Successful investing for long-term funds requires a strategic plan. This is true despite – indeed, because of – the fact that the future is unknowable.
The plan must be specific, embodying in concrete terms the best thinking of the board of trustees about the investment pool, its goals and purposes; but it also needs to be sufficiently flexible to guide the board through environments that may be very different from those prevailing at the time of its adoption.
In the past, many investment policy statements gave relatively cursory treatment to risk, its quantification and its potential impact on the asset pool. The market collapse and credit crisis of 2007-2009 demonstrated that many institutions’ portfolios carried unacknowledged risks, that their risk profiles in general were higher than they thought, and that the risk tolerance of their fiduciaries was lower than acknowledged. Today, then, it is entirely appropriate to put risk at the top of the process of investment policy development.
Financial models, as the crisis demonstrated, are anything but infallible and, when consulted, must be used with care and a healthy degree of skepticism. It is nonetheless true that the results of an appropriate simulation or modeling study can assist fiduciaries in going beyond traditional risk definitions such as volatility to examine such critical parameters as the risk of permanent loss, year-to-year declines in spending, and recovery periods. These metrics both enable and force a discussion about tolerable levels of risk, the conclusions from which can be used to guide the construction of a range of potential portfolios that embody those risks that are deemed acceptable. Projected returns from these portfolios are an outcome which, if considered insufficient, indicate either acceptance of lower contributions for the acceptable level of risk or mandate a more robust discussion about the relationship between risk assumption and needed long-term returns.
Instead of starting with return – committees work toward it.
If, ultimately, the projected range of returns is seen as ‘too low’ compared to anticipated institutional needs, then the fiduciaries must either reconcile themselves to the fact that the target return is beyond their reach given their risk limits, or accept the necessity of embracing additional risks and explicitly acknowledge them in the investment policy statement.
To help your Board of Trustees or Investment Committee members craft an investment policy statement for your endowed nonprofit organization Commonfund has prepared two Investment Policy Statement templates.
The Risk-based Investment Policy Statement template – designed for organizations with access to financial simulation and modeling tools (sometimes called Monte Carlo models) that can be used to estimate ranges of future returns for given portfolio choices and create “stress-testing” scenarios to examine the performance of portfolios in illiquid or non-normal market environments.
The Traditional Investment Policy Statement template – designed for organizations that do not have access to, or choose not to use, the financial simulation and modeling tools employed in the Risk-based Investment Policy Statement.