Investment Governance

Governance Structures

Corporate governance focuses on clarifying the mission, creating a plan, and reviewing progress toward achieving long and short-term objectives. In contrast, management efforts are geared toward outcomes—the execution of the plan to achieve the agreed-on goals and objectives. Corporate governance teams will vary in size depending on the size of the portfolio. However, a typical hierarchy usually contains:

• A governing investment committee.
• Investment staff (analysts, managers).
• Third-party resources (administrative, legal, accounting).

The following are six common elements of the task:

1. Articulate the objectives of the investment program.
2. Allocate decision rights and responsibilities among the functional units.
3. Specify processes for developing and approving the investment policy statement.
4. Specify processes for developing the program's strategic asset allocation.
5. Establish a reporting framework.
6. Undertake governance audits.

Articulating Investment Objectives and Constraints

The portfolio management team must define the essential aspects of working with the portfolio. These will vary depending on the type of portfolio in question. Individual investors, endowment funds, and defined benefit funds will all have unique characteristics that must be accounted for.

Objectives and constraints to be articulated before the investment begins include risk and return objectives. These include defining the realistic return needed for achieving the portfolio’s objectives and the maximum volatility a fund can withstand before experiencing adverse events. Constraints include tax, time horizon, legal, liquidity, and other unique considerations (Hint: use R-R + T-T-L-L-U).

Allocation of Rights and Responsibilities

Portfolio management teams may comprise several departments and individuals based on size, including investment committee staff, investment staff, and third-party resources such as administrative and legal. Roles must be defined to achieve success, and sponsoring funds should invest in the appropriate talent level.

Investment Policy Statement (‘IPS’)

The IPS is the foundational document explicitly stating how and why the funds will be managed. It is created at the outset of a portfolio management relationship and updated regularly. It is likely the most crucial step of all.

Asset Allocation and Rebalancing Strategy

The IPS should contain the asset allocation for the portfolio. This asset allocation is the fundamental driver of investment performance and should be based on thorough research and back-testing.

In addition, a rebalancing strategy is needed to keep the portfolio on track. Managers have several styles: buy and hold, constant mix, and proportion portfolio insurance. Other considerations include the rebalancing method, i.e., calendar rebalancing vs. setting percentage-deviation thresholds.

Reporting Framework

The reporting framework should be specified in advance and enhance team meetings by having the necessary and reliable data to ask and solve complex questions about the portfolio quickly. Is it on track? If not, why not? What is working well and what is not? Critical elements of an efficient reporting framework include selecting an appropriate benchmark, portfolio performance, and a performance appraisal for the governance process itself.

Governance Audit

The governance process itself needs to be open to scrutiny. Missing or weak links could cause irreparable damage to the portfolio. Important considerations for the audit are that an independent third party should do it, be unbiased, and include a thorough review of the portfolio’s governing documents. Also, it should appraise the team on its ability to execute investment objectives given the restraints of the portfolio.

A sound governance system can help reduce decision reversal risk, which is the possibility of abandoning a system or strategy at precisely the costliest moment. This can usually be mitigated by defining and writing out a complete strategy before beginning the process, but it is undoubtedly further augmented by having a governance team.

Question

Which of the following is least likely a portfolio constraint in the IPS?

1. Legal.
2. Return.
3. Time horizon.

Solution

The correct answer is B:

Return is not thought of in terms of a constraint. Although it arguably could exclude some portfolios and narrow down the selection process, return is considered an objective, something to achieve.

A and C are incorrect. They are considered constraints. Legal constraints could be related to trust or foundation requirements such as minimum annual drawdowns. At the same time, the time horizon helps inform the amount of time assets have to grow and whether or not adverse fluctuations have time to reverse themselves before liquidity events go into effect.

Asset Allocation: Learning Module 3: Overview of Asset Allocation; Los 3(a) Describe elements of effective investment governance and investment governance considerations in asset allocation