Review the process, not just performance

At this time of year, investment stewards — retirement plan sponsors, and managers and trustees of charitable organization investment committees — are receiving 2010 year-end investment performance reports and poring over them to prepare for their first 2011 meetings with their advisers and money managers.

All too often, these annual meetings place a singular focus on past and projected investment performance, which makes the portfolio seem like a ship being cast about on a sea of unpredictable economic and market conditions.

With a consistent, process-oriented approach to portfolio management, aligned to fiduciary practices, monitoring activities can be far different. Rather than concentrating on investment performance, the focus is on evaluating human performance, making sure that the key decision makers for the portfolio (the fiduciaries) create the conditions necessary to maximize the opportunity for investment success.

This isn’t to say that investment performance isn’t important; obviously, it is. But investment performance data are meaningful only in the context of established objectives for the portfolio.

That is why major fiduciary laws stress adherence to an established investment policy, which means having a well-crafted investment policy statement to serve as the business plan for managing a portfolio.

The Management of Public Employee Retirement Systems Act of 1997 is a case in point.

In Section 8b, the act reads: “A trustee [fiduciary] with authority to invest and manage assets … shall adopt a statement of investment objectives and policies … The statement must include the desired rate of return on assets overall, the desired rates of return and acceptable levels of risk for each asset class, asset allocation goals, guidelines for the delegation of authority, and information on the types of reports to be used to evaluate investment performance. At least annually, the trustee shall review the statement and change or reaffirm it.”

Therefore, the annual review should start with the investment policy statement because it provides the necessary elements to show that the portfolio is being managed effectively. Affirm that its provisions, especially stated investment objectives and policies, are clear, concise and current, or make whatever changes are necessary to serve the investors’ best interests.

If there is no statement, a responsible fiduciary should prepare one.

Next, review economic and market conditions to establish a historical perspective and formulate a hypothesis of the investment environment that is likely to prevail in the near future. The duty of prudence requires fiduciaries to take into account prevailing economic conditions and portfolio management objectives as investment strategies and potential securities selections are assessed.

The chief investment strategy concern is proper asset allocation. Fiduciaries must use diversification as a risk management tool unless it is clearly prudent not to do so.

The existing asset allocation strategy should be reviewed in light of the future investment environment hypothesis and modified if necessary.

Other strategy decisions should be reviewed next and evaluated in light of how well they have served the interests of investors to date, and how they could serve investors, and portfolio risk/return objectives. Cost, tax and management complexity implications of these strategies should be considered.

Although performance-oriented annual-review sessions often start and end with an examination of investment manager performance, the process-oriented fiduciary approach relegates this task to its proper place at the bottom of the investment decision-making hierarchy. Even so, it is an important step that requires the fiduciary to establish evidence of proper delegation of investment managers.

This is done by defining the scope of the delegation, such as asset class, investment style and other characteristics that define the role of the investment in the portfolio; comparing competing investment managers based on well-defined due-diligence criteria; selecting managers that most effectively meet the scope and due-diligence criteria; periodically reviewing the managers’ compliance with the factors that led to their selection; and replacing managers when the results of monitoring suggest superior alternatives are available.

Documentation of the deliberations and decisions made throughout the review process is critical. This establishes evidence of conformity to the fiduciary standard of care and adherence to investment best practices.

Blaine F. Aikin is chief executive of Fiduciary 360 LLC.