Playing defence when it comes to investment governance
July 17, 2019
In the world of pensions, endowments and foundations, members of governing boards and investment committees are trusted with oversight of pools of capital with significant influence over people’s lives.
Formal governance frameworks provide critical references for fiduciaries helping to steward capital for these organizations.
The CFA Institute Research Foundation released a paper this April on investment governance for fiduciaries as a reference for people in these roles.
The authors sought to create a framework for investment governance by organizing the various responsibilities of fiduciaries into a series of steps. The steps are: objective, policy, execute and resource, implement and superintend.
These steps aptly spell out the Latin word ‘operis,’ which describes field defences and the authors note that being an investment fiduciary is about defending plan members’ from risk events and uncompensated risks.
Execution, resourcing and implementation lie below what the authors call the fiduciary line, as they are often under the purview of asset managers and investment consultants. Below the fiduciary line are activities around which delegation and opacity often increase, most notably in the case of outsourced asset management and other services.
Let’s start by focusing on steps above the fiduciary line:
When establishing the context within which investment decisions will be made, the authors suggest focusing on the high-level investment beliefs that will drive internal and external decisions. They note relevant examples like focusing on simplicity to the extent possible and on investing in a beneficiary-conscious manner. These beliefs can then help guide formal objectives.
The authors introduce the ‘hierarchy of investment objectives’ as a means for articulating and organizing objectives that may be competing. Using a hierarchy of objectives can help fiduciaries align activities more closely with the goal of the overall mandate. When finalizing objectives, each should have a reasonable scale by which to appraise whether it has been met after the fact, the paper said. For example, a primary objective could include the probability of achieving a targeted excess-of-inflation return over rolling 10-year periods.
Within the hierarchy of objectives, a good result could be 70 per cent probability, with an excellent result being 80 per cent, and so on.
The establishment of the formal investment policy resides at the next step within the framework. The objective covers the what and the policy covers the how, the paper noted.
The authors discuss the importance of linking policy asset allocation to the hierarchy of investment objectives and some potential methods for doing so. As one option, it suggests a method of comparing various simulated policy asset allocations to determine to the objectives in the hierarchy of investment objectives.
Assuming the excess-of-inflation return example above serves as a primary objective, the policy allocation would ideally achieve an attractive result with it in mind (a high percentage of rolling 10-year periods where the return target is met).
As the authors outlined, alignment of policy with objectives is critical and so is the establishment of appropriately specified objectives. These will serve as a cornerstone to the organization in executing the investment mandate.
Execute and resource and implement
Just because executing and resourcing and implement rest below the fiduciary line, these are still important for fiduciaries. Let’s briefly move below the fiduciary line.
Investment fiduciaries cannot delegate accountability, the paper said, so they still have influence over what is below the fiduciary line.
Fiduciaries must be satisfied that there are appropriate resources going towards executing and implementing the investment process, the paper said.
It’s also important for fiduciaries to consider allocation of responsibilities around oversight of mandated documentation, service-level agreements and investment administration.
Another example, noted the paper, is that fiduciaries also have choices to make when it comes to implementation. The insourcing versus outsourcing decision is a common example.
Going back above the fiduciary line, the last step is to superintend those items below the line, the paper said.
Superintending involves seeking assurance regarding the alignment of relationships across the investment process, most notably with respect to compliance and acting in accordance with the risk tolerance and risk appetite of the institution.
When considering ‘operis’ and governance, it’s important to note that each step in the authors’ framework describes processes that are continuous. Objectives and policies should not remain static as the organization’s circumstances change.
Allocators often have the ability to gear their investment activities toward the long term and this can provide a significant advantage over other investors. In my view, short-term costs or concessions can be worthwhile in providing desired results over the long-term. As such, I would argue that governance frameworks represent long-term investments in their own right. Time spent initially to establish strong governance structures may result in improved risk mitigation and ideally better investment results over the long term.
And, regardless of whether an organization has established a rigorous governance framework or whether this remains an aspirational goal, there’s always room for improvement.