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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

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

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 fixed-income 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 fixed-income 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 fixed-income sector were not sufficient reason to make a switch.

Communicating effectively

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; short-term 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

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

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

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.

Craig S. Silverio is director of finance and administration for the Packaging Machinery Manufacturers Institute, Arlington, Virginia. E-mail: craig@pmmi.org.

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