The Climb to Investment Excellence E-Book

Ana Marshall

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 336

Veröffentlichungsjahr: 2023

Beschreibung

A go-to resource for institutional investors and asset allocators seeking practical advice from a proven leader in the field InThe Climb to Investment Excellence: A Practitioner's Guide to Building Exceptional Portfolios and Teams, celebrated institutional investor and asset allocator Ana Marshall draws on her 36 years' experience in finance and investment to deliver a comprehensive and practical blueprint for a resilient and high-performing institutional portfolio, as well as a reliable roadmap for the management of its stakeholders. You'll discover ready-to-deploy strategies and advice that's informed by evidence and tried and tested in the real world, helping you to build and manage your team, construct a portfolio, set your goals, select the right managers, and more. You'll also find: * Explorations of three themes that consistently define the careers of successful investors and asset allocators: strategy and planning, trust, and risk management * The critical factors every investor and allocator should consider before making any sort of impactful decision * Examinations of the importance of resilience in the face of bad fortune or mistakes A can't-miss resource for institutional investors and asset allocators, The Climb to Investment Excellence will also benefit board members tasked with overseeing their organizations' investment objectives and performance in a volatile and ever-changing market. (There is no workbook that goes alongside this book.)

Leseprobe

Table of Contents

Cover

Table of Contents

Praise for

The Climb to Investment Excellence

Title Page

Copyright

Dedication

Prologue

Notes

Part I: BASE CAMP – THE ADVENTURE BEGINS

Preparing for Base Camp

1 Identifying the Summit

Setting the Investment Objective

Understanding Constraints and Payout

Various Approaches to Policy Portfolios

Risk Tolerance

Time Horizon

Note

2 Defining Governance Responsibilities

Delegation of Authority

Extent of Delegation

Governance

Assembling the Team

Transparency into the Investment Process

Notes

Settling in at Base Camp

3 The Subtlety of Public Markets

The Role of Public Assets

Capturing Growth in Public Equities

Nuances of Fixed Income

Hedge Funds are an Essential Tool

Notes

4 Perspectives on Private Markets

The Role of Private Investments

The Illiquidity Premium

Duration of Investment Holding Period

Leverage

Traditional Fund Structures

Alternative Fund Structures

Reconciling Performance

Notes

Part II: THE EXCITEMENT OF THE CLIMB

From Base Camp to First Camp

5 Developing a Policy Portfolio

Capital Market Assumptions

Optimizer Constraints

The Cloud of Efficiency

Creating the Policy Portfolio

Range of Possible Outcomes

Stress Testing

Notes

From First Camp to Second Camp

6 Portfolio Construction

Selecting Market Beta Exposure

Diversification of Alpha Sources

Designing Asset Class Strategy

Philosophy of Concentration versus Diversified Managers

Sizing of Managers

Reassessing Sizing

Rebalancing Ranges

Internal Process

Exogenous Risks

Note

7 Active Risk

Measuring Active Risk

Size Limitations to Active Risk

Setting Expectations of Annualized Alpha

Note

8 Portfolio Hedging

Active Hedging Strategy

Volatility Management Strategy

Alternatives to Hedging

Notes

9 Liquidity Management

Illiquidity Tolerance

Unfunded Commitments

Modeling Portfolio Cash Flows

Note

10 Secondaries

Tool in Active Portfolio Management

Selection of a Secondary Agent

Constructing a Portfolio for Sale

Risk Management Benefits versus Cost

11 Benchmarks

Benchmark Design Options

Benchmark Selection

Testing the Benchmarks

Making Changes to Benchmarks

From Second Camp to Third Camp

12 Manager Selection

Evolution of Manager Selection

Setting the Bar

Refining the Skills Needed on the Team

Due Diligence Process Design

Manager Diligence and Selection Process

Sizing the Investment

Monitoring the Portfolio

Identifying Biases in Mature Portfolios

Knowing When to Quit

Note

Part III: THE SUMMIT IN VIEW

Reaching for the Summit

Note

13 Managing the Team

Team Culture

Team Structure

Decision‐Making Process

Size and Skills of Team

Leadership

Designing an Incentive Plan That Works

Notes

14 Managing Up

Developing Trust with the Board

Transparency in Reporting

Note

15 Managing Relationships with Fellow Investors

Developing True Partnership with GPs

Approaches to Diversity, Equity, and Inclusion

Notes

16 Managing the Self

The Value of Integrity, Emotional Intelligence, and Values

Honing the Competitive Edge

Notes

Glossary

Index

End User License Agreement

List of Tables

Chapter 1

Table 1.1

Table 1.2

Table 1.3

Table 1.4

Chapter 2

Table 2.1

Table 2.2

Chapter 3

Table 3.1

Table 3.2

Chapter 4

Table 4.1

Table 4.2

Chapter 5

Table 5.1

Table 5.2 Preserving Purchasing Power

Table 5.3 Comparison of Portfolio Approaches

Table 5.4

Chapter 6

Table 6.1

Chapter 7

Table 7.1

Chapter 8

Table 8.1

Chapter 9

Table 9.1

Table 9.2

Table 9.3

Chapter 10

Table 10.1

Table 10.2

Chapter 11

Table 11.1

Table 11.2

Chapter 12

Table 12.1

Table 12.2 The Four Ps of Diligence

Chapter 13

Table 13.1

Table 13.2

Chapter 14

Table 14.1

Chapter 15

Table 15.1

List of Illustrations

Chapter 1

Figure 1.1 Estimated Risk vs. Reward by Portfolio Types

Chapter 5

Figure 5.1 Risk Premia

Figure 5.2 Rolling Correlation of Daily Stock and Bond Returns

Figure 5.3 Efficient Frontiers

Figure 5.4 Cloud of Efficiency

Figure 5.5 Asset Class Expected Return and Volatility Risk

Figure 5.6 Distribution of Returns of Sample Portfolio

Figure 5.7

Guide

Cover Page

Praise for The Climb to Investment Excellence

Title Page

Copyright

Dedication

Prologue

Table of Contents

Begin Reading

Glossary

Index

Wiley End User License Agreement

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Praise for The Climb to Investment Excellence

“Institutional pools of capital are among the least understood and most important investment pools in the world. After nearly four decades in the trenches, half as a direct investor and half on the buy side of the buy side, Ana deeply understands the investment process employed by institutional Chief Investment Officers. In The Climb to Investment Excellence, she shares both the building blocks of how it all works and her unique insights into each aspect of the process. Her work is a must read for those seeking to understand how this opaque corner of the investment world operates.”

—Ted Seides, Capital Allocators

“Ana Marshall's book is required reading for anyone managing money or anyone looking to learn how to become an excellent investor—or simply looking to be inspired by the idea of investing well and doing good with it. Ana does a great job in distilling complex subjects into actionable decisions, as well as provide valuable insights on themes not normally covered well in books on investing—the importance of relationships with boards, committees, investment managers, and her team cannot be understated.”

—James Manyika, SVP Google‐Alphabet, Chair and director emeritus, McKinsey Global Institute

“Ana demystifies long‐term investing by sharing both her direct experience and the intelligence she has gathered over the last 20 years as a successful practitioner. This book is essential reading for anyone involved in a voluntary or professional basis managing long term pools of capital. There is a chapter for everyone: trustees, board/committee members, fellow CIOs and their team members. Also highly recommended reading for General Partners and investment managers who manage non‐profit money, it provides deep insight into the governance and investment practices of their investors enabling both to build stronger partnerships.”

—Sandra Robertson, CEO and CIO Oxford University Endowment Management

“This is a ‘must read’ book for investment committee and board members responsible for overseeing large sums of capital and setting the standards to achieve excellence. Very few investment professionals have been as thoughtful about the investment process as Ana. Add to that her innate ability to join the dots from disparate pieces of information and data, and you have the winning performance she has demonstrated.”

—Boon Hwee Koh, Board Member GIC and Singapore Stock Exchange

THE CLIMB TO INVESTMENT EXCELLENCE

A PRACTITIONER'S GUIDE TO BUILDING EXCEPTIONAL PORTFOLIOS AND TEAMS

ANA MARSHALL, CFA

Copyright © 2024 by Ana Marshall. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per‐copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750‐8400, fax (978) 750‐4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748‐6011, fax (201) 748‐6008, or online at http://www.wiley.com/go/permission.

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Library of Congress Cataloging‐in‐Publication Data

Names: Marshall, Ana, author.

Title: The climb to investment excellence: a practitioner’s guide to building exceptional portfolios and team / Ana Marshall.

Description: Hoboken, New Jersey : Wiley, [2024]

Identifiers: LCCN 2023024882 (print) | LCCN 2023024883 (ebook) | ISBN 9781394206698 (hardback) | ISBN 9781394206711 (adobe pdf) | ISBN 9781394206704 (epub)

Subjects: LCSH: Investments. | Portfolio management.

Classification: LCC HG4521 .M219 2023 (print) | LCC HG4521 (ebook) | DDC 332.6—dc23/eng/20230721

LC record available at https://lccn.loc.gov/2023024882

LC ebook record available at https://lccn.loc.gov/2023024883

Cover Design: Wiley

Cover Image: © Overearth/Getty Images

With gratitude to my incredible husband and kids –

my expedition team for life

Prologue

Somewhere between the bottom of the climb and the summit is the answer to the mystery of why we climb.

—Greg Child1

Climbing a technically difficult mountain like Everest, K2, or Denali is similar to creating an excellent investment portfolio. Being excellent at investing is hard. Climbing to the top of Everest or Kilimanjaro is hard. Thousands of alpinists make the attempt to reach the summit every year, both in mountain climbing and investing. Many fail to move successfully from base camp through to the summit.

This book is a handbook to help anyone with a fiduciary responsibility for overseeing or managing significant sums of capital. Many books on investing suggest there is one mountain worth climbing, one right way to do it, one definitive answer. I would argue that similar to ascending to a mountain summit, there is no single route or definitive guide to the top. Every organization has different goals, operating requirements, and priorities.

A long‐term investment strategy provides a road map that rarely is able to anticipate the cyclical and secular hazards in capital markets and the economy. There are limitations to any climbing plan, and they must be overcome to reach the top. The art of investing is how investors execute the plan in spite of the challenges on the way to the summit. My goal in this book is to give you the tools to construct an excellent investment program along with the courage to adapt plans to reach the summit.

Alpinism is similar to investing in that it is the interplay between the technical skills and endurance of the climber/investor and the conditions of the mountain/market that result in a successful summit. Before heading into any climb, having well‐honed expert technique, the right climbing gear, and knowing the routes to ascend are essential requirements for a successful climb. However, skill and a plan are not enough. To climb successfully to the summit, one must be able to adapt quickly and be able to navigate under unexpected changes in the environment. The mountains and markets are full of cautionary tales. The main goal, besides success in making it to the top, is survival.

Investing and climbing involve repetitive processes of thinking, problem solving, and executing. Thinking outside traditional frameworks, solving problems, and then executing the solution a hundred times a year, and thousands of times in a career is how to build muscle memory. It takes years of practice and living at altitudes where the air is thin and ever changing, to be able to ascend and not succumb to the wear and tear of the climb.

Importantly, one never climbs alone. There is a team that works together to improve the probability of making it to the summit. The chief investment officer (CIO) is the expedition guide charged with the responsibility of making sure the team makes it to the summit. As with any intensive sport, discipline, hard work, and practice are essential. The leader must take a group of competitive individuals and form a team that is attuned to the tempo of the mountain and the hazards of storms.

During my career I have identified attractive investment strategies only to be faced with unanticipated hazards. From my early days as a high‐yield credit analyst, I learned fundamental value didn't protect downside in the face of the Drexel Burnham Lambert bankruptcy in 1990. During the 1990s, I was recruited to summit a new, technically challenging peak: investing in emerging markets. I soon realized that company fundamentals could be blown off course by exogenous factors (currency devaluations, political coups, etc.) that suddenly appeared and turned into full‐blown storms called the Tequila Crisis of 1994, the Asian Crisis of 1997, and the Russia Crisis of 1998.

Wanting the challenges of a new adventure, I set my sights on a new summit, managing global equities, only to be caught in a blinding snowstorm when the internet bubble popped in 2000–2001. Once adjusted to the new environment, the strategic plan was, yet again, taken off course by 9/11 in 2001 and the spectacular corporate frauds of Enron and WorldCom in 2003. Successfully managing client portfolios during difficult times increased my resilience and ingrained a determination to survive whatever hazards came my way.

In 2004, I was asked to join a new expedition team to climb the most challenging mountain of my career. Laurie Hoagland2 was assembling a new expedition team to take the $4 billion Hewlett Foundation endowment to new heights. He recognized a fellow investor and believed my skills in global fixed income and equities would be of great use as we built the Hewlett diversified portfolio. I lacked certain technical skills necessary to get to first camp. He took the time to teach me the importance of governance, clear objectives, asset allocation, and developing a policy portfolio. His expectations of me were clear from the start. He expected me to take over as the expedition team leader somewhere between first and second camp. Even this plan didn't go as anticipated. As it turns out, there was so much work involved in ensuring that the investment program could weather the storm, that he and I, along with the rest of the team, knew we would be stronger staying on course together. Very little went according to our expectations. When the Great Financial Crisis (GFC) hit in 2008, the storm was clearly surrounding us. This was the moment in which Laurie and I had the critical conversation of what it would take to lead the portfolio and team to safer ground. We knew in theory what it would take to recover strength and trek on. It took grit and determination to keep moving with little visibility ahead.

Being successful in investing requires a mix of theory, practice, and luck. If the terrain and ice conditions didn't change, or if the sun, wind, or snow were perfectly predictable, then machines could do what we do. Combining theory and practice ensures that the climbing, or investing, team has the chance to change path, slow or accelerate the pace, and it improves the chance of making it to the top. The alternative is to wait out the elements as they hit parts of the endowment portfolio.

Some people believe machines can do what we do, but I would argue that investor behavior is difficult to predict in the moment. This is the reason why, despite excellent mathematical models, expected volatility still differs from realized volatility. However, we are in the early stages of knowing the capabilities of artificial intelligence, and some degree technological disruption of the investment office is likely to occur over the coming decade.

This book offers a practical guide to things any investor or anyone serving as a fiduciary (on a board or investment committee) should consider before deciding on the objective of an investment program. The practical advice combines 18 years as a GP/investor and 18 years as an allocator of capital. It sets out the skills needed to have a high probability of succeeding on the ascent, and also takes into account the luck and the resilience investors must have to climb to the summit in the investing world. It doesn't have magic formulas, nor quick fixes, because investing takes hard work and the ability to think quickly and adapt to a changing environment. However, it does provide easy‐to‐reference lists of things to consider when faced with decision points and gives ideas on how to adapt plans in order to survive and continue the climb when conditions force a change and things go wrong.

The book has three sections.

The first is focused on preparing for the climb and reaching base camp. Think of this part as the chapters on the logistics that will be crucial to make sure you and your team have a successful expedition. These are the chapters where the organization3 identifies the summit for the expedition, responsibilities are clarified, and the team has the time to adjust to the altitude (the headaches, the pressure, etc.). You need to make sure everyone involved in the expedition, including the client, the board, and the investment committee, is clear on the goal, the tools, and the capability of the team. The pacing of the expedition is established, and the decision of whether the team will carry heavy packs or lightweight packs is made. Reaching base camp and setting asset allocation policy can only be done after the logistics have been put into place and the pack lists have been checked.

The second part of the book has the practical aspects of the ascent from first camp through third camp. These chapters cover the primary responsibilities of managing an investment portfolio. Developing the policy portfolio serves as the first resting spot after leaving base camp. Between first camp and second camp, the team implements the policy portfolio, adapting and using the portfolio management tools available to navigate ever‐changing conditions. Moving from second camp to third camp, manager selection and diligence offer up different types of hazards.

The third part of the book is the final push to the summit, where leadership and endurance play a critical role. This is the most dangerous part of the climb, and also where most teams fail. This part provides tips on setting best practices for your investment program in managing all of the members of the climbing team: the investment team, the board, the managers, and the other climbers on the mountain. Creating team culture and inspiring the team as the air thins and the ice storms come, more often than not, are just a few of the challenges in managing highly competitive and ambitious climbers. Finally, in reaching the summit, an investor is forced to look within to one's competitive edge in order to find the way home.

There are three underlying themes woven into every chapter because they are always top of mind for a successful alpinist. The first is having a well‐thought‐out strategy or plan as to how the team will ascend. The second is risk management because every decision must weigh the promise of progress against the risk to the team and the mission. The third is trust because the alpinist needs to be someone who is deeply trusted by their expedition team and the other climbers on the mountain. The organizations we work for trust that we will be successful ascending to the summit, taking only as much risk as necessary to achieve our objective.

Finally, a word of encouragement as you attempt the climb. It takes years to prepare physically and mentally to be able to ascend to the summit. Many of the greatest alpinists spent years training as porters, learning from experienced alpinist teams. As porters who prepare the route and carry supplies, they spent untold hours observing the mistakes made along the way, analyzing the paths chosen, and the difficult in‐the‐moment decisions made. I spent the first nine years of my career as an analyst (porter) learning from great investors around me. I observed how teams were formed and how they fell apart. I learned that having tools and skills is not enough. I learned to identify courageous, resilient leaders in the face of adversity and also the joy that comes from taking advantage of clear skies and cheering on the team as they triumph over unforeseen obstacles.

Notes

1

Greg Child, from an interview in Jonathan Waterman, “The Natural: Greg Child,” in Jonathan Waterman, ed.,

Cloud Dancers: Portraits of North American Mountaineers

(Golden, CO: AAC Press, 1993), 280.

2

Laurence “Laurie” Hoagland was a legendary investor and mentor who understood that forming the expedition team was the key to success. He was the first CIO of Stanford Management Company and a lifelong friend of the Hewlett family.

3

Throughout the book I refer to organization or institution because that is my point of reference. The lessons and tools can apply to family offices and multi‐client fiduciaries. I also refer to the chief investment officer (CIO) as the team leader but recognize in some organizations the title of the expedition leader may differ.

Part IBASE CAMP – THE ADVENTURE BEGINS

Preparing for Base Camp

1Identifying the Summit

Attempting to climb Everest is an intrinsically irrational act – a triumph of desire over sensibility.

—John Krakauer, Into Thin Air1

Whether you are starting a new investment office, creating an investment strategy for a new client, or the investment office has existed for decades, it is important to ensure that the objective of the investment program is clear. Different types of organizations have different priorities and objectives. Almost every organization has conflicting priorities between the staff and investment committee (IC) and board, regardless of whether the organization is a family office, pension fund, endowment, or foundation. There are several areas where the board and IC need to reconcile different priorities to develop a clear and cohesive role of the investment program in funding the needs of the organization in the near and long term. Table 1.1 sets out four areas to consider.

Just because Everest is there doesn't mean that this is the right goal and that investors have to climb that particular summit. How complex one makes a portfolio is a choice, just like choosing a less difficult mountain to climb. The portfolio should not be too complex relative to the needs of the organization or too difficult to implement, taking into account the skill set and resources of the investment team.

Table 1.1

Considerations for Identifying the Summit

Setting the investment objective

Understanding constraints and payout needs

Agreement on risk tolerance

Setting the time horizon

Source: The William and Flora Hewlett Foundation.

Managing a diversified institutional portfolio that delivers consistently superior returns is hard. Unless an investment program is staffed with the technical skills and access to top investment managers, perhaps choosing a portfolio with low cost and liquid funds with less complexity may be the best option. The goal is to reach the summit and have an excellent investment program. The view from the summit is worthwhile, no matter what mountain one has chosen to climb.

Setting the Investment Objective

Since the investment program is designed to achieve the investment objective, it really is worth having a fresh conversation to ensure the organization has a clear understanding of the investment program objective formally set in the investment policy statement (IPS) approved by the board of directors. The IPS serves as the North Star for strategic asset allocation, risk management, and liquidity management of an institutional portfolio. It goes without saying that the foremost responsibility of the CIO is to provide liquidity to fund the obligations of the organization and to achieve the investment objective.

On occasion, institutions choose to modify the IPS to reflect changes in spending needs or other priorities. It is natural to expect institutions to shift priorities over time as new leadership takes on new strategic direction, and the natural rotation of members of the board surfaces new ideas. The CIO is responsible for ensuring that the latest version of the IPS reflects current priorities, because it is the clearest directive of the strategy that must be implemented to achieve the objectives of the institution.

Defining what success looks like is key. Despite having a clearly stated IPS, a CIO should not assume that a successful investment program will be judged in the same way by the board and by the institution. Agreement between the board and the IC, and clear communication with the CIO on the criteria used to judge success of the investment program are critical to long‐term achievement of the goal. The CIO needs to understand whether the IC thinks of returns in absolute terms, or in relative terms, and whether returns will be judged relative to the benchmark or relative to a narrow set of peer organizations.

Importantly, defining success does not have to be complicated. In fact, the simpler and clearer it is, the better for all concerned. Think of an IPS as the identification of the summit, and the packs and loads the expedition will have to carry to the summit. The organization can choose to burden the expedition with heavy packs (restrictions) or encourage lightweight packs to encourage adaptability. Importantly, the IPS reflects the key priorities of the organization. Below I provide examples of an IPS from three distinct organizations with different priorities.

At Hewlett Foundation, the priority is to preserve the spending power of the endowment in perpetuity by focusing on growing the endowment and on disciplined spending:

The Hewlett Foundation seeks to maintain or grow current asset size and spending power in real (inflation‐adjusted) terms with risk at a level appropriate to the Foundation's program objectives. There may be occasions when financial markets are down in ways that could require spending reductions in order to meet this objective. The board will ordinarily reduce spending in a downturn in order to mitigate the potential reduction in the Foundation's real value. (For purposes of this policy statement, a downturn is defined as negative return before payout in a calendar year.) Upon a vote of the majority of the board, the board may choose not to reduce spending in exceptional circumstances.

Some may consider defining a downturn as simply as “a negative return in a calendar year” as being too short‐term oriented. Every institution is different. From experience, our conversations with the Hewlett board have focused on high sensitivity to a material decline in the value of the investment portfolio. Hewlett's spending policy is to spend between 4.75% and 5.75% of the foundation's assets averaged over a three‐year period. As a pragmatic matter, we usually use 5.1%. If the investment return of the Hewlett endowment in any calendar year is negative, our plan calls for budgeting an amount equal to 5.1% of the estimated assets at the end of that year (i.e., without three‐year smoothing).

At Skoll Foundation, an organization where the donor is actively increasing funding, the priority is to have the endowment portfolio investments aligned with the mission:

The Skoll Foundation seeks to use all its resources to further its mission which provides the overarching framework for management of its financial capital. The Foundation acknowledges that the management of its assets must include the integration of prudent financial practices with principles of environmental stewardship, inclusive economic growth, and overall alignment with the Foundation's mission. In service of this mission the specific investment goals of the Foundation are: (1) to generate income necessary to fund the Foundation's spending on grants, program related investments and operations over the long‐term; (2) to grow the real value of the Foundation's financial assets over the long term with consideration of the Foundation's spending levels; and, (3) to seek investments in funds and companies whose practices and products further advance the Foundation's mission while avoiding investments in entities whose actions work counter to the Foundation's mission, unless the Foundation determines that engagement with such entities will result in developments that may benefit relevant communities.

At an (undisclosed) family office, the objective is compounding of the endowment and diversification from the entrepreneur's primary source of wealth:

The objective of the investment program is to generate superior risk‐adjusted returns to compound the investment portfolio, taking into account the risk tolerance of the family. The investment program should over time provide diversification away from the core business of the family. The investment program is intended to provide liquidity to support the family's philanthropic efforts and payout needs as approved by the board.

While a CIO aims to construct an optimal investment portfolio, the reality is that there are many factors that must be considered in setting the IPS such as those listed in Table 1.2.

Understanding Constraints and Payout

The IPS and the answers to the questions referenced in Table 1.2 inform the constraints the CIO must incorporate in developing the policy portfolio. Whether an organization is expected to exist in perpetuity or not impacts the level of risk and payout of the investment portfolio. It is helpful if the board incorporates a spending rule within the IPS so that the CIO can construct an investment portfolio that takes into consideration future cash‐flow needs. The spending rule is a commitment by the board that, in any given year, the cash flow needs from the investment portfolio will be limited to the agreed‐upon level.

Table 1.2

Factors to Consider in IPS

Is the organization perpetual or spend‐down?

Are there additional contributions of capital into the endowment?

What is the payout expected from the endowment portfolio?

Is there a spending rule in place?

How much of the organization's budget depends upon the endowment?

Any additional institutional constraints?

Source: The William and Flora Hewlett Foundation.

The discipline on spending budget sits with the board, not the CIO. Board members are tasked with deciding whether to maximize spending today or maximizing the probability that the organization will be able to fund payout in perpetuity. The CIO's role is to make the board aware of the implications of spending annually in excess of the return of the endowment, and then to respect the board's decision.

Another point to consider is whether the organization has additional sources of capital. In practice, rapid changes in the denominator (net asset value) create challenges for the active management of the endowment. The board should be aware of these challenges and provide as much guidance as possible, knowing that the denominator is unpredictable. University endowments and hospitals, as well as pension funds, sovereign‐wealth funds, and family offices typically receive additional sources of funding into the endowment portfolio. Boards and ICs should recognize that the CIO cannot control either the contributions or the payout from the portfolio yet is responsible for maintaining the agreed‐upon asset allocation policy. In light of this, there are likely to be periods when the deployment of the portfolio varies materially from the approved policy asset allocation mix.

The illiquidity tolerance of an organization needs to incorporate whether the institution's budget is flexible. Institutions with variable payout, or where the portfolio generates only a portion of the spending budget, tend to have higher illiquidity tolerance than organizations with a fixed payout or where the portfolio generates 100% of payout. Organizations with a significant amount of multi‐year commitments in the budget also have reduced flexibility in moderating spending.

At Hewlett, 100% of the spending budget is generated by the endowment. Because of the long‐term strategic work we fund through our grantees, the board and staff place great importance on maintaining the granting budget relatively stable. While Hewlett gives general operating support and mostly one‐year grants, the intent of the organization is to fund work within our strategic priorities for many years and maintain staff level. This type of giving means we have some flexibility in endowment spending. Working together, Hewlett's president, CFO, and I designed a flexible budgeting mechanism whereby 80% of the budgeted spending is allocated to the programs at the start of the year, and the remaining 20% is unallocated in case spending needs to be curtailed if there is a significant market dislocation.

Another consideration in setting the investment objective is the desire of the board to incorporate non‐investment criteria in the investment program. Many institutions have historically limited non‐investment guidelines to prohibitions on certain types of investments. For practical purposes, even when the IPS does not specify mission‐alignment, there needs to be common‐sense consideration by the investment team that the portfolio should not make investments that run counter to the issue areas the organization funds.

More recently, some boards have added a request to proactively invest in a diverse set of areas that advance interests of the institution. In cases like these, the IPS should specifically state goals for the investment program, as well as the criteria that should be used in managing this type of portfolio. Below are the specific details included in Skoll Foundation's IPS as an example of the clarity the board and IC have provided the investment team regarding the evaluation of fund managers and monitoring of the investment portfolio for impact. The CIO and team accepted the new IPS and adapted the expedition plan to achieve the objective.

Skoll's investments in external managers must be evaluated on the integration of environmental, social, and governance factors into investment strategy and process, including engagement on advancing diversity, equity, and inclusion within the investment firm. Special consideration is given to reducing net GHG [greenhouse gas] emissions attributable to the Skoll Foundation's portfolio to zero, integrating significant sustainability considerations into the investment process, and increasing mission‐aligned investments that further the philanthropic objectives of the foundation. The objective is generating accretive risk‐adjusted return.

Various Approaches to Policy Portfolios

While many organizations have adopted the endowment model to manage the assets of the institution, it is good practice to have a conversation with the IC to understand the benefits and drawbacks of one model versus another. It may sound like a waste of time, but a successful CIO and board should consider alternative methods for reaching the summit.

There are different approaches and strategies for an expedition. There should be a conversation about the merits and drawbacks of different models, including liquid alternatives such as the passive 70/30 equity/bond model, the high‐income model, and the risk parity model, against the backdrop of the diversified asset class mix (aka endowment model). There are also a number of models that combine a mix of direct investments in equity of companies or property, with third‐party‐managed public and private funds.

Every asset allocation approach has different risk/reward scenarios and the implications on the probability that an institution is able to achieve the investment objective set forth by the board. Below are brief overviews of other models used:

The traditional 70% equity/30% fixed income portfolio: This model can be invested on a passive basis and rebalanced monthly. The advantages of this approach are that it is simple to understand, implement, and monitor, is fully liquid, and is low cost. Unfortunately, it is expected to generate low returns relative to other approaches with higher volatility and drawdowns.

The high‐income portfolio: This approach is based on the theory that the primary objective of the portfolio is to generate annual cash flow to meet liabilities (grants and expenses). There is no obvious index to reference here, so a mix of investment‐grade and high‐yield indices can be combined and easily constructed. Unfortunately, while this portfolio reduces the variability around funding a set level of spending, the probability of a large drawdown remains high (as occurred in 2022), and the probability of maintaining the real (inflation‐adjusted) spending power of the endowment is low relative to other approaches.

The risk parity portfolio: The risk parity portfolio tries to diversify exposure to various sources of portfolio risk, rather than taking a concentrated exposure to equity risk premium as occurs in most traditional portfolios. There are many ways investors choose to implement a risk parity framework, yet at its core is the belief that one should allocate capital based on risk factors instead of asset classes by using Sharpe Ratios. Risk premia are calculated on a backward‐looking basis and assume that the relationships between asset classes and risk are relatively unchanged in the future. On a backward‐looking basis, risk parity portfolios have demonstrated success in generating superior returns and lower volatility than alternate approaches, primarily due to the benefit of strong returns in levered bonds (2010–2020). However, normalizing expected bond returns into this approach, the expected return and risk profile of the portfolio is sub‐optimal. The risk parity framework, by its very nature, requires 2–3× gross exposure (leverage) and a large allocation to bonds, both impractical for a typical institution.

Figure 1.1