Foundation Series - 4 Asset Allocation (2006-05-29)

Foundation Series - 4 Asset Allocation

(2006-05-29) by David John Marotta

When it comes to predicting your investment returns, nothing influences returns more than your portfolio’s asset allocation mix. It will determine most of your investment outcome. Endowment funds are no exception to this rule. For board members and trustees, choosing an appropriate asset mix is part of fulfilling fiduciary responsibility.

Endowments have historically favored the cookie-cutter allocation of 60% in stocks, 30% in bonds and 10% in cash. However, before you begin tinkering with the asset mix for your endowment funds, three important parameters must be established.

First, determine the time horizon. How much time do you have before you must spend down the funds? Endowments often provide a unique answer to this question. In most cases, funds are designed to exist in perpetuity. With an unlimited time-horizon, there is sufficient time to recover from a downturn in the markets. Unlike your retirement account or your kids’ college savings funds, an endowment fund with a limitless time horizon can afford to take greater investment risks.

This brings us to the second task of gauging your risk tolerance. You are probably familiar with—perhaps even painfully so—the rollercoaster ups and down of the markets. Another word for these ups and downs is “volatility.” Each investment or investment portfolio carries with it a certain level of risk, or volatility. In the investing world, bigger risks are rewarded with higher potential returns. The question is how much whiplash can you endure in order capture a big return?

Returns are the last piece of the puzzle. Fiduciaries should focus on generating smooth, long-term investment returns. Your time horizon and risk tolerance will determine your probable rate of return. Once you have determined your expected return, you should actively seek to earn the highest possible return for the amount of risk you were willing to assume. In fact, it is part of your fiduciary duty.

Using the parameters of time horizon, risk tolerance and potential returns, you are now ready to set your asset allocation. David Swenson, the illustrious endowment manager of Yale’s $15 billion endowment, offers two rules for investing endowment funds: 1) keep an equity bias and 2) diversify.

When tailoring the portfolio, keeping an equity bias is an essential part of boosting returns. Historically, stocks outperform bonds, and bonds outperform cash over the long-term. According to Ibbotson’s market data from 1925-2002, one dollar invested in 1925 would have grown to $1,775 if invested in US stock, $60 if invested in the bond market, and $18 if invested in cash. But, in case you are tempted to put all your money in stock, the tech bubble should serve as ample warning—not to mention that day in 1929.

Diversification is essential for portfolios hoping to avoid the boom and bust of the markets. Diversifying your portfolio is nothing other than an investment strategy which employs your mom’s advice about not putting all your eggs in one basket. By spreading your money across different asset classes you can reduce volatility and increase returns. The key here is to invest in asset classes which don’t move in sync with each other.

We invest in six asset classes: US stocks, US bonds, foreign stocks, foreign bonds, hard assets, and cash. Spreading out investments over asset classes whose ups and downs do not move in sync both lowers the average volatility of the portfolio while increasing overall returns.

For instance, when picking US stocks, we recommend diversifying even among sub asset classes. Our philosophy is to overweight those investments where the average return is higher and the average risk is lower. We consider such decisions a win-win situation. For example, we overweight value because they have a lower volatility and provide better returns.

Endowment funds often lean too heavily on fixed income securities. We recommend investing just enough in bonds to provide the cash needed for withdrawals for 5-7 years. This allows cash to be kept at a minimum. It also allows the remainder of the portfolio to be put in equity investments knowing that their time horizon is long enough to invest for appreciation.

Endowment portfolios should also include investments in developed and emerging market securities. Although foreign markets are more volatile than US markets, they don't move in sync with US markets. Allocating your US to foreign stock investment ratio of 80%/20% decreases your portfolio's total volatility. At a 60%/40% US/Foreign allocation, a portfolio will be just as volatile as 100% US stocks but have a higher average rate of return.

Hard Assets such as REITS, oil, gold, and other precious metals provide additional diversification to a portfolio. When stocks are down, counter-cyclicals like hard assets can help buoy returns in sinking markets.

Increasing in popularity among endowment managers are "alternative investments." This asset class includes private equity, venture capital, hedge funds and other illiquid investments such as timberland and real estate. This asset class brings further diversification but at a price.

Alternative investments are illiquid and resource-intensive. Their value is often impossible to asses, even on a yearly basis. You may not know if you hold a winner or looser until the date of sale 20 years from now. No investment committee should pursue this class of investments unless it has qualified managers with a proven track record. Because of their expense and risk, alternative investments are suitable for large endowments only.

Although alternative investments may not be appropriate, you cannot fulfill your fiduciary duty by simply playing it safe with low-risk (and low return) securities. Failing to assume the requisite risks may actually be a breech of fiduciary duty. No individual asset class or security should be considered particularly 'in' or 'out' of favor. Instead, the suitability of each investment must be based on its overall 'fit' with the portfolio.

Once your target asset allocation is set, be sure to set parameters to guide your rebalancing strategy. A good rule of thumb is to rebalance when investments drift 5% above or below the target allocation.

Asset allocation decisions will determine the growth of an organization’s investment portfolio. But good returns alone do not guarantee that you are fulfilling your fiduciary duty. Fiduciary responsibility requires that you have an investment policy and follow your written guidelines regarding risk and return.

from http://www.emarotta.com/article.php?ID=180

Foundation Series - 3 Endowment Spending (2006-05-22)

Foundation Series - 3 Endowment Spending

(2006-05-22) by David John Marotta

Non-profits seeking to establish endowment spending rates may find the task as difficult as the fundraising itself. Setting spending policy remains a balancing act between protecting purchasing power and providing for the spending needs of the institution. Ultimately, the tightrope act becomes a question of inter-generational equity. In other words, "Do we sacrifice the needs of the current generation to that of future generations, or visa versa?"

Endowment spending rates can prove a catalyst for fulfilling or killing the life of the organization itself. Years with negligible or negative investment returns only magnify the importance of having a well-developed spending policy which can see the organization through thick and thin.

As part of their fiduciary duty, trustees and board members of non-profits must develop a spending formula consistent with the stated goals of the foundation or charity. Although private foundations are required to spend 5% of net investments, other non-profit organizations such as public charities and university endowments maintain greater flexibility in determining withdrawal rates. However, just what constitutes the ideal spending rate—usually in the neighborhood of 5%—remains a controversial issue.

Four factors determine an endowment’s total value: market returns, time horizon, asset allocation, and spending. Because the first two cannot be controlled, the importance of asset allocation and spending policies become all the more essential to maintaining and increasing endowment funds.

Endowment spending rates typically fall into one of the following five profiles.

Income-oriented – Spending policies based on income yields spend all or a predetermined percentage of the returns generated by the endowment each year. For budget planning purposes, this strategy is highly unpredictable, especially when net returns are negative.

Further, income-oriented spending policies encourage investment committees to overweight income-generating securities. Investing heavily in income-oriented securities may actually compromise the overall health of the endowment.

Market-value oriented – By far, the market-value approach is the most popular spending formula among non-profit institutions. In a market-value scenario, spending is based on a percentage of the total market-value of the assets. To help smooth the rate of withdrawal, spending is typically based on a three-year rolling average of the market value.

The market-value model has received criticism since the boom and bust of the tech bubble in the late '90s. Endowments which adopted this model, despite poor returns in the 2001-2003 window, were still spending at extraordinarily high rates due to the three-year rolling average. As a result, spending remained high even in years of negative returns.

Budget-oriented – Budget-oriented spending policies also known as "constant-growth" policies increase spending incrementally, usually at the rate of inflation. Popular among organizations which rely heavily on endowment funds to prop up operating budgets, budget-oriented policies provide a much needed measure of predictability.

Using this model, if last year’s endowment spending was set at $100,000, this year’s spending would be equal to last year’s spending, adjusted for inflation. If inflation is 2.5% then, this year’s spending would be $102,500. To guard against over- or under-spending, a "band" or "collar" may be added which sets minimum and maximum yearly withdrawal rates.

Hybrids – Increasing in popularity, investment management committees are turning to hybrid models which blend market-value with budget-oriented spending policies. Yale University employs this model, determining withdrawal rates based the fund’s market value and on a weighted average of last year’s spending adjusted for inflation.

Indeterminate - Some foundations adopt no spending discipline at all. Similar to a family without a monthly budget, there is no overarching plan year-to-year governing how funds are spent. Failing to articulate a spending discipline leads to eroding principal as funds are invariably overspent.

Developing a spending policy congruent with foundation principles plays a big role in whether an organization has the continuing resources to fulfill its mission. However, no amount of double-digit returns can ultimately answer the question of who deserves the benefits of the endowment more: present or future generations.

from http://www.emarotta.com/article.php?ID=179

Foundation Series – 2 Best Practices (2006-05-15)

Foundation Series – 2 Best Practices

(2006-05-15) by David John Marotta

Perhaps you have been asked to serve as a board member or trustee for a non-profit organization. Feeling honored is a natural response, but a terrible reason for saying 'yes' to the job. Your role as committee member, board member or trustee will likely designate you as a 'fiduciary,' a role with specific legal responsibilities.

The Center for Fiduciary Studies defines a fiduciary as anyone who has the legal responsibility for managing the property for the benefit of another, exercises discretionary authority or control over assets, and acts in a professional capacity of trust rendering comprehensive and continuous investment advice.

Although the lines around the term fiduciary are blurry to say the least, what remains clear is the fact that the term "fiduciary" encompasses a wide group of people and holds them to the highest ethical standards. In some cases, fiduciaries can be held personally liable for the negative repercussions precipitated by poor decisions. So, now that you know you are a fiduciary, how can you be sure you are fulfilling your duty?

Your primary duty as a fiduciary is to act in the best interest of the trust, foundation, or charity. Beyond that, your specific fiduciary obligations are dependent on a variety of factors. Determining the exact classification of your non-profit among your state’s taxonomy of public charities and private foundations is a good first step. There are, however, some responsibilities common to all fiduciaries.

While no simple checklist can fully spell-out the specific fiduciary duties for each non-profit organization, the following is a series of best practices any charitable organization or foundation would be well-advised to consider. Because much of the day-to-day asset management falls on the shoulders of the investment committee, the following list is targeted primarily to ensure they fulfill their fiduciary responsibilities.

Set Investment Committee Operating Procedures. At the heart of any non-profit organization should be an investment committee, a team of fiduciaries specifically tasked to oversee the foundation’s assets.

• Develop an Investment Committee Operating Policy which outlines member requirements, attendance, voting procedures, reporting, etc.
• Establish communication and reporting protocol between Investment Committee, third parties, and the Board.

Develop an Investment Policy. The Investment Policy Statement (IPS) should serve as the game plan which drives all your investment decisions. If necessary, contract with other "prudent experts" such as investment advisors and investment managers who can assist you in developing and implementing your investment policy.

• Contract with "prudent experts," such as investment advisor(s) and investment manager(s), if necessary.
• Write an Investment Policy Statement, including expected return, time horizon, risk tolerance, spending policy, and asset allocation strategy consistent with organization’s mission and with Internal Revenue Code requirements. Include benchmarks for evaluating performance of investment advisors and investment managers.
• Submit the IPS for Board approval.

Implement and document adherence to policies. Earning big investment returns year-to-year or eliminating risk does not necessarily mean you are fulfilling your fiduciary duty. The implementation of a prudent investment policy is as important as the investment policies themselves. In other words, it is not how many points you scored in the game, but whether you are successfully implementing the game plan. Carefully document your actions to provide an account of due process.

• Diversify assets to specific risk/return profile according to the IPS.
• Avoid self-dealing, conflicts of interest, and prohibited transactions.
• Keep detailed records documenting the establishment of process and adherence to policy guidelines. Your records should include copies of the IPS, meeting minutes, policy decisions, investment performance reports, investment applications/forms, contracts with third parties, ADVs or descriptive brochures of all investment advisors contracted with the foundation, and all other Investment Committee memoranda and communication. Keep copies of articles of incorporation, by-laws, and/or trust agreements.

Monitor and Review. Once the IPS is in place, the Investment Committee must remain actively involved. Even if a committee has contracted with "prudent experts," the Committee never delegates its fiduciary responsibility. Ongoing supervision and review is essential. The Committee should see that prudent investment practice is followed and should monitor both the investments and investment advisor(s).

• Monitor investment practice to ensure prudent investment practice guidelines are followed as stated in the IPS.
• Monitor the performance of investment advisor(s) and other "prudent experts."
• Receive and review quarterly investment reports from the investment advisor(s). Quarterly reports should be AIMR-compliant and include time-weighted returns.
• Control and account for investment expenses and contributions.
• Review IPS annually.

Promote transparency and accountability. The foundation should promote transparency among its members and comply with state reporting standards.

• Investment Committee reports to the Board, as directed.
• File IRS Form 990-PF or Form 990 annually.
• Be prepared for public inspection of key documents including: Application for tax exempt status (Form 1023) along with all other IRS communications and Form 990 or Form 990-PF. Provide copies upon request.

No list can fully spell-out the important fiduciary responsibilities of board members and trustees. For that reason, it is imperative to retain good council. Additional resources are available from the Council on Foundations and the Center for Fiduciary Studies.

from http://www.emarotta.com/article.php?ID=178

Outlook May 2006 (2006-05-08)

Outlook May 2006

(2006-05-08) by David John Marotta

Recently, I received a letter asking for advice on whether an investor should sell a particular bond fund and reinvest the money in an appreciating stock fund. Questions like that are unanswerable without comprehensive financial planning, but I suspect the answer should be to keep the bond fund.

Over the past year, rising interest rates have caused bond prices to fall. As a result, bonds have slight capital losses. Since they have paid more interest than these losses, they have still made a profit. Although we have avoided a bond bear market, bond returns have been poor.

But as bond prices have dropped, their effective yield for new investment has risen. Bond prices are now the highest they have been in 4 years. Yield on the 10-year bond reached 5.12%, the highest since June 2002. Even the money market, which many need to be reminded is an asset class itself, is paying better rates of return at 4.6%.

The Federal Reserve has raised interest rates 0.25% for 15 straight meetings, bringing rates back to 4.75% after hitting a low of 1% in the spring of 2004. But recently, Fed members have indicated that rate hikes are near the end.

In recent months, rising interest rates have caused the housing market to slow. So far, the housing market deflation has been little more than a sigh of relief that markets are returning to normal. With more houses on the market and more houses staying on the market for longer periods of time, buyers have found some relief but are only now beginning to see the impact on sales prices.

Inflation continues to be a practical concern, but the methods used to measure core inflation have avoided those elements with the greatest price increases such as energy, healthcare, and college expenses.

The high cost of energy is not a political issue, it is an economic issue. Oil scarcity isn’t an Exxon-Mobil conspiracy to gouge the American people. It is a market reaction to the cause and effect action of supply and demand. Supply is diminishing and demand is surging. Higher oil prices will do more to conserve energy and develop alternative energy sources than all the political hand wringing in Washington D.C.

The high cost of energy has boosted the returns of hard asset stocks. Designating a portion of your asset allocation to hard asset stocks is important. In the right allocation, hard asset stocks help balance your bond portfolio and provide a smoother ride while invested in the markets. As bond prices have dropped, the rise in hard asset stocks helps balance your overall portfolio returns.

There may be a time when hard asset stocks will fail to do well. That will be the time that bonds are doing well again, and keeping the proper balance between these two investments will continue to provide better smoother returns.

Economic conditions are solid. Durable goods orders have been strong. The companies in the S&P 500 are posting their 11th straight quarter of double-digit earnings growth. Much of this positive economic news has been factored into the market with US stocks having a higher than normal P/E ratios. The short-term danger for US stocks is that economic reports won’t be as rosy as has been expected.

For this reason, we continue to believe that diversification into foreign stocks remains critical. On average, assigning the right asset allocation to foreign stocks decreases a portfolio’s volatility and increases its return.

I advised the reader who was considering switching funds that the bond fund they were currently invested in was a good fund. It was well-managed, kept expenses low, and produced a good return for the category of US bonds. If they switched, they risked moving out of the category of US bonds at exactly the wrong time.

In comprehensive financial planning, your asset allocation should be tailored to fit your financial goals and cash flow. Then, while monitoring your portfolio, rebalancing means selling what has done well and buying what has done poorly, not visa versa. This contrarian approach will save your portfolio from significant mistakes.

from http://www.emarotta.com/article.php?ID=177

Foundation Series – 1 Fulfilling Your Fiduciary Duty (2006-05-01)

Foundation Series – 1 Fulfilling Your Fiduciary Duty

(2006-05-01) by David John Marotta

If you serve as a trustee, committee or board member for a non-profit organization, you may bear more responsibility than you bargained for. Legally, you could be defined as a 'fiduciary' and held to the highest legal and ethical standards for the property entrusted to your care. In fact, you could be held personally liable for your decisions.

Chances are, the term rings a bell, but bears little real meaning. If so, you’re not alone. The Center for Fiduciary Studies estimates more than 5 million people serve in a fiduciary role and account for the management of more than 80% of the investable assets in the United States. Despite the fact that millions serve in a fiduciary role, many are wholly unaware of their legal responsibilities.

So, who qualifies as a fiduciary? And, how can you be sure you’re keeping up your end of the bargain? Ask any professional to define 'fiduciary' and they’ll tell you there is no clear-cut industry standard.

The Center for Fiduciary Studies defines a fiduciary as anyone who has the legal responsibility for managing the property for the benefit of another, exercises discretionary authority or control over assets, and acts in a professional capacity of trust rendering comprehensive and continuous investment advice.

Using this definition, the term becomes surprisingly inclusive. Investment advisors as well as members of trusts, endowments, charities, foundations and retirement plan investment committees may qualify as fiduciaries.

Amongst the confusion, three pieces of legislation guide the definition of who qualifies as a fiduciary and just what is required of such persons.

The Employee Retirement Income Security Act of 1974 (ERISA) set out to stop the corporate pension plans from defaulting. ERISA significantly raised the responsibility of investment committee members for 401k plans and other qualified retirement plans by holding committee members personally liable for losses to the funds due to negligent investment practice.

Under ERISA, plan fiduciaries are charged to act solely in the interest of the plan participants. Employee benefit plan managers cannot discharge their fiduciary duty by simply enlisting the services of a third-party administrator, but the advisor must act as a "prudent expert." Further, investment committee members of employee pensions plans are required to periodically monitor the service provider’s proper performance and prudent handling of investments.

The Uniform Management of Public Retirement Systems Act of 1994 (UMPERSA) granted similar protections to public employee plan participants. UMPERSA describes the trustee as "the highest fiduciary, [who] carries the greatest burdens of care, loyalty, and utmost good faith for the beneficiaries to whom he or she is responsible."

For trustees of private foundations and endowments, the Uniform Prudent Investors Act of 1994 (UPIA) goes on to spell out specific investment practices for fiduciaries.

UPIA requires investment committee members to diversify investments across the asset classes and achieve a payout which corresponds to assumed risk. Further, fiduciaries are required to evaluate the appropriateness of each individual investment based on its overall impact on the portfolio as a whole. As such, no investments are off the table. But, the fiduciaries must determine the suitability of each investment based on its overall impact on the portfolio.

When it comes to managing the property of another, fiduciaries are responsible for more than investment returns. While investment returns are one measure of performance, it is the investment policy driving those gains (or losses) which determine whether you have fulfilled your fiduciary responsibility. In other words, it’s not how many points you scored in the game, but how well you executed your game plan.

Establishing the game plan and executing the play are the keys to fulfilling fiduciary responsibility. Drawing on ERISA, UMPERSA, and UPIA legislation, the Center for Fiduciary Studies has outlined a series of 'best practice' standards for all fiduciaries, known as the "Uniform Fiduciary Standards of Care." To be sure you are fulfilling your fiduciary duty, you should:

1. Know standards, laws and trust provisions.
2. Diversify assets to specific risk/return profile.
3. Prepare investment policy statement.
4. Use "prudent experts" and document due diligence.
5. Control and account for investment expenses.
6. Monitor the activities of "prudent experts."
7. Avoid conflicts of interest and prohibited transactions.

If you have sought the help of outside investment advisors and administrators, it is important to note that both parties shoulder a fiduciary duty. The third-party investment advisor assumes the responsibility for the investment decisions; however, it’s still the committee’s duty to monitor the practice and performance of such managers. In addition to ongoing performance evaluation, some suggest third party investment advisors contracts re-bid every three years.

When selecting a third-party investment advisor, be sure to exercise a process of due diligence. Consider the performance of the advisor, track record, total expenses, assets under management, and performance reporting standards of the advisor. In addition to those standards, we recommend that all investment advisors report time-weighted portfolio performance compliant with the Association for Investment Management and Research (AIMR) standards.

More information on fiduciary roles and prudent investment practices can be obtained from The Center for Fiduciary Studies at www.fi360.com.

from http://www.emarotta.com/article.php?ID=176