- Written by Dugan Lopatka
How can you turn your nonprofit’s investment process into a profitable outcome? Building an investment portfolio is the same regardless of whether your organization is a large or small nonprofit, trade association or professional group, or whether your reserves total $10,000 or $10 million.
Identify Investment Pools
Creating an investment portfolio begins by identifying and defining the purpose of different funds, referred to as investment pools. Nonprofit organizations often maintain one pool of reserves. They lump operating funds with reserve funds, and group short-term restricted funds with long-term designated funds.
First, understand these concepts, then work with your staff to identify your nonprofit’s different investment pools and their purposes, time horizons and any restrictions that may apply. At this stage, you’ll need to consult various legal and accounting documents, such as your organization’s bylaws, donor documents and cash flow models.
After you have identified the separate investment pools, establish written investment policies and guidelines for each pool. Keep in mind that funds required to pay short-term expenses should not be invested in the same way as funds earmarked for long-term needs, such as an endowment or a building purchase.
For further clarification, use this guide to structure your short- and long-term pools.
Policy for Short-Term Pools
- Short-term funds (short-term reserves) are operating funds used to pay bills.
- Investment objectives include safety, liquidity and yield.
- Lucrative short-term investments are money market funds, Treasury bills, certificates of deposits and short-term, high quality bonds.
Policy for Long-Term Pools
- Long-term funds include endowments, contingency reserves and allocations for replacing buildings.
- Investment objectives are generally growth and capital preservation.
- Lucrative investments are the same as a short-term pool’s investment, with the addition of high quality equities (domestic and foreign) and long-term corporate bonds.
- Bonds may be laddered to provide a constant stream of interest income and maturities. Such a procedure reduces risk and levels interest income.
Allocate Assets Appropriately
In addition to identifying each pool’s specific return objectives and permissible investments, your investment committee should address each asset class’s minimum and maximum allocations.
For example, the investment committee may decide that equities should represent no less than 30% and no more than 60% of the total portfolio’s market value.
These asset allocation guidelines are critical when determining a portfolio’s potential risks and returns. Studies show that asset allocation decisions account for more than 90% of a portfolio’s total return. This exceeds by far the importance of selecting individual securities. At this stage, your organization may benefit from working with an investment consultant who has asset allocation software. Such software helps forecast expected rates of return and potential levels of risk in portfolios with differing asset mixes.
Diversification Is Key
Investment committees and board members who initially recoiled at the idea of having stocks in their nonprofits’ portfolios often view things differently once they understand the benefits: A long-term portfolio with a small percentage invested in common stocks is projected to produce a positive return across a five-year period — with less risk than a portfolio consisting totally of fixed-income investments.
And, by changing the portfolios’ asset mixes, investment committees and board members may further reduce their portfolios’ risk while increasing potential returns.
Diversification is the key to reducing overall portfolio market volatility. It involves assembling a portfolio of different assets whose price movements generally don’t follow each other.
For example, intermediate maturity bonds and mortgage-backed securities do little to diversify a portfolio because their price movements are closely related to changes in interest rates. On the other hand, intermediate maturity bonds have a low correlation with the price movements of common stock. Blending these two asset classes can reduce the amount of market price fluctuation in the portfolio.
This sophisticated asset allocation method is the basis for managing multibillion-dollar pension funds. But it doesn’t have be complex. Forecasting tools are making it easier for staff and volunteer leadership to understand the potential best- and worst-case scenarios for different portfolios. The technology available today is particularly useful for longer-term funds.
With the assistance of an investment consultant, your staff and board volunteers can develop written investment policies that are appropriate for your organization. After implementing the policies, the consultant can also help your nonprofit identify and hire third-party investment managers as well as help monitor the investments’ progress and each manager’s performance.
Clearly, investing won’t be successful unless you make it an ongoing process.
For further information on the investment process or for assistance in developing an appropriate investment policy, call our nonprofit CPAs. We would be glad to help you maximize the value of your nonprofit’s investments.
The CPA Compass
When it comes to taxes, being self-employed has some advantages. Whether you work for yourself...
You probably know that you can exclude up to $250,000 of gain ($500,000 for most...
Is your child taking a job this summer? If so, you both may have questions...