Seeds for the future

Nonprofits with endowments — funds where investment returns provide an ongoing source of income — are facing a volatile and complex future. Investment strategies are supposed to be a lot like gardening, you plant a radish and, like the song from stage show The Fantasticks, you get a radish.

But many nonprofits, along with the rest of the nation, embraced more exotic approaches to their investments and saw substantial losses. Because of the size of the financial crisis, even organizations with conservative investments saw declines and are seeking ways to improve returns and reduce risk.

According to a recent survey of nonprofit executives and investment committees by SEI Institutional Solutions, there is growing concern about risks in fund performance and maintaining regulatory compliance. The poll, completed in August, included educational institutions, private and community foundations, as well as arts and human service organizations. Some 15 percent of the executives polled were managing endowments less than $25 million, 54 percent were managing between $51 million and $300 million, while 5 percent had assets exceeding $1 billion.

The poll highlights several issues nonprofits should bear in mind in organizing their investment strategies. Foremost are concerns about complexity, particularly in investment vehicles, global economic outlook, and monitoring of investment managers. Based on the survey, interviews by The NonProfit Times, and related nonprofit resources, here are some suggestions on developing and managing an investment strategy.

One of the biggest areas of regulatory scrutiny of nonprofits today is directed at the board of directors. State attorneys general, the Internal Revenue Service (IRS), and other regulators want disclosure on what the board knows about the organization and how much direct control is exercised. Even without an endowment, every board should have an investment committee, even if it is part of the finance committee.

The primary responsibility of the investment committee is to set policy. According to Robert Vellutini, an investment officer with Wells Fargo Advisors in Merrillville, Ind., the committee should include "some investment or financial professionals. It’s also nice to have bankers, and people who have experience with handling investments for institutions."

James Alexander, a lawyer and consultant to Chicago-area foundations, suggested the word "diversity should include financial skills. Members should have the ability to read a balance sheet, to understand numbers. You can reach out to others who don’t want to be directors but who are committed to the mission and goals of the organization and are willing to volunteer."

Having non-board members on the investment committee is a common suggestion, both to provide immediate expertise and to create a pool of knowledgeable individuals who can fill future vacancies.

Retired banker Fred Sampias is the chairman of the investment committee for Calumet College of St. Joseph (CCSJ) in Whiting, Ind. The CCSJ committee has three trustees as members, including Sampias,

along with an outside investment manager who is also an alumnus (Vellutini).

Sampias said he likes the small size of the committee and that members are not employees of the college. "Committee meetings do have attendance from other stakeholders, including the president’s office, development and finance."

The primary responsibilities of the investment committee are to establish a written investment policy and oversee its implementation. According to the Nonprofits Assistance Fund Web site (www.nonprofitsassistancefund.org), a policy should include objectives, asset diversification, and investment criteria. The criteria example used is a humane society that would not buy stock in companies involved in animal testing. Sampias indicates the CCSJ policy is three to four pages and was developed from looking at policies at similar institutions. As is common with other organizations, the committee oversees the endowment and new monies generated by capital campaigns or other initiatives.

Asset diversification — the percentages of a portfolio divided among stocks, bonds or other investments as well as time frames — is the most important part of the policy. Diversity is also associated with risk, which can lead to superior gains as well as devastating losses. In the SEI poll, 70 percent of respondents said their organizations were using alternative investments, with 29 percent indicating the alternative made up more than 31 percent of the entire portfolio.

However, respondents managing funds with less than $300 million in assets said they are investing 15 percent or less in alternatives.

Wells Fargo’s Vellutini advises against getting too caught up in complex offerings. "You either lend your money or you take an ownership interest," he said. "There are more products possible, but the core investments are stocks, bonds, and fixed income. The industry tries to make things more complicated, but the fundamental tools have remained the same."

Alexander offered the same caution, particularly in balancing returns in relation to risk: "It’s called junk for a reason. High-quality issues sometimes don’t have the current return that lower-quality investments do. Fiduciary responsibilities should play an important role as a mitigating/moderating factor."

The Securities and Exchange Commission has an overview of asset diversification at www.sec.gov/investor/pubs/assetallocation.htm

The other side to making money through an investment strategy is spending it. Some 91 percent of the survey participants said their organizations had formal spending policies. Of those, 86 percent require annual spending of between 4 percent and 5 percent. The CCSJ policy calls for distribution of up to 5 percent of the fund. If investments perform better than the goal; the surplus is reinvested. If it doesn’t return 5 percent, "that’s where the Ôup-to’ comes into play," said Sampias.

Anticipating poor portfolio performance should be built into an investment policy. Alexander pointed out that certain types of organizations have suffered more from underperforming investments: "We can’t exclude the impact on arts organizations, where portfolios have dropped, but audiences still want performances and parents want programs in schools. We’ve always known that ticket sales don’t cover all of the costs."

While an investment policy can demand that principal be conserved, it can also allow it to be spent if the fund goes underwater. However, state laws can vary on expenditures of principal, sometimes called "historic dollar value," and it is prudent to make sure that such a policy is permitted.

The National Conference of Commissioners on Uniform State Laws (NCCUSL) in 2006 approved the Uniform Prudent Management of Institutional Funds Act (UPMIFA) and recommended it for enactment by the legislatures of the various states. The act covers both investing and spending policies. More information is available at www.upmifa.org

The Compliance Threat

Maintaining knowledge of and adherence to applicable state and federal regulations is another responsibility of the Investment Committee. "SOX (Sarbanes/Oxley legislation) was coming at the nonprofit world like the sword of Damocles," said Alexander. "There’s the ever-present monitoring from state attorneys general, looking for fraud and compliance with nonprofit mission."

In discussing new ways to make money for a nonprofit, he goes on to note "unrelated business activities will bring regulator scrutiny." Vellutini also noted civil actions can be a problem: "The thing that makes this riskier, the thing that has been happening more frequently, is lawsuits." For example, a group of donors may be unhappy that their gifts were not invested prudently.

Creating an investment policy that addresses asset allocation, spending, and compliance is one thing – overseeing its implementation is another. It is very rare for an Investment Committee to be involved in day-to-day operations. "You don’t want volunteers at the trading desk," said Alexander. "It’s hard to keep a volunteer board on task, and it can be easy to miss an opportunity. It’s hard to get out as easily as you got in. Volunteers have a much more difficult time. If you’re big enough you can hire the staff to do the day-to-day-to-day."

In or Out

The SEI survey identified three approaches to investment management: internal, consultant driven and outsourced.

With the internal model the organizations hires staff either to manage the portfolio directly or to engage and supervise fund managers. While allowing for a high degree of control and responsiveness, this approach is often not economically feasible for smaller endowments. Alexander cautioned: "There are some investment resources that require special expertise. You can’t evaluate global markets from one little desk in a little office." However, as the endowment gets larger the percentage paid to the internal investment advisor gets smaller. According to the SEI poll, 31 percent of respondents were managing portfolios internally.

For the purposes of the survey, the consultant approach involves using a consultant to identify prospective fund managers, but the final selection and monitoring remains with the nonprofit. According to this definition, 56 percent of respondents use the consultant approach.

In the outsourced model "the organization outsources all manager research, evaluation, selection, and monitoring decisions to an external fiduciary partner such as a Manager of Managers." With this definition 13 percent of survey participants were using an outsourced model.

According to Vellutini, "as soon as you decide not to put people on the payroll to make investment decisions, you’re outsourcing." For smaller endowments "there are index funds that provide good performance for not a lot of costs," advised Alexander. For larger portfolios the inside/outsource decision has to be decided by the Investment Committee. "You have to have honorable people doing good work. We’ve learned through the Madoff scandal that this doesn’t always happen. But there have also been well-intentioned people who got caught in the overall crash," said Alexander.

One advantage of the outsourced model is a more formal arm’s-length relationship between the institution and the fund managers. In considering options, Vellutini offered: "Some institutions manage their own portfolios to save money, but you also end up taking on a different fiduciary responsibility. An arm’s-length relationship with an outside manager subcontracts out to someone who does that for a living. There’s an implication that they know better what to do. Their responsibility is to make prudent investment based on the investment committee’s guidelines."

He added: "You have to stay away from meetings where people have a lot to offer in terms of institutional insights, but might not be qualified to make investment decisions, like buy GE instead of Eli Lilly. There’s always someone who thinks it’s easy to buy and sell stock, but it’s not if you want to do it well."

Trust, cost, and comfort level will all go into the decision on how to select the best investment management strategy. For new investment committees, the process of establishing an investment policy will help define the selection criteria. Creating an RFP and selection criteria will help sort through the offers and options.

The final responsibility of the investment committee is to evaluate the investment policy and the performance of investments and investment managers. There’s no set timetable for reviewing policy. It’s something that should be done as questions arise. Reviewing portfolio performance should be an annual undertaking.

Alexander suggested taking the long view on performance: Firing advisors over short-term performance probably isn’t a good decision. If they don’t produce against long-term benchmarks, and there should be benchmarks, then the relationships should be evaluated and maybe they should be shown the door."

The review should also help set expectations for the future. Vellutini said, "There were a lot of things that were possible to invest in during recent years that purported to measure the risks, but we found in the last few years that that all blew up. We had a real adjustment in our psyches since then. After you’ve been through this a few times and your gut tells you something is too good to be true, your gut is probably right." NPT