INVESTMENT GOVERNANCE BACKGROUND

Learning Outcome

describe elements of effective investment governance and investment governance considerations in asset allocation

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The document provides a comprehensive overview of investment governance, focusing on its importance for achieving investment objectives, managing risk, and ensuring compliance with laws and regulations. Key points are categorized into sections for clarity:

Learning Outcome

Describe elements of effective investment governance and considerations in asset allocation.

Investment Governance Fundamentals

Investment governance involves organizing decision-making responsibilities and oversight.
Effective governance aligns with the asset owner’s objectives, risk tolerance, and legal requirements.
It requires decision-makers to have necessary skills and capacity.

Governance Structures

Governance and management focus on achieving investment objectives but differ in roles.
Common structure: governing investment committee, investment staff, and third-party resources.
Effective models articulate objectives, allocate decision rights, specify processes for investment policies, establish monitoring frameworks, and periodically audit governance.

Articulating Investment Objectives

Essential to understand the investor’s purpose and risk/return trade-off.
Objectives vary across pension funds, endowment funds, and individual investors.
Considerations include cash inflows/outflows, risk tolerance, and liquidity needs.

Allocation of Rights and Responsibilities

Critical to delegate decisions to qualified individuals.
Size, skills, and capacity of the investment program influence the allocation of responsibilities.
Exhibit 2 showcases systematic allocation among investment committee, staff, and third-party resources.

Investment Policy Statement (IPS)

IPS serves as the foundation for fund management, outlining objectives and guidelines.

Asset Allocation and Rebalancing Policy

Strategic asset allocation is key, often requiring formal studies and simulations.
The investment committee typically approves strategic decisions, with rebalancing policies outlined in the IPS.

Reporting Framework

Effective reporting assesses progress towards goals, evaluates performance, and ensures compliance.
Includes benchmarks for performance evaluation and management reporting for decision-making.

Governance Audit

Independent audits assess the effectiveness of policies, procedures, and structures.
Aims to ensure the program's durability and adaptability to market changes and personnel turnover.

Hypothetical Case Studies

Highlight the importance of proper oversight, transparency, and basing decisions on investment considerations rather than external factors.
Case 1 (COWUP) explores governance issues related to hedge fund investments and personnel oversight.
Case 2 (Caflandia) examines sound practices in asset allocation and questionable practices in manager selection and political influence.

These points encapsulate the essential aspects of investment governance, emphasizing the need for clear objectives, effective structures, and rigorous oversight to ensure that investment programs meet their goals.

Investment governance represents the organization of decision-making responsibilities and oversight activities. Effective investment governance ensures that assets are invested to achieve the asset owner’s investment objectives within the asset owner’s risk tolerance and constraints, and in compliance with all applicable laws and regulations. In addition, effective governance ensures that decisions are made by individuals or groups with the necessary skills and capacity.

Investment performance depends on asset allocation and its implementation. Sound investment governance practices seek to align asset allocation and implementation to achieve the asset owner’s stated goals.

Investment governance structures are relevant to both institutional and individual investors. Because such structures are often formalized and articulated in detail for defined benefit pension plans, we will build our discussion using a pension plan governance framework. Elements of pension plan governance that are not directly related to the management of plan assets—plan design, funding policy, and communications to participants—are not discussed in this reading. Instead, we focus on those aspects of governance that directly affect the asset allocation decision.

Governance Structures

Governance and management are two separate but related functions. Both are directed toward achieving the same end. But governance focuses on clarifying the mission, creating a plan, and reviewing progress toward achieving long- and short-term objectives, whereas management efforts are geared to outcomes—the execution of the plan to achieve the agreed-on goals and objectives. A common governance structure in an institutional investor context will have three levels within the governance hierarchy:

governing investment committee
investment staff
third-party resources

The investment committee may be a committee of the board of directors, or the board of directors may have delegated its oversight responsibilities to an internal investment committee made up of staff. Investment staff may be large, with full in-house asset management capabilities, or small—for example, two to five investment staff responsible for overseeing external investment managers and consultants. It may even be part time—a treasurer or chief financial officer with many other, competing responsibilities. The term “third-party resources” is used to describe a range of professional resources—investment managers, investment consultants, custodians, and actuaries, for example.

Although there are many governance models in use, most effective models share six common elements. Effective governance models perform the following tasks:

Articulate the long- and short-term objectives of the investment program.
Allocate decision rights and responsibilities among the functional units in the governance hierarchy effectively, taking account of their knowledge, capacity, time, and position in the governance hierarchy.
Specify processes for developing and approving the investment policy statement that will govern the day-to-day operations of the investment program.
Specify processes for developing and approving the program’s strategic asset allocation.
Establish a reporting framework to monitor the program’s progress toward the agreed-on goals and objectives.
Periodically undertake a governance audit.

In the sections that follow, we will discuss selected elements from this list.

Articulating Investment Objectives

Articulating long- and short-term objectives for an investor first requires an understanding of purpose—that is, what the investor is trying to achieve. Below are examples of simple investment objective statements that can be clearly tied to purposes:

Defined benefit pension fund. The investment objective of the fund is to ensure that plan assets are sufficient to meet current and future pension liabilities.
Endowment fund. The investment objective of the endowment is to earn a rate of return in excess of the return required to fund, after accounting for inflation, ongoing distributions consistent with the endowment’s mission.
Individual investor. The investment objective is to provide for retirement at the investor’s desired retirement age, family needs, and bequests, subject to stated risk tolerance and investment constraints.

A return requirement is often considered the essence of an investment objective statement, but for that portion of the objective statement to be properly understood requires additional context, including the obligations the assets are expected to fund, the nature of cash flows into and out of the fund, and the asset owner’s willingness and ability to withstand interim changes in portfolio value. The ultimate goal is to find the best risk/return trade-off consistent with the asset owner’s resource constraints and risk tolerance.

As an example of how the overall context can affect decision making, the pension fund may be an active plan, with new participants added as they are hired, or it may be “frozen” (no additional benefits are being accrued by participants in the plan). The status of the plan, considered in conjunction with its funded ratio (the ratio of pension assets to pension liabilities), has a bearing on future contributions and benefit payments. The company offering the pension benefit may operate in a highly cyclical industry, where revenues ebb and flow over the course of the economic cycle. In this case, the plan sponsor may prefer a more conservative asset allocation to minimize the year-to-year fluctuations in its pension contribution.

The nature of inflows and outflows for an endowment fund can be quite different from those of a pension fund. An endowment fund may be used to support scholarships, capital improvements, or university operating expenses. The fund sponsor has some degree of control over the outflows from the fund but very little control over the timing and amounts of contributions to the fund because the contributions are typically coming from external donors.

These cash inflow and outflow characteristics must be considered when establishing the goals and objectives of the fund.

A third, inter-related aspect of defining the sponsor’s goals and objectives is determining and communicating risk tolerance. There are multiple dimensions of risk to be considered: liquidity risk, volatility, risk of loss, and risk of abandoning a chosen course of action at the wrong time.

Effective investment governance requires consideration of the liquidity needs of the fund and the liquidity characteristics of the fund’s investments. For example, too large an allocation to relatively illiquid assets, such as real estate or private equity, might impair the ability to make payouts in times of market stress.

A high risk/high expected return asset allocation is likely to lead to wider swings in interim valuations. Any minimum thresholds for funded status that, if breached, would trigger an adverse event, such as higher pension insurance premiums, must be considered in the asset allocation decision.

For individual investors, the risk of substantial losses may be unacceptable for a variety of financial and psychological reasons. When such losses occur after retirement, lost capital cannot be replaced with future earnings.

Asset owners have their own unique return requirements and risk sensitivities. Managing an investment program without a clear understanding of long- and short-term objectives is similar to navigating without a map: Arriving at the correct destination on time and intact is not compatible with leaving much to chance.

Allocation of Rights and Responsibilities

The rights and responsibilities necessary to execute the investment program are generally determined at the highest level of investment governance. The allocation of those rights and responsibilities among the governance units is likely to vary depending on the size of the investment program; the knowledge, skills, and abilities of the internal staff; and the amount of time staff can devote to the investment program if they have other, competing responsibilities. Above all, good governance requires that decisions be delegated to those best qualified to make an informed decision.

The resources available to an organization will affect the scope and complexity of the investment program and the allocation of rights and responsibilities. A small investment program may result in having a narrower opportunity set because of either asset size (too small to diversify across the range of asset classes and investment managers) or staffing constraints (insufficient asset size to justify a dedicated internal staff). Complex strategies may be beyond the reach of entities that have chosen not to develop investment expertise internally or whose oversight committee lacks individuals with sufficient investment understanding. Organizations willing to invest in attracting, developing, and retaining staff resources and in developing strong internal control processes, including risk management systems, are better able to adopt more complex investment programs. The largest investors, however, may find their size creates governance issues: Manager capacity constraints might lead to so many managers that it challenges the investor’s oversight capacity.

Allocation of rights and responsibilities across the governance hierarchy is a key element in the success of an investment program. Effective governance requires that the individuals charged with any given decision have the required knowledge and expertise to thoroughly evaluate the alternative courses of action and the capacity to take on the ongoing responsibility of those decisions, and they must be able to execute those decisions in a timely fashion. (Individual investors engaging a private wealth manager are delegating these expertise, capacity, and execution responsibilities.)

Exhibit 2:

Allocation of Rights and Responsibilities

Investment Activity

Investment Committee

Investment Staff

Third-Party Resource

Mission

Craft and approve

n/a

Investment policy statement

Approve

Draft

Consultants provide input

Asset allocation policy

Approve with input from staff and consultants

Draft with input from consultants

Consultants provide input

Investment manager and other service provider selection

Delegate to investment staff; approval authority retained for certain service providers

Research, evaluation, and selection of investment managers and service providers

Consultants provide input

Portfolio construction (individual asset selection)

Delegate to outside managers, or to staff if sufficient internal resources

Execution if assets are managed in-house

Execution by independent investment manager

Monitoring asset prices & portfolio rebalancing

Delegate to staff within confines of the investment policy statement

Assure that the sum of all sub-portfolios equals the desired overall portfolio positioning; approve and execute rebalancing

Consultants and custodian provide input

Risk management

Approve principles and conduct oversight

Create risk management infrastructure and design reporting

Investment manager manages portfolio within established risk guidelines; consultants may provide input and support

Investment manager monitoring

Oversight

Ongoing assessment of managers

Consultants and custodian provide input

Performance evaluation and reporting

Oversight

Evaluate manager’s continued suitability for assigned role; analyze sources of portfolio return

Consultants and custodian provide input

Governance audit

Commission and assess

Responds and corrects

Investment Committee contracts with an independent third party for the audit

The available knowledge and expertise at each level of the hierarchy, the resource capacity of the decision makers, and the ability to act on a timely basis all influence the allocation of these rights and responsibilities.

Investment Policy Statement

The investment policy statement (IPS) is the foundation of an effective investment program. A well-crafted IPS can serve as a blueprint for ongoing fund management and assures stakeholders that program assets are managed with the appropriate care and diligence.

Often, the IPS itself will be a foundation document that is revised slowly over time, whereas information relating to more variable aspects of the program—the asset allocation policy and guidelines for individual investment managers—will be contained in a more easily modified appendix.

Asset Allocation and Rebalancing Policy

Because of its strategic importance, the investment committee, at the highest level of the governance hierarchy, typically retains approval of the strategic asset allocation decision. A proposal is often developed only after a formal asset allocation study that incorporates obligations, objectives, and constraints; simulates possible investment outcomes over an agreed-on investment horizon; and evaluates the risk and return characteristics of the possible allocation strategies.

Governance considerations inform not only the overall strategic asset allocation decision but also rebalancing decisions. The IPS should contain at least general orienting information relevant to rebalancing. In an institutional setting, rebalancing policy might be the responsibility of the investment committee, organizational staff, or the external consultant. Likewise, individual investors might specify that they have delegated rebalancing authority to their investment adviser. Specification of rebalancing responsibilities is good governance.

Reporting Framework

The reporting framework in a well-run investment program should be designed in a manner that enables the overseers to evaluate quickly and clearly how well the investment program is progressing toward the agreed-on goals and objectives. The reporting should be clear and concise, accurately answering the following three questions:

Where are we now?
Where are we relative to the goals and objectives?
What value has been added or subtracted by management decisions?

Key elements of a reporting framework should address performance evaluation, compliance with investment guidelines, and progress toward achieving the stated goals and objectives.

Benchmarking is necessary for performance measurement, attribution, and evaluation. Effective benchmarking allows the investment committee to evaluate staff and external managers. Two separate levels of benchmarks are appropriate: one that measures the success of the investment managers relative to the purpose for which they were hired and another to measure the gap between the policy portfolio and the portfolio as actually implemented.
Management reporting, typically prepared by staff with input from consultants and custodians, provides responsible parties with the information necessary to understand which parts of the portfolio are performing ahead of or behind the plan and why, as well as whether assets are being managed in accordance with investment guidelines.
Governance reporting, which addresses strengths and weaknesses in program execution, should be structured in such a way that regular committee meetings can efficiently address any concerns. Although a crisis might necessitate calling an extraordinary meeting, good governance structures minimize this need.

The Governance Audit

The purpose of the governance audit is to ensure that the established policies, procedures, and governance structures are effective. The audit should be performed by an independent third party. The governance auditor examines the fund’s governing documents, assesses the capacity of the organization to execute effectively within the confines of those governing documents, and evaluates the existing portfolio for its “efficiency” given the governance constraints.

Effective investment governance ensures the durability or survivability of the investment program. An investment program must be able to survive unexpected market turmoil, and good investment governance makes certain that the consequences of such turmoil are considered before it is experienced. Good governance seeks to avoid decision-reversal risk—the risk of reversing a chosen course of action at exactly the wrong time, the point of maximum loss. Good investment governance also considers the effect of investment committee member and staff turnover on the durability of the investment program. Orientation sessions for new committee members and proper documentation of investment beliefs, policies, and decisions enhance the likelihood that the chosen course of action will be given sufficient time to succeed. New staff or investment committee members should be able to perceive easily the design and intent of the investment program and be able to continue to execute it. Similarly, good investment governance prevents key person risk—overreliance on any one staff member or long-term, illiquid investments dependent on a staff member.

Good governance works to assure accountability. O’Barr and Conley (1992, p.21), who studied investment management organizations using anthropological techniques, found that blame avoidance (not accepting personal responsibility when appropriate to do so) is a common feature of institutional investors. Good governance works to prevent such behavior.

EXAMPLE 1
Investment Governance: Hypothetical Case 1
In January 2016, the Caflandia Office Workers Union Pension (COWUP) made the following announcement:
“COWUP will fully exit all hedge funds and funds of funds. Assets currently amounting to 15% of its investment program are involved. Although hedge funds are a viable strategy for some, when judged against their complexity and cost, hedge fund investment is no longer warranted for COWUP.”
One week later, a financial news service reported the following:
“The COWUP decision on hedge funds was precipitated by an allegation of wrongdoing by a senior executive with hedge fund selection responsibilities in COWUP’s alternative investments strategy group.”

Considering only the first statement, state what facts would be relevant in evaluating whether the decision to exit hedge funds was consistent with effective investment governance.

Solution to 1:

The knowledge, capacity, and time available within COWUP to have an effective hedge fund investment program would need to be assessed against the stated concern for complexity and cost. The investment purpose served by hedge funds in COWUP’s investment program before it exited them needs to be analyzed.

Considering both statements, identify deficiencies in COWUP’s investment governance.

Solution to 2:

The second statement raises these concerns about the decision described in the first statement:

Hiring and oversight of COWUP executives may have been inadequate.
The initial COWUP information release was incomplete and possibly misleading. Public communications appear not to have received adequate oversight.
Divesting hedge funds may be a reaction to the personnel issue rather than being based on investment considerations.

EXAMPLE 2
Investment Governance: Hypothetical Case 2
The imaginary country of Caflandia has a sovereign wealth fund with assets of CAF$40 billion. A governance audit includes the following:
“The professional chief investment officer (CIO) reports to a nine-member appointed investment committee board of directors headed by an executive director. Investment staff members draft asset allocation policy in conjunction with consultants and make recommendation to the investment committee; the investment committee reviews and approves policy and any changes in policy, including the strategic asset allocation. The investment committee makes manager structure, conducts manager analysis, and makes manager selection decisions. The CIO has built a staff organization, which includes heads for each major asset class. In examining decisions over the last five years, we have noted several instances in which political or non-economic considerations appear to have influenced the investment program, including the selection of local private equity investments. Generally, the board spends much of its time debating individual manager strategies for inclusion in the portfolio and in evaluating investment managers’ performance with comparatively little time devoted to asset allocation or risk management.”

Solution:

Sound practices: The allocation of responsibilities for asset allocation between investment staff and the investment committee is sound practice. Staff investment expertise should be reflected in the process of asset allocation policy and analysis. The investment committee assumes final responsibility for choices and decisions, which is appropriate given its position in receiving information from all parts of the organization and from all interested parties.

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