Institutional Best Practices: Philosophy & Process

“Unity is strength...when there is teamwork and collaboration, wonderful things can be achieved.” - Mattie Stepanek

Investing can be both easy and exceedingly difficult, joyous and immensely frustrating, gregarious and isolating, rewarding and often dangerous; we welcome it all. We have a passion for learning, not just about the world and its endless and ever changing opportunities, but for learning about ourselves and our continuous improvement as stewards of the capital entrusted to us by our clients. 

We seek a deep understanding of our investments and their impact on stakeholders beyond just shareholders. This deep understanding allows us the conviction to stand by our approach during the inevitable periods when it will be out of favor and the investment landscape becomes divorced from traditional fundamental rules of value. We intentionally seek the humility and integrity to admit our mistakes and continuously improve our process. 

We are firm believers in the opportunity through innovation and the long-term potential for the human race to produce amazing things that we have not yet imagined, just as we progressed from our first manned flight to landing on the moon in roughly 50 years, we expect the innovation of our lifetimes to be similarly breathtaking. Long-term investing in such a dynamic environment requires the right philosophy, mindset, process, team, clients and culture as well as a wealth of patience and humility. We welcome it all. We are guided by the principle that investing is ownership. Ownership brings with it the responsibility to understand the mission, purpose, risks, opportunities, and societal impacts of our investments. 

We are Intentionally Invested. 

Investing Principles & Philosophy

Too often institutional investors are given an investment plan that is homogeneous and not tailored to the needs and mission of the organization itself. We recommend that institutions avoid overly-diversified crowd-following portfolios, but instead they should clearly identify their investment objectives in order to ensure that they are closely aligned to the mission of the institution. When objectives are clearly defined, it is easier to track progress toward meeting those objectives and avoid distractions of short-term relative performance to market benchmarks. We prescribe a core philosophy focused on six primary investment principles: 

Communication

Having a clearly-defined mission and portfolio objectives allows an often diverse group of professionals and volunteers to have a shared vision and road map through volatility. Clearly defined roles, responsibilities, and objectives are critical to success when multiple fiduciaries are at the table. Codifying a long-term plan for your institution is key to maintaining course as fiduciaries come and go during the life of your perpetual institution. Of course, the plan should be reevaluated periodically but should be changed infrequently.

Alignment

As much as possible, investment managers and fiduciaries should be compensated based on the success of your institution’s results. In investing, costs are often the greatest hurdle to success, so judiciously (but not blindly) minimizing expenses will likely lead to greater long-term success, particularly if any expense paid are tied to the long-term success of your organization.

Conviction

Concentrate in best ideas as opposed to overly-diversified benchmark-hugging portfolios often prescribed by investment large firms; seek out market inefficiency and pockets of capital scarcity as we believe these will provide the best long-term opportunities.

Patience

It is important to remember that most institutional investors have very long-term investment horizons; actively seek to avoid behavioral biases that would focus on short-term reactionary decisions; willingness to reduce risk when assets are not attractively priced.

Value

Investments should be made when they are expected to provide a compelling return on the capital provided that is commensurate (or better) with the level of expected risk taken. This does not mean blindly buying “cheap” stocks and avoiding“expensive” ones based on traditional measures like price-to-earnings ratio. Instead, it means dig in to do the work to find opportunities and new forms of growth not yet appreciated by the market at large.

Emotional Intelligence

Even the most seasoned investment professionals can be influenced by the emotions that come with the market’s ebbs and flows. Fiduciaries should be willing to ask tough questions of themselves and all parties involved in the institutional investment process and remain collaborative, humble and open-minded. In investing, there will inevitably be periods of market euphoria and despair, where eventhe most experienced investors will question their judgment in stewarding wealth entrusted to them. In these times, it is particularly important to have a long-term plan and roadmap inplace, to avoid the siren call of short-term emotionally-driven decision making.

Portfolio Construction

Institutional Return Objective

In defining the investment objective for an institution, it is important to distinguish between the required return and the desired return. The required return can be calculated by identifying the building blocks of the institution’s needs. At first blush, the required return for an endowment or foundation may be defined as the institution’s annual spending rate, or the amount withdrawn from the portfolio each year in furtherance of the organization’s mission. 

However, this does not take into account that providing the same level of support next year, and the year after that, and so on, will require expectations for inflation. For example, consider a donor who provides a gift to a college or university endowment and establishes an annual scholarship with that gift. It’s fairly likely that tuition will cost more ten years after the gift was made, so ideally the annual withdrawal from the portfolio will grow to provide the same level of inflation-adjusted support to the 10th student receiving the scholarship as the first. This is a central concept in institutional investment management called intergenerational equity; the principle that institutional fiduciaries should seek to provide for both present and future beneficiaries in a balanced manner.

“The trustees of an endowed institution are the guardians of the future against the claims of the present. Their primary responsibility is to preserve equity among generations.”  -James Tobin, Nobel Prize winning economist

So, if managing an endowment in support of a scholarship that provides 5% of the endowment value annually in support of the recipient’s education and tuition is expected to rise 3% next year, then the required return to maintain intergenerational equity would be approximately the sum of these two components (8%).

A desired return may include the addition of a growth component above the required return in order to allow the investment pool to appreciate in excess of spending and inflation. However, the added return target will come with additional risk, and the institution’s fiduciaries should have an open discussion regarding whether this additional risk is appropriate and prudent. The excellent quote above from James Tobin ends with, “[…] Their primary responsibility is to preserve equity among generations.” So, it may be perceived that targeting a risk level above the required return effectively saddles the current portfolio and generation of beneficiaries with extra risk inpursuit of greater returns for future generations.

The starting point for portfolio construction for every institution should be a thorough evaluation of their tolerance for risk. The two primary sources of risk that will impact an institution negatively are drawdown risk and liquidity risk. Drawdown risk refers to the potential for losses in an institutional portfolio. For example, typically fixed income securities have more stable values through time, while the value of equity securities may experience large losses over a short period of time. Liquidity risk refers to the difficulty or outright inability to sell an investment at different periods of time, potentially when an institution is in need of liquidity leading to the forced sale of assets at disadvantageous prices. The duration of investment assets should be closely matched to an institution’s liabilities. For example, a university endowment with a perpetual time horizon but an annual obligation to provide current support to the institution in the form percentage-based distributions from the portfolio must balance the desire for long-term growth from higher risk and less liquid investments against the need to provide stability and current income with a portion of the portfolio.

Institutions should evaluate both their ability and willingness to accept risk across a handful of metrics. The evaluation should not be conducted with a narrow view of the investment portfolio in isolation, but instead should encompass a review of the whole institution in aggregate. For example, in the midst of a recession the investment portfolio values may be negatively impacted alongside an increase in need from the institution for additional support to meet its core mission. In this environment, a hypothetical institution such as college or university might simultaneously be witnessing  lower revenue from gifts, tuition, and endowment income balanced against little ability to reduce costs in the short-run. The institution may need to take a special distribution from the endowment at a point when endowment assets may be trading below fair value and investment opportunities are prevalent.

An institution’s ability to accept investment risk is driven by the mission and financial conditions of the institution, and thus each is unique and individual to that institution. Each institution is unique, but common factors such as the institution's level of indebtedness, expectation for new inflows, spending rate, and size / amount of support relative to its ultimate beneficiary are common considerations when assessing ability to accept investment risk.

While the construction of a portfolio is primarily driven by an institution’s ability to accept risk, an institution’s willingness to accept risk is also very important and must be evaluated as part of the portfolio construction process. Every asset allocation review should include a short risk tolerance survey that is distributed to the institution’s Board members and key senior employees. The objective of the survey is twofold: to illicit a discussion of the potential variability of personal risk tolerance across the leaders of the institution as well the behavior biases to which all investors and institutions are vulnerable. For example, investors’ responses to questions regarding their willingness to accept investment risk can vary drastically across two dimensions: time and asset ownership. In other words, investors often tend to be willing to accept more investment risk after long periods of market gains and relative stability and less risk following recessions and market corrections (variability across time), and investors may have a greater tolerance for investment risk when managing a portfolio that is not comprised of their own personal wealth (variability across asset ownership).

Strategic Asset Allocation

Utilizing our understanding of an institution’s objectives and risk tolerance in concert with our long-term capital market expectations allows for the formation of the investment portfolio’s long-term strategic asset allocation. The strategic allocation can be thought of as the portfolio’s skeleton; it is the frame onto which all additional portfolio management decisions are incorporated. It represents a mix of core and complementary assets designed to achieve the institution’s long-term objectives with as little risk as possible (note: this allocation may also be utilized as a benchmark to determine if implementation decisions such as tactical allocation and investment selection are actually adding value relative to the portfolio’s basic framework).

Since the strategic asset allocation is driven by the overall risk level of the institution, it should be reviewed periodically but changed infrequently. We would expect a change to the strategic asset allocation only when there has been a significant change to either the core mission or the overall financial conditions of the institution.

Tactical Asset Allocation

Here we appraise the overall environment for investing. This includes an assessment of the economic and market cycle, overall financial conditions, and the opportunity provided by broad asset classes such as stocks, bonds, real estate, natural resources and private investments. Based on our expected point in the business & market cycle, an institutional portfolio manager may “tactically” chose to vary from the strategic allocation target. For example, by going overweight equities during periods of market stress and attractive prices. The amount of latitude afforded for deviations relative to the strategic allocation by portfolio managers should be clearly defined in the institution’s investment policy statement.

Tactical allocation involves making adjustments to the asset allocation in a portfolio in order to take advantage of market opportunities. One can make sense of the interplay between strategic and tactical asset allocation using the analogy of a ship at sea. Upon departure, a clear course is charted to the ultimate destination (the course being the strategic allocation). But if the course could be tactically modified so as to encounter favorable winds or to avoid a storm, the ship would follow a slightly different path. In this way, we establish a fixed allocation with a destination in mind, but we may build into this plan enough flexibility to seize opportunities and avoid rough seas along the way.

This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. Past performance may not be indicative of future results. These materials are not intended as any form of substitute for individualized investment advice. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Investment Research Partners, LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.