Rethinking investment policy

Market chaos, like that seen in the fourth quarter of 2008 and the first quarter of 2009, can be disruptive not only to portfolio market values but also to the application of governance policies and to the management of risk. This paper presents some strategies for meeting these challenges in the current market environment and for avoiding related problems during potential market turbulence in the future. The ideas here discussed are applicable to anyone with responsibility for the long-term management and investment of capital, whether for a retirement fund, an endowment, or a foundation.

Drafting a resilient investment policy

Investment committees will benefit from the formulation of a detailed Investment Policy Statement as it provides an accepted framework within which to manage a portfolio's investments. A prudently constructed Investment Policy Statement provides guidance on both strategic (long-term) and tactical (short-term) decisions by addressing the following:

• Objective(s) of the funds
• Investment time horizon
• Roles and responsibilities of all the players
• Permitted investment vehicles
• Acceptable asset classes
• Allocation ranges
• Liquidity and illiquidity
• Rebalancing guidelines
• Watch list (monitoring) criteria

As with an organization's mission statement, the Investment Policy Statement provides direction and guidance but remains at the policy level. The day-to-day tasks required to carry out the policy are not within the purview of the investment committee.

A broader definition of risk is indicated. For instance, risk could be defined as the risk that money will not be available when it is needed. Not having the wherewithal when necessary is, of course, a significant problem, and can be the result, in general terms, of any of the following threats:

• Poor returns (the investment did not grow enough to meet the expected return or investment objective or, worse, was lost)
• Illiquidity (the money is simply unavailable, because the investment cannot be readily sold when the cash is needed)
• Inflation (the original sum has lost value and therefore purchasing power)

As with an organization's mission statement, the Investment Policy Statement provides direction and guidance but remains at the policy level. The day-to-day tasks required to carry out the policy are not within the purview of the investment committee.

In down markets, investment committees may be tempted to think tactically about asset allocation and to start delving into the details of manager performance. While tactical moves may help investors capture opportunistic gains (e.g., investing in distressed situations or secondary private equity deals in the current environment), there is always the danger that tactical moves will be made at the wrong time. Market timing carries substantial risk of buying high and selling low.

Instead of falling into this trap, investment committees should examine situations within the framework of the Investment Policy Statement. This forces them to make conscious decisions about deviating from the organization's established investment policy. Although the existence of an Investment Policy Statement does not prevent investment committees from making tactical or even permanent changes to the portfolio's investments, it requires a more deliberate analysis before changes can be made. By thus limiting themselves to policy-level concerns and decisions, rather than becoming mired in implementation issues, investment committees are less likely to be thrown off balance in severely dislocated markets.

Get a new set of lenses for analysis

To address the issue of risk in the portfolio, committees should look at their portfolios using a number of different lenses or taking a number of different perspectives. Historically, committees have defined risk as the standard deviation of returns, (i.e., how much returns can be expected to vary, either up or down, in a given period). However, risk can no longer be thought to reside solely in the two dimensions of return and volatility. Committees must consider additional outside market forces, such as liquidity and inflation, when contemplating both strategic and tactical moves. By addressing these factors when the portfolio and the market are not in crisis, committees enhance their ability to act rationally in times of turmoil.

A broader definition of risk is indicated. For instance, risk could be defined as the risk that money will not be available when it is needed. Not having the wherewithal when necessary is, of course, a significant problem, and can be the result, in general terms, of any of the following threats:

Lens #1: Minimum acceptable returns

The events of the last two years have shown that while three-standard-deviation events are rare, they do happen. Consequently, committees need to spend considerably more time examining the probabilities that the investment returns will reach some unacceptable level (such as a negative return). When adopting asset class targets, investment committees should reach a consensus about what the minimum acceptable return should be and the timeframe within which it is to be earned.

Lens #2: Liquidity

Committees should analyze their assets specifically according to liquidity (i.e., how easily the investment can be turned into cash). In this way, committees can see whether the investments they have correspond to the percentage of the portfolio that will be needed for short-, intermediate-, and long-term spending. Adjustments can be made so that the portfolio is invested according to these time horizons. This is similar to liability-driven investing strategies, although most committees are not looking to match their spending and their investments as closely as a liability-driven investment strategy would entail.

Many committees are also using the Investment Policy Statement to define "illiquid" for the portfolio and to include restrictions on how much of the portfolio can be invested in such illiquid assets as private equity, hedge funds with possible withdrawal restrictions, or real estate.

During the recent economic turmoil, illiquidity proved to be a major problem. In 2008, a leading industry survey showed a marked disparity, when it came to investing in relatively illiquid assets, between large not-for-profit portfolios (i.e., university endowments greater than $1 billion) and smaller not-for-profit portfolios (i.e., those worth from $51 million to $100 million). At the time, large investors were 40% to 50% invested in less liquid, alternative investments, whereas their smaller counterparts were only 15% to 25% allocated to these areas. Large endowments had less of their portfolios invested in fixed income and U.S. equities than their smaller counterparts did. The thought was that with their far greater resources, the larger funds could afford to have some illiquid investments; however, liquidity took on greater significance in the down market.

In general, pension plans were not invested in private equity to the same extent as endowments, but they nevertheless encountered liquidity issues as collateral funds and some hedge funds implemented redemption restrictions. This experience re-emphasizes the need to understand a fund’s investment documents prior to investment.

Lens #3: Inflation

Elevated levels of inflation may still be off in the future but they look likely. The past several years have generated low inflation and even times when deflation was considered the danger. However, with the amount of monetary stimulus being generated by the federal government, the industry expectation is that inflation will pick up in the medium to long term. The big questions are when the medium term will start, how long the elevated inflation will last, and how high inflation will go.

Inflation protection is a perfect example of a tactical decision committees will likely have to make in the next two to three years. This environmental factor is rarely addressed directly in the Investment Policy Statement; however, committees must review the portfolio to determine which areas are sensitive to inflation and which areas may act as hedges against inflation. Depending on the outcome of this analysis, a committee may choose to address inflation within the current structure (e.g., by adding Treasury Inflation Protected Securities to the fixed income allocation) or to add an additional asset class, such as commodities.

Emphasize downside protection

Committees used to examine various investments' expected returns and anticipated volatility as part of their asset allocation discussions. However, two- and three-standard-deviation events were thought to be too unlikely to be given much consideration. Committees tended to make decisions based on whether or not the one-standard deviation band around the expected return was acceptable. Experience has shown that an event being unlikely is not the same as it being impossible.

Given the extraordinary losses in the last quarter of 2008 and the first quarter of 2009, questions have been raised about the continued relevance of modern portfolio theory and its reliance on diversification of asset classes and models based on forward-looking expected return and volatility. The value of portfolios with a traditional 60/40 asset allocation between equities and fixed income fell 20% to 30% in 2008. Correlations between asset classes approached one, meaning that the diversification of assets did not dampen losses. All asset classes did poorly. Having had a painful reminder that volatility swings both up and down, committees need to take a more detailed look at the assumptions underlying their asset allocation targets. Emphasis on downside protection should be a major priority.

Endowments and foundations, particularly the larger ones, were thought to be at the forefront of investment innovation, investing heavily in private equity and hedge funds. Only recently, large university endowments were being touted as visionary investors, and committees managing portfolios a fraction of the size have considered how they could mimic these institutions’ investment styles. Committees looked with envy at the 20% and 30% returns of these larger endowments while their own funds generated midteen returns.

When liquidity dried up in late 2008, the downside of investing in private equity and hedge funds emerged. Those with high percentages invested in private equity found themselves staring at large unfunded commitments, and, in some cases, discovering they were hard pressed to meet capital calls. Hedge funds implemented withdrawal restrictions to slow redemptions, complicating the use of these strategies. Bonds became the haven of choice, and investors who had lost over 30% in the stock market were content to tread water or eke out a slim gain with core fixed income investments, particularly U.S. Treasuries. No one is interested in repeating this dynamic.

Navigating the road ahead

Modern portfolio theory can no longer be seen as the be-all and end-all of portfolio construction. Investment committees need to review their portfolios periodically from the variety of angles mentioned above, including expected return, volatility, liquidity, and sensitivity to inflation. By determining the portfolio's long-term needs and identifying unacceptable outcomes, committee members will be able to refer to their Investment Policy Statement to help them ride out short-term market disruptions.

Investment committees should construct a detailed Investment Policy Statement to create a broad strategic framework that is specific to their organization’s objectives and that systematically analyzes the portfolio from many vantage points. Once established, these statements should be reviewed annually. Establishing this governance framework will facilitate objective thinking and enable investment committees to provide leadership to staff and other constituents during difficult economic environments. Moreover, it bears repeating, Investment Policy Statements need to be drafted when markets (and market participants) are experiencing a period of relative calm.

Investment committees will undoubtedly continue to pull the levers at their disposal to improve investment performance. Ideally, the Investment Policy Statement will create dependable, rational guidelines within which these investments are managed. Ultimately, if well formulated, the Statement will provide direction that is broad enough to encompass all of a portfolio’s investment objectives, so that tactical and strategic decisions can be made in a proactive manner rather than in extremis.