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

ii

PREFACE

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, CFA

Chief Investment Officer, Pavilion Advisory Group Inc.

iii

ROLES AND RESPONSIBILITIES

OF INVESTMENT FIDUCIARIES
by Richard P. Marra, Senior Consultant

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

TO SAFEGUARD AND EFFECTIVELY

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

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.

Sources
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

ETHICS AND CONFLICTS OF

INTEREST
by Keith Mote, CFA, Managing Director

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.
The 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

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.

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.

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

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.

Sources
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

INVESTMENT COMMITTEE
GOVERNANCE BEST PRACTICES
by Susan McDermott, CFA, Chief Investment Officer

The purpose of governance best practices is to promote the interests of the

organizationboth its mission and supporting financial objectives.
While 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.

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 whipsawed
moving 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.

WHILE 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 longrange 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.

INVESTMENT COMMITTEE GOVERNANCE

BEST PRACTICES (CONTD)
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.

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

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. Interquarter 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.

FINAL 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.

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

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.
The 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.

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.

AN IPS COMMUNICATES TO ALL

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

10

INVESTMENT POLICY STATEMENT (CONTD)

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.

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

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.

11

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:
TARGET
ALLOCATION

ALLOWABLE
RANGE

Equities

50%

40% to 60%

Fixed Income

25%

15% to 35%

ASSET CLASS

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.

12

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;

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

evaluate the experience, qualifications and

investment approach;

Outperform the Composite Benchmark

over rolling three- to five-year periods.

evaluate performance, risk and portfolio

characteristics, as well as investment
management fees; and

Investment Managers

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.

13

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.

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.

14

INVESTMENT STRATEGY
DEVELOPMENT
by Antonio DiCosola, CFA, Senior Consultant

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.
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

ASSET ALLOCATION MODELING

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:

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:

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.

15

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.

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.

INSTITUTIONAL BEST PRACTICE

REQUIRES FORMAL REVIEWS
CONDUCTED QUARTERLY WITH THE
APPROPRIATE PERSONNEL.

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.

16

INVESTMENT MANAGER SELECTION,

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

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.
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.

17

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.

FIDUCIARIES ALSO MUST

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

18

INVESTMENT MANAGER SELECTION,

MONITORING AND REPLACEMENT (CONTD)

19

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.

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;

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.

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;

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.

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.

20

FEE CONSIDERATIONS
by Susan McDermott, CFA, Chief Investment Officer

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.
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.

21

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.

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.

FEES HAVE A DIRECT IMPACT ON

PERFORMANCE AND FIDUCIARIES MUST
ENSURE THAT THEY ARE FAIR AND
REASONABLE.
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.

22

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

OCIO (Outsourced Chief Investment Officer) or discretionary consulting

arrangements involve subtle changes to the fiduciary responsibilities described in
previous chapters.
There are various reasons why an organization
may want to outsource the investment decisionmaking 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.

ANOTHER CONSIDERATION, AND ONE NOT

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

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.

23

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;

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, nondiscretionary 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.

are a registered investment advisor, a bank

or insurance company;

24

OCIO APPLICATIONS (CONTD)

LEVEL OF DISCRETION

CONFLICTS OF INTEREST

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:

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.

1. asset allocation;
2. manager selection and termination;
3. tactical asset shifts;
4. manager structure;
5. transition management;
6. rebalancing; and
7. liquidity management.

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.

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.

25

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.

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

26

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 earlystage 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.

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)

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.

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.

Average Duration An estimate of how much an individual bond or

an entire portfolios price/market value will fluctuate in response

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

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.

27

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 closedend 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 coinvestment 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 longterm 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.

28

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.

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.

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.

Debenture or Unsecured Bond

collateral.

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.

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.

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

29

A bond not backed by specific

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.

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.

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
dividends.

Percentage of earnings paid out as

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, marketvalue 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 aftertax yield. This measure is often necessary to compare taxable and
tax-free investments, since tax-free issues tend to have lower pretax 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

30

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.

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.)

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.

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.

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.

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

31

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
per period.

The number of dollars earned per dollar invested

Interest Rate Swaps A method to manage interest rate risk

where parties trade the cash flows corresponding to debt owned.
For example, trading fixed rate debt for variable rate debt.
Investment Grade Bond Bonds rated BBB and above or Baa and
above. Lower-rated bonds are classified as speculative-grade or
junk bonds.
J-Curve Refers to the performance pattern typically exhibited
by private equity investments. In the early years of a funds life,
the manager is making investments that are carried at cost and
taking fees, which results in a decline in the investors value. As
the investments begin to move toward realization, the investors
value climbs above the original cost toward profitability. The
performance pattern is similar to the letter j.
Junk Bonds Industry expression for bonds with a credit rating of
BB or lower. These bonds have a greater likelihood of defaulting
on interest or principal payments than do investment grade
bonds.
Leverage Borrowing funds to increase the amount invested in a
particular position. Leveraging magnifies the risk of a strategy as
adverse market shifts magnify losses and could force a partial or
complete liquidation of the portfolio.
Limited Partner Unlike a general partner, a limited partner does
not play an active role in the business and normally is liable for
partnership losses or debts only to the extent of its invested
capital.
Liquidity The ability to exit a security or fund quickly. Different
types of funds have different liquidity terms.
Load Fund A mutual fund with a sales commission, or load.
Lock-up The time period for which investors are precluded from
withdrawing or redeeming their investments in a fund.
Long/Short Equity
Includes both directional and market
neutral strategies. The manager takes long and short positions in
equities, seeking to profit both from the long and short positions.
Directional managers will alter the ratio of long to short positions
depending on market views. Market neutral managers allocate an
equal amount to long and short positions to remove market risk
and profit solely from stock picking decisions.
Maintenance, or Variation, Margin As established value below
which a traders margin cannot fall. Reaching the maintenance
margin triggers a margin call, requiring the investor to provide
additional cash or collateral as backing for their positions.
Margin Describes securities purchased with money borrowed
from a broker.

32

APPENDIXDEFINITIONS

Market Cap The market capitalization of a strategy or public

corporation equals the market price multiplied by the number of
outstanding shares.
Market or Systemic Risk, Firm-Specified Risk Market risk is risk
attributable to common macroeconomic factors. Firm-specific
risk reflects risk peculiar to an individual firm that is independent
of market risk.
Market Neutral Investing in financial markets through a strategy
that may result in an investment portfolio not correlated to the
overall market movements and insulated from systematic market
risk. However, there is no guarantee a fund will meet its objective.
Market Order A buy or sell order to be executed immediately at
current market prices.
Market Portfolio The portfolio for which each security is held in
proportion to its market value.

Money Market Includes short-term, highly liquid, and relatively

low-risk debt instruments.
Mortgage-Backed Security
Ownership claim in a pool of
mortgages or an obligation that is secured by such a pool. Also
called a pass-through, because payments are passed along from
the mortgage originator to the purchaser of the mortgagebacked security.
Most Favored Nations Clause This clause ensures that any
side agreements negotiated by other investors in investment
management agreements will be received by all investors.
Multi-Strategy
Investment philosophy allocating investment
capital to a variety of investment strategies, although the fund is
run by one management company.

Market Price of Risk

A measure of the extra return, or risk
premium, that investors demand to bear risk. The reward-to-risk
ratio of the market portfolio.

Municipal Bonds Bond issued by a state, city, or local government.

Municipalities issue bonds to raise capital for their day-to-day
activities and for specific projects that they might be undertaking
(usually pertaining to development of local infrastructure such as
roads, sewerage, hospitals, etc.). Interest on municipal bonds is
generally exempt from federal tax.

Market Risk Market risk is synonymous to the classes price/

yield behavior of bonds. As yields fall, bond prices rise; as yields
rise, bond prices fall. In some contexts, this phenomenon may be
called interest rate risk or price risk.

Net Exposure The exposure of a hedge fund to the market at the

present time. It is calculated by subtracting the short percentage
from the long percentage. For example, if a fund is 100% long and
25% short, then the net exposure is 75%.

Market Segmentation or Preferred Habitat Theory The theory

that long- and short-maturity bonds are traded in essentially
distinct or segmented markets and that prices in one market do
not affect those in the other.

Net Income All ordinary income and capital gains net of income
taxes and other expenses.

Market Timing Seeking to profit from market price fluctuations

by moving in and out of stocks, bonds, cash and other asset
classes.
Market-Book Ratio
value per share.

Market price of a share divided by book

Mark to Market Describes the daily settlement of obligations on

futures positions.
Maturity The maturity of a security is the date the issuer makes
the final principal payment to the security holder. After maturity,
no further obligations or rights exist between the two parties. At
maturity the issuer pays the redemption value to the holder, along
with the final interest coupon payment.
Mezzanine Debt Provides a middle level of financing in leveraged
buyouts-below the senior debt layer and above the equity layer.
A typical mezzanine investment includes a loan to the borrower,
in addition to the borrowers issuance of equity in the form of
warrants, common stock, preferred stock, or some other equity
investment. Mezzanine financing shares characteristics of both
debt and equity financing.
Modern Portfolio (MPT) Principles underlying analysis and
evaluation of rational portfolio choices based on risk-return
trade-offs and efficient diversification.

33

No-fault Divorce A term of the partnership agreement that

allows limited partners to halt additional capital contributions if
there is a loss of confidence in the general partner. The ability to
terminate individual general partners is an important right limited
partners should demand. This term assures a proper check and
balance if the managerial harmony of the general partnership
becomes disrupted.
Nonsystematic Risk Nonmarket or firm-specific risk factors that
can be eliminated by diversification. Also called unique risk or
diversifiable risk. Systematic risk refers to risk factors common
to the entire economy. Odd Lot Bonds traded at the less than
normal trading units. A general rule of thumb is bond increments
of less than $1,000,000 total par or face value are considered
odd lots, while greater than $1,000,000 are considered round
lots or institutional lots.
Open (good-till-canceled) Order A buy or sell order remaining
in force for up to 6 months unless canceled.
Open-End (mutual) Fund A fund that issues or redeems its own
shares at their net asset value (NAV).
Opportunistic
A general term describing any fund that is
resourceful and opportunistic in nature. These types of funds
are usually aggressive and they seek to make money in the most
efficient way at the given time.
Original Issue Discount Bond A bond issued with a low coupon
rate that sells at a discount from par value.

Out of the Money Out of the money describes an option where

exercise would not be profitable. In the money describes an
option where exercise would produce profits.
Over-the-Counter Market An informal network of brokers and
dealers who negotiate sales of securities (not a formal exchange).
Par Value The face value of the bond.
Pass-Through Security Pools of loans (such as home mortgage
loans) sold in one package. Owners of pass-throughs receive all
principal and interest payments made by the borrowers.
Passive Management Buying a portfolio to represent a broadbased market index without attempting to search out mispriced
securities.
Paid-in Capital The amount of committed capital a limited
partner has actually transferred to a venture fund. Also known as
the cumulative takedown amount.
PIPEs An acronym for private investing in public equities.
Portfolio Company The company or entity into which a fund
invests directly.
Portfolio Insurance The practice of using options or dynamic
hedge strategies to provide protection against investment losses
while maintaining upside potential.
Preferred Return 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 Hurdle Rate.
Preferred Stock Nonvoting shares in a corporation, paying a
fixed or variable stream of dividends.
Price/Book Ratio The share price of a stock divided by its net
worth, or book value, per share. For a portfolio, the weighted
average price/book ratio of the stocks it holds.
Price-earnings Ratio
The ratio of a stocks current price to
its per-share earnings over the past year. P/E is an indicator of
market expectations about corporate prospects; the higher the
P/E, the greater the expectations for a companys future growth.
For a portfolio, the weighted average P/E of the stocks it holds.
Also referred to as P/E multiple.
Primary Market New issues of securities are offered to the public
here.
Private Equity A term used to describe the universe of all venture
investing, buyout investing and mezzanine investing. These
represent investment in private companies not tradeable on the
public market stock exchanges.
Program Trading
Coordinated buy and sell orders of entire
portfolios, usually with the aid of computers, often to achieve
index arbitrage objectives.

Prospectus A final and approved registration statement including

the price at which the security issue is offered. For mutual funds,
includes the fees, investment restrictions and guidelines of the
fund, among other things.
Protective Covenant
A provision specifying requirements of
collateral, sinking fund, dividend policy, etc., designed to protect
the interests of the bondholders.
Protective Put Purchase of stock combined with a put option that
guarantees minimum proceeds equal to the puts exercise price.
Public Offering, Private Placement A public offering consists of
bonds sold in the primary market to the general public; a private
placement is sold directly to a limited number of institutional
investors.
Put Bond A bond that the holder may choose either to exchange
for par value at some date or to extend for a given number of years.
Put Option The right to sell an asset at a specified exercise price
on or before a specified expiration date.
Put-Call Parity Theorem An equation representing the proper
relationship between put and call prices. Violation of parity allows
arbitrage opportunities.
Random Walk Describes the notion that stock price changes are
random and unpredictable.
Rate of Return The gain or loss on an investment over a specified
period, expressed as a percentage increase over the initial
investment cost. Gains on investments are considered to be any
income received from the security plus realized capital gains.
Ratings Bond ratings are intended to characterize the risk of holding
a bond. These ratings, or risk assessments, in part, determine the
interest that an issuer must pay to attract purchasers to the bonds.
The ratings are expressed as a series of letters and digits.
Real Assets Tangible assets used to produce goods and services
of an economy. These include land, buildings, equipment and
commodities.
Real Interest Rate
The excess of the interest rate over the
inflation rate. The growth rate of purchasing power derived from
an investment.
Realized Compound Yield Yield assuming that coupon payments
are invested at the going market interest rate at the time of their
receipt and rolled over until the bond matures.
Rebalancing Realigning the proportions of assets in a portfolio
as needed, typically to keep them in line with the target asset
allocation specified in the investment policy.
Redemption Fee Fee charged upon a voluntary redemption from
an investment vehicle.
Redemption Notice Period Required notification period of an
intended redemption request. Notification is usually required in
writing.

34

APPENDIXDEFINITIONS

Redemption Value
Most fixed income securities pay 100%
of face value (par) at maturity. Some may pay more or less at
redemption, depending upon call and put terms for the issue.
These amounts would be paid on corresponding call and/or
put dates. Redemption value is that amount paid to redeem the
securities.

Risk Premium An expected return in excess of that on risk-free

securities. The premium provides compensation for the risk of an
investment.

Registration Statement Required to be filed with the SEC to

describe the issue of a new security.

R-Squared (R2) A statistical measure that indicates the extent

to which the variability of a security or portfolios returns is
explained by the variability of the market. The value will be
between 0 and 1. The higher the number, the greater the extent
to which the portfolio returns are related to the market return. An
R-Squared value of .75 indicates that 75% of the fluctuation in a
portfolios return is explained by market action.

Reinvestment Rate The reinvestment rate is the rate at which

intermediate income will be invested. Many securities like bonds
make payments between the settlement date (or valuation date)
and some horizon date. To analyze the return of all these cash
flows, the payments are assumed to be reinvested at a userdefined rate until the investment horizon date.
REIT (Real Estate Investment Trust) REITs invest in real estate or
loans secured by real estate and issue shares in such investments.
Relative-value Strategies
Relative-value strategies seek to
profit from the mispricing of related financial instruments. These
strategies utilize quantitative and qualitative analyses to identify
securities or spreads between securities that deviate from their
fair market value and/or historical norms.
Repurchase Agreements (Repos) Short-term, often overnight,
sales of government securities with an agreement to repurchase
the securities at a slightly higher price. A reverse repo is a
purchase with an agreement to resell at a specified price on a
future date.
Residual Claim Refers to the fact that shareholders are at the
bottom of the list of claimants to assets of a corporation in the
event of failure or bankruptcy.
Residual Risk Residual risk is the unsystematic, firm-specific,
or diversifiable risk of a security or portfolio. It is the portion
of the total risk of a security or portfolio that is unique to the
security or portfolio itself and is not related to the overall market.
Diversification of a portfolio can reduce or eliminate the residual
risk of a portfolio.
Residuals Parts of stock returns not explained by the explanatory
variable (the market-index return). They measure the impact of
firm-specific events during a particular period.
Riding the Yield Curve Buying long-term bonds in anticipation
of capital gains as yields fall with the declining maturity of the
bonds.
Risk Arbitrage Relative value investment strategy that seeks
to exploit pricing discrepancies in the equity securities of two
companies involved in a merger-related transaction. Strategy
entails the purchase of a security of the company being acquired,
along with the simultaneous sale in the acquiring company.
Risk-Free Asset An asset with a certain rate of return; often
taken to be short-term Treasury bills.
Risk-Free Rate The interest rate that can be earned with certainty.
An example is the yield on the three-month Treasury bill.

35

Risk-Return Trade-Off If an investor is willing to take on risk,

there is the reward of higher expected returns.

Secondary Funds Funds that specialize in purchasing the limited

partnership interests of private equity funds from other investors.
This type of partnership provides some liquidity for the original
investors. These funds buy their interests in a fund after it has
at least partially deployed capital to portfolio companies. Unlike
fund of fund managers, which generally invest in blind pools,
secondary buyers can evaluate the underlying companies in
which they are indirectly investing.
Secondary Market The secondary market enables investors to
buy and sell stakes in private equity funds after initial transactions
between the general and limited partners.
Secondary Sale The sale of private or restricted holdings in a
portfolio company to other investors.
Securitization
Pooling loans for various purposes into
standardized securities backed by those loans, which can then be
traded like any other security.
Security Market Line Graphical representation of the expected
return-beta relationship of the CAPM.
Security Selection Decision
to include in a portfolio.

Choosing the particular securities

Seed Stage An investment strategy involving portfolio companies

which have not yet fully established commercial operations, and
may also involve continued research and product development.
Sharpe Ratio Sharpe ratio is a measure of the risk-adjusted return
of a portfolio. The ratio represents the return gained per unit of
risk taken. The risk of the portfolio is the standard deviation of the
portfolio returns. The calculation is essentially the excess return
divided by the standard deviation of the portfolio return.
The Sharpe ratio can be used to compare the performance of
managers. Two managers with the same excess return for a
period but different levels of risk will have Sharpe ratios that
reflect the difference in the level of risk. A low Sharpe ratio
exhibits comparatively more risk for the desired return compared
to the other manager. For two managers with the same level of
risk but different levels of excess return, the manager with the higher
Sharpe ratio is preferable because the manager achieved a higher
return with the same level of risk as the other.

Short Sale The sale of shares not owned by the investor but
borrowed through a broker and later repurchased to replace
the loan. Profit comes from initial sale at a higher price than the
repurchase price.
Short Seller One who sells a security without owning it, with an
obligation to buy the security at a later time, and repay the security
creditor who had lent it for sale. Profits will result if the investor is
able to buy it back later at a lower price.
Soft Dollars The value of research services that brokerage houses
supply to investment managers free of charge in exchange for the
investment managers business.

securities that are currently trading at prices out of their historical

range. Will involve longing an undervalued security and short
selling an overvalued security.
Stock Selection An active portfolio management technique that
focuses on advantageous selection of particular stocks rather
than on broad asset allocation choices.
Straight Bond A bond with no option features such as callability
or convertibility.
Street Name Describes securities held by a broker on behalf of
a client but registered in the name of the firm.

Sortino Ratio Calculated by dividing the rate of return for a portfolio

that is above the risk free rate and dividing it by the downside
deviation (similar to the loss standard deviation but the downside
deviation considers only returns that fall below a defined Minimum
Acceptance Return (MAR) rather than the arithmetic mean).

Subordination Clause
A provision in a bond indenture that
restricts the issuers future borrowing by subordinating the new
leaders claims on the firm to those of the existing bond holders.
Claims of subordinated or junior debtholders are not paid until the
prior debt is paid.

Special Situations Investing Investment strategy that seeks to

profit from pricing discrepancies resulting from corporate event
transactions, such as mergers & acquisitions, spinoffs, bankruptcies
or recapitalizations. Also known as event driven.

Substitution Swap Exchange of one bond for a bond with similar

attributes but more attractively priced.

Speculation Undertaking a risky investment with the objective of

earning a positive profit compared with investment in a risk-free
alternative (a risk premium).
Speculative Grade Bond Bond rated Ba or lower by Moodys, or BB
or lower by Standard & Poors, or an unrated bond.
Spot Rate The current interest rate appropriate for discounting a
cash flow of some given maturity.
Spot-Futures Parity Theorem, or Cost-of-Carry Relationship
Describes the theoretically correct relationship between spot and
futures prices. Violation of the parity relationship gives rise to
arbitrage opportunities.
Squeeze The possibility that enough long positions hold their
contracts to maturity that supplies of the commodity are not
adequate to cover all contracts. A short squeeze describes the
reverse; short positions threaten to deliver an expensive-to-store
commodity.
Standard Deviation
Standard deviation (SD) is a statistical
measure of portfolio risk. SD is equal to the square root of the
variance of the data points in a series. It reflects the average
deviation of the observations from their sample mean. In the case
of portfolio performance, the SD describes the average deviation of
the portfolio returns from the mean portfolio return over a certain
period of time. SD measures the width of the range of returns. The
wider the typical range of returns, the higher the SD of returns, and
the higher the portfolio risk. If returns are normally distributed (i.e.,
has a bell shaped curve distribution), then approximately 2/3 of the
returns would occur within plus or minus one standard deviation
from the sample mean.
Statistical Arbitrage
Market neutral relative value investment
strategy that involves the utilization of a quantitatively-based
investment methodology that identifies securities or groups of

Support Level A price level below which it is supposedly difficult

for a stock or stock index to fall.
Systematic Risk Risk factors common to the whole economy, for
example Non-diversifiable risk; see market risk.
Technical Analysis Research to identify mispriced securities that
focuses on recurrent and predictable stock price patterns and on
proxies for buy or sell pressure in the market.
Tender Offer An offer from an outside investor to shareholders
of a company to purchase their shares at a stipulated price,
usually substantially above the market price, so that the investor
may amass enough shares to obtain control of the company.
Term Premiums Excess to the yields to maturity on long-term
bonds over those of short-term bonds.
Terms and Conditions The financial and management conditions
under which venture capital limited partnerships are structured.
Term Structure of Interest Rates The pattern of interest rates
appropriate for discounting cash flows of various maturities.
Third Market
market.

Trading of exchange-listed securities on the OTC

Time-Weighted Return
An average of the period-by-period
holding period returns of an investment.
Total Return The total change in value of an investment over
a given period (usually one year) that results from both income
(interest, dividends) and capital appreciation (change in fair
market value from the purchase price).
Tracking Error Tracking error is simply the standard deviation
of a portfolios relative returns to some benchmark. Whereas the
standard risk measures of standard deviation measures the absolute
return volatility, tracking error measures the volatility of the return

36

APPENDIXDEFINITIONS

differences between the portfolio and the benchmark over time. A

portfolio that is actively managed in an aggressive manner would
have a large amount of tracking error versus its index, whereas a
portfolio that is constrained to look like its index (an index fund
being the extreme) would have smaller amounts of tracking error.
Treasury Bill U.S. government securities debt issued at a discount
from the face value at maturity an maturing in less than one year.
Treasury Bond or Note Debt obligations of the federal government
that make semiannual coupon payments and are sold at or near par
value in denominations of $1,000 or more.
Treynors Measure Ratio of excess return to beta.
Turnover Rate A percentage of a funds holdings that has changed
over the past year. Portfolios with high turnover rates incur higher
transaction costs and are more likely to realize and distribute capital
gains or losses to investors.
UBTI (Unrelated Business Taxable Income) In the hedge fund
and private equity world, tax-exempt organizations may become
liable for UBTI when income is earned from investments that utilize
leverage. Most tax-exempt organizations invest in offshore entities
to minimize exposure to UBTI.
Up-Capture and Down-Capture
The amount of upward or
downward movement in the benchmark that is captured by a
particular fund manager.
Value Investment Style Investment strategies equity managers
use to select the stocks of companies they believe are underpriced
relative to the market. A variety of sub styles exist (absolute value,
relative value, etc.).
Variance A measure of the dispersion of a random variable. Equals
the expected value of the squared deviation from the mean.
Venture Capital Venture Economics uses the term to describe the
universe of venture investing (see Private Equity). It does not include
buyout investing, mezzanine investing, fund of fund investing or
secondaries. Angel investors or business angels would also not be
included in the definition.
Vintage Year
capital.

The year of fund formation and first takedown of

Volatility A relative measure of how rapidly the price of a security

falls or rises within a short period of time.
Writing a Call Selling a call option.
Yankee Bonds Bonds denominated in U.S. dollars, issued in the
U.S. by non-U.S. borrowers. Such borrowers typically include foreign
governments (also called Sovereigns), agencies and provinces of
foreign governments (i.e., Province of Ontario), foreign corporations

Sources
Bodie, Kane, Marcus, Investments, Richard D. Irwin, Inc., 1989
www.cadoganmanagement.com
Hedge World. www.investorwords.com. UBS Warburg: In Search of Alpha

37

and super-regional issuers (i.e., European Coal and Steel, International

Bank for Reconstruction and Development (The World Bank), etc.).
Yield Curve Market convention uses the term curve to describe
the graphic of market interest rates for U.S. Treasury issues (deemed
to represent the risk free rates) by maturity ranging from three
months out to thirty years. In a normal interest rate environment, an
investor is rewarded with higher income/yield for successively longer
investment maturities.
Yield to Call The yield to call is the interest rate that will make the
present value of the cash flows equal to the price paid for the bond
if it is held to its first call date. Yield to call is computed in the same
manner as yield to maturity, except that the maturity date is replaced
by the first call date and that the redemption value at maturity is
replaced by the call price. Call price and dates are disclosed in the
bonds indenture agreement.
Yield to Maturity Yield or yield to maturity (YTM) is defined as
the internal rate of return of a bonds cash flows. It is the discount
rate expressed as a percent which equates a bonds market price
(principal + accrued interest) with the present value of its future cash
flows (coupon and principal payments). YTM can be viewed as simply
an alternative method for stating a bonds price. It is also a convenient
yardstick for simply comparing the potential return of alternative
investments at any given point in time.
In calculating YTM, coupon income, redemption value, interest earned
on interest, as well as the timing of each cash flow, are all taken into
account from settlement to maturity. All intermediate cash flows are
assumed to be reinvested at the stated YTM itself. The YTM may only
be realized when the bond is held to maturity and all cash flows are
reinvested at exactly the YTM rate.
For most securities, this rate is quoted in terms of the compounding
convention of the security. Money market instruments quote yield on
a simple interest basis, whereas bonds are quoted on a semi-annual,
compounded basis. Except in the case of zero-coupon instruments,
yield is not an assured rate. In addition, it suffers from the inherent
limitations of any internal rate of return (see IRR). This is one of the
reasons why there exist other frameworks within which to compare
securities.
Yield Spread The difference in yield between comparable securities
or sectors generally expressed in the market in terms of the yield
premium or extra yield spread. The extra yield reflects what the
issuer must pay for borrowings over and above that of a U.S. Treasury
bond of similar maturity (deemed the risk free or default free
borrowing rate). As such, the risk or yield spread/premium of any
particular issuer may change over time in response to fundamental
changes in the issuers overall credit fundamentals (profitability,
balance sheet strength, competitive position in its industry, etc.) or
cyclical changes in the overall economy and capital markets.
Zero Coupon Bond A bond paying no coupons that sells at a
discount and provides payment of the principal only at maturity.

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