberorCommiieeMemberisaffiliated;rathersuchrelaIonshipsmustbedisclosedandtheaffiliatedBoardorCommiieeMembershouldrecusehimselffromanydecisionspertainingtotheaffiliatedfirm.

Simplecanbeharderthancomplex:Youhavetoworkhardtogetyourthinkingcleantomakeitsimple.Butit'sworthitintheendbecauseonceyougetthere,youcanmovemountains

SteveJobs

ThankyouforyourImeandIwouldbehappytospeakwithyouaboutanyofthetopicswecoveredtoday.

Chris Magaña [email protected]

www.imscapital.com

AdvancedBonusCase-BenchmarkingShenanigans

Scenario:Nonprofitclienthasworkedwiththeinvestmentmanagerforovertenyears.Theporeoliosizeisover$1.5millioninassetswithmulIpleporIonsrestrictedandvariousannualpayouts(ranging2%-5%peryear).TheInvestmentmanagerusesanacIve(dynamic)benchmarkandreplacesabout20%ofthemanagersannual.TheInvestmentmanagertypicallyaddsand/orsubtractsabout1-2assetclassesperyearbasedonperformanceandtheinvestmentmanager’smacroeconomicforecast.TheinvestmentmanagerisrouInelya“preferred”($10k)sponsorattheNonprofit’sannualevent.InvestmentManager:Chargesaflat125bps(1.25%)annuallyforit’sinvestmentmanagementservices.DuJes:Theinvestmentmanagerisresponsibleforinvestmentduediligence,maintainingadequatecashreservesandreporIngtheinvestmentresultstotheNonprofit’sfinancecommiiee.TheNonprofithasnotputtheinvestmentmanagementrelaIonoutforanRFPsinceitstartedit’scurrentrelaIonshipwiththeinvestmentmanager.

CaseBenchmarking(Issues)Fees:Investmentmanagercharges1.25%annualwhichtranslatesinto$18,750peryear.Ifyoufactorinthe$10,000sponsorshiptheNonprofitonlypays$8,750peryearwhichtranslatesinto$8,750/1,500,000=.58%or58bps.Thatismuchmorereasonablegiventhefactthatthisisanonprofitclientwithasizeableporeolio.

Issues:q  ConsiderincludingastaIcbenchmarkq  UsetheacIve/dynamicbenchmarkforevaluaIngindividualassetclassmanagers.TheacIve/dynamicbenchmarksarenothelpfulfor

assessingtheinvestmentmanager’sassetallocaIonskills.Tofinishthestoryonthisissue.q  Poreolioaveragedabout60%stockand40%bondsoverthelast10years.q  AS&P500(60%)and(40%)BarclaysAggregatedindexstrategyoutperformedby2.5%peryearoverthepast10years.q  The“strategicallocaIondecisions”haveshowntobelessthanstrategic(6out7trailedtheS&P500overtheImeperiodtheywere

held.q  Theunderperformancecoststheclientabout$185Kover10years(That10KannualsponsorshipiscosJngtheorganizaJonmore

thantheyreallyknow).

BeforethisinformaIoncametolighteveryoneassumedthemanagerdidapreiygoodjobastheyshowedaposiIvereturnduringthelast10years(theS&P500wasup8%andbondsdidabout5%...it’stherisingIdelipsallboatsscenario).TheyalsoreallyliketheinvestmentmanagerandappreciatedthewhathadbecomeanannualcontribuIonof10KtoNonprofit’sannualevent.TheinvestmentmanagerwouldswitchequitybenchmarksfromImetoIme.ThesechangesviolatedtheNonprofit’sIPSbutthefinance/investmentcommiieedidnotchallengetheinvestmentmanageronthemaier.Ineveryinstancethebenchmarkchangeimprovedtheinvestmentmanager’sperformance.q  TheinvestmentmanagerneedstobeheldaccountablefortheIPS.It’sagoodpracIcetoasktheinvestmentmanager(s)periodically

ifthecurrentIPSistoorestricIveinanyway.ThismakesforgooddiscussionsaboutpotenIalfuturerevisionsorhelpsgalvanizetheNonprofitontheir“core”investmentbeliefs.