Investment Policy for Auxiliary Organizations

A well-written investment policy defines and explains the financial and investment goals the chosen investment strategy is expected to accomplish. Return objectives must be specific and measurable so they can be evaluated as to whether the portfolio is meeting its investment goals. Specific return objectives, along with the institution's spending-rate policy, are often included as an appendix to the main investment policy.

Investment objectives, which target endowment returns relative to those achieved by financial markets or peers, also must be weighed and defined. Examples are:

• "The primary investment objective of the endowment is to attain a total return matching or exceeding the portfolio's composite benchmark." (This benchmark should be explicitly defined in the written policy.)
• "The secondary investment objective is to earn a total return matching or exceeding the college's peer group." (The appropriate peer group should be defined in the policy.)

The peer benchmark comparison is important since each institution relies on its endowment earnings to support operating costs and scholarships. Lagging investment performance compared to peers weakens an institution's competitive position.

1. Does your policy have specific, measurable investment return goals?
2. Do your investment return goals relate to your institution's spending-rate policy?
3. Are performance benchmarks identified, both for the financial markets and for the institution's peer group?

The level of risk an endowment fund may experience is viewed from the perspective of the Prudent Person Rule, which has the purpose of testing whether investments made by board members are reasonable. The Prudent Person Rule is part of the Uniform Prudent Management of Institutional Funds Act (UPMIFA) and is the legal basis that underlies endowment investment management policies and practices. UPMIFA regulations require that in the absence of a clear donor restriction in the gift instrument the following factors must be considered when investing institutional funds:

1. General economic conditions
2. Possible effects of inflation or deflation
3. Expected tax consequences, if any, of investment decisions or strategies
4. Role that each investment or course of action plays within the overall investment portfolio of the fund
5. Expected total return from income and the appreciation of investments
6. Other resources of the institution
7. Needs of the institution and the fund to make distributions and to preserve capital
8. An asset’s special relationship or special value, if any, to the charitable purposes of the institution

The requirements of California’s UPMIFA statute need to be clearly understood by the governing board of each auxiliary organization. UPMIFA applies to institutional funds existing or established after January 1, 2009, and governs decisions made after that date.

Using the legal framework of UPMIFA, the development of a strong investment policy should include discussion of the risks that impact the investment performance of an institution’s portfolio. Many types of risk exist, including volatility, inflation, deflation and underperforming one’s peers.

The proper time horizon for most college and universities is long-term, at least 10 to 15 years. Often, however, the effective time horizon becomes much shorter, to the detriment of the endowment, because of an investment committee’s inclination to take action (usually resulting in a change in strategy) in order to minimize any negative outcomes during its watch. It is important to note that the longer the time horizon and the lower the propensity to panic, the more risk an endowment can assume and the greater the returns it can therefore achieve over the longer term.

The most relevant and comprehensive definition of risk is “failing to achieve one’s policy objectives.” Anything that increases the likelihood of failing to achieve one’s objectives can be accurately defined as “risky.” Therefore, it is necessary for policy objectives to be clearly articulated and agreed upon before board members talk about what is “risky.”

All actions, strategies and asset classes should be considered or reviewed in this light: Will they enhance or erode the chances of achieving the objectives of the investment policy? Those that increase the probability of attaining goals should not be considered risky.

Individuals and institutions will assign different priorities to different types of risk, depending on their views on risk and risk tolerance. That is why a strong investment policy will explicitly describe and define the risks that the committee and staff believe are most relevant. The remaining portions of the policy, especially asset allocation, can then be structured accordingly.


Checklist Questions:
1. Has your governing board studied the requirements of California’s UPMIFA statute and understand its relevance to the investment policy?
2. Does your institution’s investment policy have a discussion on risks and their impact on investment portfolio performance?
3. Has the long-term horizon of the investment strategy been clearly stated?
4. Is there a clear link between the institution’s views on risk and its policy on asset allocation?

Determining what percentage of the portfolio will be invested in various asset classes—stocks, bonds, real assets, private capital, hedge funds—is the single most important component of an investment policy. Numerous studies have shown that asset allocation accounts for the majority of investment performance. Asset-allocation guidelines should be logically consistent with the endowment's specified return objectives and relevant risks.

For most institutions, the allowable ranges or variation from target should be relatively narrow. Narrow asset-allocation ranges allow the flexibility to make small bets or tactical tilts while protecting the investment policy and the endowment from the pressure to abandon sound, long-term strategy in the face of short-term adversity.

1. Does your institution's investment policy specify asset allocation guidelines and are they defined within narrow ranges?
2. Does the policy statement include a discussion on the institution's view of risk and its impact on the asset-allocation guidelines?
3. Do the asset-allocation guidelines reflect the long-term view toward measuring investment performance?

A strong investment policy should explain why each asset class is included in the portfolio and the specific role it is expected to play. Each type of equity investment (domestic, international, emerging markets, private) has a particular purpose within the investment portfolio. An investment portfolio may also include other asset groups regarded as "hedging" assets. These types of investments include absolute-return strategies, inflation hedges (real estate, timber, energy and Treasury Inflation Protected Securities) and deflation hedges such as intermediate and long-term U.S. Treasury bonds.

Each type of equity asset should have an expected performance objective in relation to the institution's spending rate. For example, an investment policy may state that equity asset classes have a long-term expected real return above the college's spending rate. Furthermore, U.S. equities are intended to offer good liquidity and avoid currency risk, while U.S. emerging markets equities are expected to generate higher returns than other equities because of their smaller size and greater growth prospects.

"Hedging" assets are used to provide some protection against various risks facing the endowment. For example, inflation hedges, such as inflation-linked bonds, energy, real estate, commodities, timber, and natural resources funds, are intended to protect against unexpected inflation and sustained periods of general price increases.

When an investment policy articulates the rationale for different types of assets, there can be no doubt or confusion about why any particular asset class has been included in the portfolio.

1. Does your institution's investment policy explain the purpose of each asset class?
2. Is the rationale for each class of equities explained in relationship to the institution's spending rate?
3. Are “hedging” assets a part of your investment portfolio strategy and is their rationale explained in the policy?

Rebalancing is the process of adjusting or returning a portfolio toward the target asset allocation specified in the investment policy. Rebalancing is important because it keeps the institution's asset allocation from straying too far from policy guidelines. An asset mix allowed to drift with market returns automatically ensures that the portfolio will be overweighted in an asset class at market peaks and underweighted at market lows, a formula for guaranteed underperformance. Failure to rebalance also increases the portfolio's risk level. If an endowment has drifted from its asset-allocation targets and a major market event occurs, the portfolio could be exposed to more risk than anticipated.

Two major methods of rebalancing exist: the calendar-based method and the use of target ranges. The calendar-based method simply means that the asset classes are rebalanced back to their policy targets at pre-specified points in time, most often quarterly or at year-end. Securities are then bought and sold as necessary to bring each asset class back to its policy target.

The other major method of rebalancing depends on the creation and use of asset-allocation ranges. To implement this rebalancing strategy, the investment policy must specify the acceptable ranges around the target asset allocation. Rebalancing should then occur whenever the limits of any range are breached.

The most efficient way to rebalance is available when cash flows occur on a regular basis. Funds coming into or being taken from the endowment can be used to rebalance the portfolio. Rebalancing can be accomplished quite efficiently by adding incoming dollars to asset classes that are below their target weight and by removing spending dollars from overweighted asset classes.

1. Does your institution's investment policy expressly state that rebalancing will occur when the asset classes go beyond their policy ranges?
2. Is the methodology to be used for rebalancing stated in the policy?

Benchmarks provide the standards against which investment performance is measured. An ideal benchmark is:

• clearly defined
• representative of the targeted strategies, opportunities or activities
• investable
• measurable

Good benchmarks meeting these criteria are available for virtually all traditional asset classes. Such is not the case for alternative asset classes, where benchmarks are not available. Instead return objectives (an absolute return of 8 percent, for example) or manager universes (available from consultants, custodians or third-party providers) usually serve as benchmarks for alternative asset classes.

At the total endowment level, it is not uncommon to have several benchmarks, all of which should correspond directly to financial and investment objectives. Often three types of benchmarks, all conveying valuable but different information, are used at the total portfolio level:

1. Spending rate + inflation. This benchmark measures the financial objective of most institutions: maintaining the real or inflation-adjusted value of the endowment. Achieving this goal is critical to safeguard the purchasing power of the endowment. A real growth component of 1 percent or so is sometimes added.
2. An average of the benchmarks of each asset class weighted by the target allocation stated in the investment policy. Comparing actual performance with this benchmark conveys whether an investment policy is being implemented effectively.
3. Peer performance. Comparing actual performance with a peer group reveals whether the institution is maintaining a competitive financial position. Peer benchmarking will also show if an endowment is being too aggressively or too conservatively managed. Institutions with investment performance that consistently outperforms its peers may be operating with relatively high levels of risk. At the other extreme, endowment performance consistently underperforming may be managed too conservatively.

A good investment policy should change infrequently. Benchmarks for individual managers should not be included in the investment policy, because determining proper manager benchmarks is more of an implementation task, not a policy issue.

1. Does your institution's investment policy state clearly the benchmarks to be used to evaluate investment performance?
2. Are benchmarks assigned for each asset class?
3. Do the benchmarks include comparison with an appropriate peer group of institutions?

Another component of a strong investment policy is an explicit statement on indexing. Indexing attempts to match performance of an index by assembling a portfolio that invests in the same securities that make up an index. This is often referred to as passive management. The current trend is to have a blend of passive and active management in the portfolio.

The benefits of indexing are low fees and performance that is reliably consistent with the markets. Generally, U.S. stock and bond markets are very efficient and indexing in these asset classes generally outperforms active management over time. For every manager who outperforms an index, another will underperform it. Thus, average performance coupled with higher costs for active management will result in underperformance of the index.

The potential to outperform the market is one advantage of actively managed funds. Active managers can also respond to downturns in the market to mitigate losses.

Please refer to Endowment Management: A Practical Guide for a more detailed description of each of the seven characteristics.

Socially responsible investing is an investment strategy that seeks to consider both financial return and how the environmental/social/governance practices of the company impact the good of society. In 1978, the CSU Board of Trustees passed a resolution asking auxiliary organizations to take into account the social responsibility of those corporations in which stock is purchased or held. Each investment policy should include a statement of the board’s position on socially responsible investing.

Strategies for socially responsible investing may include green investing, shareholder advocacy or seeking investments that align with the university’s mission and values. Negative screening is often the first consideration in socially responsible investing but is generally inadequate in its impact. The policy might also address how the board will respond if a corporation’s practices violate the public good, such as environmental pollution, harm to the health of workers or lack of gender equality in leadership.