Setting A Course
In a related article, Who Controls The Money?, we discussed different approaches to managing foundation assets. In this article we discuss the “Institutional Approach”.
Of the 45,000 foundations we estimate that only about 5% follow the institutional approach described below that is more common in endowments. It bears noting that the 2,000 or so “institutional” foundations tend to be some of the largest.
The process at a larger/more institutionalized foundations takes a formal and considered approach to investing – the structure might include the components in the “Institutional Blueprint” below and follow an “Institutional Process”.
- Investment Committee
- Investment Policy Statement (IPS)
- Asset Classes
- Asset Ranges
- Consultant / CIO / OCIO
- Asset Allocation
- Manager/Security Selection
- The foundation’s trustees might create a subset to serve on the investment committee.
- The investment committee, perhaps in conjunction with a consultant, or Chief Investment Officer (CIO) or Outsourced CIO (OCIO) might write an investment policy statement (IPS) laying out the goals and often asset class thresholds. The IPS are typically in place for long periods – 10 years or more.
- The foundation may use in-house resources (their own investment staff, which is only the case at the very largest) or hire a firm to implement their policies.
- In-house or external money managers invest the foundation’s assets according to the IPS.
The Investment Policy Statement
The investment policy statement (IPS) is a set of guidelines that lay out the general objectives and rules concerning the management of the portfolio. They typically define the types of investments that can be made and offer some structure to the portfolio by creating asset allocation ranges and defining benchmarks. A simple example of the asset allocation might look like this:
|0 – 10%
|3 month Treasury
|20 – 40%
|30 – 60%
|S & P 500
|10 – 30%
|0 – 10%
Investment policy statements can be as simple or as complicated as you want as you add in constraints on other factors like volatility, liquidity, concentration, and others. But even in the simple version outlined above, one can begin to see that a lot of the decision making choices for the portfolio has already been greatly narrowed down.
With asset allocation ranges set, and the underlying benchmarks identified, the next step it to define a composite benchmark, typically comprised of the asset class benchmark components, for example 5% 3 month treasury bill, 30% Barclays Aggregate, 45% S&P 500, 15% MSCI and 5% HFR Composite from the example above.
Institutional Model Benefits
One of the main benefits of the institutional model is that it provides a clear roadmap for managing assets. The rules are laid down for all to see providing explicit guidelines. For foundations that have trustees who serve limited time terms this can be especially helpful to maintain the process already in place, essentially retaining an “institutional memory”.
This approach can help avoid conflicts as the IPS offers an already decided upon gameplan to be executed as well as clear deliverables from those executing the gameplan.
Writing an IPS is a great exercise as it forces attention on constraints that might get overlooked or ignored, such as liquidity or position concentration, that can turn around and bite in times of crisis.
In many ways, one can say that the institutional model can help avoid many big mistakes because the typical authors, consultants, use solid economic theory and a history of learning from past problems in designing a policy.
The flip side of avoiding big mistakes is that it can hinder taking advantage of big opportunities as investment policy statements can be rigid. Additionally an IPS, and especially asset allocation ranges can be stuck in time as they are infrequently revisited. If a new asset class emerges, it can take years to make it onto the radar of an institutional mindset, and if an asset class withers away, the IPS may still force money into a dying area.
Often Smart, Rarely Brave
If a money manager exceeds the asset allocation ranges, he is liable to get fired, especially if his bet was wrong, so he is likely to stay in the lanes drawn up in the IPS. Furthermore, matching the performance of the composite benchmark is as easy as could be by simply matching the weights of the benchmark. With the ranges and benchmark weights decided, the portfolio manager tries to optimize performance based on the constraints laid out in the IPS. So the manager will use the levers in his control to try to beat the benchmark. For example if he thinks U.S, stocks will do better than international stocks, he will increase the portfolio’s allocation to the U.S. and away from foreign markets. Or if he is worried about stock prices falling, he will load up on cash and bonds.
While it may seem that portfolio managers have significant leeway to change allocation, they tend to “hug” the benchmark allocations, as significant deviation from the benchmark allocation could mean significant deviation in performance. Most institutional portfolio managers are paid according to how much money they run, not how well they perform, so they do not want to run the risk of substantial underperformance (and possibly getting fired), so the easiest way to mitigate the risk of substantial underperformance is to stay close, or “hug” the benchmark,
As asset classes have expanded from just stocks and bonds to alternative strategies, like private equity, venture capital, distressed debt, real estate, and commodities, the asset allocation ranges and composite benchmarks have grown increasingly complex. The core (and valid argument) that portfolio managers make is that they want to know how they are going to be evaluated and thus paid. So if, for example the asset allocation range calls for 10-20% in venture capital, there should be an appropriate weighting in the composite benchmark. Naturally different institution may choose different asset classes and different allocation ranges, resulting in many custom benchmarks making comparisons to other institutions difficult. Did the portfolio manager do a good job, or was it just the fact that one institution had a different IPS from the other?
Not a Single Answer
Returning to the core question about who controls the money, in the case of the institutional approach, it is a combination of the authors of the IPS with strategic implementation of the portfolio manager. The trustees a few steps removed.