For Foundations, a Mix of Prudence and Daring Is the Key to Investing

Any investor’s challenge is to beat inflation and make a profit, but grant-making foundations face special hurdles in choosing the right mix of assets.

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Foundations in many cases must earn at least 9 per cent on their assets — roughly the average annual return of the U.S. stock market in recent decades — to keep their endowments from shrinking.

That is because private foundations must distribute at least 5 per cent of their investment assets each year in the form of grants and related expenses. Add to that a federal excise tax of up to 2 per cent on the foundations’ income, plus investment fees and other overhead expenses of 1.5 or 2 per cent of assets, and the pressure to make a healthy investment return builds.

“No super-conservative asset allocation is going to sustain that sort of return over time,” says Dan Mohn, an executive at the Presbyterian Church (U.S.A.) Foundation, which manages endowment money and other assets for the denomination.

The question for foundations, then, is how aggressive to get. The answer, Mr. Mohn says, is for trustees to establish “reasonable and consistent” spending rules for the foundation, then match the policy with investments that provide “stable, consistent returns.”

A broadly diversified portfolio, heavy on stocks, has been the best bet over time, he says.

Alternative investments can also help energize a portfolio. But some of those deals require more patience than others — something that a foundation or endowment with heavy spending pressures may not have.

Investments such as energy partnerships and venture-capital funds, for example, may require that money be tied up for years until profits begin to flow. If stocks go into a pro- tracted slump and too much of an endowment’s other money is locked into long-term alternative deals, a foundation could feel a serious pinch.

“The problem with a lot of endowments is that we’ve had a 15-year bull market, and I don’t think they really understand what might happen if we end up in a two-year bear market,” says Linda Strumpf, chief investment officer of the Ford Foundation.

“If you’ve got 40 per cent of your endowment locked up in alternatives where you’re not getting a whole lot of distributions, and you end up in a bear market, the only thing you have to make payout with are your stocks.”

And that, she adds, could mean selling those stocks at a loss just to raise needed cash.

In the 1970s, the Ford Foundation’s assets, tied up partly in venture-capital and other long-term deals, shrank from $4-billion to $1.7-billion as the institution needed to sell stock in a declining market to pay grants and other expenses, Ms. Strumpf says. “We never want to be caught in that position again,” she says.

Of course, there is a flip side to the argument that long-term alternative investments can be a handicap for endowments. Proponents say that most endowments can afford to play the waiting game with a portion of their money because it is unlikely that they will have to pay out a huge chunk of their assets in any given year.

Institutions that invest too conservatively can be just as reckless as those that place too big a bet on a dry oil well or a poorly located office building.

Take, as an example, a foundation that employs an “income-only” spending policy and relies on interest from bonds and stock dividends to pay for grants. It reaps none of the rewards when the stock market soars, and it suffers when bond interest and dividends are low. All three circumstances — soaring stocks and poor bond and dividend payouts — have prevailed in recent years.

A better strategy, Mr. Mohn says, is to base spending on an average of total investment returns over a three- or five-year period after calculating for inflation and overhead of 1 per cent or so. That way, he says, investment managers can go for “maximum returns” without jeopardizing grant making or other spending in any single year.

Key to any investment strategy is to have a board of trustees that is savvy, engaged, and committed to holding a course over the long term. That’s especially true for alternative strategies that demand staying power.

“The downside is when boards make decisions in a vacuum,” says Mr. Mohn. “They make a decision that seems to be sound, and then they reverse course and panic because of a short-term event.

“Then,” he adds, “they assure their losses.”