Fund Management

Successful foundations create and implement written investment policy statements to guide the effective management of their foundation’s assets. The investment policy statement incorporates a foundation’s:

  • Goals and objectives
  • Spending plan
  • Desired rate of return
  • Tolerance for risk
  • Time horizon

A written investment policy statement is the set of rules the investment manager uses when overseeing the foundation portfolio. It also enables the foundation board to maintain a disciplined investment approach, even during difficult market environments.

Asset Classes
An effective investment policy helps the investment manager determine which types of securities are suitable for the foundation and further helps the manager determine how those assets should be allocated across the three broadest categories of investment vehicles: 1) cash and cash equivalents, 2) fixed income, and 3) equities. Each of these asset classes has unique characteristics that, allocated in the correct proportions, will balance the often-competing needs of higher investment return and risk reduction.

Each asset class provides a different degree of risk and expected return. Risk is defined as the volatility of returns or the degree of fluctuations in market value. Cash equivalents include money market mutual funds, savings accounts and securities maturing within 90 days. Cash equivalents typically provide lower expected returns, but they also provide liquidity, current income, and stable market values.  Cash equivalents are considered the least risky of the asset classes since market value fluctuation is minimal. There is, however, significant risk that cash equivalents will not be able to keep pace with inflation over time.

Fixed income securities such as U.S. Treasury bonds, corporate bonds and mortgage-backed securities typically provide higher expected returns than cash equivalents, but also bear a higher degree of risk.  Fixed income securities have the ability to outpace inflation, providing a steady increase in purchasing power over time. The value of fixed income securities changes as interest rates change.  The value of corporate bonds also changes when the credit quality of the underlying corporation changes. As a result, fixed income securities tend to have more fluctuation in market value than cash equivalents.

Equities, often referred to as common stocks, are more volatile investment instruments.  In recent years, equities have risen and fallen frequently. The fluctuations in stock prices are caused by a number of factors including the health of the economy, the prospects for a company’s future profitability and overall demand for stocks by investors. While price fluctuation can be worrisome, equities tend to outperform both cash equivalents and fixed income securities over long time horizons.

Combining Asset Classes
Determining the appropriate mix of asset classes may seem daunting. The foundation’s investment policy provides guidance for this task, because it outlines the desired rate of return and risk tolerance level of the foundation. In addition, the spending plan and the time horizon of the foundation are key factors in selecting the right mix of asset classes. The desired rate of return, risk tolerance, spending plan and time horizon must all be taken into consideration to determine the asset allocation that is most likely to achieve the foundation’s goals and objectives. For example, a high risk-tolerance and a two-year time horizon could put the portfolio in a catastrophic position if it were invested 100 percent in equities. Stock values can fluctuate widely over a two-year time period. Generally speaking, for short-term investment horizons, a portfolio should be invested primarily in fixed-term securities and cash equivalents to avoid significant loss of principal. Over longer time horizons, a higher allocation to equities may be appropriate.

A study done by Ibbotson Associates has shown that a portfolio invested in 75 percent fixed income and 25 percent equities provides a greater expected return and lower risk than a portfolio invested in 100 percent fixed income. How is this possible? Because these asset classes are not highly correlated.

Correlation is the statistical measure of how the returns of two asset classes move relative to each other. When two asset classes move up in value during the same time period or down in value over the same time period, they have a high positive correlation. Conversely, when each moves in opposite directions over the same time period, they have a high negative correlation. Investment managers seek to utilize asset classes that have low or negative correlation in order to reduce fluctuations in value.

To be successful, a foundation must abide by the directives of its investment policy and periodically review investment results with the investment manager. Periodic review provides an opportunity for the foundation board to 1) better understand the investment manager’s approach, 2) ensure that the investment manager is in compliance with the investment policy statement, and 3) review the foundation’s circumstances. For example, a benefactor may make an enormous contribution that significantly increases the overall size of the foundation. That would likely change the foundation’s risk tolerance, requiring an investment policy statement amendment and asset allocation changes.

For more information, contact Paul Kruse at pkruse@bankerstrust.com.