In December 2019, when you could still gather in a classroom sans mask, I was invited to give a lecture as the presenter for the Dean’s Executive and Research Seminar series at Cal State Bakersfield. I had a packed house and the presentation was well received (though I have on occasion cleared out bigger rooms than that). Little did we all know how much the world would change in just three short months.
The subject matter of the presentation was governance and wealth management, now more timely than ever with the impact of the pandemic on the economy and markets. Warren Buffet is fond of saying, “You don’t know who is wearing a bathing suit until the tide goes out.” With local foundations and endowments the tide went out starting this year in February with the reaction of securities markets worldwide to the COVID-19 pandemic, and the implosion of oil prices when the Russians and Saudis were unable to agree on production limits.
As fundraising for nonprofits has slammed to a halt, many organizations have been forced to rely on their accumulated reserves and endowments, shining a spotlight on how well they have managed the fiduciary responsibility to preserve the real value of the resources they have been entrusted with. Real value means the value after inflation, distributions to beneficiaries and the associated costs to manage the assets. UCLA for example uses a required return target of 5 percent plus CPI net of asset management costs. CSUB Foundation uses 5.25 percent plus CPI net of investment expenses pertaining to the endowment and reserves. CALPERS uses a 7 percent target, and it should be noted it recently terminated its chief investment officer after underperforming this return requirement for two years in a row.
One of the entertaining (sad, I know) activities I have engaged in as a result of having my work desktop at home has been the review of quite a few of the 990 tax returns required to be filed by local nonprofits, as well as their audited financial statements and investment policy statements. These documents are required to be furnished by the nonprofit upon request to whomever may wish to see them and are the minimum disclosure requirement for these organizations. Reviewing these documents can be a bit like solving a forensic accounting crossword puzzle. They always tell a story, and it can be one the organization is hoping you don’t look into too closely.
To those who do look, what you find can be surprising. Audited financial statements that do not disclose the attribution for changes in the value of assets, for example. Asset allocation structures that contain too many non traditional assets. Too much short term cash and cash equivalents and not enough traditional growth type holdings. Over weights in international equities or restrictions within the Investment Policy Statement handcuffing the actual asset manager by imposing limitations that should be delegated to the CIO or asset managers as they take into consideration economic and market conditions subject to a variety of changing factors. Persistent long term underperformance versus the relevant peer group under the guise of taking a “conservative” approach to asset allocation. This can be just an excuse for poor performance and an improperly specified risk profile.
A well-written investment policy statement is the first order of business when establishing a governance framework. This document provides the blueprint, so to speak, for the organization to stay on track toward accomplishing short and long term objectives established by the board of directors. Typically it will include a description of the organization and its objectives, current and future beneficiaries, the risk profile and annual return objective, strategic and tactical asset allocation guidelines, annual planned percentage distributions from any endowment, just to name a few of the important sections within an investment policy statement. It is important to note that foundations and other nonprofit organizations are typically perpetuities with no mortality, unlike a natural person. As such, the most serious risk to most nonprofits is the loss of purchasing power or real value over time due to systemic underperformance versus a properly specified benchmark and stated investment policy return objective.
Organizations with outdated or poorly designed investment policy statements that do not focus on the preservation of the real value of an endowment or asset pool after costs, inflation and distributions may lose ground that will be difficult to make up. This problem may have been exacerbated this year if the finance or investment committee did not have asset managers in place prior to February who understood how to reallocate assets in order to benefit from the historic rally we have seen in technology, health care and fixed income since the Powell “credit backstop” press conference of March 23.
Once objectives are established and the investment policy statement is in place, implementation of the policy is next. This typically involves evaluating and hiring one or more professional asset managers which the board then will have the responsibility to supervise. The CIO (small foundations will often hire an outsourced chief investment officer or OCIO) will typically recommend managers to the investment committee consistent with the asset allocation guidelines and, once hired, the board must monitor performance and risk adjusted return versus properly designed benchmarks. They must replace managers who after a suitable time period are not providing superior risk adjusted results relative to their peer group. A CIO or OCIO should have proper industry qualifications such as a CFA or CIMA designation and preferably be an expert in global macroeconomics and technical analysis.
On a related note, an organization must have separation of governance and fiduciary responsibility from the actual individuals or organizations managing the money. That means you or any closely related individual to you should not under any circumstances have a seat on a board of directors at the same time that you or any closely related individual provides discretionary investment management services to an organization. The fiduciary line between governance and implementation of policy should be respected at all times by the organization and by providers of professional services to the organization.
Communication with the public is another important principle. Public nonprofits taking in tax deductible contributions should have a website, and it is important for them to make timely, transparent disclosures of financial information to the public. Providing access to the 990, audited financial statements, performance reports, current revisions of the investment policy statement and conflict of interest disclosures satisfy minimum reporting transparency requirements for nonprofits. The public can gain access in this way to historic income and expense data, balance sheet info and how much is being paid out to current beneficiaries versus organizational expenses, how much money is received in contributions. They should in addition provide a synthesized report of performance for the last one, three and five years and since inception with peer group and benchmark comparisons. Using such a report, the interested community member can understand whether or not the organization has been successful in consistently performing in line with the stated performance objectives as stipulated by the investment policy statement.
If you serve on a nonprofit board, you should understand principles of governance regardless of whether or not you are on the finance or investment committee. Your obligation is to the current and future beneficiaries of the organization. If you agree to serve on the investment committee, you should understand how to construct and evaluate an investment policy statement and be aware of how important it is to have one in place. Consistency of risk adjusted return and proper diversification for the economic cycle is what matters and avoiding heavily concentrated exposure in individual issues. Whether or not someone may have made money on their own investments is not a qualification to serve on the investment committee. Prospective board members should know that reporting transparency is a fiduciary obligation and organizations must make timely disclosures of financial results to the public. If you are a member or contributor to a nonprofit organization that you care about, you should ask the executive director about how the organization communicates its results to the public. Ask about online disclosure and whether the website contains all of the documents necessary to review the financial performance of the organization.
Making sure that our nonprofits are governed properly is the responsibility of everyone in the community who may benefit from the services and/or facilities provided by the organization. We should all want to know what is being done with public money, making sure that there are no undisclosed conflicts of interest, and that board members are vetted for competence, not just whether or not they will write a big check to the organization.
Frank J. Colatruglio, CFA, CFP, has been an adjunct lecturer in finance at CSUB and is a member of the CFA Institute and the CFA Society of Los Angeles.