Developing an Asset Allocation Strategy

As needs in their communities continue to grow, community foundations recognize the importance of making the right investment decisions. That’s because good investments help attract donors, preserve the long-term purchasing power of assets, and increase the amount of money available for grantmaking.

Unless you are a chief investment officer or have a degree in finance, the complexities of investments, spending policies, and asset allocation can be overwhelming. However, as a staff or board member of a community foundation, you have a responsibility to be a steward of the organization’s assets. This responsibility doesn’t mean that you actively manage the foundation’s assets, but you do oversee the investment management process.

The National Standards for U.S. Community Foundations™ stipulates that community foundations have investment policies that include asset allocation guidelines, a spending policy, and criteria for measuring investment performance. In addition, all community foundations in compliance with the National Standards must make available to the public upon request the names of its investment managers, fees charged (including investment and administrative fees), and a list of the governing body or appointees responsible for investment oversight and investment.

Most experts consider asset allocation the most important factor in determining long-term investment returns. Therefore, community foundations must view asset allocation with a return objective in mind, while also realizing that they are investing for the long term—which will mean periodic ups and downs in the market. The key for community foundations is finding a balance between risk (the measurable possibility of losing or not gaining asset value) and the long-term need to increase the value of the assets. Many community foundations also consider socially responsible investing—the practice of aligning a foundation’s investment policies with its mission. Their investment strategies may include making program related investments (PRIs) and refraining from investing in corporations with products or policies inconsistent with the foundation’s values.

Ask Yourself

When considering asset allocation, consider the following:

• How can we support our spending policy and maintain our assets?
• How can we strike a balance between our tolerance for short-term volatility and the long-term need to preserve the real value of our assets?
• Do members of the investment committee have the relevant experience to oversee how the foundation’s assets are managed? Are they fully engaged in the foundation’s mission and grantmaking?
• What is the appropriate amount of risk we can tolerate?
• Under what circumstances should we consider rebalancing our portfolio? What corrective action should we take when market trends cause our allocations to veer beyond the targeted ranges?

Investment Basics

If you are new to institutional investing, it will help to gain a basic understanding of asset classes and other investment tasks. Please note: The information below offers a primer on ways to think about your foundation’s investment objectives and strategies—it is not a comprehensive examination. Always consult a skilled investment professional before making investment decisions.

Develop an overall asset allocation strategy

Asset allocation is the practice of spreading risk across a range of investment classes and management styles in order to balance the effect of any single aspect of the market. In simple terms, asset allocation is a prime determinant of how your portfolio performs. It is your board’s single most important investment strategy decision, because it ultimately affects your foundation’s ability to maintain the purchasing power of its assets over long periods of time.

Most community foundation portfolios contain a mix of stocks (equities), bonds (fixed income), mutual funds, alternative investments (hedge funds or private equity), real estate, and various cash equivalents.

To develop an asset allocation strategy as part of your overall investment strategy, your board and/or investment committee must oversee the following tasks:

1. Calculate a return requirement: A return requirement is the rate of return on the investment your foundation needs in order to maintain the value of its endowment and meet its spending goals.
   
   To calculate your return requirement, add the following: 1) the annual percentage of assets your foundation will spend to cover grants, 2) the expected rate of inflation over the investment time period, and 3) the estimated investment-related fees and expenses, as well as administrative and organizational costs. For example:

1. Consider risk tolerance and time horizon: A number of factors affect how your foundation will allocate its assets. For example, how much risk or market volatility is the board willing to accept?
   
   You will need to define your risk tolerance—stating what is (and what is not) acceptable regarding the likelihood and frequency of returns falling below what is expected. Riskier asset classes may have a greater potential payoff, but a higher likelihood of returns not meeting expectations. Community foundations can manage volatility by diversifying their portfolios and investing to meet return objectives rather than to maximize returns.
   
   You will also need to determine your time horizon (the amount of time over which you will invest). Because community foundations are in the business of perpetuity, almost all invest for the long term and diversify across many asset classes to minimize their exposure to risk and balance out the effects of the market.
   
   Some community foundations have significant cash flow requirements, and bonds may be used to provide a steady stream of income over time. These foundations might also add bonds to the mix of other asset classes to help temper volatility in the market. Other community foundations might find that bonds are a less prudent strategy, as these instruments can require a longer waiting period to see maximum payoff (10 to 30 years). Keep in mind that bonds may be traded in the open market just like stocks and other liquid investments.
2. Develop a strategy and written investment and spending policies: Your foundation’s investment and spending strategies and policies will help guide the board, the investment committee, and investment consultants and managers who monitor your foundation’s portfolio. National Standards for U.S. Community Foundations stipulates that these policies should include the following components:
   • description of asset allocation parameters— parameters for different types of assets, such as equities, cash, bonds, etc.
   • measures used to evaluate investment performance
   • guidelines for diversification—parameters regarding the percentage of the investment portfolio that can be invested in a particular company, issuer of bonds, etc.
   • guidelines to prevent violation of the excess business holding rules for assets held in donor advised funds
   • spending policy

In addition, National Standards requires that community foundations have policies in place regarding who reviews investment performance and investment managers, the frequency and regularity of the reviews, and evidence of the most recent reviews.

For the latest trends in asset allocation, review the most recent edition of Investment Performance and Practices of Community Foundations.

Frequently Asked Questions

Who makes asset allocation decisions?

The board’s fiduciary role is to oversee investments; however, its members may delegate certain functions to investment/finance staff or an investment committee. Because the board has ultimate oversight responsibility, it is important that its members consider investments in a larger context.

Most community foundations delegate asset management to an external professional or firm or a series of managers, who then monitor investment performance and adhere to the foundation’s directives. Be sure that someone from your community foundation (staff member, board member, or investment committee) monitors asset allocations at least once annually—ideally, quarterly.

Investing for the Long Term

“Having the luxury of being a long-term investor by definition is a community foundation’s greatest single advantage in terms of investment strategy. It means that we can virtually ignore all but the most macro consideration (i.e., asset allocation) in our investment approach. And, as any advisor worth their PowerPoint presentations will tell you, that is by far the single greatest determinant of long-term investment success.”

– Triangle Community Foundation

Should we reduce our percentage of stocks when there is volatility in the market?

The unanimous response to this question is “No.” Because community foundations are in the business of perpetuity, they must invest for the long term. It’s extremely important for long-term investors to invest for both good and bad markets. Once you adopt a strategic allocation policy for your endowment pool, you shouldn’t change it in response to short-term market jitters. This goes against setting an asset allocation policy and sticking with it, which is what most investment managers advise. Here’s what your colleagues said:

• “The surest way to defeat volatility is to invest for the long term. Once you start trying to ‘time the market’ by throttling back, you’re bound to go wrong. After all, how will you know when to add the percentage of stocks back...after the S&P goes up 25 percent? Volatility cuts both ways...”
• “It may be tempting to reduce stock exposure during a time of volatility, but that would be a knee-jerk reaction and not prudent investing.”
• “The only reason for reducing the equity portion of your portfolio is if you are already overweighted in stocks compared to your asset allocation target.”

There may be times, though, when you may be concerned about public perception. Instead of making abrupt changes to your asset allocation, a less reactive approach may be to build in target and acceptable ranges for each strategic allocation in your portfolio.

What are the pros and cons of alternative investments?

Alternative investments, such as hedge funds, private equity, real estate, and commodities, can carry higher risks (although some investment managers may disagree) and are less liquid (more difficult to convert to cash) than some other investment classes. More and more foundations are diversifying some of their investments into alternative investments, finding that they offer greater flexibility when seeking returns in excess of the spending requirement. In 2005, community foundations allocated 11.2 percent of their total asset mix to alternative investments—the highest number ever reported in the Council’s Investment Performance and Practices survey. Of all alternatives, hedge funds are the most common. Here are some examples of how your colleagues are investing in alternatives:

• “We are at $700 million, and have a 15 percent allocation to alternatives.”
• “We are at $60 million, and invest 10 percent of our assets in a ‘fund of funds’ hedge fund.”
• “We decided to have 20 percent of our investment pool allocated to hedge funds. The remaining allocation will be 20 percent fixed income, 25 percent large cap, 20 percent small cap, and 15 percent international equity. Our investment pool is $35 million and our asset size is $45 million.”

The benefit of alternative investments is that their performance is independent of other stocks or bonds. Still, there are many considerations to make before investing in alternatives, such as liquidity, timing, and reporting.

Another consideration: Some community foundations note that it can take investment managers who focus on alternative investments up to six weeks longer to produce statements. To deal with the bookkeeping issue, most use preliminary estimates to calculate their books and prepare their donor statements. As one colleague said, “We don’t hold our books open at the end of the month or quarter to wait for these values. We realize we are usually on a month lag as to the alternative investments we hold. The only time that it’s a problem is at the year’s end, but our auditors check to make sure we are not materially off from the actual year end values.” In addition, the new auditing standards for alternative investments should be considered before investing in this asset class, as they can be quite onerous.

Alternative investments generally carry higher investment fee rates than other asset classes. What’s more, because fees for alternative investments are generally the same for all portfolio sizes, larger foundations do not have a fee advantage.

Are index funds a good choice for small community foundations?

Index funds are passively managed mutual funds that seek to track the performance of a benchmark market index such as the S&P 500 or the Russell 3000. With a management fee typically no higher than half a percent, the limited expense and low maintenance of index funds makes them an attractive alternative for small community foundations.

Index funds simplify investing. When you buy shares in an index fund rather than purchasing individual stocks or buying shares in a mutual fund, you don’t have to do much research. With index funds, you elect to participate in the gains earned by all the companies whose shares are in the index, rather than selecting individual stocks. For this reason, index investing has been called a “no muss, no fuss” approach.

Because the risk is low, some believe the returns can be lower as well. Yet index investors will tell you that they earn solid returns over a long period of time—without having to take on the emotional pains that come with high risk. Here’s what your colleagues said:

• “Index funds are a good way for a small foundation to go. We avoid the costs of paying someone to oversee the investments and pay money managers too. It’s easy to pay these folks when the market is riding high and gains are good. But those same fees become burdensome in down markets.”
• “Our investment committee debated the issue of managed investments versus passive investments. They decided that the cost of managed investments and the potential negative public relations when a managed fund does not meet the market indices was not worth it. We have our assets allocated 60 percent stocks and 40 percent fixed income, and use index funds for the investments.”

How do investment fees work?

As a part of managing their assets, community foundations must pay fees on their investments. These fees pay the funds’ investment manager or managers. The fee rate a community foundation pays is generally a function of two factors: the size of the portfolio (in many, but not all cases, fee rates are lower for larger portfolios) and the level of diversification used by a community foundation. Allocations to alternative investments and international and small capitalization equities generally carry higher costs than large cap stocks and bonds.