Jeffery V. Bailey, CFA, and CFA, Thomas M. Richards, Bailey, CFA Jeffery V. A PRIMER FOR INVESTMENT TRUSTEES Understanding Investment Committee Responsibilities A PRIMER FOR INVESTMENT TRUSTEES Joanne M. Hill, Dave Nadig, Matt Hougan Jeffery V. Bailey, CFA, and Thomas M. Richards, CFA With an appendix on international ETFs by Deborah Fuhr A PRIMER FOR INVESTMENT TRUSTEES Understanding Investment Committee Responsibilities Second Edition Jeffery V. Bailey, CFA, and Thomas M. Richards, CFA Statement of Purpose The CFA Institute Research Foundation is a not-for-profit organization established to promote the development and dissemination of relevant research for investment practitioners worldwide. Neither the Research Foundation, CFA Institute, nor the publication’s edito- rial staff is responsible for facts and opinions presented in this publication. This publication reflects the views of the author(s) and does not represent the official views of the CFA Institute Research Foundation. The CFA Institute Research Foundation and the Research Foundation logo are trademarks owned by the CFA Institute Research Foundation. CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for the Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. © 2017 The CFA Institute Research Foundation. lA l rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Cover Image Photo Credit: istocksdaily/Getty Images ISBN 978-1-944960-29-2 Dedication In memory of my mother, Joyce Keller JVB To Diane TMR © 2017 CFA Institute Research Foundation. All rights reserved. iii Biographies Jeffery V. Bailey, CFA,previously served as senior director, Benefits, at Target Corporation, where he supervised the investment programs and administration of the company’s defined-benefit and defined-contribution plans, nonqualified retirement plans, and health and welfare plans. Formerly, Mr. Bailey was a managing partner of Richards & Tierney, a Chicago-based pension consulting firm specializing in quantitative risk control techniques. Prior to that position, he was assistant executive director of the Minnesota State Board of Investment, which manages the pension assets of Minnesota public employees. Mr. Bailey has published numerous articles about pension management. He co-authored the textbooks Investments and Fundamentals of Investments with William F. Sharpe and Gordon J. Alexander and co- authored the Research Foundation of CFA Institute publication Controlling Misfit Risk in Multiple-Manager Investment Programs with David E. Tierney. Mr. Bailey received a BA in economics from Oakland University and an MA in economics and MBA in finance from the University of Minnesota. Thomas M. Richards, CFA, is co-founder of Richards & Tierney, an investment consulting firm that provided investment analytical services to institutional investment organizations. In 2007, Nuveen Investments acquired Richards & Tierney. During his investment career, Mr. Richards has pub- lished a variety of papers in the investment finance literature and has been a frequent speaker at investment conferences and seminars. He is a co-author of the chapter on performance evaluation published in the textbooks Managing Investment Portfolios and Investment Performance Measurement. Mr. Richards has been a trustee of the Research Foundation of CFA Institute and served as chair from 2009 to 2012. He earned a BS in mathematics from Bucknell University and an MS in finance from the Pennsylvania State University. © 2017 CFA Institute Research Foundation. All rights reserved. v Contents Acknowledgments ................................................................................. xi Foreword ................................................................................................ xiii Introduction ........................................................................................... 1 Our Target Audience ...................................................................... 1 Organization of the Book ............................................................... 3 Takeaways ...................................................................................... 9 Session 1. Governance Structure ............................................................ 11 Governance Basics ......................................................................... 11 Roles and Responsibilities .............................................................. 13 Lines of Authority .......................................................................... 19 Accountability Standards ............................................................... 21 Fiduciary Duty ................................................................................ 22 More on the Trustees ..................................................................... 24 Takeaways ...................................................................................... 25 Questions Molly Should Ask .......................................................... 26 Session 2. Investment Policy................................................................... 30 The Importance of Investment Policy ............................................ 30 Defining Investment Policy ............................................................ 30 Policy Asset Mix: Selection and Rebalancing ................................. 32 Investment Policy as a Stabilizer .................................................... 33 Reviewing Investment Policy ......................................................... 34 The Investment Policy Statement .................................................. 35 Takeaways ...................................................................................... 37 Questions Molly Should Ask .......................................................... 38 Session 3. The Fund’s Mission ................................................................. 40 The Fundamental Conflict ............................................................. 41 Liabilities ........................................................................................ 44 Contributions ................................................................................. 45 Takeaways ...................................................................................... 47 Questions Molly Should Ask .......................................................... 47 Session 4. Investment Objectives ........................................................... 49 Criteria for Effective Investment Objectives ................................... 49 Examples of Investment Objectives ............................................... 52 Takeaways ...................................................................................... 54 Questions Molly Should Ask .......................................................... 54 Session 5. Investment Risk Tolerance ..................................................... 56 © 2017 CFA Institute Research Foundation. All rights reserved. vii A Primer for Investment Trustees Returns Are Only Half the Story .................................................... 56 Types of Investment Risk ................................................................ 57 Measuring Risk ............................................................................... 58 Relationship between Risk and Expected Return .......................... 60 Managing Risk through Diversification .......................................... 61 Risk Budgeting ............................................................................... 62 Investment Risk Tolerance ............................................................. 63 Takeaways ...................................................................................... 65 Questions Molly Should Ask .......................................................... 66 Session 6. Investment Assets .................................................................. 68 Types of Investment Assets ............................................................ 68 Diversifying across Asset Classes ................................................... 69 Market Indexes ............................................................................... 69 External and Internal Investment Management ............................ 72 Active and Passive Management ................................................... 73 Separate Accounts and Commingled Funds .................................. 75 Alternative Investments ................................................................. 76 Fees and Expenses ......................................................................... 78 Takeaways ...................................................................................... 80 Questions Molly Should Ask .......................................................... 81 Session 7. Defined-Contribution