New investment policy yields happy returns.

How a balanced investment portfolio of stocks and bonds has positioned the Packaging Machinery Manufacturers Institute for future earnings growth.

A common trait of successful organizations is the ability to adapt to changes in their environment. In the early 1990s, falling interest rates caused a dramatic decrease in investment revenues for many associations. Those that continued with their conservative styles of investing experienced considerable financial setbacks.

Opting for a more "entrepreneurial" approach, the Packaging Machinery Manufacturers Institute (PMMI), Arlington, Virginia, decided in 1994 to step outside of its conservative comfort zone and change an investment policy that had served it well for decades. The result? An increase in investment revenues of 200 percent in only 12 months. The decision to risk change is still paying off today.

Exploring nontraditional investment opportunities

Until the early 1990s, PMMI was comfortable with a conservative investment policy, which was, in essence, laddering certificates of deposits (CDs) - in other words, spacing maturities evenly. With interest rate returns of 8-10 percent, PMMI did not see the need to pursue alternative methods of investing. PMMI's returns mirrored what investors could expect by investing in the stock market, without the added risks of investing in stocks.

However, as interest rates fell in the early 1990s, so did PMMI's investment revenues. From a high of $785,000 in 1990, investment revenues fell to $506,000 in 1993. Over time, this loss of revenue would total in the hundreds of thousands of dollars. With no Outlook for higher interest rates in sight, it became apparent that it was time to explore what to PMMI were nontraditional investment opportunities. Here's what happened.

Based on historical data, we determined that better returns could be achieved by investing a portion of PMMI's reserves in the stock market. Investing in the stock market is, in theory, only appropriate for investors that can commit funds for the long term. Fortunately, PMMI had $10 million in reserves, of which only $3 million at the most would ever have to be used to meet yearly expenses. This $7 million level made it possible for PMMI to support a commitment to long-term investing. Note: Each organization has to determine for itself what level of reserves is sufficient to allow this type of investing.

The first course of action was to revise PMMI's conservative investment policy that only permitted investing in fixed-income securities (certificates of deposit and bonds). We hired an investment adviser to help develop the new policy. The adviser would also help in selecting an investment manager and monitoring investment performance.

Staff first presented the new policy to PMMI's executive committee, which also served as the finance committee. Both the executive committee and, subsequently, the board struggled with the issue. Here's why. Historically, the board supported a conservative investment philosophy for PMMI. Yet, individually or through their own companies, board members admitted to a more aggressive approach with their money. So why wasn't it as easy to adopt a more aggressive approach for PMMI's investments?

In a down market, it is conceivable that PMMI's investments could decline in value. The prospect of standing in front of his or her peers and reporting the first negative investment return in the 60-year history of the organization was not a very pleasant thought to any board member. No one wanted to be the first to report an investment loss.

The board's concerns were further muddied by a stock market environment in early 1994 that investors predicted was due for a "correction" - in other words, a downturn. However, shown that across time a balanced investment portfolio (stocks and fixed income) would likely provide better returns than an exclusive, fixed-income portfolio, PMMI's board stepped out of its comfort zone. It decided to adopt the new investment policy, which provided a maximum portfolio allocation in stocks of 40 percent.

Seeking a good fit in a manager

PMMI selected a manager with a passive fixed-income investment style. In essence, such a manager "buys and holds" bonds to maturity. In a stable interest environment, this style reduces volatility of the overall portfolio by "locking in" the returns provided from the bond interest income. This was a conservative "hedge" to offset any (negative) fluctuations in the stock sector of the portfolio. Further, it gave PMMI a reliable base upon which to budget a portion of its investment income.

In addition, the investment policy set limits on the types of stocks that the investment manager could invest in. For example, the manager could not invest more than 20 percent of the stock portfolio in any one industry sector. This prevents a negative market swing in various sectors (e.g., technology, health care, oil, and so forth) from having a significant adverse effect on PMMI's portfolio. Further, the manager must invest in well-known, highly capitalized companies, with no more than 5 percent of the stocks invested in any one company. These parameters were designed to lessen the volatility of the stock portfolio (see sidebar, "Reserve Funds Investment Plan").

As mentioned, PMMI's manager has a passive "buy and hold" bond philosophy. Given a significant change in interest rates, the investment manager has discretion to either shorten or lengthen maturities. However, in general, the manager's philosophy is to hold the bonds to maturity.

There are certainly valid arguments against this type of passive fixed-income investing. The most obvious is that the manager is not adding value or investment expertise to this sector of the portfolio, but merely replicating the prior practice of laddering CDs. Why should PMMI pay for this? We had to weigh the merits of this argument further.

Staff reviewed the historical fixedincome returns of its manager with the universe of active fixed-income managers. We found that an active manager, on average, could add an additional 1 percent to the return of the fixed-income sector by adding value from active trading. With a fixedincome portfolio of more than $6 million, this would provide an additional $60,000 of revenues annually. However, this approach had drawbacks.

Transferring the fixed-income sector to an active bond manager would negate the discounted management fees that were negotiated with the current manager. This would reduce the additional 1 percent return from active trading. PMMI would also have the additional administrative tasks of maintaining a 40-60 balanced portfolio with separate managers. Finally, while most active bond managers produce greater returns in "up" markets, they often fall farther in "down" markets.

Taking all of these points into consideration, PMMI's board reaffirmed its commitment to passive fixed-income investing, concluding that the incremental returns (and added risk) from active management of the fixedincome sector were not sufficient reason to make a switch.

Communicating effectively

PMMI's new investment policy experienced some early growing pains. As feared, financial markets did not perform well in 1994. While the market value of PMMI's stock portfolio increased by $90,000, the bond portfolio experienced a market decline of more than $200,000 in 1994. There was concern that PMMI had made a mistake by adopting the new policy.

The policy specified quarterly reporting to the finance committee on the investment performance of the portfolio. This communication was key during the early phase of this new policy. After all, a $200,000 decline in the value of the bonds would be enough to unnerve anybody.

Investment performance was measured against standard industry benchmarks. While the manager's returns were not positive, they were, nonetheless, similar to the industry return. Further, staff reiterated that the market decline of the bond portfolio would eventually be recovered - once the bonds approached maturity. And, more importantly, this new policy was a long-term strategy; shortterm fluctuations in the value of the portfolio (both favorable and unfavorable) were going to occur. This dialogue helped lessen concern over short-term performance.

Staying the course

As a result, PMMI's leaders did not waver from the new investment philosophy. They were convinced that, in the long term, this new investment approach would prove to be the correct one. The result?

When PMMI adopted the new investment policy in 1994, investment revenues totaled $523,000. During 1995, financial markets recovered, and the institute reported total investment revenues of $1.555 million - an increase of nearly 200 percent over 1994. Seventy percent of the increase was attributable to stocks. The market surge continued in 1996, with investment revenues of $1.489 million. And, as predicted, the market value of the bonds has returned as the bonds near maturity.

Many financial experts had been predicting that the market could not continue the surge that it had experienced since early 1995. True to form, the stock market experienced considerable volatility during 1997. PMMI's investment returns suffered temporarily, as well.

However, PMMI did not feel compelled to make any dramatic changes to its investment policy. The institute had made a long-term commitment and was not interested in trying to guess when to get in or out of the market. History has shown this is almost impossible to predict. Thus far, this new policy had served the institute well. So, why panic?

Fortunately, by year end, the market stabilized. As a result, PMMI reported an additional $2.32 million of investment revenues during 1997 - an increase of more than 50 percent since 1996.

Establishing a short-term policy

While the crux of the new investment policy focused on long-term strategy, an investment policy for short-term investing was also necessary (see sidebar, "Short-Term Funds Investment Plan").

Investing in stocks would not be appropriate for the short term. Therefore, short-term funds are invested in fixed-income securities - primarily in CDs. Maturities are spaced out evenly so that funds will be available to meet monthly operating expenses; idle cash in the bank is swept into overnight investments. Both of these activities provide additional sources of investment income for PMMI.

Ensuring continuing education

Another important component of this process is an ongoing educational process with the board. Each year, staff meets with new board members as part of an overall orientation program. The institute's investment policy is reviewed in detail so that new board members gain an understanding of the policy and its long-term objectives.

Staff also maintains an ongoing review process of its investment policy with PMMI's finance committee. Since the inception of the new policy, staff and the board have addressed the following issues:

* Asset allocation - Given its comfort level with the new policy, the board voted to increase the stock allocation of the reserve portfolio to 50 percent. While past performance is no guarantee of future results, both the board and staff believe that this change will add value to the portfolio in the long term.

* Stock portfolio diversification - A limitation inherent with one manager is that you receive one style of stock selection. There are two primary styles of investing in stocks: growth and value. PMMI's manager was a growth-style manager.

Growth-style investing concentrates on stocks whose earnings rates are higher than those of the average company. Value investing focuses on stocks that are inexpensive in relation to their earnings or assets. Across short periods of time, one style is usually in favor over the other. Both styles fluctuate in and out of favor. However, during extended periods of time, the performance of both styles are similar. The risk of investing in only one style of stocks is that performance can suffer in the short term.

While PMMI was committed to the stock market for the long term, it was also interested in mitigating the effects of dramatic market swings across the short term. As a result, in late 1997, PMMI selected a second manager with a value style of stock investing. By combining opposing styles, PMMI was ensuring a smoother earnings path in the short term, one that would achieve the same returns of one management style across the long term.

* Diminishing cash flow - Since the inception of the new policy, a significant portion of PMMI's returns were coming from stock market appreciation and less was coming from fixed-income sources. Across time, PMMI had less cash available to meet operating expenses.

In addition, the board wanted to develop a process that allocated a portion of the reserve fund's growth to help support member programs. Merely allowing the portfolio to grow without any plan for its use was of no benefit to the membership. So PMMI adopted a spending policy that allocated a portion of the reserve fund's assets to fund member programs (see sidebar, "Reserve Fund Spending Policy").

Given its process of continual evaluation of investment strategies, PMMI believes that it is well-positioned to achieve future earnings growth. While the association's leadership understands that short-term fluctuations undoubtedly will occur from time to time, the leadership firmly believes that its strategy is appropriate for the long term.

Based on this experience, PMMI looks forward with continued optimism for many happy returns in the future.

RELATED ARTICLE: Operating Funds Investment Plan (September 14, 1996)

The purpose of the operating fund is to provide sufficient cash to meet the budgeted financial obligations of PMMI in a timely manner. The primary goal of investing operating fund assets is to ensure that working capital is invested as fully as possible in high-quality, liquid securities to maximize investment income.

Investment objectives

1. Preservation of principal 2. To provide liquidity 3. To maximize investment income within the constraints of 1 and 2

Investment guidelines

Acceptable investments shall include:

* Federal insured certificates of deposit

* Money market funds or their equivalent

* Commercial paper rated A-1 or better

* Repurchase agreements with underlying rating of A or better

* U.S. Treasury and agency debt instruments

Maturity: Investments in the operating fund will be limited to one year or less.

Performance measurement

Maximizing investment income is a secondary consideration to providing liquidity and maintaining safety of principal. Performance will be reported quarterly and compared to a short-term treasury bill index.

Management responsibility

Staff: The responsibility for short-term investment decisions will rest with the director of finance [who] will provide an investment status report to the finance committee once a quarter. Staff will review the investment policy at least annually and will present to the finance committee any recommended changes.

Finance committee: The committee will monitor investment decisions to ensure that they fulfill the investment objectives of this policy. The committee will also consider any proposed revisions to the investment policy and recommend any appropriate action to the board.

Board of directors: The board will establish and approve all investmerit policies for [PMMI].

RELATED ARTICLE: Short-Term Funds Investment Plan (September 14, 1996)

The short-term fund is for the investment of money expected to be held no longer than three years to provide funds to meet requirements from unbudgeted expenses and for capital expenditures.

Investment objectives

1. Preservation of principal 2. To provide liquidity 3. To maximize investment income within the constraints of 1 and 2.

Investment guidelines

Acceptable investments shall include:

* Federal insured certificates of deposit

* Money market funds or their equivalent

* Commercial paper rated A-1 or better

* Repurchase agreements with underlying rating of A or better

* U.S. Treasury and agency debt instruments

* Corporate debt rated A or better

* Mutual funds that meet the above-listed criteria

Maturity: The investments in the short-term fund shall be no longer than three years.

Performance measurement

The short-term fund will be evaluated quarterly. Returns will be compared to the Consumer Price Index and one-year Treasury notes. The primary goal of the short-term fund is to provide liquidity to the operating fired as needed. Accordingly, maximizing income is a secondary consideration.

(Editor's note: Management responsibilities for short-term investment decisions are the same as for the operating funds investment plan that appears on page 60).

RELATED ARTICLE: Reserve Funds Investment Plan (September 14, 1996)

The purpose of this investment plan is to set forth a clear understanding of the investment policy, guidelines, and objectives for the reserve funds of the Packaging Machinery Manufacturers Institute (PMMI). It also provides the association's investment manager with an understanding of the guidelines, limitations, and direction that the finance committee and board of directors feel are most appropriate for this plan.

The reserve fund of PMMI exists for general investment purposes. Preservation of capital is the primary investment goal for these funds with growth of capital as the secondary objective. It is anticipated that the time horizon available for investment of these funds is at least three to five years or an average market cycle. The board of directors is authorized to select an investment manager to provide services necessary for it to perform its obligations as set forth in the policy statement.

The investment manager, the designated agent of the board of directors, shall be guided by certain general investment guidelines and objectives that the board shall review from time to time.

Investment objectives

1. Preservation of capital 2. Long-term capital appreciation

Investment guidelines

Reserve funds: These funds are to be invested in a portfolio of highquality stocks and bonds as follows.

* Stock specifications. Equities may be chosen from the New York Stock Exchange, American Stock Exchange, and National Market System. No minimum market capitalization is required. However, securities should be invested in wellknown highly capitalized companies. No more than 5 percent of the portfolio (at cost) should be invested in any one security or more than 20 percent of the portfolio (at cost) in any one industry.

* Bond specifications. Fixed-income investments may include U.S. Government obligations and their agencies or corporate debt securities rated AA or better by Moody's or S&P. The weighted average maturity of the portfolio will be at the discretion of the manager but in keeping with a conservatively oriented portfolio. The fixed-income portfolio should be diversified with no investment in a single issuer to exceed 10 percent of the portfolio at cost, with the exception of U.S. Government bonds and its agencies. Municipal bonds and foreign bonds are prohibited.

Asset allocation: The specific asset allocation for this portfolio will be set up by the finance committee and board of directors. Allocation provisions will be reviewed on a regular basis and may be changed from time to time by the board of directors. The current desired allocation is 50 percent in stocks and 50 percent in bonds.

Within these guidelines, the investment manager has the authority to invest less than the maximum allocation in stocks depending on market conditions.

Monitoring of guidelines, objectives, and results: The investment manager's progress in meeting the objectives contained in the plan will be reviewed by the finance committee every six months and by the board of directors once a year. The investment manager will report holdings and performance to the finance committee on a quarterly basis.

Performance measurement:

Risk - It is not acceptable for the portfolio to decline in a value by more than 7.5 percent during any one quarter or consecutive quarters. In [the] event [this happens], the investment adviser will arrange a meeting with the investment manager to discuss what further action should be taken.

Return - There are two return objectives: One is to outperform the CPI (Consumer Price Index) over a full market cycle (which is defined as three to five years). The second objective is to equal a 5050 blend of S&P 500 and Lehman Brothers Govt/Corp Intermediate index, over a full market cycle.

Management responsibility:

Staff - The director of finance will provide an investment status report to the finance committee once a quarter. Staff will review the investment policy at least annually and will present to the finance committee any recommended changes.

Finance committee - The committee will monitor investment decisions to ensure that they fulfill the investment objectives of this policy. The finance committee will also consider any proposed revisions to the investment policy and recommend any appropriate action to the board.

Board of directors - The board will establish and approve all investment policies for [PMMI].

RELATED ARTICLE: Reserve Fund Spending Policy

PMMI's entry into the stock market has provided excellent returns from the market appreciation of the stocks in the portfolio. However, it has also created a challenge as PMMI no longer receives as much cash (from fixed-income investments) to pay for program expenses.

In addition, PMMI did not have a plan for how to spend the market appreciation of the stock portfolio. Members saw no value in building up a huge reserve if there was no plan to use the returns to help fund member programs.

Staff was charged with developing a spending policy for PMMI's reserve fund. The goal of this spending policy would be to define a percentage of the fund's return (from stock market appreciation) to be used to support program expenses. This income would be added to the fixed income from the bonds to determine the annual amount of investment earnings available to support operations.

This policy would serve a dual purpose. It would provide a fixed amount of revenue that PMMI could count on to meet program expenses. It would also demonstrate to the membership that the organization has a process to allocate the returns from the reserve fund to support member programs.

The only other component of the policy is that it needs to provide safeguards to ensure that inflation would not erode the purchasing power of the fund's assets. Without this, the value of the portfolio would diminish across time.

From a review of spending policies of foundations and endowments, staff proposed, and PMMI's board adopted, the following reserve fund spending policy. It was predicated on an average historical return on stocks of 10 percent.

* PMMI will budget 6 percent of the reserve fund's stock portfolio as operating revenue.

* If the stock portfolio returns are more than 6 percent, the next 4 percent of earnings will not be spent, but will be retained to maintain the purchasing power of the fund due to the effects of inflation.

* Stock earnings in excess of 10 percent will be used to offset future investment earnings shortfalls. In addition, the board, at its discretion, can allocate a portion or all of this amount to fund a subsequent year's operating deficit. This could be done in lieu of raising membership dues or exhibit rental fees to balance the budget.

RELATED ARTICLE: When to Update Your Policy

You know it's time to update your organization's investment policy when you experience change in your

* investment goals;

* risk tolerance; or

* time horizon (short term versus long term).

RELATED ARTICLE: Benchmarks for Evaluating Performance

In comparing portfolio performance to market indices, compare the portfolio to a benchmark that accurately reflects the composition of the portfolio. For example, a portfolio that is invested 50 percent in government bonds and 50 percent in large company stocks - similar to the portfolio of the Packaging Machinery Manufacturers Institute (PMMI) - needs to be compared to a benchmark that combines 50 percent of a government bond index and 50 percent of an appropriate stock index (e.g., S&P 500).

Benchmarks can be further customized to reflect greater portfolio diversification. For example, if the 50 percent stock portfolio is invested in both growth and value stocks, the benchmark could be 25 percent Russell Growth index and 25 percent Russell Value index.

Most importantly, don't automatically compare portfolio performance to "the market," as very few portfolios are invested 100 percent in stocks.

Another method PMMI also uses is to compare the performance of our investment manager with the performance of other investment managers who have a similar management style.

Investment management styles fluctuate periodically; when growth is in favor, value may be out of favor, and vice versa. Failing to equal a benchmark may be more attributable to the investment company's style being out of favor than to its performance. This type of analysis would help your organization reconcile whether your manager's performance is acceptable, particularly for those periods when the investment company may not be equaling the benchmark.

RELATED ARTICLE: Why Use an Investment Adviser?

Few associations have the expertise on staff necessary to manage a diversified investment policy that permits investing in the stock and bond markets. Therefore, selecting an investment adviser, who will help with the selection of an investment manager, is a critical element in the process of managing this function.

Why not just hire a money manager and avoid the additional costs of services provided by an investment adviser? Doesn't the money manager actually provide the services you require? Not necessarily. The following benefits sold the Package Machinery Manufacturers Institute on the need to use the services of an investment adviser to assist in the management of its investment portfolio:

* Assistance in charting the investment course - developing the investment policy statement, defining the investment goals and objectives, and planning investment strategy.

* Assistance in asset allocation - developing an allocation that matches the organization's risk profile and reviewing the investment structure, including an analysis of style.

* Evaluation and selection of investment managers.

* Monitoring and measurement of manager performance.

RELATED ARTICLE: Questions to Ask a Prospective Investment Manager

* What is your firm's investment philosophy, investment process, and style?

* What turnover of the firm's professionals have you experienced during the past five years?

* What are the qualifications of portfolio managers, specifically their education and work experience?

* What is the amount of assets under management as well as the amount of assets being managed under the strategy we are considering?

* Do you manage money for other professional organizations?

* What is your 10-year past performance history?

* Are your returns in compliance with standards of the Association for Investment Management and Research, Charlottesville, Virginia?

* Are your returns audited?

* What is your fee and do you provide a discount for nonprofit organizations?

* Do you have all appropriate federal and state registrations?

* Can you provide us with client references?

* Does your firm have fidelity insurance and bonding?

* Is your firm owned by employees (who have a vested interest in the outcome of their investment decisions)?

Craig S. Silverio is director of finance and administration for the Packaging Machinery, Manufacturers Institute, Arlington, Virginia. E-mail: [e-mail].