A Primer for Investment Trustees (a

summary)
Jeffrey V. Bailey, CFA,
Jesse L. Phillips, CFA, and
Thomas M. Richards, CFA
Investment trustees oversee the investments and investment process for a variety of institutions, such as pension funds, endowments and foundations, insurance companies, TaftHartley funds, and some special-purpose trust funds.
Even though trustees are not expected to be experts, their responsibilities
require them to understand basic investment principles so they can exercise
good judgment in their approval of investment policies, processes, investment
managers, staff, and other related parties. This is no small task given the challenges and complexities of the investment markets and the scarcity of training
materials and resources available to most trustees.
A Primer for Investment Trustees is, as its title implies, a go to source of
information that is essential for understanding basic investment principles
and the role of trustees in the investment decision-making process. It has been
written specifically for trustees in a language and style that is understandable
and comprehensible. It is also a key resource for investment professionals and
others who work with and for investment trustees.
The primer is the trustees personal trainer, guiding them through a
funds entire investment decision-making process. It covers governance structure, investment policy, mission, investment objectives, investment risk tolerance, investment assets, performance evaluation, and ethics in investing.

Governance Structure
Investment trustees are fiduciariesthat is, people who assume responsibility
to oversee a pool of investable assets on behalf of some other person or entity.
As fiduciaries, trustees have a duty to act solely for the benefit of that person
or entity. The governance structure provides the framework for the trustees to
carry out their fiduciary duties and oversee not only the investment portfolio
but also all the participants in the investment processsuch as staff, investment managers, custodians, and consultants.

Published 2011 by the Research Foundation of CFA Institute

Summary prepared by John L. Maginn, CFA
2013 The Research Foundation of CFA Institute 

A Primer for Investment Trustees

The governance structure can be thought of as a three-legged stool: one

leg being the roles and responsibilities assigned to the various decision makers, a second leg being the lines of authority and reporting relationships, and
the third leg being accountability standards and related reports for monitoring and evaluating the actions of those decision makers in carrying out their
assigned responsibilities. Other aspects of the governance structure include
due diligence (appropriate oversight), checks and balances (decentralized decision making), reporting and monitoring (timely distribution of information),
transparency (access to pertinent information), and compliance with industry
best practices (periodic audits and reviews).
The organizational design of the investment committee or board is an important element that facilitates good governance and the trustees ability to fulfill their
fiduciary duties. Such matters as number of members, selection of members, diversity of experience, terms of office, meeting frequency, length of meetings, meeting
agendas, and leadership are all components of a sound governance structure.

Investment Policy
The most important function of investment trustees is to establish, maintain,
and adhere to the funds statement of investment policy, which is the rule
book for all involved in the investment process. The policy statement is an
expression of the trustees attitudes or investment philosophy and their longrange strategic plan for the investment portfolio. Too often, sound investment
policies are either not established or are not followed, which leads to ad hoc
direction and decision making and hinders all the decision makers. A properly
constructed investment policy serves as an autopilot setting in normal times
and as a stabilizer during stressful markets.
A comprehensive investment policy will cover the funds mission, investment objectives, investment risk tolerance, the portfolio asset mix (allocation),
governance structure, and performance evaluation process and criteria. It is
a living document that requires periodic review by the trustees. It is a means
of communication with and between the trustees, staff, managers, custodians,
consultants, and other interested parties. It ensures continuity through the
turnover of trustees, staff, and investment managers. Finally, it is a baseline
against which to evaluate proposed policy changes.

Mission
The mission of a fund or investment portfolio is to provide financial benefits
to certain parties, such as pension benefits or grants distributed by endowments or foundations. The financial stability of the fund depends on a balance
between the level of contributions and/or sufficiency of assets, the investment
return earned, and the level of distributions or benefits. Various ratios of assets,
2

2013 The Research Foundation of CFA Institute

Investment Objectives

liabilities, and rates of return are used to measure a funds financial stability.
Tension can develop, especially in the case of defined benefit pension plans,
between those responsible for funding the plan and the beneficiaries in terms
of the level of benefits provided. Market volatility, tax, and other considerations can add to the complexity of the funds mission. The market value of a
funds assets varies over time and is subject to both short-term and long-term
volatility, whereas the liabilities (obligations) funded can vary between shortterm grants and long-term pension benefits. Funding (contribution) policies
are subject to change over time as a result of the growth in liabilities, the level
of investment returns, or in the case of defined benefit pension funds, the discount rate to determine the amount of future liabilities. All of these factors
require understanding on the part of the trustees.

Investment Objectives
With the funds mission providing high-level direction, it is important that
more detailed direction be included in the funds investment policy statement
to assist in defining the structure of the investment program and to serve as a
guide to the trustees, staff, and investment managers in the ongoing management of the investment portfolio. It also serves as a retrospective measure of
results. By defining the funds investment objectives and risk tolerance, guidance is provided regarding the critical trade-off between expected reward and
risk within the funds investment policy.
Investment objectives must be specified in advance (not ad hoc) and written so as to be unambiguous and measurable, actionable and attainable, and
reflective of the funds risk tolerance as agreed to by the trustees. Objectives
must be clearly stated and easily measured against general market and/or specific asset class benchmarks (indices). They must be capable of being acted upon
by the staff and investment managers and attainable (realistic and achievable).
Finally, the investment objectives must be consistent with the funds mission.

Investment Risk Tolerance

Investment returns are tangible and after-the-fact, whereas investment risk
is, to some extent, intangible and before-the-fact. Risk is a measure of the
range of investment values in the future and is difficult to measure and predict.
Benjamin Graham, the father of security analysis, is attributed with saying
that the essence of investment management entails the management of risk,
not the management of returns.
A variety of investment risks can affect the attainment of investment
objectives and thus the success of the investment program. The primary types
of investment risk exposures fall into the following categories: capital market
risk, active management risk, and liquidity risk. Capital market risk is broadly
2013 The Research Foundation of CFA Institute 

A Primer for Investment Trustees

defined as the sensitivity (volatility) of the markets to economic events (e.g.,

changes in the business cycle). Risk is inherent in the capital markets, and
investors should hold risky assets only if they are paid (rewarded) to do so.
Active management risk refers to the uncertainty of an individual managers
performance relative to the market or peers. The difference between a managers performance and that of the benchmark is referred to as active management return, which can be either positive or negative. Liquidity risk arises
when there is no active or organized market for a funds investment, such as
private placement debt or private equity. It can also arise in the less actively
traded sectors of the public market.
Risk is not easy to measure, but it needs to be measured and monitored
either in qualitative or quantitative terms or some combination of both that is
acceptable to the trustees, staff, and investment managers. Standard deviation
is a widely used statistical measure of the dispersion of returns. But it should
be understood that there is no single best measure of investment risk. As mentioned earlier, there is a balance between investment return and investment
risk. Investors who accept a high level of risk do so with the expectation (but
not the certainty) of a high level of return. Over long periods of time, asset
classes with higher standard deviations of return (such as common stocks)
actually have earned higher returns.
The most widely used means of managing risk is diversification, or not
putting all (or most) of your eggs in one basket. It is often referred to as the
free lunch for investors. Although diversification is effective, it is difficult
to achieve and requires finding the appropriate balance between industries,
sectors, and asset classes that are uncorrelated; that is, their returns are not
affected equally or largely by common sources of risk. Thus, it is important to
reflect both investment return objectives and risk tolerance in the diversification of the funds investment portfolio.
Many funds today engage in risk budgeting to manage their risk levels while
striving to achieve their targeted expected returns. Risk budgeting involves the
use of sophisticated quantitative risk models to help measure the riskreturn balance and guide the determination of the most appropriate asset mix for the fund.
Trustees must guard against confusing their personal risk tolerance with
the funds risk tolerance. Each trustees risk tolerance reflects his or her own
financial situation. No formula can determine the trustees collective risk tolerance, but collectively, the trustees share a fiduciary responsibility to define the
funds risk tolerance to the best of their ability.

4

2013 The Research Foundation of CFA Institute

Investment Assets

Investment Assets
Asset classes are collections of securities that have common attributes. Broadly
speaking, there are three major asset classes: common stocks (equities), bonds
(fixed income or debt), and alternative investments (generally, real estate, commodities, hedge funds, and private debt and equity). The trustees primary
responsibility, guided by the investment policy statement, is to diversify the
funds portfolio widely among various classes of risky assets.
With regard to who will manage the funds assets, typically, investment
managers with expertise in a particular asset class or subclass will be retained.
In the case of larger funds, internal staff may have the requisite expertise. The
question of internal versus external managers is typically a matter of cost and
the degree of investment control.
With regard to how the funds assets will be managed, active versus passive management is yet another consideration for the trustees. Passive management (indexing) is a simple, low-cost form of investment management that
has been gaining acceptance over the past four decades. Again, the higher cost
of active management must be measured against the potential for earning positive active management returns.
With regard to what types of accounts to use for the external management of the funds assets, trustees must consider separately managed accounts
versus commingled funds. Control, cost, and access are the key considerations.
Because high minimum balances often are required by separate account managers, smaller funds tend to use commingled accounts. Separately managed
accounts offer more direct control but generally involve higher fees.
No matter who manages them or how the funds are managed, the trustees
need to select appropriate benchmarks for measuring the results (performance)
of the staff, investment managers, and consultants. For publicly traded securities, market indices are widely used as benchmarks, and increasingly benchmarks are being developed for alternative investments. Approving benchmarks
that are readily available, understandable, and appropriate for the investment
assets being measured is an important responsibility of the trustees.

Performance Evaluation
Measuring and evaluating the performance of the funds assets is an important
aspect of the hierarchy of accountability, responsibility, and authority within the
funds governance structure. It is a quality control check that not only describes
the investment results but also explains the sources of relative performance.
Selecting the right measure is important. The simplest measure is the
change in the portfolios value from one measurement period to the next.
However, that measure is limited because trustees typically have no control
2013 The Research Foundation of CFA Institute 

A Primer for Investment Trustees

over the cash flows in (contributions) and out (withdrawals) of the fund. Thus,
the investment community uses rates of return that are calculated to remove
the effect of various non-investment or non-trustee-controlled changes.
Rates of return can be calculated in several different ways. First, return
is typically defined as the total return, which includes the change in market value and the investment income from the assets in the funds portfolio
over a defined measurement period, such as a calendar quarter or a year. Total
return can be calculated on a time-weighted or money-weighted basis. Again,
because trustees typically have no control over fund cash flows, time-weighted
rates of total return are most commonly used to measure performance.
Performance benchmarks serve as a standard for measuring relative performance. The most informative benchmarks have certain basic properties. They
should be (1) unambiguousclearly understood; (2) investablerepresent an
alternative investment, such as an index fund; (3) measurablereadily calculable; (4) appropriatereflect managers typical risk characteristics and area
of expertise; (5) specified in advanceidentified for and communicated to
managers prior to the evaluation period; and (6) ownedacknowledged and
accepted by the trustees, staff, managers, and consultants. Although the performance of peers seems to be a simple and suitable alternative standard of
measurement, peer groups are rarely appropriate because of differences in their
missions, investment objectives, and risk tolerance. Plus, they are not investable.
Performance attribution is the process of identifying the factors that
caused the funds performance. Many factors can explain performance.
Identifying and attributing performance among those factors provides the
trustees valuable feedback for evaluating the effectiveness of the investment
process (macro attribution) and the investment managers (micro attribution).
Performance appraisal is the process of distinguishing between luck and
skill on the part of the staff and investment managers and their ability to outperform an appropriate benchmark. To identify skill, active manager returns
earned by the manager are compared with their active management risk,
using such specific measures as the Sharpe ratio or the information ratio. The
Sharpe ratio compares the managers excess return (actual return less the riskfree rate) with the total risk of the managers portfolio (the standard deviation
of the portfolios return). The information ratio compares the managers active
management return (actual return less benchmark return) with the active
management risk of the managers portfolio (the standard deviation of the
portfolios active management returns).

6

2013 The Research Foundation of CFA Institute

Ethics in Investing

The trustees, staff, and consultants need to assess a range of qualitative and
quantitative factors when hiring or terminating investment managers. These factors include people, process, procedures, price (fees), and performance. Also, the
trustees and staff need to periodically assess investment strategy decisions relative
to their economic rationale, diversification value, and liquidity characteristics.

Ethics in Investing
The ethical conduct of the trustees reflects on the individual, the entire board,
and the institution they are serving. The guiding ethical principles for trustees
should be (1) act in the best interests of the funds beneficiaries; (2) act with
prudence, competence, independence, and objectivity; (3) adhere to the funds
mission and all related legal requirements; (4) act in a transparent manner in
all official activities; and (5) maintain confidentiality with regard to the fund
sponsor, beneficiaries, and investments.

2013 The Research Foundation of CFA Institute