the non-proﬁt fiduciaries’ handbook · 1. reward › three fundamental considerations in...

Russell Investments

INVESTED. TOGETHER.™

Heather MyersAngie Santo-WalterManisha Kathuria, CAIALila Han, CFA, CAIA

The Non-profit Fiduciaries’ HandbookA step-by-step guide to investment strategy for non-profit investors

2015/2016

INVESTED. TOGETHER. ™

Russell Investments Russell Investments

IntroductionAs a non-profit fiduciary, you have a difficult job. You need to ensure that your organization has the money, talent, experience and resources to fund your non-profit’s mission. And you need to do this in an ever-changing market environment. This means you need to set clear and achievable goals, adapt quickly to rapidly changing circumstances, continually look for the appropriate balance between investment risk and return, and find effective ways to implement and manage your chosen strategy.

We know it’s a lot to ask, which is why we have created this handbook to serve as a resource for fiduciaries who are new to their roles, or who simply want to brush up on a few concepts. The handbook is designed to provide practical advice, planning tools and best practices to help you successfully fulfill your responsibilities.

In sections where we feel deeper discussion is warranted, we have included worksheets you can complete with your investment team or questions you can ask to prompt discussion. Our goal for this book is to provide you and your team with a roadmap that gives your investment program the highest probability of achieving your mission-driven goals.

Sincerely,

Lisa Schneider, CFAMANAGING DIRECTOR, NON-PROFITS AND HEALTHCARE SYSTEMS

Lisa Schneider

Frank Russell Company owns the Russell trademarks used in this material. See “Important information” for details.

Russell Investments Russell Investments

Table of contentsSECTION I: DEFINING YOUR MISSION-DRIVEN

GOALS AND OBJECTIVES Worksheet: Your organization’s vital statistics 2

An effective investment program 3Three fundamental considerations 4Investment returns matter 5Taking the right risks 6Inflation can make a big difference 7Expected long-term growth rate is going to present challenges 9Key levers for managing an effective non-profit investment program 11Spending policy lever 12Worksheet: Dependence on spending 13Worksheet: Spending policy 17Liquidity lever 18Worksheet: Liquidity profile 23Risk tolerance lever 26Worksheet: Risk tolerance 28Strategic asset allocation lever 30Investment beliefs 32Is sustainable investing one of your investment beliefs? 33Your investment policy statement 34Before we move on... 37

SECTION II: OVERSEEING YOUR OUTCOME-ORIENTED PORTFOLIO

Chapter 1: DesignThe world has changed 44Factoring in things beyond your control: the capital markets 46Time for a new approach 48Asset allocation has evolved from asset class to asset roles 50Worksheet: Asset class to asset role 53Worksheet: High-level design considerations 54Portfolio design: model portfolios 56Worksheet: Which model portfolio matches yours? 57From strategic asset roles to portfolio design 58

Asset allocation differs among non-profits 60Some common design myths 62Before we move on... 64

Chapter 2: ConstructPicking the right managers 68Worksheet: How robust is your manager research process? 70Active and passive 72Before we move on... 74

Chapter 3: ManageWhat you need to do to effectively manage your portfolio 781. Know where the portfolio is 792. Know where you want the portfolio to be 803. Know how to get there 82Worksheet: How do your decision-making and implementation processes compare? 86Before we move on... 88

SECTION III: BUILDING A STRONG RISK MANAGEMENT AND FIDUCIARY FRAMEWORK

Chapter 1: Risk managementHolistic risk management is critical 94Developing a risk governance structure 95Fiduciary roadmap 96Worksheet: How does your risk management program stack up? 100

Chapter 2: Being an effective fiduciaryAs a fiduciary, you are always in control 104Three guiding principles for fiduciaries 107Building a delegation structure 108Worksheet: What does your delegation structure look like? 111Worksheet: How do your resources compare with similarly sized non-profit investors? 113Good governance matters 114

CLOSING THOUGHTS

GLOSSARY

APPENDIX: TYPES OF NON-PROFITS

Defining your mission-driven goals and objectives

Section I: Defining your mission-driven goals and objectives 3Russell Investments 2

Let’s start with capturing your organization’s mission and a few other vital statistics. A mission statement is critically important; it spells out your non-profit’s reason for being. Are all of your fiduciaries clear on your mission? You need to articulate your mission and formally review it at regular intervals. If you have not, we encourage you to do so.

Are you clear on the investment outcomes needed to support your mission?

WORKSHEET

Organization ___________________________________________________________

Mission _______________________________________________________________

We wish to exist: In perpetuity Not in perpetuity

To what extent does your non-profit rely on your investment program (what percentage of the annual operating budget is supported by the program)? _______________________________________________________

Does your non-profit have any investment restrictions (does it require screening

for certain investments)? Yes No

YOUR GOALS

Typical goals of a non-profit’s investment program include:

Support current spending needs

Support future spending needs

Maintain sustainable spending levels

Ensure predictability of spending

____________________________________________ ____________________________________________ ____________________________________________

Use the extra lines to add goals that are unique to your non-profit, or to replace a “typical” goal These three factors are closely intertwined.

Without the original endowed capital or donations, your non-profit wouldn’t have come into existence. Its continued existence and success depend on your adoption of an appropriate investment strategy and careful management of spending.

The vast majority of non-profit organizations are established with the goal of pursuing a specific mission in perpetuity.

Three critical factors can help ensure your long-term survival and success:

Funding your mission: Your mission is your non-profit’s reason for being—so your ability to financially support the mission is critical to your success and longevity.

Capital preservation: Your organization won’t survive for long if it erodes its asset base.

Intergenerational equity: To finance your mission, year after year—while preserving capital—you need a long-term investment strategy.

1

An effective investment program is essential to fulfilling your mission

2

3


It is critical to a non-profit’s long-term survival that its spending be aligned with its overall portfolio target return. In the long run, spending in excess of the return generated by your portfolio will lead to a decline in assets and limit your capacity to sustain your spending program.

So, what is the minimum return you need to make to maintain your status quo?

That level of return is generally called the target return, which can be calculated as follows:

Investment returns matter— a lot

1. Reward ›

Three fundamental considerations in non-profit investment management

To earn positive returns Grow your portfolio to accommodate ongoing spending.

To manage risk Know which risks are worth taking and which risks aren’t. To reduce the likelihood of capital loss and/or the inability to fund your spending program.

2. Risk ›

3. Inflation › To maintain purchasing power Ensure intergenerational equity.

Target return = Spending + Inflation + Expenses (e.g., investment management and operating)


Taking the right risks is critical

Decide on the target return you wish to achieve (for example: 3.5% spending + inflation + expenses).

Evaluate how much risk you may need to take in order to achieve that target return.

Take only those risks for which you believe you will be compensated.

Risk has many different meanings depending upon context. Later in this handbook we will discuss risk in terms of risk tolerance and managing downside risks. When you are establishing your investment program, you need to determine which risk premia you wish to exploit. A risk premium is the amount of return you can expect to receive in compensation for taking risk. Risk is an essential component of your investment program, and you need to assume some level of risk in order to meet your target return.

To determine which risk premia you should exploit, you need to:

Credit, equity, currency and illiquidity are some examples of risk premia, and most investment programs will have some exposure to each.

To preserve your capital and maintain the purchasing power of your assets, your target return must—at a minimum—be equal to the rate of inflation.When calculating your target return, it’s important that you choose a measure of inflation that best reflects your non-profit’s sector because not all sectors experience the same rate of inflation. For example, those in the health care and education sectors typically face an inflation rate materially higher than inflation in other parts of the economy.

Inflation can make a big difference

SOME COMMON MEASURES OF INFLATION

INFLATION MEASURE WHAT IS MEASURED

U.S. Consumer Price Index (CPI)

CPI measures the average change over time in the prices paid by urban consumers for a basket of consumer goods and services.

Medical CPI An index that measures the medical components of the CPI, including hospital and nursing care services, and prescription and over-the-counter drugs.

Educational CPI An index that measures the educational components of the CPI, including college tuition, fees and textbooks.

Higher Education Price Index (HEPI)

An index that tracks the main cost drivers in higher education. The index covers most campuses’ current operational costs, e.g., salaries of faculty, administrative, clerical and service employees.

My organization’s inflation measure is: __________________________

Because: ____________________________________________________


Sources: Medical, Education and US CPI data are from the Bureau of Labor Statistics; HEPI data is from Commonfund Institute–2013 HEPI Update; G7 CPI data is from the Organization for Economic Co-operation and Development (OECD). Data as of June 2014.Data is historical and not indicative of future results.

The chart below shows how various measures of inflation can track quite differently in the same market environment. That is why it’s important to ensure that you are appropriately measuring your inflation exposure. Using an inflation measure that most closely mirrors the inflation in your specific sector will allow you to more accurately estimate the target return you need to achieve to preserve the purchasing power of your assets.

-2%

0%

2%

4%

6%

8%

2013

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

Medical CPI Education CPI HEPI U.S. CPI

Exp

ecte

d re

turn

sThe inflation measure you select is important

The chart below shows the expected long-term growth rate predicted by professional forecasters from 1992 to 2014. It tells a grim story. Over the coming 10 years, forecasters expect the inflation-adjusted growth of a passive portfolio of stocks and bonds to fall to 3.3%—a level that would make supporting a 5% spending rate unsustainable.

What this means is that non-profit fiduciaries are going to have to think differently about how they go about meeting their return objectives.

Expected long-term growth rate is going to present challenges

SURVEY OF PROFESSIONAL FORECASTERS

3.8%

2.3%

5.0%

3.3%

8.7%

5.6%

1%

3%

5%

7%

9%

Exp

ecte

d re

turn

s

10 yr inflation 60/40 inflation-adjusted 60/40 nominal

2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

Source: Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters & Russell Investments. Data as of January 2014.Expected returns on this chart are the expectations that the Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters had during the time period noted on the chart above. These are 10 year forward looking forecasts.Data is historical and is not indicative of future results. 60/40 = 60% equity, 40% bond portfolio. Equity returns were calculated using the S&P 500 Index, bonds were calculated using the U.S. Treasury 10 year bond.Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

COMMON MEASURES OF INFLATION


While the outlook for market returns has declined, there are still ways to help improve portfolio returns.

Here are five strategies to embrace going forward:

Surviving and thriving in a low-growth environment

Be nimble: Gone are the days when you can set and forget your asset allocation. Markets are fast moving and increasingly complex; you need to be fleet of foot to capture evolving market opportunities.

Be mindful of your spending rate: Unless you have a legal requirement to spend 5% annually, you should have flexibility as to how much you spend.

Manage liquidity: Minimize the risk of a future liquidity squeeze while contributing to your long-term growth via a well-structured liquidity management process.

Manage risks holistically: Focus not just on investment risk, but also on governance issues and other types of risks. This should help increase the probability of long-term success.

Take an organization-wide perspective: Be aware of the impact your investment program has on the ability to achieve the broader goals of the non-profit.

Focusing on these strategies can help you better navigate today’s market environment and lay the groundwork for effective management of your investment program.

Source: Russell Investments Research. “Drivers of investment management success for non-profit organizations.” Heather Myers and Mike Ruff; March 2014.

These levers are intertwined, which means that the decisions you make about one will impact the others.

There are other tools to help you effectively manage your investment program. Throughout this handbook, we refer to these as levers, which we will identify and discuss at each step of the process.

At the highest level of the investment process, the four primary levers are:

Key levers for managing an effective non-profit investment program

LiquiditySpending

policy

Risk toleranceStrategic assetallocation

1

2

3

4

5


SPENDING POLICY LEVER

How dependent is your spending on your investment program?A number of factors will help you determine the extent of your organization’s reliance on your investment program.

Those factors include your:

Before you can determine which spending policy is right for you, you need to understand your specific circumstances. On the opposite page, we provide a worksheet that will help you do that.

Circle: “Yes” (Y) for each statement that applies to you.

“No” (N) for each that does not.

“Not applicable” (N/A) when a statement doesn’t apply, or when you aren’t sure.

Organization type

Ability to fundraise

Organization’s cash flow

Organization’s goals

If the majority of your answers are “Yes” (Y) to questions 1, 4, 5, 6, 9 and 10, your non-profit is very reliant on the returns produced by your investment program to meet your spending needs. This means that any restrictions placed on your dollars will have a significant impact on your ability to meet your spending target.

The flip side of not having enough money to meet your needs is the matter of spending too much. UPMIFA (Uniform Prudent Management of Institutional Funds Act) considers a spending rate above 7% to be imprudent. While adoption of this 7% UPMIFA rule varies among U.S. states, acknowledging its prudence and understanding your circumstances are key to determining the spending policy that is right for you.

WORKSHEET

CIRCLE ONE

1 We have an IRS-mandated spending requirement. Y N N/A

2 We have the ability to fundraise to increase our contributions to the investment portfolio.

Y N N/A

3 The funds we are able to raise are unrestricted. Y N N/A

4 The funds we are able to raise are either restricted or a combination of restricted and unrestricted.

Y N N/A

5 We do not have the ability to fundraise and we cannot increase our contributions to the investment portfolio.

Y N N/A

6 We wish to exist for as long as possible. Y N N/A

7 Spending for our current beneficiaries is more important than ensuring spending for our future beneficiaries.

Y N N/A

8 Our goal is to spend down our assets over time. Y N N/A

9 We intend to fund a significant project in the next few years, which will require additional spending (for example: a new building).

Y N N/A

10 We rely heavily on our investment returns to meet our annual obligations (for example, 20% of your annual operating budget comes from your endowment).

Y N N/A

11 We are sensitive to the spending trends of our peers. Y N N/A

12 Other: __________________________________________ Y N N/A


SPENDING METHODOLOGY DESCRIPTIONPERCENTAGE USING RULE

Percentage of moving average assets, e.g., 5% of 3-year average

Typical spend of 1% to 7%, based on 1- to 7-year averaging 77%

Select spending rate each year

Each year, you determine the percentage of your investments to spend on mission activities

12%

Hybrid rule, e.g., Tobin rule A blended methodology of a combination of past spending and a portion of current assets

7%

Spend all current income Spending all income generated from your investment program in any given year

3%

Percentage of beginning-of-year (BoY) market value

Spending a percentage of the BoY market value

3%

The table below summarizes some of the methodologies most often used by non-profit investors.

Non-profit investors’ high use of moving average assets is not necessarily an endorsement for this methodology. Many non-profits have selected this only because their peers use it, not because they have done extensive analysis into whether or not it is the best methodology for them.

Source: NACUBO-Commonfund Study of Endowments, 2013. Percentages based on 835 study participants. Source: Russell Investments Research. “Non-profit spending rules.” Steve Murray; October 2011.


Understanding your spending policy optionsSpending policy is key to determining the pattern of distributions from your investment program.

Your spending policy has two components:

Spending rate

Spending methodology

FOR EXAMPLE

SPENDING POLICY SPENDING RATE SPENDING METHODOLOGY

4% of 3-year average assets

4% 3-year averaging

$4 million annually, adjusted for inflation

$4 million Spending rate adjusted by annual inflation rate

12


Keep this target return number in mind as you go through the Design, Construct and Manage sections of this handbook. You will need to ensure that the asset allocation you build can support this target return.

YOUR SPENDING POLICY

Before we move on, take a few minutes to address the following questions regarding your spending policy.

Our spending policy is: __________________________________________________

________________________________________________________________________

We selected this policy because: ___________________________________________

________________________________________________________________________

We were comfortable with our spending policy during the financial crisis.

Yes No

ARE YOU OVERSPENDING?

Remember, spending more than the inflation-adjusted return generated by your portfolio will lead to a decline in the purchasing power of your assets.

Your spending rate .............................................................................. _________ %

+ projected rate of inflation ............................................................ _________ %

+ expenses (e.g. investment management and operating) .......... _________ %

= Your target return ........................................................................ _________ %

WORKSHEET


How well does your spending policy meet your needs? Different policies can affect your program’s ability to maintain the intergenerational equity balance. For example, certain policies, such as 5% of BoY, shown as the blue line in the chart below, are on average better for current beneficiaries; other policies, such as the 5% of 3-year average shown as the gray line in the chart, reduce the overall spending rate during rising markets and effectively provision more spend for the future.

Different spending methodologies can also impact the variability of your year-to-year spend levels, which in turn can be challenging when forward planning in uncertain markets and funding environments.

3%

4%

5%

6%

7%

8%

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

5% of BoY 5% of 3-year average Tobin rule

Am

ount

of s

pend

ing

Source: Hypothetical example provided for illustrative purposes only.

IMPACT OF DIFFERENT SPENDING METHODOLOGIES


Source: Russell Investments Research. “Liquidity Management: A critical aspect of a successful investment program for non-profit organizations.” Manisha Kathuria and Heather Myers; October 2013.

Establish your cash flow expectations: Identify the sources, timing and flexibility of your cash inflow and outflow.

Organize your flows by time horizon: Classify your cash requirements based on their time horizon, and map them against the liquidity profile of your investment portfolio.

Incorporate a variety of approaches to achieve your required liquidity profile: These include asset allocation, sensitivity/stress analysis, spending policy, rebalancing and derivatives.

Document and frequently monitor your liquidity profile: Continuously monitor your liquidity profile along with other critical risk factors, and document clear liquidity guidelines in your investment policy statement.

Keep up with regulatory changes: They could impact your liquidity considerations.

In simple terms, having a holistic liquidity program means aligning the liquidity profile of your investment portfolio with your time horizon and cash-flow demands. If you do that, you should be able to meet your spending obligations as they come due, without incurring unacceptable losses.

The key steps to establishing a holistic liquidity program for your organization are:

What does a holistic liquidity program look like?

Having illiquid assets in your portfolio can help you meet your long-term objectives; however, you need to understand the potential impact they may have on your ability to meet your spending targets. In other words—illiquidity is not inherently bad; it just needs to be managed.

LIQUIDITY LEVER

Understanding the impact of liquidity Even if your organization has a steady hand on its spending policy, if it’s not paired with sound liquidity management, the results can be disastrous. Before we get into what sound liquidity management involves, let’s start by defining what we mean by liquidity in the context of your investment program.

Liquidity allows you to:

Meet your spending requirements.

Deploy your capital opportunistically to take advantage of evolving market conditions.

Rebalance your portfolio as needed or wanted.

Meet pre-existing private capital commitments.

During the financial crisis, illiquidity became an issue for many non-profits. Aside from the known illiquid investments some had in their portfolios, other “presumed liquid” investments became illiquid during the crisis, leading to a severe liquidity squeeze. As a result, some institutions were unable to fund their missions.


The liquidity profile of your portfolio can shift in response to unforeseen market movements over time. Modeling portfolio allocations could help identify such shifts. Mapping your investment portfolio’s liquidity profile vis-à-vis its asset allocation can be helpful, as shown below.

SAMPLE LIQUIDITY PROFILE

LIQUIDITY LEVEL

ALLOCATION

ASSET CLASS

HIGHLY LIQUID / LIQUID

SEMI-LIQUID / ILLIQUID

HIGHLY ILLIQUID

Equity

20.0% Global equity 100% 0% 0%

5.0% Emerging markets equity 100% 0% 0%

Fixed income

8.0% Core fixed income 100% 0% 0%

2.0% Global fixed income 100% 0% 0%

2.5% Cash and cash equivalents 100% 0% 0%

5.0% Global high yield debt 100% 0% 0%

5.0% Emerging markets debt 100% 0% 0%

Alternatives

5.0% Long / short hedge funds 100% 0% 0%

15.0% Non-directional hedge funds 50% 50% 0%

4.0% Commodities 100% 0% 0%

3.0% Global listed infrastructure 100% 0% 0%

3.0% Global listed real estate 100% 0% 0%

7.5% Private equity 0% 20% 80%

15.0% Private real estate 0% 60% 40%

100% TOTAL WEIGHTED AVERAGE 70% 18% 12%

LIQUIDITY LEVER

Understanding your liquidity profile Once the sources and uses of cash are identified, it is useful to classify the cash requirements of the asset pools based on their time horizon. This will allow you to match your liquidity requirements with the liquidity profiles of your investments.

A sample liquidity profile classification is shown below:

ACCESS TO CASH LIQUIDITY LEVEL

Daily Highly liquid

Quarterly Liquid

Less than 2 years Semi-liquid

2 to 5 years Illiquid

More than 5 years Highly illiquid

A liquidity profile should consider not only the different types of assets, such as: public versus private, equities versus fixed income, and Treasuries versus distressed debt, but also the investment vehicle (i.e., a commingled, daily liquid fund versus a separate account with longer lockups).


WORKSHEET

LIQUIDITY LEVEL

ALLOCATION

A

ASSET CLASS

HIGHLY LIQUID/ LIQUID

B

SEMI-LIQUID/

ILLIQUID

C

HIGHLY ILLIQUID

D

Equity

% Global equity1 % % %

% Emerging markets equity % % %

Fixed income

% Core fixed income % % %

% Global fixed income % % %

% Cash and cash equivalents % % %

% Global high yield debt % % %

% Emerging markets debt % % %

Alternatives

% Long / short hedge funds % % %

% Non-directional hedge funds % % %

% Commodities % % %

% Global listed infrastructure % % %

% Global listed real estate % % %

% Private equity % % %

% Private real estate % % %

100% TOTAL WEIGHTED AVERAGE % % %

LIQUIDITY WORKSHEET

Building your liquidity profile On the facing page is a worksheet for you to build out your organization’s liquidity profile:

Step 1 › Map your policy asset allocation for all asset classes included in your investment policy.

Use the chart on page 21 as a guide to the “typical” liquidity profile of each underlying investment vehicle in each asset class. If the liquidity profile of the investments in your portfolio are significantly different, use those instead.

Calculate the total weighted average of each column (B, C, and D) using the following calculation:

Monitor your liquidity profile and repeat steps 1–3 periodically.

Step 2 ›

Step 3 ›

Step 4 ›

Total weighted

average(of Column B)

For example, the total weighted average of highly illiquid assets (column D) from page 21 would be calculated as follows:

(0.075 x 0.8) + (0.15 x 0.4) = 0.12 or 12%This process would then be repeated for each liquidity level column.

= Sum of: Column A x Column B (asset class (liquidity level of allocation) an asset class)

1 For purposes of this chart, your global equity allocation should include global, international, U.S., single country, and developed markets equity allocation.


NORMAL MARKET ENVIRONMENT

Do you know the extent to which such a shift could impact your portfolio?

Stressed market environment based on experience in 2008/2009, when some investments became less liquid than expected. There is no guarantee that any stated expectations will occur. Some portfolios in stressed market environments may have more drastic impact on liquidity than the scenario depicted above. These examples are for illustrative purposes only.

STRESSED MARKET ENVIRONMENT

Highlyliquid64%

Highly illiquid7%Illiquid

2%Semi-liquid0%

Liquid27%

Highlyliquid53%

Highly illiquid8%Illiquid

0%

Semi-liquid27%

Liquid12%

Highly liquid / liquid

Semi-liquid / illiquid

Highly illiquid

LIQUIDITY LEVER

Stress-testing your liquidity profileIt is critical to evaluate the liquidity profile of your portfolio in both normal and stressed environments. This means that for each asset class, the liquidity expectation in normal environments needs to be identified and then compared against the estimated downside experience in stressed markets. An example of a liquidity profile for a normal versus a stressed market environment is shown on the facing page. The asset allocation was kept constant in both the normal and stressed scenarios; the example doesn’t take into account any change in asset valuations.

In this example, it is important to note the large increase in the semi-liquid allocation (from 0% to 27%) and the reduction in liquid and highly liquid (down from a combined 91% of the portfolio to 65%) that takes place in the stressed market environment.


WHAT IS YOUR PERCEPTION OF RISK?

For example, do you feel that investing in stocks in a bull market is not as risky as investing in stocks in a bear market? This is a subjective judgment of risk, and it can color your overall willingness to tolerate risk. You should also differentiate the subjective judgment of individual investment committee and board members from that of the group, as you consider what makes the most sense for your non-profit.

3

RISK TOLERANCE LEVER

Understanding your risk tolerance

Ultimately, you need an investment approach designed to deliver the returns you need within a level of risk you can survive. One of the benefits to come out of our recent experience with the 2008 global financial crisis is that many non-profit boards and investment committees are now better able to articulate how much loss they can tolerate.

We encourage you to discuss the following three points with your investment committee:

WHAT IS YOUR CAPACITY TO TOLERATE LOSS?

This hinges on, among other things, the flexibility of your spending program. Access to new assets (for example, those flowing from fundraising activity) can also affect the capacity of an organization to tolerate risk.

1 WHAT IS YOUR WILLINGNESS TO TOLERATE LOSS?

Meaning, if you take this risk, will you be able to sleep at night?

2


Other observations affecting my risk tolerance:

____________________________________________________________

____________________________________________________________

____________________________________________________________

____________________________________________________________

____________________________________________________________

This exercise is a starting point for discussion with your investment committee.

In general: If most of your answers are in column A, you tend to have a lower tolerance for risk.

If most are in column B, you have a medium tolerance for risk.

If most are in column C, you have a higher tolerance for risk.

Even if two non-profits answered the worksheet questions identically, they might still ultimately make different risk choices, due to the differing nature of their organizational goals.

One other risk to consider is reputational or headline risk. This is something you will need to discuss in detail with your investment committee and factor into the decisions you make around your strategic asset allocation.

RISK TOLERANCE WORKSHEET

Determining your risk tolerance

The answers to the following questions are critical inputs into your strategic asset allocation process, and will allow your committee to see the potential impact of different asset allocations. In the table below, select the characteristics that most closely align with your investment program to determine your risk tolerance level.

A B CCIRCLE

A, B OR C

I could tolerate:

Up to a 20% loss in any one year

A 20% to 35% loss in any one year

A 35% to 50% loss in any one year

A B C

My annual spend is:

More than 5%, so I can tolerate limited liquidity risk

Between 4% and 5%, so I can tolerate moderate liquidity risk

Less than 4%, so I can tolerate a lot of liquidity risk

A B C

My time horizon is:

Short (1 to 3 years)

Medium (3 to 5 years)

Long term (5 or more years)

A B C

I expect future inflows:

No, I am not able to secure future inflows

Yes, I am able to secure some additional inflows

Yes, I am able to secure significant additional inflows

A B C

There are a number of additional demands on my assets (operating expenses, funding of enterprise activities, etc.):

Yes, there are high demands on my assets

Yes, there are some demands on my assets

No, there are minimal demands on my assets

A B C

WORKSHEET


Prioritize the levers to align with your desired goals These levers don’t operate in isolation; prioritizing one will have an impact on the others. At some point, you will need to decide which of the four levers is most important and prioritize it, then manage the rest of the levers accordingly.

For instance, the chart below shows how the levers might look if you prioritize a high spending rate. To grow in perpetuity, you would then also need to take an aggressive approach to achieving your target return, which implies a high risk tolerance and the need for a greater allocation to illiquid assets—thus, a more aggressive strategic asset allocation.

If you find that you aren’t willing to trade off one lever for the other, then it may be necessary to reevaluate your priorities. For example, as shown in the chart, if you do not truly have a high risk tolerance, then you may need to rethink your high spending target.

HIGH

LOW

HIGH

LOW

HIGH

LOW


LIQUIDITYLEVER

RISK TOLERANCE

LEVER

AGGRESSIVE

CONSERVATIVE

STRATEGIC ASSET

ALLOCATION LEVER

STRATEGIC ASSET ALLOCATION LEVER

Strategic asset allocation

The final key lever is strategic asset allocation (SAA).

SAA is how much you ultimately decide to allocate to specific asset classes. Your SAA is your long-term policy allocation to all strategies, not only at a high level, such as equities, fixed income and alternatives, but also at a sub-asset-class level. For instance, your SAA within equities should denote the allocation to global equity, emerging market equity, international equity, U.S. large cap equity, U.S. small cap equity, etc.

Your SAA can also be a guidepost for managing your investment program. Bands (ranges or limits) are often set around the target or policy SAA to allow the portfolio to move within these limits. Should your portfolio start to deviate outside these bands in response to changing market conditions, periodic rebalancing can bring it back on track.

We will explore this topic in-depth in the Design section.


Though all beliefs deserve thoughtful consideration, there is a specific area that we believe deserves deeper review—sustainable investing. It is an area that non-profit fiduciaries are addressing with increasing frequency, and we feel that it should be among the topics you address with your investment committee.

While industry terminology continues to evolve, in this book we use the term “sustainable investing” to encapsulate a broad spectrum of strategies that seek to capture both financial and non-financial returns. This includes strategies such as: screening, impact investing, mission-related investing, shareholder engagement, the integration of environmental, social and governance (ESG) criteria in the investment process, etc.

Is sustainable investing one of your investment beliefs?

Whether or not you decide to engage in sustainable investing, we encourage you, as a fiduciary, to adopt a proactive approach for evaluating the issue and documenting the rationale for your ultimate decision.

Source: Russell Investments Research. “Governance process for evaluating sustainable investing: A guide for non-profit fiduciaries.” Heather Myers and Manisha Kathuria; July 2014

Allowing you to take action in an uncertain world.

Helping to identify inconsistencies in investment portfolios.

Helping avoid paralysis in a world of information overload.

Enabling efficient decision-making and supporting deeper institutional memory.

Your investment beliefs drive all aspects of your investment program—from high-level governance functions, to the actual investment decisions being made, to the reporting and metrics used to evaluate success.

There is no way to directly measure what a person or organization believes to be true; we cannot “observe” beliefs. However, it is possible to look at the actions the person or organization takes and infer a set of implied beliefs from those actions.

Beliefs can get you ahead by:

Investment beliefs drive your investment program

If you have not already done so, taking the time to document your investment beliefs can be very beneficial. Beliefs can be grouped by area, such as beta beliefs and alpha beliefs. For instance, the belief that equities should outperform bonds is a beta belief; the belief that active managers will outperform passive management over the long term is an alpha belief. Think about why you have selected the investments you have and the allocation you use—what are the beliefs driving those decisions? When you identify inconsistencies between what you believe and how you are invested, you should discuss them and take action, which may require a change in your investment program.


GOVERNANCE

Mission, purpose and scope

Investment time horizon

Statement regarding fiduciary responsibility under UPMIFA

Definition of roles and responsibilities

Expected return goals and objectives

Unique circumstances

Delegation of authority

INVESTMENT STRATEGY

Investment philosophy

Strategic asset allocation policy: target allocation and ranges

Restricted and unrestricted investments

Investment structure and guidelines

Spending policy

Risk policy and benchmarks for measurement

Liquidity policy

Sustainable investment policy, if applicable

ACCOUNTABILITY

Monitoring and review process

Standards for measuring performance

Rebalancing policy

Handling of spending for underwater funds

Other operational guidelines

Here is a checklist of the key elements that should be included in an IPS:

The investment policy statement (IPS) captures your beliefs and expectations and provides long-term, strategic guidance on how to align your non-profit’s mission, objectives and policies.

The IPS is also an important tool for educating new fiduciaries on the purpose of the investment program, and it helps sustain your non-profit’s mission over the long term.

The four levers, previously discussed, are the pillars of your IPS:

Documenting your decisions and beliefs in your investment policy statement

Spending policy

Liquidity

Risk tolerance

Strategic asset allocation

1

2

3

4


Clearly defining the goal you are trying to achieve.

Agreeing on a spending policy with which you are comfortable.

Deciding how much liquidity you need.

Determining how much risk you are comfortable taking.

Understanding the role of strategic asset allocation.

Before we move on…

In this section, we have focused on defining your mission-driven goals and objectives, which requires having addressed the following critical subjects:

Ensuring that your fiduciaries are in agreement on these issues, and that their decisions are documented in your investment policy statement, is critical to effectively creating and managing your outcome-oriented portfolio, which we will cover in the next section.

Taking your IPS from good to great

A GOOD IPS SHOULD...

A GREAT IPS SHOULD ALSO...

› Clearly delineate the responsibilities of all parties involved in the non-profit’s investment program.

› Present the portfolio’s financial objectives within the context of how much risk the fiduciaries are willing and able to bear.

› Express a long-term strategic asset allocation for the portfolio that is specific, yet sufficiently broad to allow for flexibility in implementation, so as to enable response to shorter-term opportunities and risks.

› Set out operational guidelines and rules for monitoring and reviewing all facets of the investment program.

› Implicitly guide stakeholders’ alignment with the mission, objectives and policies of the non-profit.

› Outlast the tenure of the non-profit’s current investment committee or board—unless fundamental or philosophical differences emerge and necessitate change.

› Be able to educate new board members on the thinking that has preceded them and the rationale for current practices.

What differentiates a good IPS from a great one is nuanced, yet imperative for effective governance of your investment program.

Source: Russell Investments Research. “Elements of a clearly defined investment policy statement for non-profits.” Greg Coffey and Lila Han; April 2014.

Overseeing your outcome-oriented portfolio

Section II // Overseeing your outcome-oriented portfolio 41Russell Investments 40

DESIGN: Focusing on your investment objectivesThe goal of the Design phase is to determine a strategic asset allocation for your investment program based on your goals and objectives, your spending policy, risk/return profile and liquidity needs.

CONSTRUCT: A total-portfolio viewThe Construct phase involves developing a total-portfolio view, looking across equity, fixed income, alternatives and other areas to make the best possible risk/return tradeoffs by diversifying across asset classes, investment styles and investment managers to achieve your desired outcome.

MANAGE: Dynamic access to a widened opportunity setThe Manage phase is about continually assessing the changing market environment and adapting your portfolio, as needed, in real time. This approach to portfolio management requires that you always know where your portfolio currently is, where you want it to be, and how to get it there.

Overseeing an outcome-oriented portfolio This section focuses on helping you oversee the creation of an outcome-oriented portfolio. By “outcome-oriented” we mean a portfolio designed to meet a desired set of outcomes that reflect an investor’s unique needs and circumstances.

While a specific target return may be a desired outcome, so too may be a specific level of risk, liquidity, volatility or spending. In other words, the objective and/or outcome of the portfolio can be more multifaceted than simply beating a market benchmark.

There are three critical steps involved in the creation and management of an outcome-oriented portfolio.

We have termed these steps:

Design

Construct

Manage

1

2

3

Section II // Overseeing your outcome-oriented portfolio 43

Chapter 1: Design


PRIVATE FOUNDATIONS2

2 Source: 2007, 2013 Council on Foundations—Commonfund Study of Investments for Private Foundations. The fiscal year of foundations typically cover January 1 through December 31.

0% 10% 20% 30% 40% 50% 60%

Private capital

Real assets

Hedge funds

Fixed income

Equity

0% 10% 20% 30% 40% 50% 60%

Private capital

Real assets

Hedge funds

Fixed income

Equity

2006

2013

2006

2013

Asset allocation

Asset allocation

4634

13

10

1820

715

1418

5344

16

9

1113

25

1015

Section II // Chapter 1: Design

These factors—along with significant shifts in how markets behave—have changed the ways non-profits are investing, as you can see from the following charts.

ENDOWMENTS1

The world has changed For many of today’s non-profit investors, the focus has shifted from income generation to long-term total return. This shift has been driven by an increased understanding of and familiarity with a broader range of investments (including new and niche strategies), market globalization, significant evolution in attitudes toward and understanding of risk, and better awareness of regulatory changes, including the passage of UPMIFA in most U.S. states.

0% 10% 20% 30% 40% 50% 60%

Private capital

Real assets

Hedge funds

Fixed income

Equity

0% 10% 20% 30% 40% 50% 60%

Private capital

Real assets

Hedge funds

Fixed income

Equity

2006

2013

2006

2013

Asset allocation

Asset allocation

4634

13

10

1820

715

1418

5344

16

9

1113

25

1015

1 Source: 2007, 2013 NACUBO-Commonfund Study of Endowments. The fiscal year of endowments typically cover July 1 through June 30.

Has your portfolio shifted significantly since 2006? Yes No

If yes, how? __________________________________________________

_____________________________________________________________


Interest › rates

Currency ›

Why this matters: For example, as interest rates rise, bond prices decrease—with the impact generally being greater on longer-duration investments. Typically, investors are most concerned about their fixed income allocation in such markets, but rising interest rates can also impact other strategies.

How to manage the effects of interest rates: You need to be conscious of the interest-rate sensitivity of your portfolio, including its potential impact on the performance of your equity, fixed income, hedge fund and/or real asset exposures. If you adequately diversify your portfolio by incorporating strategies with different interest rate sensitivities, you can mitigate some of the risk from sharp increases/decreases in interest rates.

Why this matters: Exposure to non-domestic currencies is an inevitable result of global investing. If a foreign currency appreciates versus the base currency (say, the U.S. dollar) in a portfolio investment, then that asset will be worth more in U.S. dollar terms—but the opposite would be true if the foreign currency depreciated.

How to manage currency exposures: A traditional approach to managing currency exposure is to hedge the currency exposures resulting from your international investments. An alternative approach is to treat currency as a standalone risk and manage it outside of, and in addition to, asset-class risk/return characteristics.


Factoring in things beyond your control: the capital marketsAs you design your strategic asset allocation, it is important to understand the reasoning behind capital market forecasts. For example, are forecasts based on short-, medium- or long-term views? Are they historical or forward looking? A better understanding of these matters, as well as of those outlined below, could influence how you choose to allocate your investable assets.

Correlation › Why this matters: If the asset classes in your portfolio are all highly correlated, then in an extreme market event—such as the 2008 global financial crisis—they will all move in the same direction, magnifying the negative impact on your portfolio.

How to manage correlation: Investing across a range of sectors, geographies and asset classes can result in relatively lower correlations. Negatively correlated strategies can also be incorporated to hedge risks or exposures in a portfolio.

Why this matters: If your objective is to grow your assets over the long term and/or to spend a percentage of your assets, then you are probably aiming for a consistent return over inflation. CPI is the most commonly used measure of inflation in capital market forecasts.

How to manage the effects of inflation: When evaluating different strategies, you should consider their relationship to inflation. For example, real assets have demonstrated inflation linkages; and when evaluating these investments you need to take into account not only the inflationary environment, but also how underlying cash flows might be explicitly or implicitly tied to inflation.

Inflation ›


ATTRIBUTES

› Built holistically (from the top down) with your investment objectives in mind

› Dynamic asset allocation across all asset classes

› Risk optimized at the total-portfolio level

› Changes do not require approval as long as they are within approved ranges

› Ability to incorporate opportunistic strategies when appropriate

A MULTI-ASSET PORTFOLIO


A PORTFOLIO OF MULTIPLE ASSET SLEEVES

ATTRIBUTES

› Built asset class by asset class (from the bottom up) with a goal to outperform a benchmark

› Static asset allocation across all asset classes

› Risk optimized at the asset class level

› Changes may require approval within a quarterly meeting frequency environment

› May limit the incorporation of opportunistic strategies

Time for a new approach to portfolio designWe have seen how the changing world and markets have led non-profit investors to evolve their approaches to investing. We have also seen increased correlation of risks and returns.

To combat this, multi-asset portfolios have emerged. Instead of assembling the portfolio sleeve by sleeve, non-profits are focusing on multi-asset solutions as a way to manage their investments at a total-portfolio level.

The key differences between traditional portfolio design comprised of individual asset sleeves and a multi-asset portfolio designed holistically are illustrated below.


Alternatives

U.S. equity GROWTH› U.S. equity› Non-U.S. equity developed› Emerging markets equity› Hedge funds: Long/short equities› Infrastructure: Listed› Real estate: Listed

RETURN ENHANCEMENT› High yield fixed income› Emerging markets debt› Distressed debt› Real estate: Private non-core real estate› Hedge funds: Event driven hedge funds› Private capital: Private equity, debt,

infrastructure, etc.

Commodities

Distressed debt

Non-U.S. equity developed

Emerging markets equity

U.S. Core fixed income

High yield fixed income

Real estate

Hedge funds

Private capital

Infrastructure

Cash / short duration

Equities

Fixed income

Cash

Emerging markets debt

Global fixed income

RISK REDUCTION / DIVERSIFICATION› U.S. core fixed income› Global fixed income› Real estate: Private core real estate› Commodities› Hedge funds: Relative value,

tactical trading› Cash / short duration

This more holistic approach to asset allocation, which we call a “roles-based investment framework,” involves categorizing strategies into three specific roles—growth, return enhancement and risk reduction/diversification.

This is not an exhaustive list of strategies.

Source: Russell Investments Research. “Drivers of investment management success for non-profit organizations.” Heather Myers and Mike Ruff; March 2014.

ASSET ROLE APPROACH


Asset allocation has evolved from asset class to asset rolesIn keeping with this shift toward a top-down multi-asset investment approach, each investment needs to be chosen and evaluated based on the role it will play in the portfolio. Since some assets may fulfill more than one role, it may be necessary to evaluate an investment’s role from multiple perspectives to decide how it can best serve the desired outcomes of the portfolio.

ASSET CLASS APPROACH

Alternatives

U.S. equity GROWTH› U.S. equity› Non-U.S. equity developed› Emerging markets equity› Hedge funds: Long/short equities› Infrastructure: Listed› Real estate: Listed

RETURN ENHANCEMENT› High yield fixed income› Emerging markets debt› Distressed debt› Real estate: Private non-core real estate› Hedge funds: Event driven hedge funds› Private capital: Private equity, debt,

infrastructure, etc.

Commodities

Distressed debt

Non-U.S. equity developed

Emerging markets equity

U.S. Core fixed income

High yield fixed income

Real estate

Hedge funds

Private capital

Infrastructure

Cash / short duration

Equities

Fixed income

Cash

Emerging markets debt

Global fixed income

RISK REDUCTION / DIVERSIFICATION› U.S. core fixed income› Global fixed income› Real estate: Private core real estate› Commodities› Hedge funds: Relative value,

tactical trading› Cash / short duration


Now, use the following table to convert your current portfolio allocation from asset class to asset role.

ASSET ROLE APPROACH YOUR ASSETS’ ROLE

GROWTH

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

Total _____ %

RETURN ENHANCEMENT

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

Total _____ %

RISK REDUCTION / DIVERSIFICATION

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

_______________________ _____ %

Total _____ %

GROWTH

› U.S. equity

› Non-U.S. equity developed

› Emerging markets equity

› Hedge funds: Long/short equities

› Infrastructure: Listed

› Real estate: Listed

RETURN ENHANCEMENT

› High yield fixed income

› Emerging markets debt

› Distressed debt

› Real estate: Private non-core real estate

› Hedge funds: Event driven hedge funds

› Private capital: Private equity, debt, infrastructure, etc.

RISK REDUCTION / DIVERSIFICATION

› U.S. core fixed income

› Global fixed income

› Real estate: Private core real estate

› Commodities

› Hedge funds: Relative value, tactical trading

› Cash / short duration

WORKSHEET


Reframing your portfolio by asset rolesOver the next few pages we will have you walk through your portfolio and evaluate how it looks in a roles-based framework.

Let’s define the asset roles we have been discussing:

Growth: Includes equity-oriented assets and is the growth engine of the portfolio; expect equity-like return and risk characteristics.

Return enhancement: Includes higher-return, higher-risk assets than the growth allocation. Less-liquid assets are included in this allocation.

Risk reduction / diversification: Includes strategies that provide diversification to the growth and return enhancement allocations. Generally, expect lower returns with less risk than what you would experience with the growth allocation.

It’s important to remember that shifting to a roles-based framework is not just an exercise in taking your existing portfolio and shifting it to the growth, return enhancement and risk reduction/diversification allocations. The discussion you should be having is around how much you want to allocate to each of these approaches first, and then figuring out which asset classes you want to use to achieve those allocations.


BELIEFS (identify a few of your critical beliefs)

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

CONSTRAINTS (e.g., liquidity, among other considerations)

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________


GOAL (target return of x% + inflation + expenses)

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

EXPECTATIONS (information from capital markets forecasts)

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

______________________________________________________________________

High-level design considerationsThe next step in designing your strategic asset allocation is to reaffirm components from our earlier discussion—specifically the goals, beliefs, expectations and constraints for your portfolio.

Use the table below to capture these key inputs for your investment program.

WORKSHEET


MODEL PORTFOLIO

GROWTH

RETURN ENHANCEMENT

RISK REDUCTION /

DIVERSIFICATION TARGET RETURN

DAILY LIQUIDITY TARGET

A 42% 10% 48% CPI + 3.5% 90%

B 60% 11% 29% CPI + 5% 85%

C 50% 18% 32% CPI + 5% 70%

Your current portfolio allocation (as on page 53):

MY PORTFOLIO % % % CPI+ % %

The model portfolios displayed are based upon different target returns, rather than different types of non-profit organizations. We chose this approach because there is a greater difference between the portfolios when classified by goals than by type of organization.

While there can be many factors determining your portfolio allocation, we have seen that differences in how you express the key design inputs can drive the bulk of design variation.

Based on your design considerations from pages 54–55, in the table below, circle the model portfolio (A, B or C) that you believe most closely aligns with your considerations.

WORKSHEET


Portfolio design: model portfolios are a starting pointTo provide you with a better understanding of how these high-level design considerations come together in the design of a portfolio, we have created three model portfolios with distinctly different allocations across the three asset roles.

Target return: inflation (CPI) + 3.5%

Target return: inflation (CPI) + 5%

MODEL PORTFOLIO A

(High liquidity)

Minimum 90% daily liquidity

MODEL PORTFOLIO B

(High liquidity)


MODEL PORTFOLIO C

(Less liquidity)


42%

10%

48%

60%11%

29%

50%

18%

32%

Growth Return enhancement Risk reduction / diversification

How does your portfolio allocation compare with the model portfolios (A, B or C) above? If they do not align, do you know why?

______________________________________________________________________

______________________________________________________________________


PORTFOLIO ROLE

STRATEGIC ASSET

ALLOCATIONAPPROVED

RANGES

Growth 55.0% 45% – 70%

U.S. equity 20.0% 15% – 25%

Non-U.S. equity developed 15.0% 10% – 15%

Emerging markets equity 6.0% 0% – 10%

Hedge funds: Long / short equities 5.0% 0% – 10%

Infrastructure: Listed 5.0% 0% – 5%

Real estate: Listed 4.0% 0% – 5%

Return enhancement 15.5% 0% – 35%

High yield fixed income 5.0% 0% – 5%

Emerging markets debt 0.0% 0% – 5%

Distressed debt 0.0% 0% – 5%

Real estate: Private non-core real estate 0.0% 0% – 5%

Hedge funds: Event driven hedge funds 2.5% 0% – 5%

Private capital 8.0% 0% – 10%

Risk reduction / diversification 29.5% 5% – 30%

U.S. core fixed income 10.0% 5% – 15%

Global fixed income 5.0% 0% – 10%

Real estate: Private core real estate 7.0% 0% – 10%

Commodities 5.0% 0% – 5%

Hedge funds: Relative value, tactical trading 2.5% 0% – 5%

Cash / short duration 0.0% 0% – 5%

PORTFOLIO TOTAL 100.0%

Ass

et c

lass

Ass

et c

lass

Ass

et c

lass


From strategic asset roles to portfolio designHaving determined the allocation between the three asset roles, you will need to set the strategic asset allocation within each role. For each asset class role, there is a range of possible strategies and implementation choices. Portfolio design combines these choices to give the best chance of delivering on your desired outcomes.

Determining which sub-asset classes and strategies to include is a lengthy and detailed process. The key design considerations you have already addressed serve as foundational information for populating your strategic asset allocation. Additionally, implementation considerations that could impact your allocation also come into play—for example, those concerning size of assets, ability to access a desirable strategy, or fee sensitivity.

As you can see in the chart on the facing page, the end result should be a strategic asset allocation policy that articulates allocation to the three strategic asset roles and to asset classes within each role, including their target levels and approved ranges.


Source: Russell Investments Research. “Dimensions of difference in nonprofit investing.” Bob Collie; August 2012.

OTHER ORGANIZATIONAL CONSIDERATIONS

Other organizational considerations that may result in different asset allocations include:

› The non-profit’s life cycle For example, is it in spend down mode or constrained by the

fact that its portfolio is underwater and/or is the portfolio the only source of cash flow to support its programs? Or is the non-profit stable and growing in perpetuity, and has greater flexibility to pursue certain investment strategies?

› Non-operating private foundations are required to spend at least 5% of their assets each year (or be subject to tax penalties)

Many other organizations, such as community foundations, public charities and universities, do not have such tax requirements (subject to regulatory changes).

› Size can also make a difference For example, for smaller non-profits, some investment

choices can be either prohibitively expensive, too challenging to implement in a diversified portfolio allocation or simply unavailable.


Asset allocation differs among non-profits The universe of non-profit investors is far from homogenous, so asset allocation can differ significantly from one non-profit to another—even among those who may seem to be very much alike.

Here are a few reasons why asset allocations might differ—aside from the obvious reasons of different objectives, risk tolerance, liquidity and spending.

DIFFERENT MISSION

Broad areas of difference are due to the very nature of the individual non-profit organization, including:

› The mission and history of the organization.

› The resources and expertise it has available to apply to its investment program.

› The limitations or constraints (such as the regulations and tax laws) under which it operates.

DIFFERENT INVESTMENT BELIEFS

Some investment beliefs are widely held, others less so.

› Where beliefs differ among investors, asset allocations may also differ.

› Sources of return premia—liquidity, equity risk and so on—are variable over time.

› On occasion, some risk premia may even become negative.

Thus, even if there is general consensus about the long-term characteristics of an asset class, investors will, at times, take sharply different views about its current attractiveness.


OTHER INVESTMENT CONSIDERATIONS

FOR EXAMPLE

Returns were negative for 2008, but there was still a large dispersion in returns. For example, global equities returned -43.8%, while hedge funds and global credit returned -18.4% and -1.5%, respectively.1

So, while diversification may not have guaranteed a positive return, nor guaranteed your capital, it certainly would have eased the pain associated with having invested solely in equities.

FOR EXAMPLE

As they begin to mature, illiquid investments can be highly cash-generative. Distributions occur at least annually, if not more frequently, such as quarterly. Depending on the strategy, manager and vintage year selected, cumulative distributions can typically range from 140% to 180% or more of the original invested capital, over a full investment cycle of 10 to 15 years.2

FOR EXAMPLE

The “endowment model” is often characterized by relatively low allocations to traditional equities and bonds and higher allocations to alternative asset classes, including private equity and hedge funds. These allocations generally result in less-liquid portfolios, and thus may not be suited to a number of non-profits for a variety of reasons, including: size, inflexibility of spending commitments, and lack of cash from non-investment sources. Yet while the endowment model may not be suitable for all non-profit investors, it can be a successful investment approach for those who can implement it well.

1 Credit Suisse Global Investment Yearbook 2009. Past performance is not necessarily a guide to future performance.

2 Source: Russell Investments’ private capital assumptions across all major private market strategies, modeled over a full private market cycle, as of January 2014.


›

›

›

Some common design myths

MYTH REALITYDiversification doesn’t work. All assets suffered badly during 2008—so why bother?

Dispersion matters—not just correlation.

In a perfect world, with perfect information flow, it should be easy to figure out the optimal allocation to each strategic asset role, as well as each asset class and sub-asset class. But information flows are not perfect. That is why it is easy to be led astray by one or more portfolio design myths.

We have picked three that we think are particularly important, and below we discuss what investors often perceive to be the truth (the myth) versus the reality.

MYTH REALITYIlliquidity is undesirable. Well-managed illiquidity can

contribute significantly to long- term growth.

MYTH REALITYThe “endowment model” is the go-to portfolio for today’s non-profit investor.

The best response to today’s low-return environment will depend on each organization’s circumstances. One size does not fit all.


GOALInflation + X%

Return enhancem

ent %Risk reducti

on /

dive

rsifi

catio

n %

Growth %

DESIGN

CONSTRUCT

MANAGE


Before we move on…Don’t be surprised if you find that after you have gone through this process, your objectives/outcomes look quite different than those you started with. That’s because there can often be a big difference between a portfolio built around a targeted outcome and one built around a benchmark of market indices.

Let’s take stock of where you are at the end of the Design phase.

Ideally, you should have:

Articulated your beliefs on how the capital markets will behave.

Set your portfolio goals in terms of percentage allocation to growth, return enhancement and risk reduction/diversification.

Determined the portfolio design components contained within each portfolio role.

All of this information should be captured in your IPS and will be used as the foundation for building out the underlying components of your strategic portfolio, which we will dive into in the next chapter, Construct.


Chapter 2: Construct


…through a scalable, repeatable, research process Critically reviewing a universe of more than 15,0001 possible options as you seek to find the right manager(s) and product(s) is not only challenging, but labor-intensive. It is not as easy as just selecting this year’s top performer—because manager performance is not consistent over time. For example, only 29% of first-quartile managers in 2013 remained in the first quartile a year later.2

You need a robust manager research process that: Analyzes portfolio characteristics and performance to give you a clear quantitative picture Important factors to evaluate include: portfolio construction, portfolio turnover, stability over time, consistency and sources of relative performance.

Provides a clear qualitative view of organizational and investment process characteristics Qualitative evaluation of potential investment managers includes an assessment of a provider’s leadership, investment professionals, decision-making, investment and risk management processes, and the conceptual basis of the investment strategy.

Is scalable and appropriately resourced Ensuring that you are able to meet one-on-one with managers at their offices, conduct ongoing operational due diligence reviews, and be in possession of a list of “just in case” managers to select from when changes are needed requires a well-trained, dedicated team.

1 Total investible universe of money manager products, across asset classes. Russell Investments data as of June 30, 2014.

2 Russell Investments global equities manager research data as of June 30, 2014.

Section II // Chapter 2: Construct

Picking the right managers for your strategic allocation… Populating the strategic asset allocation with managers can be like putting together a complex puzzle. Constructing a portfolio is not as simple as selecting managers to fit each strategy. Individual managers bring individual strengths and biases to the table.

Here are a few rules that should help you select strategies and managers that can give your portfolio the best chance of meeting your desired outcomes.

Pick managers whose strengths are in asset classes and risk profiles directly aligned with the objectives you have set for your investment program.

Seek to limit uncompensated portfolio risk. Ideally, you want your portfolio to deliver excess returns relative to the benchmarks, without introducing unnecessary risks.

Provide diversification by including managers/strategies that have diverse and complementary investment styles and processes.

Understand the drivers of excess return for different strategies. Is security selection the driver of excess returns or is it sector allocation?


A B C

Identification

Screening based on past performance is a primary driver of manager identification. True Partially true Not true

Our investment committee members have great access, they are our sole source for identifying prospective managers. True Partially true Not true

Our initial list of managers comes from screening an external manager based on a few key criteria. True Partially true Not true

We have outsourced manager identification to an expert. Not true Partially true True

Analysis and selection

We highly value meeting managers on site before hiring them. Not true Partially true True

Combining quantitative and qualitative analysis is important to us. Not true Partially true True

We have delegated analysis and selection to a manager research expert. Not true Partially true TrueWe see no value in deep analysis prior to selection; knowing the manager has shown good recent performance is good enough. True Partially true Not true

We select managers based on word of mouth that they are good and have sound investment strategies, without considering their fit with our portfolio. True Partially true Not true

Ongoing due diligence

We have no time to perform ongoing due diligence ourselves. True Partially true Not true

We rely heavily on our peers and investment committee members to keep us informed about the managers. True Partially true Not true

We have outsourced ongoing due diligence to a manager research expert and rely on them to inform us of important changes. Not true Partially true True

Any additional observations on your manager research process:

____________________________________________________________

____________________________________________________________

still have some room for improvement. Finally, if most of your responses are in Column C, you have the potential for a robust process, but we would still encourage you to review your process to identify any other potential gaps.


WORKSHEET

How robust is your manager research process? Do you believe there are gaps that need to be filled? To gain clearer insight into your process, take a few minutes to answer the questions in the table below. Select the answer that best reflects your current manager research process.

If most of your answers are in Column A, we would encourage you to revisit your manager research process, as there may be significant opportunities for improvement. If most of your answers are in Column B, you are on the way to a reasonable process, but


When determining which of these approaches to consider, there are several factors to keep in mind:

Take only those risks for which you believe you may be rewarded.

Fee constraints may drive the decision to incorporate passive management for part of an allocation.

Passive or smart beta may be used to provide certain exposures in a more cost-effective way than active management.

Your liquidity needs will be a factor in your decision making.


Striking the right balance between active and passive When determining which managers and exposures to incorporate into your investment portfolio, you also need to determine how you want to gain access to those market exposures.

These exposures can be accessed via one or more of the following approaches:

Active strategies: Active managers aim to deliver better risk-adjusted returns than those associated with passive approaches. The active approach can provide the flexibility to respond more quickly to shifting market and economic circumstances. The risks associated with these strategies are derived from the skills and approaches of each individual manager.

Passive strategies: A passive approach simply aims to track the behavior of an index that represents the asset class or market to which you want to have exposure, or a composite index that represents your strategy. The risks associated with these strategies align with those in the broader markets.

Smart beta strategies: Smart beta is viewed as a blend of active and passive and is used to obtain exposure to specific short-term market opportunities.


inco

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%

%

% Event

% Private % Private % Private%

% Cas

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Low

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income

(hedge funds)equity

real assets

equity

markets equity

developed

equit

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fixed

Distressed

Emerging

driven

non-corecapital core real Commoditie

san

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fixed% B

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igh

debt

markets

debt

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% Short

% Core

%

Liquid

% Long/short

% Emerging

% International

% D

om

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GOALInflation + X%

Return enhancem

ent %Risk reducti

on /

dive

rsifi

catio

n %

Growth %

DESIGN

CONSTRUCT

MANAGE


Before we move on…The Construct phase is all about building the total portfolio that seeks to meet your desired outcomes.

Having worked through this phase, you should have:

Populated your strategic asset allocation with individual strategy allocations.

Identified whether your manager research process is robust enough to select the managers for your investment programs.

Gained an understanding of how active and passive strategies can best serve your portfolio.


Chapter 3: Manage


As you review your portfolio, keep the following questions in mind:

Are there any exposures that seem out of alignment with the outcomes you are trying to achieve?

Have any of your investment strategies drifted outside of their approved allocation ranges? If so, do you know why?

Who is responsible for monitoring these exposures?

With what frequency are these underlying exposures reviewed with you?

Do you have the ability to view your portfolio components separately, as well as in total?

Do you have the right reports/monitoring systems to show you the details you need to adequately review your exposures?

Do your reports show you how your portfolio is positioned around specific sectors, underlying securities, currencies, countries, etc.?

By having clear visibility into where your portfolio is today, you can stress-test the portfolio, evaluate its sensitivity to different scenarios or risks, and understand how it might react in different market environments. Then you can better determine what changes you may need to make to keep your portfolio aligned with your strategic asset allocation or to capture specific short-term market opportunities.

1. Know where the portfolio is

Section II // Chapter 3: Manage

In order to effectively manage your portfolio, you need to do three things:

Know where the portfolio isUnderstand current portfolio exposures.

Know where you want it to beDetermine tactical shifts in response to market opportunities. Know how to get thereAdapt the portfolio and implement changes as needed.

1

2

3

What you need to do to effectively manage your portfolio


Reflecting on your hypothetical portfolio, let us assume that the highlighted boxes in the example below show your actual allocations. After considering the questions on the facing page, you have reviewed your exposures and gotten answers to the questions on the facing page, you have decided that in order to capture some specific opportunities and mitigate certain risks, you need to shift some of those allocations.

ASSET CLASSSTRATEGIC

ALLOCATIONAPPROVED

RANGESACTUAL

ALLOCATIONDESIRED

ALLOCATIONTACTICAL

SHIFTS

U.S. Equity 20% 15% – 25% 20% 22% + 2%

Non-U.S. equity developed 15% 10% – 15% 15% 15%

Emerging markets equity 6% 0% – 10% 6% 6%

Hedge funds: Long / short equities

5% 0% – 10% 5% 5%

Infrastructure: Listed 5% 0% – 5% 3% 5% + 2%

Real estate: Listed 4% 0% – 5% 4% 2% – 2%

Growth TOTAL 55% 53% 55%

High yield fixed income 5% 0% – 5% 3% 4% + 1%

Emerging markets debt 0% 0% – 5% 0% 2% + 2%

Distressed debt 0% 0% – 5% 0% 0%

Real estate: Private non-core real estate

0% 0% – 5% 0% 0%

Hedge funds: Event driven hedge funds

2.5% 0% – 5% 5% 5%

Private capital 8% 0% – 10% 10% 10%

Return enhancement TOTAL 15.5% 18% 21%

U.S. core fixed income 10% 5% – 15% 10% 7% – 3%

Global fixed income 5% 0% – 10% 5% 5%

Real estate: Private core real estate

7% 0% – 10% 6% 6%

Commodities 5% 0% – 5% 5% 3% – 2%

Hedge funds: Relative value, tactical trading

2.5% 0% – 5% 3% 3%

Cash / short duration 0% 0% – 5% 0% 0%

Risk reduction / diversification TOTAL

29.5% 29% 24%

PORTFOLIO TOTAL 100% 100% 100%

Ret

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Ris

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duct

ion

/ div

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Gro

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FOL

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› Are the investment strategies you have previously chosen performing as you expected?

› Does your portfolio include an array of risk and return sources?

› Has the liquidity of your portfolio changed in response to the current market environment?

› How are the markets expected to perform, and what type of environment are you entering into?

› Is now the time to make changes to your portfolio?

› If you make the changes, will you still be operating in line with your investment objectives?

› Where will the money come from to facilitate the desired shift (e.g., new cash inflows, or reallocation from another manager/strategy)?

Once you have the right reports and have gained visibility into your current portfolio, your next task is to determine whether you are comfortable with the exposures. Are the risks in the portfolio worth taking? Or do they simply need to be better managed? What capital markets assumptions should be factored into your evaluation?

Some questions you will want to have answered before making any changes include:

2. Know where you want the portfolio to be


The manager change approach is best used when you are seeking to add a new exposure to your portfolio, get rid of an existing exposure or move away from a manager who either isn’t performing as you expected or whose investment strategy doesn’t align with your portfolio outcomes.

Let’s say you have determined that you want to increase your allocation to high-yield fixed income and emerging markets debt and have decided that a manager change is the best approach to take. For emerging markets debt, you are adding a manager (Manager C) who will give you that exposure. For high yield, you are swapping out an underperforming manager (Manager A) for one whose strategy more closely aligns with the current market environment, and you are increasing the size of the mandate to be given to that new manager (Manager B).

A. Manager change

PORTFOLIO ROLE Return enhancement Return enhancement

ASSET CLASS High yield fixed income Emerging markets debt

STRATEGIC ASSET ALLOCATION

5% 0%

APPROVED RANGE 0% – 5% 0% – 5%

ACTUAL ALLOCATION 3% 0%

DESIRED ALLOCATION 4% 2%

TACTICAL SHIFTS +1% +2%

IMPLEMENTATION Terminate Manager A; Hire Manager B

Add Manager C


In order to implement the determined changes, you need to have the right tools for moving the portfolio in line with your desired allocation.

There are three approaches that can help you get from where you are now to where you want to be:

Manager change

Manager weight change is the traditional means of adjusting exposures in your portfolio

Tactical positioning strategies are used to take short-term positions, either to capture opportunities as they are identified or to mitigate risk without altering the underlying manager makeup of the portfolio

Let’s finish this example using your hypothetical portfolio. In the preceding step, you determined which allocations you wanted to adjust. Now we will walk you through how you might use the three approaches to achieve your desired exposures.

3. Know how to get there

A

B

C

Inefficiently implementing your decisions can cost you money and time that could have been used instead to further your mission.


You can implement tactical positioning strategies in your portfolio in a variety of ways, including exchange-traded funds (ETF), futures, derivatives, overlays, etc. Such approaches are best used when you want to capitalize on short-term market shifts without altering the underlying manager makeup of your investment portfolio.

In this example, we are going to illustrate how you can increase your U.S. equity exposure through a futures overlay. Recall the 2% reduction to commodities you made in the manager weight change example on the facing page. Instead of using that money to invest in another U.S. equity manager directly, you were able to use those funds to purchase Russell 1000© futures contracts to create the additional exposure synthetically. This approach allowed you to gain the additional exposure without incurring the trading costs of changing the underlying managers.

C. Tactical positioning strategies

PORTFOLIO ROLE Growth

ASSET CLASS U.S. Equity

STRATEGIC ASSET ALLOCATION 20%

APPROVED RANGE 15% – 25%

ACTUAL ALLOCATION 20%

DESIRED ALLOCATION 22%

TACTICAL SHIFTS + 2%

IMPLEMENTATION Use cash from reducing Manager Z to gain equity

exposure via futures overlay


The manager weight change approach is best used when you merely want to adjust the portfolio weights allocated among the present managers.

In this example, you determined that you wanted to adjust the weights allocated to each of the asset classes listed below, but wanted to make those adjustments with the managers currently in your portfolio. You took 2% of your real estate allocation (Manager X) and shifted that to infrastructure (Manager W). Then you reduced your allocations to both U.S. core fixed income (Manager Y) and commodities (Manager Z), and used that money to fund the manager changes in the previous example and the futures overlay (which we will discuss next).

B. Manager weight change

PORTFOLIO ROLE Growth Growth Risk reduction

Risk reduction

ASSET CLASS Infrastructure: Listed

Real estate: Listed

U.S. core fixed income Commodities

STRATEGIC ASSET ALLOCATION 5% 4% 10% 5%

APPROVED RANGE 0% – 5% 0% – 5% 5% – 15% 0% – 5%

ACTUAL ALLOCATION 3% 4% 10% 5%

DESIRED ALLOCATION 5% 2% 7% 3%

TACTICAL SHIFTS + 2% – 2% – 3% – 2%

IMPLEMENTATIONIncrease

allocation to Manager W

Reduceallocation to Manager X

Reduce allocation to Manager Y

Reduce allocation to Manager Z


ACCESS TO DATA FOR:SLOWEST TIME TO GET INFORMATION:

Monitoring holdings and resulting risk in your portfolio

Monitoring performance data

Annually

Quarterly

FASTEST TIME TO GET INFORMATION:

WHAT IS YOUR TIMESCALE?

Daily

Daily

IMPLEMENTATION:SLOWEST TIME FROM DECISION TO ACTION:

Portfolio manager change

Portfolio manager weight change

Opportunistic tilt in response to market shift (tactical positioning strategies)

Modification to your spending rate (if necessary)

6 months or more

6 months or more

1 month or more

Once every 3 years

FASTEST TIME FROM DECISION TO ACTION:

WHAT IS YOUR TIMESCALE?

1 month or less

2 weeks or less

Same day

Once a year

WORKSHEET

How do your decision-making and implementation processes compare?Ensuring that your investment committee is in agreement with the outcomes you are trying to achieve, as well as with how quickly you need to implement tactical shifts in your portfolio to achieve them, is critical to the success of your investment program. If your implementation timescale is significantly misaligned with the “fastest” listed below, your committee should discuss why that is so, and determine what actions to take to achieve better alignment.


As you seek to take advantage of shifts in the markets, the way you execute portfolio changes is critically important.

You need to:

Be able to implement changes efficiently and quickly, while understanding the opportunity cost involved.

Take liquidity needs into consideration.

Ensure that your changes do not create a misalignment with your strategic asset allocation.


Before we move on…You have worked hard to set up your investment program around your desired portfolio outcomes. The Manage step is key to increasing the likelihood that all of your hard work will pay off. By understanding what you own, knowing where you want your portfolio to be, and having the tools to get the portfolio there quickly and efficiently, you ensure that your investment program stays aligned with the goals, beliefs, expectations, constraints and portfolio design unique to your non-profit.

inco

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% Event


% Cas

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(hedge funds)equity

real assets

equity

markets equity

developed

equit

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loan

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Distressed

Emerging

driven


san

d cas

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volat

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fixed% B

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debt

hedgefunds

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hedg

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% Short

% Core

%

Liquid

% Long/short

% Emerging

% International

% D

om

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GOALInflation + X%

Return enhancem

ent %Risk reducti

on/d

iver

sific

atio

n %

Growth %

DESIGN

CONSTRUCT

MANAGE


inco

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%

% Event


% Cas

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(hedge funds)equity

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Distressed

Emerging

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san

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% Short

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Liquid

% Long/short

% Emerging

% International

% D

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Kno

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get th

ere

Know w

here you are

Know where you want to be

GOALInflation + X%

Return enhancem

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dive

rsifi

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Growth %

Building a strong risk management and fiduciary framework

Russell Investments // 93

Chapter 1: Risk management

Russell Investments // 95Russell Investments 94

Developing a risk governance structure

Given the unavoidable trade-offs between risk and reward, it is critically important that as a fiduciary you understand that the risks requiring oversight are numerous.

One way of organizing risks is to catalog them under five broad categories:

Fiduciary: Broadly speaking, risks that arise from inadequate policies and procedures.

Structural: Asset structure biases, such as a built-in small cap tilt.

Implementation / operational: Risks related to the implementation of strategies as well as operational policies and procedures.

Market: Risks associated with the market.

Enterprise: Consideration of the entire organization and the risks that impact it.

These five broad risk categories can be mapped onto each component of the fiduciary roadmap (as shown in the graphic on the next page). Identifying the risks associated with each step will help you to understand and appreciate the primary risks involved at each stage of the portfolio management process, and to develop an appropriate protocol for managing those risks.

1

2

3

54

Section III // Chapter 1: Risk management

Holistic risk management is critical to the success of your investment programIn the investment world, most people think of risk as being that which resides within a specific investment portfolio. But investment risk is not the only risk that can impact a non-profit’s ability to meet its goals. Legal risks, as well as operational, structural or other enterprise risks specific to your non-profit’s circumstances or expectations, need to be managed as well.

Some risks are unique to a particular type of non-profit, such as charitable organizations or hospital foundations. Some are unique to the entity itself, such as a small liberal arts college, which faces risks of a different character than those of a large state university. Still, many risks are common to all investors.

Your ongoing success depends upon your ability to understand the risks and benefits in evolving market opportunities and to manage your portfolio dynamically while avoiding undue risks. A well-crafted and robust approach to risk management can help you do that, and lead to healthier outcomes for your entire organization.

Source: Benefits and Pensions Monitor (Special Report on Risk). “Defining Risks.” Bruce Curwood and Heather Myers; April 2014.


AREAS OF RISK

FIDUCIARY STRUCTURALIMPLEMENTATION / OPERATIONAL MARKET ENTERPRISE

› Decision making› Legislative / legal› Documentation› Publicity

› Maverick › Resources

› Policy › Outcomes

› Spending› Return assumptions

› Rebalancing › Cashflow › Inflation› Currency

› Liquidity

› Regret › Active / passive

› Benchmark

› Timing

› Hedging

› Interest rate

› Volatility

› Style

› Sector

› Country

› Diversification

› Political

› Press › Research › Holding concentration

› Trading › Transition management › Securities lending

› Systems / technology

› Tolerance › Monitoring › Oversight

› Transparency › Guideline breach

› Compliance

› Benchmark › Custodial

› Ongoing due diligence

› Audit / accounting


This is not an exhaustive list.

Governance

Asset class strategy

Objective setting

Asset allocation

Portfolio structure

Manager selection / monitoring

Execution

Performance measurement& evaluation

Portfolio risk management

Strategic planningDESIGN

Portfolio managementCONSTRUCT

Review & controlMANAGE

Fiduciary roadmap


Source: Russell Investments Research. “Are you sure you’re managing all of your risks? A holistic risk management approach for non-profit investors.” Lisa Schneider and Mike Ruff; March 2014.

Understand the NATURE of the risks within your investment program, and what could CAUSE them to occur.

Understand the different risk MEASURES; for example, there may be a high tolerance for risk as measured by standard deviation, but much less tolerance for drawdowns or significant losses.

ASSESS the relative magnitude of the risks and their potential impact on your investment program. Separate minor, more acceptable risks from major risks. ASSESS how and whether those risks have been addressed or mitigated by past actions. Develop a list of risks, in order of priority, that require further action.

MANAGE the largest, unaddressed risks first.

Continually REVIEW the risks within the hierarchy of those that are most critical. Monitor the risks, and add new risks to your list as they are identified.


Understanding and monitoring the impact of riskOnce you have mapped out the identifiable risks, the next step is to determine how each risk will be measured, assessed and managed.

To help you do this, we offer the following steps:

As a fiduciary, you need to ensure that you have access to appropriate tools—tools that will help you understand and manage the risks in your portfolio. For you, high-level reports that give snapshots of a portfolio’s key metrics (past, present, future) will help all those involved in your investment program to stay focused on their individual roles and stay informed, without being overwhelmed.

UNDERSTAND THE NATURE AND CAUSE

MEASUREREVIEW

MANAGE ASSESS


CHECK IF YES

Lack of financial resources for best-in-class risk management

Risk management is not an important priority

Not enough time in investment committee meetings to identify the risks that are of greatest concern

The investment committee and fiduciaries disagree on what are the most critical risks to manage

Limited transparency into the portfolio makes it very difficult to assess risks

Others

If you ranked your risk management program lower than great, the worksheet below may help you identify some of the weakest links in your program (check all that apply):

WORKSHEET


We have identified which risks are most important to manage Yes No

All of the risks we believe are important to manage are being assessed and measured on a regular basis Yes No

We have hired experts to help us measure, assess and manage the risks Yes No

Our governance process includes at least an annual review of our risk management process Yes No

We stress-test the portfolio at least annually to understand the biggest market impacts on the portfolio Yes No

How does your risk management program stack up?

To ensure that you have a clear understanding of your risk management program, take a few minutes to respond to the statements below:

WORKSHEET

Based on your answers to the questions above, how would you rate your risk management program?

Poor Good Great

Russell Investments // 103

Chapter 2: Being an effective fiduciary


We have seen a shift toward outsourcing more decisions to investment professionals, particularly since the 2008 global financial crisis. Many fiduciaries are actively engaged in discussions regarding which decisions they are comfortable making, and when it might make sense to partner with others.

OCIO: Discretionary outsourcing provider

Review& controlMANAGE

Governance

Portfolio risk management

Objective setting

Asset allocation

Asset class strategy

Manager selection / monitoring

Performance measurement & evaluation

StrategicplanningDESIGN

PortfoliomanagementCONSTRUCT

Execution

Portfolio structure

Con

sult

ant

Clie

nt

OC

IO p

rovi

der

Clie

nt

Pre-crisis Post-crisis

Determine line of discretion

Section III // Chapter 2: Being an effective fiduciary

FIDUCIARY ROADMAP

As a fiduciary, you are always in control However, that does not mean you have to do everything yourself. Effective governance is about the ability to steer, give direction and intervene when shortcomings are identified. There is often a disconnect in time between how markets behave, when decisions need to be made and how often your team can meet to review those decisions.

The fiduciary roadmap shows a clear hierarchy of decisions fiduciaries must make in running their portfolio’s investments. Fiduciaries should always retain control of governance and objective setting, and should be very involved in strategic asset allocation decisions as well. That said, it is really up to the individual organization to determine where the line of discretion should be drawn.

The challenge of control is to identify: How decisions are made

Who makes them

How they are monitored


Three guiding principles for fiduciaries As you think about your role as a fiduciary, there are a few key principles which should guide you:

Be inquisitive› Build a complete picture of the factors affecting a decision.› Identify risks, payoffs and contingencies.› Ensure that this picture is unbiased.› Know your own biases, and seek out and embrace

different perspectives.› Do not allow early conclusions to choke inquisitiveness.› Actively challenge and extend your conclusions.

Prioritize› Strategic decisions that have the biggest potential

impact on the investment program need to be made in a timely manner.

› Brief reports that highlight key information quickly, frequently and on a timely basis are more powerful than comprehensive reports that take time to absorb, or are infrequent or delayed.

Know when to delegate› Have a clear understanding of your team’s skills,

expertise and time constraints. › Understand that not all decisions can be afforded

the full degree of inquisitiveness in the time available to fiduciaries.

› Ensure that decisions are made by those best placed to make them.

1“Governance Practices among U.S. Institutional Investors.” Greenwich Associates (2011)

1

2

3


How has the role of the fiduciary changed? It’s not just the markets and how portfolios are constructed that has changed, it is also how fiduciaries need to react to this new environment. Below is an outline of some of the key shifts that have taken place over the past decade that have impacted the role of the fiduciary.

THEN NOW

TRADITIONAL MODEL EMERGING BEST PRACTICES

DESIGN

Committee focused on managers Committee focused on policy

UMIFA UPMIFA

Strategic asset allocation (review every three years)

Strategic asset allocation (review annually)

CONSTRUCT

Asset class focused Asset role focused

Formulaic asset rebalancing Dynamic asset rebalancing

Unsophisticated passive Overlays/tilts

MANAGECustomized administration Timely, flexible reporting

Quarterly review of investment program

Monthly review of investment program

Approximately one in four endowments/foundations feels that its investment program is unable to quickly and effectively respond to new situations and opportunities.1


In this example:

The non-profit board retains direct control of the objectives and defines the strategy to support those objectives.

The investment committee develops the broad investment strategy and the OCIO controls the portfolio structure decisions (such as: where to include active management, how to build out and adapt specific strategies, etc.).

The OCIO is authorized to appoint managers and control the overall portfolio construction to achieve the desired portfolio structure.

The appointed third-party investment managers select securities, trade, and execute the hedging and dynamic risk management.

DESIGN CONSTRUCT AND MANAGE

STRATEGIC PLANNING PORTFOLIO MANAGEMENT REVIEW & CONTROL

FIDUCIARY LEVEL

Policy

Define investment objectives, asset allocation, spending, risk and liquidity

Strategy

Determine asset class strategies and structure

Policy management

Portfolio construction, manager due diligence and implementation

Dynamic asset allocation

Actively managing risk and return objectives in real time

Review and control

Review for compliance vs. objectives

GOVERNING: Board Decides Oversees Oversees Oversees Review IC decisions

MANAGING: Investment committee

Recommends to board

Decides Oversees Reviews quarterly Review OCIO’s decisions

OPERATING: OCIO working with client

Recommends Recommends Decides Manages within pre-set targets in IPS

Review managers /control portfolio

OPERATING: Third-party investment managers

Security selectionand execution

Compliance vs. guidelines

› ›


How delegation can help you retain controlTo ensure that your governance structure is adequately resourced, there should be a single entity or person with decision-making responsibility for each step of the road map. There should also be a group/individual with ultimate oversight or responsibility, and there could be several groups that recommend actions or provide input.

We have provided an example below, and continued on the facing page, that depicts a discretionary outsourcing (OCIO) approach. What’s unique about this approach is that it allows the investor’s OCIO to implement portfolio-level decisions (actions within the orange rectangles) in real time. A non-discretionary outsourcing approach, on the other hand, would require that such decisions be approved by the investment committee, typically on a quarterly basis.

STRUCTURED GOVERNANCE PROCESS: DISCRETIONARY OUTSOURCING APPROACH


What does your delegation structure look like?Spend a few minutes completing the chart below for your organization’s decision-making structure. In the spaces below, mark “D” for Decide, “R” for Recommend or “O” for Oversee.

Note: There should be only one “D” in each column, except for review and control, which are oversight functions.

DESIGN CONSTRUCT AND MANAGE

STRATEGIC PLANNING

PORTFOLIO MANAGEMENT

REVIEW & CONTROL

FIDUCIARY LEVEL Policy Strategy

Policy management

Dynamic asset

allocationReview

and control

GOVERNING

MANAGING

OPERATING: OCIO PROVIDER

OPERATING: THIRD-PARTY MANAGERS

› ›

WORKSHEET


If you identify a place where there is more than one decision-maker, you should rectify this; only one group/person should be the final decision-maker.

Building a delegation structureThe “discretionary” governance structure of the preceding page is just one possible governance configuration. A wide variety of possible structures could be adopted, depending on how fiduciaries define their decision hierarchy, and the resources they have at their disposal.

Basic guidelines that all governance structures should embrace:

The non-profit board must always retain fiduciary control of the objectives and the overarching strategy; owning these directly is part of governing.

Delegation should be to the person or entity (internal or external) deemed most competent to make that decision, and who has the time and resources to make effective and timely decisions.

For each decision, one, and only one, person or entity should be identified as the decision-maker.

Decision-making and oversight should be separated, and just as there should be exactly one clearly identified decision-maker, there should also be exactly one clearly identified overseer to avoid “playing to several masters.”


How do your resources compare with similarly sized non-profit investors?One measurement of “resources” is the professional staffing of a non-profit’s investment function, based on the average number of full-time-equivalent employees in the organization.1 In the table below, the average “resources” for different asset sized endowments are listed. As you can see, there is a significant jump in resourcing for portfolios with over $1 billion in assets.

SIZE (USD) RESOURCES (full-time equivalents)

$25m – $50m 0.4

$51m – $100m 0.4

$101m – $500m 1.0

$501m – $1 billion 2.5

Over $1 billion 9.3

Above average Average Below average

HOW DOES YOUR NON-PROFIT COMPARE IN TERMS OF STAFFING?

Your organization’s asset size is: _________________________________________

The number of staff members (full-time equivalents) dedicated

to investments is: ____________

There are other considerations frequently cited relative to resources—such as depth of skill of the investment committee members or use of a consultant—but ultimately, you must weigh the effectiveness of part-time help versus that of dedicated professionals.

1 2013 NACUBO-Commonfund Study of Endowments

WORKSHEET


Have you changed with the times?

Good governance is becoming more challenging, because:

Markets are moving faster and becoming more complex.

The range and sophistication of investment choices has increased.

Investment committees can be pressed for time, and resources can be limited.

Some fiduciaries have chosen to address their governance concerns by simplifying their investment programs. That is a rational choice for fiduciaries of non-profits with fewer resources, where risk can be adequately contained through simplified strategies implemented passively.

Others have chosen to embrace complexity and have added internal resources or outsourced many implementation functions to support their decision.

A third group is becoming the “squeezed middle,” aspiring to the sophistication of larger and better resourced non-profit organizations, but lacking the resources to achieve it. These tend to be midsize non-profits with investment strategies similar in complexity to those of larger investment programs, but, again, with far fewer resources. This group also hasn’t outsourced as much as smaller non-profits have. Thus, the governance challenge is most acute for fiduciaries of these midsize non-profits.

Russell Investments // 115Russell Investments 114 Section III // Chapter 2: Being an effective fiduciary

Good governance matters All too often, the decisions that define the ongoing governance and control processes come about accidentally and aren’t sufficiently examined. Habits are formed. People move on. Processes grow stale. Decisions aren’t documented. And reports become so familiar in appearance and tone that you stop seeing the information they are intended to convey. For fiduciaries to retain effective control, you need to explicitly focus on governance and regularly review processes and decisions.

Good governance may not ensure success, but it does materially improve your odds of a good outcome. Research has shown that the value of good governance could be as much as 2.4% per annum1 in additional or “unlost” return. Imagine how many projects you could fund with that savings over time.

1 ”The Pensions Governance Deficit: Still With Us.” Ambachsteer, Capelle & Lum, Rotman. International Journal of Pension Management, Volume 1, Issue 1, Fall 2008.

Russell Investments 116 Russell Investments 117

› Pay close attention to risk

Risk can make or break your ability to meet your investment goals. Make sure you have a strong, robust risk management process that you evaluate and adjust as situations change.

› Really understand who is doing what to help you achieve your goals

You don’t have to do it all, but you do need to make sure it is all being done. This is about your ability to steer, give guidance and intervene when you see a potential gap—and then to decide who is best equipped, internally or externally, to fill that gap.

Serving as a non-profit fiduciary is an important job. You have committed to this for the long haul, and we thank you for it. Your dedication to your organization fills a vital role in our society, and we hope this handbook helps you build and manage an investment program that will help fund your mission for many years to come.

Closing thoughts Congratulations, you made it! Now the hard work begins…

As we have expressed throughout this handbook, effectively managing an investment program is a complex, ongoing process that involves dozens of key stakeholders, all working toward a common goal. In closing, we want to leave you with a few big ideas:

› To achieve your goals, they must be clear, aligned and documented

It’s very hard to get where you are going if you do not know where that is. Your job is to set clear guidance for your team, and to understand where there may be hang-ups or misalignments along the way. Being clear and consistent about the goals you are trying to achieve, and the levers you are going to use to get there, is critical.

› The process should support your goals

Your ability to meet your goals is dependent on your ability to design, construct and manage a dynamic investment program aligned with your desired outcome. As the markets move and your non-profit’s situation changes, do not be afraid to revisit the process to make sure you are still getting the information you need to ensure that your portfolio is in alignment with the goals you are trying to achieve.

Closing thoughts

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Restricted endowments /investments: Assets or income that are restricted as to their use, the types of organizations that may receive grants from them or the procedures that may be used to make grants from such funds.

Standard deviation: A measure, in the same units as the original data, of the variability, volatility, or dispersion of a data set around the average value of that data set (i.e., the arithmetic mean); positive square root of the variance.

Strategic asset allocation: The long-term mix of assets that is expected to achieve an investor’s long-term objectives, given the investor’s investment constraints.

Tactical asset allocation: The decision to deliberately deviate from the strategic asset allocation in an attempt to add value based on forecasts of the near-term relative performance of asset classes.

Time horizon: The length of time over which an investment is held; it can vary depending on an investor’s goals and constraints as well as on the nature of the investment.

Tobin rule: The Tobin spending rule sets annual spending to a percentage of the prior year’s spending, adjusted for inflation, plus the long-term spending rate times the market value of assets. The formula for the Tobin spending rule is: [X% * prior year’s spending * (1 + inflation)] + [(1-X%) * Spending Rate * Market Value of Assets]; also known as a hybrid rule.

Tracking error: The standard deviation of the differences between the deviation over time of the returns on a portfolio and the returns on its benchmark.

Volatility: A statistical measure of the dispersion of returns for a given security or market index. Can be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security on a stand-alone basis.

UMIFA: The Uniform Management of Institutional Funds Act is a uniform law, passed in 1972, that provides rules regarding how much of an endowment a charity can spend for what purpose, and how the charity should invest the endowment funds. Under UMIFA, a charity could never spend below the historic dollar value of the endowment.

Underwater fund: Per UPMIFA, a fund is underwater at any point in time that its dollar value falls below its historic dollar value, where historic dollar value is defined as the original gift corpus at the time of setting up the fund.

Unrestricted endowment/investments: An unrestricted fund is one that is not restricted by the donor to specific uses, or for which restrictions have expired or been removed.

UPMIFA: The Uniform Prudent Management of Institutional Funds Act is a uniform act, approved on July 13, 2006, that provides guidance on investment decisions and endowment expenditures for non-profit and charitable organizations. UPMIFA replaced the requirement restricting non-profits from spending below the historic dollar value of their assets with a new requirement that spending should be at a rate that will preserve the purchasing power of the principal over the long term. The adoption differs state-by-state.

GlossaryAlpha: Risk-adjusted outperformance over the return of a relevant market benchmark.

Beta: A generic term for market risk, systematic risk or non-diversifiable risk.

Correlation: A measure of the strength of a relationship between two variables; essentially, two variables are correlated when a change in one variable is always accompanied by a change in the other variable. Variables can be positively or negatively correlated.

Currency risk: The risk associated with the fluctuation of foreign exchange rates; also called foreign exchange risk.

Derivatives: Contracts (agreements to do something in the future) that derive their value from the performance of an underlying asset, event or outcome.

Diversification: The practice of combining assets and types of assets with less than perfect correlation in a portfolio for the purpose of reducing risk.

Endowment model: A portfolio that typically has low allocations to traditional equities and bonds, with a significantly higher proportion of assets allocated to nontraditional asset classes such as absolute return, private equity, real estate and hedge funds.

Factor exposures: An expression of how much the return of a security or group of securities is driven by having exposure to specific market factors, which are fundamental variables that can be observed, such as market capitalization, growth, momentum, value, leverage, volatility, etc.

Index: A portfolio of securities (such as shares or bonds) that represent the market or a specific portion of it.

Inflation: The percentage increase in the general price level from one period to the next; a sustained rise in the overall level of prices for goods and services.

Inflation risk: The risk associated with the rise or fall of inflation levels and the impact on purchasing power and value of assets after accounting for inflation.

Interest rate risk: The risk associated with interest rate changes and its impact on bond prices and other financial instruments.

Intergenerational equity: Managing assets with a total-return approach, instead of an income-oriented approach, in order to adjust for unanticipated inflation and preserve long-term purchasing power for the benefit of both current and future beneficiaries.

In perpetuity: An infinite time horizon, often used in the context of a non-profit organization that has the time horizon of existing forever.

Rebalancing: The process of adjusting the weights of the constituent securities in an index or the weights of assets in a portfolio.

Glossary


PUBLIC CHARITYIRS code: 501(c)(3) 509(a)(1), (2), or (3)

NON-IRS CLASSIFICATION

TYPICAL TIME HORIZON

INITIAL SOURCES OF FUNDS

TYPICAL DISTRIBUTIONS

TYPICAL CONTRIBUTIONS AND REVENUE

SPENDING REQUIREMENTS

FEDERAL TAX STATUS

TAX FILING REQUIREMENTS

Educational institution

Perpetuity Original gift corpus from donor (typically alumni) to setup the endowment.

Provide long-term support of the operating budget of the educational institution (e.g. scholarships).

Continued donations from alumni, including support through fundraising campaigns, and investment returns.

No statutory mandates dictating minimum payout levels.

Tax-exempt May be liable for tax on unrelated business income.

Must file IRS Form 990 or 990-EZ annually, if gross receipts are more than $50,000. Must file Form 990-T if gross unrelated business taxable income is $1,000 or more.

Community foundation

Perpetuity Permanent funds, including donor advised funds, field of interest funds, and component funds, established by many separate donors for the long-term diverse, charitable benefit of the residents of a defined geographic area.

Run programs or give out grants for meeting the local community’s needs. Achieve diverse set of goals set by a wide set of donors.

Receive at least one-third of their support from the general public, including support from fundraising campaigns, and investment returns.



Must file IRS Form 990 or 990-EZ annually, if gross receipts are more than $50,000. Must file Form 990-T if gross unrelated business taxable income is $1,000 or more.

Appendix: Types of non-profits The table below lists the different types of non-profit organizations and their respective considerations. You may have more specific requirements, but generally your non-profit would fall into one of these categories. Please note that this is not an exhaustive list and is not meant to be representative of all tax-exempt organizations as classified by the IRS Code.

Appendix: Types of non-profits



PUBLIC CHARITYIRS code: 501(c)(3) 509(a)(1), (2), or (3)







FEDERAL TAX STATUS


Hospital or medical research foundation

Perpetuity Original gift corpus from the hospital or a medical sciences research organization.

Run programs or give out grants for meeting health-focused mission. Achieve the goals set by the hospital or aligned with a certain medical research issue.

Receive at least one-third of their support from the general public, including support from fundraising campaigns, fees from services (in some cases) and investment returns.



Must file IRS Form 990 or 990-EZ annually, if gross receipts are more than $50,000.

Must file Form 990-T if gross unrelated business taxable income is $1,000 or more.

Churches or conventions or associations of churches

Perpetuity Original gift corpus typically created by a large group of faithful members who make charitable gifts to further their religious beliefs through the mission of the organization.

Run programs to support the spiritual and religious mission of the organization.

Support usually from members in the form of tithes or other forms of offerings. Investment returns serve as additional source of revenue.


Tax-exempt

May be liable for tax on unrelated business income.

Not required to file annual Form 990 or 990-EZ.


Supporting organization (can be Type I, II, or III (functionally integrated or non- functionally integrated depending on type of relationship with the supported organization and other factors)

Perpetuity Original corpus comes from the supported organization or contributions from a limited group of donors, such as an individual or family, which is typically another public charity.(e.g. an alumni foundation supporting a school/university)

Supports the mission of the public charity that it is directly supporting.

Varies, but can be from a limited number of donors, such as an individual or family or entity or from the general public and can include support through fundraising campaigns, and investment returns.

No statutory mandates dictating minimum payout levels for Type I, II or functionally integrated Type III. Non-functionally integrated Type III supporting organizations required to distribute greater of 85% of adjusted net income and 3.5% of average fair market value of investment assets to its supported organization(s).

Tax-exempt

May be liable for tax on unrelated business income.

Must file IRS Form 990 or 990-EZ annually regardless of level of gross receipts.





PRIVATE FOUNDATIONIRS code: 501(c)(3)







FEDERAL TAX STATUS


Non-operating private foundation

May be limited time or perpetuity

Original corpus usually comes from an individual, family or corporation, but also could be from a hospital conversion transaction.

Non-operating foundation doesn’t usually carry out direct charitable activities but makes grants to other charities.

Additional contributions from original donor(s) and investment returns.

Required to distribute 5% of the average fair market value of its investment (non-charitable use) assets annually. Specific rules apply regarding the types of contributions that count towards the 5% minimum.

Required to pay taxes of 1–2% on its annual net investment income (includes interest, dividends, rents, royalties, capital gains).

Must file IRS Form 990-PF annually.


Operating private foundation

May be limited time or perpetuity

Original corpus usually comes from an individual, family or corporation.

Operating foundations typically carry on direct charitable activities and make few, if any, grants to other charities.

Additional contributions from original donor(s), fees for services, fundraising campaigns from general public and investment returns.

Special tests must be met to ensure that the assets are being used primarily to carry out direct charitable activities.

Required to pay taxes of 1–2% on its annual net investment income (includes interest, dividends, rents, royalties, capital gains).

Must file IRS Form 990-PF annually.

Must file Form 990-T if gross unrelated business taxable income is $1,000 or more



Important informationNothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

Copyright © Russell Investments Group, LLC. 2015-2016. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

First used: January 2015 (Disclosure revision: July 2016)

USI-20722-01-18

ACKNOWLEDGEMENTSThis handbook was created by Heather Myers, Angie Santo-Walter, Manisha Kathuria, Lila Han. The authors would like to thank Anne Banks, Ellen Bilski, Greg Coffey, Bob Collie, Rebekah Dunn, Jean-David Larson, Mary Beth Lato, Cameron Lochhead, Jana Marcelia, Michele McKinnon, Marci Mill, Steve Murray, David Myers, Ryan Rasner, Mike Ruff, Lisa Schneider, Mary-Jean Serene, Mike Smith, and Deanna Stevenson for their invaluable contributions and suggestions.

ABOUT RUSSELL INVESTMENTSRussell Investments is a global asset manager and one of only a few firms that offers actively managed multi-asset portfolios and services, which include advice, investments and implementation. Russell Investments stands with institutional investors, financial advisors and individuals working with their advisors using our core capabilities that extend across capital market insights, manager research, asset allocation, portfolio implementation and factor exposures to help investors achieve their desired investment outcomes.

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