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Asset Allocation for Non-Profits: a Fiduciary's Guidebook

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Asset Allocation for Non-Profits: a Fiduciary's Guidebook Russell Research Russell Asset allocation for non-profits: A fiduciary’s guidebook fiduciary’s A Asset allocation non-profits: for Russell Research Asset allocation for non-profits: A fiduciary’s guidebook Introduction by Bob Collie, FIA Chief Research Strategist, Americas Institutional Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of each document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Table of contents PAGE # TITLE AUTHOR(S) PUBLISHED 2 Introduction Bob Collie, FIA 4 Once upon a time... D. Don Ezra, FIA September 2012 A historical overview of the development of asset allocation for non-profit organizations 14 Dimensions of difference in nonprofit investment Bob Collie, FIA August 2012 22 Balancing investment and spending decisions for Steve Murray, Ph.D, CFA March 2000 endowments and foundations 30 Non-profit spending rules Steve Murray, Ph.D, CFA October 2011 36 Understanding the effects of spending policies for Yuan-An Fan, Ph.D August 2004 endowments and foundations Steve Murray, Ph.D, CFA 62 Purpose and origin of the 5% payout rule for non-operating Aurea Astro September 2003 private foundations John H. Ilkiw, CFA 67 The 5% payout rule for non-operating private foundations Aurea Astro September 2003 72 Are 5% distributions an achievable hurdle for foundations? Steve Murray, Ph.D, CFA August 2012 82 Endowments, foundations and the inflation challenge Steve Murray, Ph.D, CFA June 2010 Leola Ross, Ph.D, CFA 98 Liquidity: From afterthought to headache Greg Nordquist, CFA January 2012 Tom Fletcher, CFA 104 Russell’s model portfolio framework for endowments Janine Baldridge, CFA, CAIA July 2008 and foundations 108 Constructing an alternatives portfolio Steve Murray, Ph.D, CFA September 2011 122 Responsible investment: Five tests of an SRI/ESG policy Bob Collie, FIA August 2008 Heather Myers 130 Volatility-responsive asset allocation Bob Collie, FIA August 2011 Michael Thomas, CFA Mike Sylvanus 148 Currency exposure for nonprofits Ian Toner, CFA July 2012 156 Modeling illiquidity in a multi-period stochastic projection Jim Gannon, EA, FSA, CFA November 2011 162 Correlations have fat tails, too Bob Collie, FIA July 2012 Russell Investments // Asset allocation for non-profits: A fiduciary’s guidebook // Table of contents / p 1 Introduction The nonprofit sector comprises over 1 million organizations and $3 trillion of assets in the U.S. alone1. Those organizations provide tens of billions of dollars a year in research funding, grants, scholarships and other direct support for thousands of good causes. This is a sector whose mission is never far from top of mind. The success of the nonprofit sector is supported not only by donations and bequests, but also by investment programs designed to protect and grow those assets. Investment practices have moved a long way since courts drew up restrictive “legal lists” in the immediate aftermath of the South Sea Bubble of 1720 and, today, nonprofit organizations are among the world’s investment leaders, with fingers in every market pie around the world. By: Bob Collie, FIA At the heart of any sound investment program is a strategic asset allocation policy. While it can be difficult to define precisely the line between asset allocation policy and its Chief Research Strategist, implementation, in general terms asset allocation involves determining how much of an Americas Institutional investment portfolio is to be directed to certain broad asset categories—so much to equities, so much to fixed income, so much to real estate, and so on—while implementation then takes that broad policy and puts the money to work. Helping our institutional clients with their strategic asset allocation policies has been a core part of Russell’s service for almost 40 years. And while the underlying question addressed by asset allocation policy has not changed over the years, the approach and the clarity of the picture we can draw have advanced greatly. This guide sets out the primary principles that drive the asset allocation decision. It consists mainly of papers that have already been published by Russell—most of them within the past four years—but it opens with two previously unpublished pieces. The first is a history of asset allocation as seen through the eyes of Don Ezra. Don is able to tell the story of the development of best practices from firsthand experience, and his paper tracks the changes and the papers that have marked milestones along the path to where we are today—papers discussing practices which may have been superseded by current practices (and which have not been included in this compendium), but which form an important part of how we got where we are. The other new paper asks the question: Why do the strategic asset allocation policies of nonprofit organizations differ from one another? In a compilation such as this, it is helpful to establish that context up front: to make explicit the factors—risk tolerance, investment beliefs and organizational considerations—that drive the asset allocation decision. 1 Data from the Urban Institute National Center for Charitable Statistics as of 2010. These figures include public charities and private foundations but exclude other tax-exempt organizations such as credit unions, civic leagues and so on. Russell Investments // Asset allocation for non-profits: A fiduciary’s guidebook // Introduction / p 2 Several papers are devoted to the question of spending policy and its interaction with asset allocation. The relationship between spending and asset allocation is a two-way relationship; each decision is affected by the other. Other papers cover a range of associated topics: inflation; liquidity; portfolio construction and the question of alternative investments; social responsibility; responding to volatility; currency exposure. The compilation closes with papers devoted to two thorny elements of the modeling that lies behind most asset allocation decisions: the question of modeling liquidity, and the interactions between asset classes. No compilation of papers about asset allocation could ever be complete; there will always be new perspectives to consider or new developments that demand response. So while this is not quite a definitive guide to asset allocation for nonprofit organizations—we cannot claim it is “Everything You Need to Know About . .”—we hope you will find it to be a solid step in that direction. Thank you for reading. Russell Investments // Asset allocation for non-profits: A fiduciary’s guidebook // Introduction / p 3 Once upon a time In one sense, the development of asset allocation practices among non-profit organizations is a story of the gradual loosening of regulatory shackles. Another way to tell of the evolution in practices is to look at the development of asset allocation theory and how it has been applied in practice by leading institutional investors across the years. It is this perspective which is taken in the paper that follows. It is a firsthand experience related by Don Ezra, who played a central role in the emergence of best practices at Russell and indeed across the investment industry. Don’s a good observer; George Russell has said of him that “His unique skill is to spot the incoming blips on the horizon, and identify which ones are the important ideas and which are safe to ignore.”1 This story of the historical development of asset allocation theory helps to set the context for the rest of this guidebook. It tells us how we got to where we are, suggests a sense of order in today’s world and reminds us that best practice will continue to advance and evolve. 1 Russell, G. (2010). “Success by Ten.” p. 50. Russell Investments // Asset allocation for non-profits: A fiduciary’s guidebook // Once upon a time… / p 4 Once upon a time… A historical overview of the development of asset allocation for non-profit organizations The pioneers Once upon a time there were no principles for portfolio construction. A portfolio was By: Don Ezra simply a collection of securities, each selected individually for its expected return. SEPTEMBER 2012 Harry Markowitz introduced two notions in 1952 [16]. One was that the expected return had a range of uncertainty, and this range might be different for each security. The other was that securities didn’t all move together. Therefore diversification could reduce the downside potential of a portfolio to less than the average of the individual security downsides. Risk and covariance: the foundations of modern portfolio theory. William Sharpe said: “Markowitz came along, and there was light [3].” Sharpe himself brought a defining clarity to that light in 1963, with the observation that the stock market itself is a factor common to all stocks, and greatly influences the returns of each stock [18]. The relationship between the volatility of a stock and the volatility of the market he termed beta. And from his work emerged the Capital Asset Pricing Model, the notions of diversifiable and non-diversifiable risk—and the notion of an asset class. Obviously today these concepts have been greatly refined. Mean-variance efficiency now itself sounds like an ancient concept.
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