APPENDIXDEFINITIONS

FIDUCIARY PRIMER

Best practices for managing an investment pool

by Pavilion Advisory Group

TABLE OF CONTENTS

Roles and responsibilities of investment fiduciaries

1

Ethics and conflicts of interest

3

Investment Committee governance best practices

5

Investment policy statement

9

Investment strategy development

15

Investment manager selection, monitoring and replacement

17

Fee considerations

21

OCIO applications

23

Appendixdefinitions

27

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PREFACE

A fter many years of working with a variety of Investment Committees, my colleagues and I have observed thousands of committee meetings. Weve seen meetings that are tightly focused with clear decisions being made and others where decisions get deferred continually or theres gridlock. Weve been there to witness what works and, conversely, what happens when things go badly.

We understand that Investment Committees face many challenges: knowledge requirements, resource and time scarcity, the growing complexity of the investment landscape as well as heightened legislative risk. Through all of this, there are some basic guidelines that may assist committee members in fulfilling their fiduciary roles.

Our experience over several decades led us to write this booka primer that sets out the requirements for and responsibilities of an effective and engaged Investment Committee member. Its an aid to learn how to separate the important from the unimportant, know what questions to ask and, most significantly, understand a committee members role in supporting the growth of his or her organizations investment pools.

The Fiduciary Primer was created for Investment Committee members, whether new to the role or experienced, governing all types of asset pools including defined benefit plans, defined contribution plans, endowments, foundations, healthcare systems, public funds or Taft-Hartley plans. Each brief chapter covers the need-to-know particulars and best practices on one aspect of managing an investment pool. References at the end of chapters provide interested readers with direction on how to delve further into the subject matter. Finally, the appendix contains definitions of the most commonly used words in managing investment pools.

We wrote this book so that others might benefit from our experience. In this regard, I hope you learn from it. I hope you enjoy it.

SUSAN MCDERMOTT, CFAChief Investment Officer, Pavilion Advisory Group Inc.

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1ROLES AND RESPONSIBILITIES OF INVESTMENT FIDUCIARIESby Richard P. Marra, Senior Consultant

Fiduciaries have an important role in the administration, management and oversight of assets. A fiduciary is the person legally appointed and authorized to hold assets in trust for another person or manage the assets for the benefit of the other person rather than for his or her own profit. Using discretion in administering, managing or controlling the assets makes that person a fiduciary to the extent of such discretion or control. Thus, fiduciary status is based on the functions performed, not just a persons title. An institutional investment programs fiduciaries typically will include trustees, investment managers, investment advisors, administrative committees, investment committees and those individuals or firms that can exercise discretion or control over the assets. Generally actuaries, accountants and attorneys are not fiduciaries when acting in their professional capacity.

Fiduciaries have important responsibilities and are subject to high standards of ethical behavior because they act on behalf of participants and their beneficiaries in a retirement plan or sovereign wealth system or on behalf of donors in a not-for-profit or charitable organization.

These responsibilities include:

acting solely in the interest of plan participants and their beneficiaries for retirement plans;

giving primary consideration to donor intent as expressed in the gift instrument for endowments and foundations;

carrying out their duties prudently;

following plan documents (unless inconsistent with ERISA);

diversifying investments;

paying reasonable expenses for services;

avoiding prohibited transactions and self-dealing; and

in general, developing an investment strategy appropriate for the fund or charity.

Institutional investors serve organizations with various purposes: endowments for higher education and museums, private and public foundations, corporate or public retirement funds, sovereign wealth funds, healthcare systems, insurance companies and central banks. To safeguard and effectively manage their assets, institutional investors must implement proper governance and internal management structures.

TO SAFEGUARD AND EFFECTIVELY MANAGE THEIR ASSETS, INSTITUTIONAL INVESTORS MUST IMPLEMENT PROPER GOVERNANCE AND INTERNAL MANAGEMENT STRUCTURES.

2Sources

Clapman, Peter, Waddell, Christopher Clapman Report 2.0, Model Governance Provisions to Support Pension Fund Best Practice Principles The Stanford Institutional Investors Forum Committee on Fund Governance, 2013

U.S. Department of Labor, Employee Benefit Security Administration, Meeting your Fiduciary Responsibilities, February 2012

The Employee Retirement and Income Security Act of 1974 (ERISA) sets the standard of conduct for those who oversee and manage corporate employee retirement plans and their assets. The Department of Labor is responsible for administering and enforcing the provisions of ERISA. The standard of fiduciary conduct for endowments and foundations is established under the Uniform Prudent Management of Institutional Funds Act (UPMIFA), adopted in 2006. Sovereign, state, local or municipal laws will set the standards of conduct for those who are responsible for sovereign wealth funds, public and municipal retirement systems and other institutional investment pools.

The duty to act prudently is one of a fiduciarys primary responsibilities. Prudence, or good faith, focuses on the process of making and implementing fiduciary decisions. Fiduciaries who do not follow the basic standards of conduct, or worse, act negligently, may find themselves facing personal liability.

Board members, trustees and staff members are encouraged to participate in fiduciary training and to seek legal counsel for any questions regarding the extent of their responsibilities.

3The CFA Institute has conducted a significant amount of research and provides some of the best guidance on ethics. Its mission is To lead the investment profession globally by promoting the highest standards of ethics, education and professional excellence for the ultimate benefit of society. Many investment professionals are Chartered Financial Analyst (CFA) charterholders.

The CFA Institute issues this important designation to individuals who pass three consecutive exams. A core portion of the exam curriculum relates to ethics. In addition to ethical guidelines for the investment profession, the CFA Institute outlines a Code of Conduct for endowments, foundations and charitable

organizations (see General Principles of Conduct below) as well as a separate Code of Conduct for pension funds. These codes were developed with global industry input and are quite comprehensive1.

Establishing an environment where ethical behavior is valued will go a long way in preventing unnecessary conflicts of interest. It also will provide a process for handling conflicts with integrity and in the best interests of the primary stakeholders whether they are the participants in a retirement plan, the organization in support of operations or the grantees in the case of foundations.

In real life, the knowledge and connections

The varied roles, backgrounds and interests of trustees, investment committee members, management and others involved with an institutions investment pools result in unavoidable conflicts of interestwhether real or perceived.Upfront discussion of ethics and values, and clear policies for dealing with conflicts of interest, are necessary to encourage good stewardship of an institutions investment assets. Moreover, they will do much to aid in protecting the organization from reputational risk, as well as subpar investment decisions.

GENERAL PRINCIPLES OF CONDUCT

Individuals associated with endowments, foundations and charitable organizations who are responsible for the oversight and stewardship of the financial resources of such organizations must:

Act with loyalty and proper purpose, and in the case of pensions, in the best interests of the plan participants.

Act with skill, competence, prudence, and reasonable care.

Abide by all laws, rules, regulations, and founding documents.

Show respect for all stakeholders.

Review investment strategy and practices regularly.

ETHICS AND CONFLICTS OF INTERESTby Keith Mote, CFA, Managing Director

4Sources

1 The full Codes of Conduct can be found at http://www.cfainstitute.org/ethics/codes.

www.cfainstitute.org

CFA Institute, Code of Ethics & Standards of Professional Conduct (effective 1 July 2014). http://www.cfapubs.org/toc/ccb/2014/2014/6

Ethics Resource Center. www.ethics.org

National Council of Nonprofits

of Trustee and Investment Committee members can be both beneficial and controversial. Often Trustees and Investment Committee members are selected for boards and committees because of their expertiseexpertise that typically comes from long, successful careers in investment management, banking or law.

These individuals can help guide investment decisions, provide for better and more effective decision-making, and garner access to funds/managers with very limited capacity.

These same individuals, however, have loyalties related to their business interests and, sometimes, these loyalties can be conflicting. To improve the likelihood that investment

decisions are made in the best interests of the institution being served, it is wise to have a conflict of interest policy requiring that:

Trustees/committee members act in good faith, with due care, with undivided loyalty, and in the best interests of the institution or stakeholders served;

business and professional affiliations be disclosed;

affiliated individuals recuse themselves of decisions between their business and the institution for which they are serving in a trustee or committee member capacity;

a range of investment options and competitive pricing be considered, especially when there is a potential conflict of interest;

all due diligence be performed in a manner that maintains the utmost in integrity and objectivity, to protect the institutions interests and reputation;

the process to reach decisions and the decisions themselves are documented; and

Investment Committee members annually declare that no conflicts of interest exist and potential conflicts of interest have been disclosed to the Chairperson.

ESTABLISHING AN ENVIRONMENT WHERE ETHICAL BEHAVIOR IS VALUED WILL GO A LONG WAY IN PREVENTING UNNECESSARY CONFLICTS OF INTEREST.

5While goals may be different for each organization, they typically include growing the real value of the corpus, protecting the organization during periods of market and business stress and ensuring that the organization can meet its obligations. An ancillary objective is to make effective, as well as efficient decisionsas this keeps the governing body engaged. Below, we outline in brief the key aspects that contribute to governance best practices.

The purpose of governance best practices is to promote the interests of the organizationboth its mission and supporting financial objectives.

INVESTMENT COMMITTEE GOVERNANCE BEST PRACTICESby Susan McDermott, CFA, Chief Investment Officer

COMMITTEE COMPOSITION

Number of Investment Committee members: Five to eight individuals are ideal.

A small group tends to promote more consistent attendance and usually is more efficient than a larger group. With a small group, each individuals contributions are important and absences are noticeable. Decisions can be made quickly with less need to re-visit decisions or risk decision reversal when previously absent committee members weigh-in at a later time. Also, it minimizes delays in decision making that can occur in the absence of a quorum. Often large groups struggle to bring issues to a conclusion as a multitude of viewpoints are considered and additional discussion takes place.

Committee member knowledge: Members should have a level of knowledge sufficient to evaluate complex investments and make effective and efficient decisions.

There is no need for every Committee member to be an investment expert. In fact, different backgrounds and opinions can lead

to better decisions. Those most familiar with the business often bring good perspectives on the amount of risk the organization can bear, while those familiar with investments can enhance the knowledge of the full Committee and lead to more efficient decision making. Perhaps most important is members willingness and time to participate and their ability to focus on the needs of the organization rather than personal agendas or preferences.

Leadership: A strong and inclusive chairperson is ideal.

The chairperson helps to set direction for the investment program and coordinates activities with management and the investment advisor. At meetings, this individual should maintain focus on the decisions that need to be made (policy and investment strategy), rather than letting meetings drift to administrative or other topics best handled by management or the advisor. The chairperson gathers input from all Committee members, ensuring Committee member engagement, and moves

the discussion toward decisions. The larger the Committee, the more important it is to have a strong chairperson.

Committee member tenure: Length of tenure should be at least five years for the core of the Committee, with one or two new members added every few years.

Continuity of investment policy and strategy is important. When investment policy and strategy change too frequently, or when Committee members change rather than the organization or market, there is a risk of being whipsawedmoving into popular areas that have performed well just as they are going out of favor. Having a core group of Committee members leads to improved continuity of strategy. Some Committee turnover, however, provides fresh perspective and guards against group think.

6WHILE GOALS MAY BE DIFFERENT FOR EACH ORGANIZATION, THEY TYPICALLY INCLUDE GROWING THE REAL VALUE OF THE CORPUS, PROTECTING THE ORGANIZATION DURING PERIODS OF MARKET AND BUSINESS STRESS AND ENSURING THAT THE ORGANIZATION CAN MEET ITS OBLIGATIONS.

RESPONSIBILITIES (SEE ALSO PAGE 9INVESTMENT POLICY)

Generally, the Investment Committee is responsible for:

understanding the organizations budget, spending constraints, debt structure, as well as short- and long-range financial plans.

defining acceptable short- and long-term risks. Committee member viewpoints must be consistent with the Funds time horizon.

determining investment goals.

determining an investment strategy that is tied to the organizations goals and considers the organizations constraints (liquidity, debt levels and revenue streams). For ERISA plans, Committee members must act solely in the interest of plan participants and their beneficiaries.

reporting back to the Board/Trustees periodically.

ensuring appropriate delegation to management, staff, the consultant or others, so that the focus stays on important policy decisions and minimizes administrative or other low-value decisions.

7INVESTMENT COMMITTEE GOVERNANCE BEST PRACTICES (CONTD)

Sources

Ellis, Charlie D., Best Practice Investment Committees. The Journal of Portfolio Management. Winter 2011

Biggs, John H., Board Basics, The Investment Committee. Association of Governing Boards of Universities and Colleges, 1997

Schacht, Kurt, Stokes, Jonathan J., Doggett, Glenn, Investment Management Code of Conduct for Endowments, Foundations, and Charitable Organizations. CFA Institute, August 2010

http://www.dol.gov/ebsa/publications/fiduciaryresponsibility.html

ACCOUNTABILITY

Organizations often draw Investment Committee members from their local community, particularly if the investment pool is a foundation or endowment supporting a local charitable organization, school, museum or healthcare system.

Organizations often select local bankers, investment specialists or lawyers for their expertise, as well as knowledge of the organization. This can result in actual or perceived conflicts of interest between the individuals business focus and the organizations needs.

To minimize conflicts of interest and encourage allegiance to the organization, it is recommended to:

have a policy to determine procedures and disclosure requirements for dealing with conflicts of interests (see page 3 for more detail);

ensure appropriate levels of due diligence are conducted;

ensure that appropriate checks/balances are in place;

know the cost structure and validate its consistency with the goals and the design of the investment program; and

maintain a record of the Committees workagendas, materials and minutes.

8FINAL WORDS OF WISDOM

Practice patienceAll investment strategies experience periods of underperformance. Give them time to work.

Dont spend too much time on universe comparisons, e.g., seeking to mimic the large university endowment model when assets, risk tolerance and staff support may be insufficient. Be true to the organizations goals.

Provide periodic education consistent with Committee member needs.

MEETING DYNAMICS

Time allocation

Dedicate the time necessary to make effective and informed decisions. Quarterly meetings that are two hours in length are often sufficient to deal with key issues. Inter-quarter calls can be held to deal with some matters that require a more timely decision. Additional meetings can be scheduled as needed, or some tasks can be delegated to a subcommittee, management or the advisor.

Preparation

Request that Committee members review meeting materials in advance of the meeting. When Committee members are familiar with the materials, the meeting can be focused on discussion items and decisions, rather than a presentation of the facts.

Education and training: Ensure periodic education.

Education needs to be tailored to the Committee members needs and is particularly important for ERISA fiduciaries. ERISA sets out general rules to which fiduciaries must adhere (exclusive benefit, diversification,

plan document, prohibited transactions). Failure to adhere to these rules can result in costly lawsuits. Education can involve market updates, an explanation of new strategies, fiduciary requirements in general or under ERISA, basic investment concepts, etc.

Relevancy: Periodically re-examine current practices.

Policies in place should meet current circumstances of the organization and take into context the current state of the markets.

Agendas: Meeting agendas should focus on asset allocation and investment strategy decisions.

Asset allocation and strategy decisions drive the investment return long-term and as a result, should be the focus of meetings. A brief review of the managers and their performance is necessary but, generally, these should be secondary discussion items unless a problem is identified that needs to be addressed.

9The IPS ensures the portfolio is aligned with the institutions long-term objectives, even during periods of economic turmoil when emotions or instinct may sway individuals to act illogically. The IPS also provides continuity, an important feature as the composition of decision-making bodies at institutions can change.

For retirement plans governed by ERISA, an IPS is required. According to ERISA, for every qualified company retirement plan there are certain fiduciary responsibilities for managing the plan assets. The IPS documents these responsibilities and outlines the process for ensuring that fiduciaries adhere to them.

While an IPS is client-specific and customizable, certain sections are crucial and should be included as a matter of best practices.

The primary components of an IPS for an institutional organization are outlined below.

SCOPE AND PURPOSE STATEMENT

This section, while not mandatory, defines the purpose of the organizations investment pool(s) and outlines the scope of authority over them. An institutions Board of Directors or Board of Trustees typically has authority to officially adopt and change an IPS. The frequency with which the IPS will be reviewed formally (annually in most cases) may be noted in this section.

Developing and adhering to an investment policy statement (IPS) is crucial. An IPS communicates to all relevant parties the objectives, guidelines and constraints to be followed in managing the investment program. It should be a dynamic document, taking into account a changing investment environment, as well as changes in the organizations financial circumstances, objectives or management.

INVESTMENT POLICY STATEMENT by Kerry L. Elsass, CAIA, Senior Consultant

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AN IPS COMMUNICATES TO ALL RELEVANT PARTIES THE OBJECTIVES, GUIDELINES AND CONSTRAINTS TO BE FOLLOWED IN MANAGING THE INVESTMENT PROGRAM.

DELEGATION OF RESPONSIBILITIES

This section is critical to an IPS and should always be included. The IPS should state clearly the responsibilities of all parties involved with the investment program. Parties include:

Board of Directors/Trustees

The Board has overall responsibility for the adoption of the IPS and the success of the investment program. Typically the Board approves the IPS and delegates management of the investment program to the Investment Committee.

Investment Committee

The Investment Committee has responsibility for implementing the investment policy and generally overseeing the investment program. Committees most often have authority to make investment decisions such as the hiring of investment managers, custodians, consultants and other service providers. They also are responsible for monitoring the investment program on a regular basis, as well as ensuring adherence to the guidelines set forth in the IPS. The Investment Committee may recommend to the Board changes to the IPS that they believe are warranted.

Investment Managers

Investment managers are charged with investing assets in the style for which they were hired and in accordance with the objectives and guidelines stated in the IPS. This section also may outline reporting requirements such as the obligation to report team, organizational or process changes. Investment Consultant

An investment consultant is hired to assist with the oversight and management of virtually all investment-related functions of an institutions investment program. Consultants make recommendations pertaining to asset allocation, manager selection and termination, and rebalancing. In addition, it is the consultants duty to keep the Investment Committee abreast of opportunities and risks related to capital markets trends, and to measure, evaluate and report on the investment program and investment manager-level performance on a regular basis, either quarterly or monthly.

Third-Party Service Providers

In addition to the parties listed above, some IPSs define responsibilities of third-party service providers such as custodians, plan record-keepers and administrators.

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INVESTMENT POLICY STATEMENT (CONTD)

CONSULTANTS MAKE RECOMMENDATIONS PERTAINING TO ASSET ALLOCATION, MANAGER SELECTION AND TERMINATION, AND REBALANCING.

INVESTMENT OBJECTIVES

This section should always be included in an IPS. Objectives are client-specific and always vary by institution. They outline the return and risk objectives of each investment pool. These objectives provide a framework for deciding the optimal, long-term asset allocation. The concepts of inflation, spending policy or liability structure should be considered when developing return and risk objectives.

ASSET ALLOCATION

Asset allocation strategy is typically determined via a combination of an asset allocation study and forward-looking guidance. This section defines the asset classes, the target allocation and lower and upper bounds around the targets. This section is critical to a successful investment program, as it provides for continuity of strategy, particularly during market swings that can sway sentiment.

The asset allocation should be reviewed formally every few years for consistency with the organizations objectives. Providing a range for each asset class is important so that rebalancing is not required on a too frequent basis and to allow for the implementation of shorter-term, tactical asset allocation decisions when appropriate.

Typical asset classes in institutional investment programs include equities, fixed income and alternatives such as real estate, private equity and hedge funds. Some organizations finely delineate these categories and establish targets and ranges for sub-categories. For example, within equities there may be targets and ranges specific to U.S. equities, non-U.S. developed equities and emerging markets equities.

The granularity of the asset allocation defined in the IPS is based on Board or Investment Committee preference. However, the institutional investment community has migrated towards more flexible IPS asset allocation targets and guidelines in recent years so that there is flexibility to reduce risk or enhance return when dealing with market changes.

The following exhibit provides an example of an institutions long-term strategic asset allocation targets and ranges:

ASSET CLASS TARGET ALLOCATIONALLOWABLE

RANGE

Equities 50% 40% to 60%

Fixed Income 25% 15% to 35%

Real Estate 10% 0% to 20%

Hedge Funds 10% 0% to 20%

Private Equity 5% 0% to 10%

Formal rebalancing procedures may be outlined in this section or in a separate section, and are critical to ensuring that the assets are aligned with long-term target allocations.

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INVESTMENT POLICY STATEMENT (CONTD)

SELECTION/TERMINATION OF INVESTMENT MANAGERS

This section outlines the process and requirements for selecting and terminating investment managers. For example, for manager selection, the responsible party would:

identify a range of investment manager candidates;

obtain relevant information about the investment managers experience, qualifications and investment approach;

evaluate the experience, qualifications and investment approach;

evaluate performance, risk and portfolio characteristics, as well as investment management fees; and

document the selection process.

There are a variety of reasons why an investment manager would be terminated by an organization. For example, an investment manager should be terminated when the investment advisor, Investment Committee and Board has lost confidence in the managers ability to:

achieve stated performance and risk objectives, including benchmark and universe median hurdles;

comply with investment guidelines;

comply with reporting requirements; and

maintain a stable organization and retain key, relevant investment professionals.

PERFORMANCE BENCHMARKS

Performance benchmarks are designed to provide a quantitative basis to judge the effectiveness of investment programs and investment managers.

This section of the IPS outlines performance expectations at the total fund level, asset class level, and of investment managers. It also outlines the timeframe for evaluating performance, which can be somewhat subjective. Examples of language are below:

Total Fund

Outperform the Composite Benchmark over rolling three- to five-year periods.

Investment Managers

Outperform a passive, style-specific index over rolling three- to five-year periods.

Outperform the median of a style-specific peer group over rolling three- to five-year periods.

Assume a level of risk no greater than is appropriate for the investment managers specific investment mandate.

Specific benchmarks are outlined in an appendix or the quarterly performance report so that the IPS does not have to change when benchmarks change.

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MANAGER GUIDELINES

Manager guidelines are an important part of the IPS because they set expectations and restrictions for the management of the portfolio.

Manager guidelines are set out by asset class and describe any constraints and restrictions on the assets such as liquidity, marketability, diversification, credit quality, duration limits, derivatives usage, etc.

EVALUATION & REVIEW PROCESS

The ongoing monitoring of investment programs is critical to their success. This section lays out the steps and frequency for the evaluation of the investment program and its performance.

At a minimum, Investment Committees should strive for periodic meetings (preferably quarterly) to review asset allocation, performance and adherence to investment guidelines and restrictions.

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Objectives and goals should be determined based on the needs of the organization in concert with the market environment, in order to allow for more attainable results. Qualitative objectives, constraints, risk tolerance, liquidity profile and cash flow needs should be translated into quantitative figures, wherever possible.

INVESTMENT PHILOSOPHY

An important aspect of establishing and maintaining a successful investment program is determining the appropriate investment philosophy for the organization. The philosophy will serve as a backdrop for the overall investment strategy and includes components such as:

philosophy on adherence to a strict, strategic, long-term asset allocation or the ability to add opportunistic tilts to the portfolio;

importance of diversification and diversification preferences within the portfolio;

specific emphasis on reducing downside risk or capturing upside within a strategy;

approach on integration of risk management;

how costs are viewed and analyzed within the investment program;

views on, and ability to bear, illiquidity risk; and

incorporation of socially responsible investing goals.

Components of the investment philosophy can be integrated into the investment policy statement and also should be evident within the construction of the portfolio.

ASSET ALLOCATION MODELING

Asset allocation modeling that incorporates an asset/liability framework should be used to assist in the decision-making process. Both stochastic and deterministic modeling processes can be used that:

measure and illustrate the impact of changing the asset allocation under various spending/cash flow projections and market environments;

provide an enhanced perspective of the increase/decrease in risk taken (potential dollars at risk) by moving along the efficient frontier; and

stress-test the portfolio for unanticipated risk and market environments.

Various simulations can be incorporated to express a variety of outcomes including stressing the portfolio to view downside scenarios in poor equity market environments. Other common scenarios include strong equity market environments along with both rising and falling interest rate environments. The use of actual historical performance results under the various proposed asset allocations is recommended to supplement quantitative simulations derived through the asset allocation modeling process.

Developing, implementing and adhering to a customized investment strategy is a key facet in establishing a successful investment program. Investment strategy development begins with establishing objectives and goals for the investment program, while taking into account constraints, risk tolerance, liquidity profile, cash flow needs and other requirements outlined in the investment policy statement.

INVESTMENT STRATEGY DEVELOPMENT by Antonio DiCosola, CFA, Senior Consultant

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This exercise is particularly useful to analyze how varying asset allocations have performed under specific market environments. The goal is to determine which asset allocation best meets the objectives and risk tolerances.

PORTFOLIO STRUCTURE

Following the determination of an overall investment philosophy and asset allocation, a review of the portfolios structure is warranted. This includes an analysis of the:

approach to active versus passive management and desired allocation to such strategies;

overall level of concentration within active portfolios;

inclusion of appropriate investment styles;

allocation across equity strategies, geographies and capitalizations;

allocation to fixed income strategies, including mix of investment grade, high yield, non-dollar and inflation protected securities;

use of alternative strategies including liquidity analysis and return objectives; and

use of separate account or pooled fund (mutual, commingled fund or limited partnership) investment vehicles.

Risk preferences and pre-determined investment philosophy should be taken into consideration. The portfolio structure is driven by both the asset allocation and the investment policy. The asset allocation decision, availability of products in a particular asset class and liquidity requirements of the portfolio, will make a significant impact on the structure. Views on performance relative to the benchmark also drive portfolio structure. Investment programs designed to outperform benchmarks by a wide margin will employ a different structure than those that seek to minimize performance deviations relative to the benchmark. An effective investment manager structure should, at a minimum, achieve prudent diversification within the parameters of the funds size, cost considerations and operational efficiencies.

ASSET ALLOCATION MONITORING

Asset allocation relative to policy should be monitored monthly. Institutional best practice requires formal reviews conducted quarterly with the appropriate personnel. We recommend establishing a rebalancing policy that outlines when actual asset allocations should be rebalanced and which parties are responsible for monitoring and implementation. To ensure that the investment program remains on track with long-term objectives, we recommend a formal review of asset allocation approximately every two-to-three years. Also, when changes occur to any of the key factors that impact risk orientation, such as investment objectives, financial resources, organizational issues, business conditions, committee composition, spending policy or demographics, we recommend a formal review.

INSTITUTIONAL BEST PRACTICE REQUIRES FORMAL REVIEWS CONDUCTED QUARTERLY WITH THE APPROPRIATE PERSONNEL.

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There is no definitive checklist for selecting investment managers. However, there are certain factors that should be considered to enhance the likelihood of successful outcomes. Fiduciaries also must document the factors that allow them, as prudent experts, to assess whether the investment manager is appropriately skilled for the mandate. In practice, this involves evaluating both qualitative and quantitative factors. At a minimum, the following factors should be evaluated:

organization;

investment team;

investment philosophy and process;

risk;

portfolio characteristics;

fees and other expenses; and

performances.

The importance of these factors varies depending on the mandate, but there should be clear, pre-established minimum standards to:

1. identify a range of possible investment manager candidates that meet acceptable levels of qualitative and quantitative criteria;

2. evaluate the candidates independently and based on fit within the current investment program; and

3. document the selection process. Fiduciaries should be able to demonstrate the existence of processes and adherence to them.

Whether an Investment Committee retains or delegates responsibility for investment manager selection, the establishment of a framework for the selection process is critical to achieving success and fulfilling fiduciary obligations.

INVESTMENT MANAGER SELECTION, MONITORING AND REPLACEMENT by Casey Stevens, CFA, Consultant & Cori E. Trautvetter, CAIA, Senior Consultant

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FIDUCIARIES ALSO MUST DOCUMENT THE FACTORS THAT ALLOW THEM, AS PRUDENT EXPERTS, TO ASSESS WHETHER THE INVESTMENT MANAGER IS APPROPRIATELY SKILLED FOR THE MANDATE.

Onsite due diligence with the managers key decision makers may be warranted to assess some qualitative aspects. In certain circumstances, such as hedge funds and private equity, operational due diligence may be necessary.

MANAGER HIRING

Once a manager has been selected, there are several steps that need to be completed in order to place money with that manager. This is particularly important when engaging a manager for separate accounts, in which case the following documents should be reviewed:

Investment management agreement ensure that it meets the organizations investment, reporting and client servicing needs. Engage legal counsel for a formal legal review.

Investment guidelines establish written investment guidelines that outline diversification requirements and concentration limits, types of securities that can and cannot be purchased, procedures for dealing with policy violations, performance objectives and benchmarks. This helps to establish a common framework between the organization and manager for evaluation purposes.

For pooled investment vehicles, such as mutual funds, commingled funds and limited partnerships, the governing documents of those vehicles (e.g., prospectus, trust agreement, limited partnership agreement) will outline permissible investments and parameters, liquidity, fees, etc. The investor needs to understand the key contents of these documents and verify consistency with their objectives. For less liquid investments such as hedge funds and private market investments, legal review of the limited partnership agreements is strongly recommended.

MANAGER MONITORING AND REPLACEMENT

Fiduciaries need to monitor managers regularly, typically quarterly. Written investment guidelines that outline diversification requirements and concentration limits, types of securities that can and cannot be purchased, procedures for dealing with policy violations, performance objectives and benchmarks, should be instituted. This helps to establish a common framework between the Investment Committee and manager for evaluation purposes.

Key evaluation metrics include:

returns and risk relative to stated performance objectives (returns are best evaluated net of fees and expenses);

the extent to which a manager has managed the portfolio consistent with its stated investment philosophy or style (e.g., holdings, portfolio characteristics);

stability of the organization and investment team; and

adherence to the investment guidelines and other restrictions contained in the Investment Policy Statement, manager guidelines or investment agreements.

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INVESTMENT MANAGER SELECTION, MONITORING AND REPLACEMENT (CONTD)

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Performance objectives should be created as a means to properly measure and evaluate each managers success. While absolute returns may be considered, returns should be assessed relative to active managers (peer groups) and passive (index) benchmarks.

If a manager underperforms, Investment Committees should give the manager a reasonable time period to improve performance, during which increased scrutiny is advised. If there is no acceptable improvement within the designated time period, the search process for a replacement should be initiated and the manager replaced. The typical rule of thumb is to replace a manager after three years of underperformance, or over a shorter time period if the performance shortfall is very large and accompanied by other team or organizational changes.

The monitoring process should focus on identifying significant changes that could have a material impact on the managers ability to successfully implement and repeat its intended strategy. The most frequently occurring material changes include:

departure of key investment professionals;

ownership changes;

change in investment philosophy or process;

legal or regulatory issues;

rapid growth in assets under management, accounts, or expansion of strategy offerings;

account losses;

operational or compliance issues; and

client service issues.

Investors should analyze each material change on a case-by-case basis with the objective of determining whether the change causes a significant deterioration in confidence related to the managers ability to successfully implement its strategy.

There are times when it may be prudent to promptly dismiss a manager. In other situations, such as a change to the organizations ownership structure, it may be prudent to increase scrutiny to assess the success of the transition before determining next steps. The unique circumstances surrounding a change may lead to different actions in seemingly similar situations.

THE MONITORING PROCESS SHOULD FOCUS ON IDENTIFYING SIGNIFICANT CHANGES THAT COULD HAVE A MATERIAL IMPACT ON THE MANAGERS ABILITY TO SUCCESSFULLY IMPLEMENT AND REPEAT ITS INTENDED STRATEGY.

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There are multiple fees involved in managing an institutional investment program. Among these are:

CUSTODIAN BANK

Typically, assets are held by a custodian bank for safekeeping and investment operations purposes. Custodians hold the financial assets, settle trades, handle corporate actions, disbursements and contributions, collect interest and dividends, etc. In addition, they provide an accounting function as well as independently value the plan assets.

Fees are charged most often on the asset size, number and types of portfolios, and number and types of transactions. If the custodian acts as trustee, there is an additional charge for these responsibilities.

RECORDKEEPING

Typically, recordkeepers are used by defined contribution plans to account for the transactions of each individual participant as well as handle the plan-level accounting. Similar to custodians, recordkeepers perform accounting and reporting services. Recordkeepers also may handle participant communication services. Fees vary by plan size (asset level and number of plan participants), the number and types of options offered and the service level.

INVESTMENT MANAGER

Investment manager fees are stated as a percentage of the assets managed and based on a sliding scale: the larger the assets, the lower the percentage fee. For example, fees may start at 75 basis points (bp) on the first $25 million, 50 bp on the next $25 million and 35 bp thereafter. Fees vary by type of manager with fixed income fees being the lowest, followed by U.S. large cap equity, U.S. small cap equity, and international and emerging markets equity. Alternative strategies typically have the highest fees and include both a management fee and an incentive fee. Incentive fees often have a hurdle that must be met before the manager receives the incentive fee. Hedge fund strategies typically have a high water mark, requiring that the clients investment be above this level before the manager can take a performance fee. A number of databases exist that provide fees for different asset classes, market segments and managers. A managers fee can be compared easily to managers of similar style to determine fee fairness.

INVESTMENT CONSULTANT

Investment consultancy fees vary depending on the service levels and the amount of discretion. Service packages can be la carte or bundled. It is most typical to access investment consulting services in bundled form that includes: investment policy development, asset allocation modeling, investment structure recommendations, investment manager selection and performance measurement and evaluation. Fees are dependent on the number of investment pools, the complexity of the investment structure, meeting frequency, as well as the level of discretion.

In addition to being responsible for how funds are invested, fiduciaries also are responsible for how funds are spent. In this regard, fees have a direct impact on performance and fiduciaries must ensure that they are fair and reasonable.

FEE CONSIDERATIONS by Susan McDermott, CFA, Chief Investment Officer

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FEES HAVE A DIRECT IMPACT ON PERFORMANCE AND FIDUCIARIES MUST ENSURE THAT THEY ARE FAIR AND REASONABLE.

Fees may be quoted on a flat-dollar basis or as an asset-based fee. Some firms, typically brokerage-related consulting firms, may collect commissions or charge managers additional fees that are not readily apparent to the plan sponsor. Plan sponsors should request disclosure of all fees including the commissions paid to the consultant by related entities.

OTHERACTUARIAL, LEGAL, ACCOUNTING, AUDITING

There are a number of other fees associated with the oversight of an investment program, including actuarial, legal, accounting and auditing. Some of these services may be purchased in conjunction with services for other related entities, which will affect pricing. Typically, these are quoted based on the scope of services.

Fiduciaries have an obligation to assure fair pricing for services rendered. Fair pricing does not necessarily mean the lowest pricing, as quality and the range of services are factors that should be taken into consideration.

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There are various reasons why an organization may want to outsource the investment decision-making process. There may be:

a frustration with the existing process that is cumbersome, time consuming or inefficient;

a desire to reduce or limit fiduciary responsibility;

a goal of introducing a more tactical investment approach;

a need to focus on the organizations strategic business; or

a lack of internal investment expertise or resources.

Regardless of the reason, the following outlines how fiduciary roles change under an OCIO arrangement as responsibilities change.

For ERISA plans, the law clearly defines who is a fiduciary. For other types of plans or investment programs, ERISA still provides strong guidance on who is a fiduciary to the investment program.

OCIO (Outsourced Chief Investment Officer) or discretionary consulting arrangements involve subtle changes to the fiduciary responsibilities described in previous chapters.

ANOTHER CONSIDERATION, AND ONE NOT WITHOUT CONTROVERSY, IS WHETHER AN INVESTMENT ADVISOR CAN HAVE DISCRETION AND NOT BE A 3(38) FIDUCIARY.

OCIO APPLICATIONS by Alyssa B. Cheatham, CFA, CAIA, Senior Consultant& Thomas H. Dodd, CFA, CAIA, FSA, Executive Director

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ERISA CONSIDERATIONS

For investment programs subject to ERISA, one of the primary decisions is whether your OCIO investment advisor should be a 3(21) fiduciary or a 3(38) fiduciary.

ERISA Section 3(21) defines who is a fiduciary with respect to the management of an ERISA plan. For investment advisors, the relevant part of Section 3(21) states that a fiduciary is anyone who is paid to provide investment advice to a plan.

Department of Labor regulations state that a person is deemed to provide investment advice if the person makes recommendations regarding the purchase or sale of securities or other property and (i) has discretionary authority with respect to the purchase or sale of securities or other property or (ii) renders advice to the plan:

on a regular basis;

pursuant to a mutual agreement, arrangement or understanding;

that serves as the primary basis for investment decisions with respect to plan assets; and

based on the individualized needs of the plan.

All ERISA fiduciaries are 3(21) fiduciaries because that is the ERISA section where fiduciary is defined. A Section 3(38) fiduciary is merely a special type of 3(21) fiduciary. Section 3(38) fiduciaries, also called investment managers, are fiduciaries who:

have discretion to manage, acquire or dispose of plan assets;

are a registered investment advisor, a bank or insurance company;

have acknowledged in writing their fiduciary status with respect to the plan; and

are properly appointed according to the terms of the plan.

The distinction between a 3(21) and 3(38) fiduciary is subtle but important. ERISA Section 405 makes it clear that the 3(38) fiduciary has full fiduciary responsibility for its investment decisions. Other plan fiduciaries are relieved of fiduciary responsibility for all decisions made by the 3(38) fiduciary, provided that the plan sponsor monitors the 3(38) fiduciary.

In the case of a 3(21) fiduciary, the plan sponsor is not relieved of fiduciary responsibility for decisions made by the 3(21) fiduciary. Instead, the plan sponsor and 3(21) fiduciary share responsibility and are considered co-fiduciaries.

Another consideration and one not without controversy, is whether an investment advisor can have discretion and not be a 3(38) fiduciary. This is sometimes referred to as a full scope 3(21) fiduciary. This is in contrast to a limited scope 3(21) fiduciary that is a traditional, non-discretionary investment advisor. The full scope 3(21) would be possible if the investment advisor had discretion but does not comply with all the requirements of being a 3(38) fiduciary.

In an OCIO program, many of the decisions formerly made by the Investment Committee and management will be made by the advisor. The Investment Committee needs to decide on its role, the tasks that will reside with management, and the tasks that will be delegated.

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ONE OF THE PRIMARY DECISIONS THAT ORGANIZATIONS NEED TO MAKE WHEN IMPLEMENTING AN OCIO PROGRAM IS SELECTING THE LEVEL OF DISCRETION TO GRANT AN INVESTMENT CONSULTANT.

OCIO APPLICATIONS (CONTD)

LEVEL OF DISCRETION

One of the primary decisions that organizations need to make when implementing an OCIO program is selecting the level of discretion to grant an investment consultant. There are a range of services that can be delegated to the advisor leading to a relationship where, at one extreme, the advisor has complete discretion or, at the other extreme, minimal discretion. Services that can be delegated include:

1. asset allocation;

2. manager selection and termination;

3. tactical asset shifts;

4. manager structure;

5. transition management;

6. rebalancing; and

7. liquidity management.

TRANSPARENCY

Transparency should exist at two levels. First, the OCIO investment advisor should provide complete transparency into its investment process and philosophy. Second, the Investment Committee should be able to see most individual securities in the portfolio. (The exception to this may be the securities held by some hedge fund managers.) This would include information on all portfolio transactions prior to or soon after implementation, such as the replacement of one manager with another. Additionally, the advisor should provide the Investment Committee with periodic updates on their economic and market view and how that relates to portfolio positioning.

CONFLICTS OF INTEREST

The organization or Investment Committee needs to be aware of any potential conflicts of interest when entering into an OCIO relationship. The biggest conflict is where the OCIO advisor offers proprietary asset management products. As the advisor makes money on these products, there is an inherent conflict with placing assets with proprietary products as opposed to with third-party investment managers. Additionally, there are issues of fair dealing and capacity. As assets grow within these proprietary products, it may be difficult to equitably allocate capacity across all clients.

FEES

All fees charged by the investment advisor, investment managers, custodians and other related vendors need to be fully disclosed. The Investment Committee should make sure that the fees are competitive. This can be difficult when fees for several services are bundled together.

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EXIT CONSIDERATIONS

Organizations entering into an OCIO relationship need to review how to exit the relationship should that be necessary. Maintaining contracts directly with the underlying investment managers and custodian makes termination of the OCIO investment advisor more straightforward. The underlying managers and custodian need not be disrupted if there is a move to another advisor, minimizing unnecessary trading or transition costs. If the investment management or custodian contracts are with the advisor, terminating the advisor may require liquidation of the underlying investments. Ensuring that appropriate market exposure is maintained during transitions is a necessity.

MONITORING THE ADVISOR

Metrics to monitor and measure the investment advisors performance can be both qualitative and quantitative. On the qualitative side, metrics might include whether the investment program is meeting its long-term objectives of supporting the mission of the organization, meeting effectiveness and service levels. Quantitatively, benchmarks and peer groups can be established to compare to the investment programs returns including both return and risk measures.

Sources

DOL: U.S. Department of Labor, Employee Benefits Security Administration

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APPENDIXDEFINITIONS

Accrued Interest The amount a buyer of a fixed-income security must pay the seller as compensation for holding the security between the last coupon payment date and settlement/trade date. The accrued interest, added to the instruments dollar price, constitutes the net amount, net proceeds or invoice amount the seller will receive from the buyer. Active Management A money-management approach based on informed, independent investment judgment, as opposed to passive management (indexing), which seeks to match the performance of the overall market (or some part of it) by mirroring its composition.

Alpha A measure of the managers value added above the benchmark due to security, sector or trading decisions.

American Option, European Option An option that can be exercised at any time between the purchase date and the expiration date. Most options in the U.S. are of this type. This is the opposite of a European-style option, which can only be exercised on the expiration date.

Angel Investor A person who provides backing to very early-stage businesses or business concepts. Angel investors are typically entrepreneurs who have become wealthy, often in technology-related businesses as entrepreneurs themselves.

Arbitrage Attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.

Asset Allocation Decision The division of money among stocks, bonds, real estate, cash and other types of investments.

Asset-Backed Securities (ABS) Broadly defined, ABS covers a variety of bond issues collateralized by different types of financial assets, most typically backed by receivables (i.e., auto loans, credit cards, home equity loans, etc.). The contractual cash flows from these assets are aggregated into a securitized trust and the cash flows repackaged into a security. The principal and interest payments on the receivables are collected by the agent trustee and passed-through to the individual security holder in the same manner as regular bond cash flows. The security structure provides for two or more classes of securities with varying maturities that are retired in sequence. By providing for separate classes of securities with varying maturities, the ABS structure enables a lender to create a bond obligation that appeals to different investors.

Asset-Liability Management An investment strategy, typically used by defined benefit plans or insurance companies where the investment of the assets is managed so as to earn a similar return as the liabilities. Often this involves investment in bonds with a similar duration to the liabilities.

Average Coupon The weighted average coupon/interest due on a portfolio of interest bearing investments. The average is computed by weighting each coupon (the interest rate earned on the security) by the market value of the security.

Average Duration An estimate of how much an individual bond or an entire portfolios price/market value will fluctuate in response

to a change in interest rates. To estimate the price sensitivity of a security or portfolio, multiply its duration by the change in rates. If interest rates rise by one percentage point, the price of a security or portfolio with an average duration of five years will decline by about 5%. If rates decrease by a percentage point, the security/portfolios price would rise by 5%. (Rates rise, prices fall. Rates fall, prices rise = the inverse relationship of rate movement and price change in fixed income securities.)

Average Maturity The average length of time until bonds held by a portfolio reach maturity and are repaid. In general, the longer the average maturity, the more a bond portfolios value will fluctuate in response to changes in market interest rates.

Average Quality An indicator of credit risk, this figure is the average of the credit ratings assigned to the portfolios securities holdings by bond rating agencies. Agencies assign credit ratings after an appraisal of a bond issuers ability to meet its obligations. Quality is graded on a scale, with an Aaa indicating the most creditworthy bond issuers.

Average Yield The market value weighted average yield to maturity (YTM) of a portfolio of bonds. YTM is generally considered the best indication of an individual bonds potential return if held to final maturity, or the potential future return of an entire portfolio as measured at any given point in time.

Backwardation Holds that futures price will be bid down to a level below the expected spot price.

Basis Point One hundredth of one percent, as of interest rates, or investment yields, e.g. 1 basis point = .01%.

Beta A measure of the systematic risk of a security or portfolio. Beta measures the historical sensitivity of a portfolio or security to movements in the market index. The value for beta is expressed as a percentage of the market where the market beta is 1.0. A security or portfolio with a beta above the market has volatility greater than the market. If the beta of a security is 1.3, a one percentage point increase in the market return resulted, on average, in a 1.3 times increase in the securitys return. A security or portfolio with a beta below the market has lower volatility than the market and the return on the security will move less than the market return, assuming all other factors are held constant. As such, beta does not explain all of the risk in a stock/bond or the entire portfolio. (See R-squared)

Bond A debt security issued by a corporation, government or agency. Bonds represent borrowing by the issuer. The issuer pays interest in return for the use of the money. Bonds are most often issued in $1,000 increments. The interest rate on a bond is quoted in an annual number/rate, with the payments made semi-annually (i.e., one half of the annual coupon/interest is paid each six months.) Normally, bonds have a stated maturity date at which time the face value plus the balance of any interest owed (the last six-month semi-annual interest payment) is returned to the investor. Bonds issued by corporations or the U.S. government are generally taxable. Income on bonds issued by state governments or municipalities is generally exempt from taxes.

Call The right of the bond issuer to redeem a bond before its stated final maturity date.

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Call Option An option contract that gives the holder the right to buy a certain quantity (usually 100 shares) of an underlying security from the writer of the option, at a specified price (the strike price) up to a specified date (the expiration date).

Call Price, Call Date, and Yield to Call Some bonds may be callable before maturity by the issuer, typically on coupon payment dates. Frequently, these issues pay par (face value) plus a premium over par on the call date for the right to call the bonds prior to maturity. Call provisions in conjunction with current market conditions will affect the expected cash flow of the bond. Market participants frequently evaluate these securities by calculating yields to these call dates, especially if there is a strong likelihood that the issuer will exercise these rights. The lowest of the yields, under all scenarios, is called the yield to worst. The yield to worst can become the effective yield measure used by the market to price the issue. It is a street convention to price par-callable bonds using their next call date if they are trading above par, and to price them to maturity if trading at, or below, par.

Call Protection A characteristic of some callable bonds in which the bonds may not be called for a specified initial period, usually two to three years.

Callable Bond A bond the issuer has the right to redeem prior to its maturity date, under certain conditions. When issued, the bond will explain when it can be redeemed and what the price will be. In most cases, the price will be slightly above the par value for the bond and will increase the earlier the bond is called.

Capital Call The process by which the general partner of a fund requests the capital committed by the limited partner for investments. Most general partners today call down capital only as they require it, rather than in pre-set amounts according to a rigid timetable.

Capital Gains The amount by which an assets selling price exceeds its initial purchase price. A realized capital gain is an investment that has been sold at a profit. An unrealized capital gain is an investment that hasnt been sold yet but would result in a profit if sold.

Capital Markets Line (CML) A graph relating risk (as represented by the market portfolios beta) and the required return for the market portfolio.

Capital Structure Arbitrage A companys equity and debt can be mispriced relative to one another. Securities specialists analyze company capital structures to be able to purchase the undervalued security and take short trading positions in the overpriced security to extract an arbitrage profit. Also known as intra-capitalization arbitrage.

Carried Interest Also known as an incentive fee, this is the percentage of profits (generally 10% to 20%) that general partners receive from the investments made in the fund they manage. Carried interest can be applied to all of the profits or to the profits over a certain hurdle rate such as 8% or Treasury bills plus 3%.

Cash Equivalents Highly liquid, very safe investments that can be easily converted into cash, such as Treasury Bills and money market funds.

Cash Flow Matching A form of immunization, matching cash flows from a bond with the cash flows of the liability.

Catch-up Provision A common term of a private equity partnership agreement. Once the general partner provides its limited partners with their preferred return, if any, it typically enters a catch-up period in which it receives the majority, or all, of the profits until the agreed upon profit-split, as determined by the carried interest, is reached.

Clawback Provision A provision that allows for a review of the total profit distribution from a private equity partnership at the end of the term. In essence, the clawback provision is a promise to repay limited partners at the end of the term if the general partners received more money than they should have over the life of the partnership.

Closed-end (mutual) Fund A fund with a fixed number of shares outstanding, and one that does not redeem shares the way a typical mutual fund does. Closed-end funds behave more like stock than open-end funds: closed-end funds issue a fixed number of shares to the public in an initial public offering, after which time shares in the fund are bought and sold on a stock exchange, and they are not obligated to issue new shares or redeem outstanding shares as open-end funds are. The price of a share in a closed-end fund is determined entirely by market demand, so shares can either trade below their net asset value (at a discount) or above it (at a premium).

Co-investor (Private Equity) A limited partner with co-investment rights can invest directly in a company backed by the fund managers. In this way, the limited partner ends up with two separate stakes in one company. Often used loosely to describe any two parties that invest alongside each other in the same company, this term has special meaning in relation to limited partners in a fund.

Collateral Assets pledged by a borrower to secure a loan or other credit, and subject to seizure in the event of default. Also called security.

Collateralized Mortgage Obligation (CMO) A CMO is a type of mortgage pass-through bond. Like a standard pass-through bond, a CMO is a bond backed by a mortgage collateral pool in which the cash flow from the collateral is used to retire the bond. Unlike a standard pass-through bond, however, where the cash flow passes through to all of the bondholders on a pro-rata basis, the CMO structure provides for two or more classes of securities with varying maturities, the CMO structure enables a lender to create a mortgage obligation that appeals to short- and intermediate-term investors, as well as the more traditional long-term mortgage investor. The structure also enables the lender to modify some of the features of traditional mortgage-backed securities such as monthly payments and lack of call protection that have prevented greater participation in the mortgage market by certain investors, while at the same time offering those investors higher yields than comparable corporate or government obligations.

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APPENDIXDEFINITIONS

Commitment A limited partners obligation to provide a certain amount of capital to a fund.

Common Stock Securities representing equity ownership in a corporation, providing voting rights, and entitling the holder to a share of the companys success through dividends and/or capital appreciation. In the event of liquidation, common stockholders have rights to a companys assets only after bondholders, other debt holders, and preferred stockholders have been satisfied.

Comparison Universe The collection of money managers of similar investment style used for assessing relative performance of a portfolio manager.

Contango Theory Holds that the future price of a commodity exceeds the expected future spot price.

Convertible Arbitrage Taking a long position on the convertible bond and short position on the common stock of the same company. Positions are designed to generate profits while protecting the principal from market moves. Profits are derived from the fixed-income security (coupon interest) as well as the short sale of the stock (short interest rebate less stock dividend). In addition, the manager profits from short-term position adjustments of the short stock position. Adjustments are made when the hedge ratio changes. Use of leverage is often two to ten times equity capital.

Convertible Bond A corporate bond, usually junior in the capital structure, that can be exchanged, at the option of the holder, for a specific number of shares of the companys preferred or common stock.

Corporate Bond Debt obligations issued by for-profit corporations. Proceeds from debt issues are intended for general working capital purposes to support ongoing operations of the entity, or for specific project financing. Such debt issues are part of the corporations legal capital structure and are therefore recorded on the official financial statements as liabilities. The extent to which any corporation relies on such borrowings is a measure of the borrowers leverage, measured as the percentage of the overall capital structure composed of debt. More highly leveraged borrowers are deemed to be of higher credit risk (risk of default) and consequently, command a higher risk premium/cost of borrowing/bond interest rate in the market. The overall credit/default risk of any specific corporate issuer is also reflected in the quality debt rating the issuer is assigned by the nationally recognized bond rating agencies.

Correlation Measures the degree to which two variables are associated. Correlation is a commonly used tool for constructing a well-diversified portfolio. Correlation values range from +1.0 to -1.0. A correlation of +1.0 ( 1.0) means the two variables move in exactly the same (opposite) direction. A correlation of zero means the movements of the two variables are unrelated.

Coupon Rate The coupon rate is the annual rate of interest on the bonds face value that the issuer agrees to pay the holder until maturity. Most bonds pay interest semi-annually. The term coupon comes from the manner by which bonds were historically redeemed. Attached to older bond certificates were a series of coupons, one for each coupon payment date stipulated in the

bonds indenture. At each coupon payment date, the bondholder would clip the appropriate coupon and present it for payment. Such issues were known as coupon or bearer bonds. Today, most issuers no longer issue bearer bonds. Instead almost all bonds are now offered in book-entry registered form. Also called coupon yield.

Covariance A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns move together. A negative covariance means they vary inversely.

Covered Call A combination of selling a call on a stock together with buying the stock.

Credit Risk Credit risk is the possibility that an issuer of a debt security or a borrower may default on its obligations.

Cross Hedge Hedging a position in one asset using securities on another related asset.

Current Yield The current yield of a bond is the annual coupon dividend by the market price of the bond. While useful in comparing alternative investment opportunities and the overall market value income yield of a single issue or entire portfolio at a single point in time, it is an inadequate measure of ultimate return because it takes into account neither the entire amount nor the timing of the cash flows of an individual bond or entire portfolio.

Day Order A buy or sell order that automatically expires if it is not executed during that trading session.

Debenture or Unsecured Bond A bond not backed by specific collateral.

Dedicated Short Bias Dedicated short sellers were once a robust category of hedge funds before the long bull market rendered the strategy difficult to implement. A new category, short biased, has emerged. The strategy is to maintain net short as opposed to pure short exposure. Short biased managers take short positions in mostly equities and derivatives. The short bias of a managers portfolio must be constantly greater than zero to be classified in this category.

Dedication Strategy Refers to multi-period matching of a bond portfolios cash flows from interest and maturities to the cash flows on a set of liabilities.

Default Premium A differential in promised yield that compensates the investor for the added risk of holding a corporate bond that entails some risk of default.

Defined Benefit Plan A pension plan where the employee receives a pension benefit that is an annuity based on number of years of service and salary history.

Defined Contribution Plan A pension plan in which the employees benefit is based on their contributions to the plan and the success of the investments chosen.

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Derivative A financial instrument whose value is based on, and determined by, another security or benchmark (i.e. stock options, futures, interest rate swaps, floating-rate notes, inverse floating rate notes, either the interest only (IO) or principal only (PO) portion of an underlying mortgage pass-through security.

Discount Function The discounted value of $1 as a function of time until payment and market interest rates.

Discounted Dividend Model (DDM) A formula to estimate the value of a firm by calculating the present value of all expected future dividends.

Discretionary Account An account for which the holder gives the investment manager the authority to implement investment decisions, either absolutely or subject to certain restrictions.

Distressed Debt Corporate bonds of companies that have either filed for bankruptcy or appear likely to do so in the near future. The strategy of distressed debt firms involves becoming a major creditor of the target company by acquiring the companys bonds at a deep discount. This gives them the leverage to have a significant say during either the reorganization or liquidation, of the company. In the event of a liquidation, distressed debt firms, by standing ahead of the equity holders in the line to be repaid, often recover all of their money, if not a healthy return on their investment. Usually, however, the more desirable outcome is a reorganization that allows the company to emerge from bankruptcy protection. As part of the reorganization, distressed debt firms often forgive the debt obligations of the company in return for sufficient equity compensation.

Distribution Cash or stock disbursed to the limited partners of a private equity fund. Stock distributions sometimes are referred to as in-kind distributions. The partnership agreement governs distributions to the limited partners, as well as how any profits are divided among the limited partners and general partner.

Diversifiable Risk Firm-specific, or nonmarket risk that can be minimized through appropriate portfolio construction.

Diversification Spreading a portfolio over many investments with low correlations to one another to avoid excessive exposure to any one source of risk.

Dividends A distribution of cash or securities made at the discretion of the board of directors to the equity shareholders of a corporation. Also, a distribution of cash from net income made by a regulated investment company.

Dividend Payout Ratio Percentage of earnings paid out as dividends.

Dollar-Weighted Return The internal rate of return on an investment.

Downside Risk Downside risk differentiates between good risk (upside volatility) and bad risk (downside volatility). Whereas standard deviation treats both upside and downside risk the same, downside risk measures the standard deviation of returns that are below the target. Returns above the target are assigned a deviation of zero. Both the frequency and magnitude of underperformance affect the amount of downside risk.

Duration A primary measure of interest rate risk. It is intended to measure the price sensitivity (and therefore market risk) of a fixed income security or portfolio to interest rate changes. Bonds with longer durations exhibit greater price sensitivity to interest rate changes than bonds having shorter durations. Duration is generally expressed in years.

Dynamic Hedging Constant updating of hedge positions as market conditions change.

EAFE Index The Europe, Australia, and Far East Index from Morgan Stanley Capital International. An unmanaged, market-value weighted index designed to measure the performance of the developed international equity markets.

Early Stage A venture capital fund investment strategy involving investment in companies for product development and initial marketing, manufacturing and sales activities.

Earnings Growth Rate The average annual rate of growth in earnings, typically measured over the past five years for stocks.

Earnings Yield The ratio of earnings to price on a stock.

Efficient Frontier The line on a risk-reward graph comprised of all efficient portfolios from a risk/return perspective.

Efficient Market Hypothesis The theory that all market participants receive and act on all relevant information as soon as it becomes available. Proponents of the efficient market theory believe that there is perfect information in the market. Since everyone has the same information, the price of a security should reflect the knowledge and expectations of all investors. The bottom line is that an investor should not be able to beat the market since there is no way for him/her to know something about a security that is not already reflected in its price. There is evidence to dispute the basic claims of this theory, and most investors do not believe it.

Equities This generic term includes securities that represent an owner relationship with a business, rather than a creditor relationship. These include common and preferred stocks and partnership interests issued by corporations, but not bonds.

Equity Market Neutral A strategy is designed to be equally long and short equity portfolios. Market neutral portfolios are designed to control for a number of factors such as beta, style, capitalization, sector, industry, currency and other exposures. Use of leverage is often one to five times equity capital.

Equivalent Taxable Yield The yield that must be offered before factoring in taxes so that an investment pays off a certain after-tax yield. This measure is often necessary to compare taxable and tax-free investments, since tax-free issues tend to have lower pre-tax yields due to the fact that the investments proceeds will not be reduced by taxes. Tax equivalent yield is equal to the required after-tax yield divided by (1 minus the tax rate).

Event-driven Strategy The manager, usually a hedge fund, takes significant positions in limited number of special situation companies. The situations are unusual in a variety of ways and offer profit opportunities; e.g., depressed stock; event offering significant potential market interest (e.g., company is being

31

APPENDIXDEFINITIONS

merged with or acquired by another company); reorganizations; bad news emerging that will temporarily depress stock (so manager shorts stock), etc.

Event Risk The risk that the value of a security or other instrument will change due to an unexpected event, such as a takeover, a corporate restructuring, an unanticipated change or event in the market environment, a natural disaster or a change in the regulatory environment.

Eurodollars An American dollar held by a foreign institution outside the U.S., usually a bank in Europe, often as a result of payments made to overseas companies for merchandise.

European Option An option that can be exercised for a short, specified period of time just prior to its expiration, usually a single day.

Exercise or Strike Price Price set for calling (buying) an asset or putting (selling) an asset.

Expected Return The probability-weighted average of possible outcomes.

Face Value/Par Amount The face amount, or face value, of a security is the amount the issuer pays the holder at maturity. Different security types have different face value denominations. Most bonds are quotes in multiples of $1,000 face value. For example, 50 bonds would be equivalent to holding $50,000 face value of a bond.

Financial Assets Financial assets such as stocks and bonds are claims to the income generated by real assets or claims on income from a corporation or the government.

Fixed Income Arbitrage The arbitrageur aims to profit from price anomalies between related interest-rate securities. Most managers trade globally with a goal of generating steady returns with low volatility. This category includes interest rate swap arbitrage, U.S. and non-U.S. government bond arbitrage, forward yield curve arbitrage, and mortgage-backed securities arbitrage. Use of leverage is often 20 to 30 times equity capital.

Flight to Quality Describes the tendency of investors to require larger default premiums on investments during periods of uncertain economic conditions.

Floating-Rate Bond A bond whose interest rate is reset periodically according to a specified market rate.

Forward Contract An arrangement calling for future delivery of an asset at an agreed-upon price.

Forward Interest Rate An interest rate specified now for a loan that will occur at a specified future date. As with current interest rates, forward interest rates include a term structure that shows the different forward rates offered to loans of different maturities.

Fundamental Analysis Research to predict stock value that focuses on such determinants as earnings and dividends prospects, expectations for future interest rates, and risk evaluation of the firm.

Funded Status Refers to the funding level of a pension plan. Typically it is a measure of the ratio of the assets to that of the liabilities. If a plans assets equal its liabilities, it is 100% funded. A plan that is underfunded will have a funded status below 100%; plans that are overfunded will have a funded status in excess of 100%.

Funded Status Volatility A measure of the impact on plan funding levels related solely to interest rate changes.

Fund-of-Funds An approach to investing in which a manager invests in various funds formed by other investment managers. The benefits of this approach include diversification and access to managers that may be otherwise unavailable and often, a more extensive due diligence process. The main drawbacks are over diversification and an added layer of fees.

Futures Contract A standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Unlike options, futures convey an obligation to buy. The risk to the holder is unlimited and, because the payoff pattern is symmetrical, the risk to the seller is unlimited as well. Dollars lost and gained by each party on a futures contract are equal and opposite.

Futures Option The right to enter a specified futures contract at a futures price equal to the stipulated exercise price.

General Partner A General Partner is the managing partner responsible for the operation of the limited partnership, typically a hedge fund or private equity fund.

Geometric Average The nth root of the product of n numbers. It is used to measure the compound rate of return over time.

Global Macro Opportunistic hedge fund strategy where the manager takes long and short positions in any of the worlds major capital or derivative markets. These positions reflect their views on overall market direction as influenced by major economic trends and/or events. Portfolios can include stocks, bonds, currencies, and commodities, and derivatives. Use of leverage is common.

Gross Exposure The absolute level of exposure of a hedge fund to the market at the present time, including leverage. It is calculated by adding the long exposure to the absolute level of short exposure.

Growth Investment Style Investment strategies equity managers use to select the stocks of companies they expect to have above average earnings growth. A variety of sub styles exist (growth at a reasonable price, momentum, quality growth, etc.)

Hedge Fund A broad term describing a variety of investment strategies where the manager has broad leeway to invest in public market securities, some illiquid securities, use leverage, invest long and short, and invest in derivative securities. Typical investments are made through limited partnership structures.

High Water Mark The assurance that a fund only takes fees on profits unique to an individual investment. For example, a $1,000,000 investment is made in year 1 and the fund declines by 50%, leaving $500,000 in the fund. In year 2, the fund returns

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100%, bringing the investment value back to $1,000,000. If a fund has a high water mark, it will not take incentive fees on the return in year 2, since the investment has not grown beyond its initial value. The fund will only take incentive fees if the investment grows above the initial level of $1,000,000.

Hurdle Rate The minimum investment return a fund must exceed before a performance or incentive fee can be charged. For example, if a fund has a hurdle rate of 10% and the fund returns 25% for the year, the fund will only take incentive fees on the 15% return above the hurdle rate. Also called Preferred Return.

Immunization The term used to describe a bond portfolio designed in such a way that any changes in the general level of interest rates will affect the total expected return from the portfolio in the same manner as the liability stream the bond portfolio is immunizing.

Implied Volatility The standard deviation of stock returns that is consistent with an options market value.

In the Money An option whose exercise price is below the current stock price so that exercising the option would produce profits.

Incentive Fee The fee on profits earned by the fund for the period. For example, if the initial investment was $1,000,000 and the fund returns 25% during the period (creating profits of $250,000) and the fund has an incentive fee of 20%, then the fund receives 20% of the $250,000 in profits, or $50,000.

Index Arbitrage A strategy designed to profit from temporary discrepancies between the prices of the stocks comprising an index and the price of a futures contract on that index.

Index Fund A portfolio holding securities in proportion to their representation in a market index such as the S&P 500 or the BC Aggregate. The manager makes no determination as to the future value of the security.

Information Ratio A risk statistic that measures the excess return per unit of residual non-market risk in a portfolio. The ratio is equal to the alpha divided by the residual risk. Because the information ratio represents a residual-risk adjusted measure of excess returns, the resulting value can be looked at as the excess return per unit of risk that is due solely to the specified risks associated with the securities in the portfolio and by definition could be diversified away.

Internal Rate of Return (IRR) The IRR is the discount rate that equates the present value of the future cash flows of an investment to the cost/market value of the investment. Hence, the net present values of cash outflows and cash inflows equal zero when IRR is used as the discount rate.

Interest Rate Risk Fluctuations in bond prices in response to the general movement of the interest rates.

Initial Public Offering Stock issued to the public for the first time by a formerly privately owned company.

Inside Information Nonpublic knowledge about a corporation possessed by corporate officers, major owners, or other individuals with privileged access to information about a firm.

Insider Trading Trading by officers, directors, major stockholders, or others who hold private inside information allowing them to benefit from buying or selling stock.

Interest Rate The number of dollars earned per dollar invested per period.

Interest Rate Swaps A method to manage interest rate risk where parties trade the cash flows corresponding to