Investments

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This is part of "What Every Grantmaker Should Know & Frequently Asked Legal Questions."

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Although a foundation's grantmaking activity typically attracts the most attention, its investment activity is, in many ways, the true heart of its operations. The more successful a foundation's investment returns, the more charitable funds it will have available to fulfill the organization's mission. A foundation, therefore, needs sound, effective investment policies and practices to maximize its effectiveness as a grantmaker.

Here are things all grantmakers should know about investments.

What the Law Requires

Fiduciary Duties of the Board

The overall responsibility for a foundation's investments rests with its board of directors or trustees. The governing board of a foundation has a legal obligation to manage the foundation's assets and income prudently. If a foundation is not a "pass-through" foundation but instead holds assets that it invests to produce income for grantmaking and operational purposes, its board members have a fiduciary obligation to establish and monitor prudent investment policies and oversight functions.

The board can rely either on internal board or staff expertise, or it can obtain outside expert advice, depending on the foundation's size, complexity and internal resources. A board member is entitled to rely upon information, opinions and reports from staff, board committees and outside professionals and experts the board member reasonably believes to be reliable and competent. Even if a board uses outside investment help, board members need to be familiar with the foundation's investment results and insist that investment managers provide them with the necessary information to ensure that they are properly fulfilling their legal fiduciary responsibility to the foundation.

Laws Regulating Investment Strategy

Most states have adopted laws governing the investment of charitable assets, including the Uniform Prudent Investor Act (UPIA). This law embraces the concept of modern portfolio theory, under which prudent investment policy is based on diversification of assets, long-term performance benchmarks and the importance of a portfolio's total return on investment. No particular category of investments is barred. Rather, an investment is viewed in the context of the entire portfolio, and investment managers are expected to balance risk and return in making investment decisions.

Most states have also adopted the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which, among other things, makes many of the concepts in the UPIA applicable to the investment of institutional funds, including endowment funds, held by a charity for its own use. UPMIFA also addresses spending from those funds.

In 2006, the National Conference of Commissioners on Uniform State Laws adopted the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which updates UMIFA by incorporating the provisions of modern portfolio theory from UPIA and the Uniform Principal and Income Act to permit more efficient management of charitable funds. In addition, UPMIFA modifies the requirements for fund expenditures, giving managers more flexibility. It is expected that many states will adopt UPMIFA, or at least parts of it, over the next several years.

Jeopardizing Investment Rules

In addition to state corporate or trust law, UPMIFA, and UPIA, private foundations are subject to the federal excise tax rules that bar "jeopardizing investments." Jeopardizing investments are those that show a lack of reasonable business care and prudence in providing for the long- and short-term financial needs of the foundation. Although no category of investment is considered inherently too risky, certain types of investments receive particular scrutiny, including trading in securities on margin; trading in commodities futures; investments in working interests in oil and gas wells; purchase of puts, calls and straddles; warrants; selling short; investments in junk bonds; risk arbitrage; hedge funds; derivatives; distressed real estate; and international equities in third-world countries.

Jeopardizing investments should be distinguished from "program-related investments," which may take the form of a financial investment but are made primarily for charitable rather than investment purposes. Examples of program-related investments include buying shares of a small business in an economically depressed area, micro-lending programs and providing seed money to capitalize a community development loan fund. Even though they may be risky, program-related investments do not violate the jeopardizing investment rules. In order to qualify as a program-related investment, three conditions must be met:

  • The primary purpose of the investment must be to accomplish the foundation's charitable purposes
  • Production of income cannot be a significant purpose of the investment.
  • The investment cannot involve lobbying or political campaign activity.

Other

Foundation board members should also be aware of other legal issues that may arise in the investment context, such as the prohibition against excess business holdings, which generally prevents a private foundation from holding a substantial interest in a single company or business enterprise (although there is a five-year period for disposing of excess business holdings acquired by gift or bequest). There are also legal and investment issues to be considered when a foundation receives contributions of specific assets subject to donor restrictions on use or sale, or assets that the donor or the board wishes to put to use in furtherance of the foundation's charitable purposes. In these situations, professional advice is particularly important.

Investment Committees

Many boards delegate investment responsibilities to an investment committee. The majority of the committee is usually comprised of board members, although sometimes a foundation will also invite non-board members with particular investment skills and expertise to serve on the committee.

The main role of the investment committee is to recommend investment policies and guidelines that protect the foundation's investment assets. The committee should develop an investment strategy and continuously monitor the foundation's investment portfolio through comprehensive analysis and review of the performance of the investments and managers. Typical duties and responsibilities of a foundation's investment committee include the following:

  • Formulate and amend, as required, the foundation's investment and spending policy statements for recommendation to the board.
  • Develop and maintain an investment strategy to accomplish the foundation's goals.
  • Adopt and revise investment management agreements as needed with consultants, managers and custodians for approval by the board.
  • Meet periodically (at least annually is recommended) with the investment consultants to review and assess the investment strategy.
  • Review the asset allocation, individual manager and combined portfolio performance on a regularly scheduled basis (at least quarterly is recommended), and make any course corrections necessary.
  • Meet with each investment manager on a regular basis to review style, performance, guidelines and objectives to ensure compliance and a clear understanding of the foundation's position and goals.
  • Recommend the addition, deletion and replacement of investment managers as appropriate, consistent with the goals and objectives of the foundation's investment policy.
  • Manage investment assets not managed by professional investment managers.
  • Report on a timely basis all committee findings, activities and recommendations to the board.

A foundation should have a written description of the roles and responsibilities of its investment committee. (See sample investment committee descriptions.)

The Investment Policy

A foundation should have in place a sound, effective investment policy to guide its investing activities. A foundation investment policy may include the following elements:

Definition of the Investment Duties: The policy should spell out the roles and responsibilities of the board, investment committee, staff and consultants in managing investments.

Spending Policy: A spending policy describes the processes and procedures the foundation will follow to calculate the percentage of its endowment or unendowed assets available for grants and operating expenses each year. In establishing a spending policy, a foundation should consider such important issues as whether it wants to meet or exceed the minimum 5 percent payout requirement (if it is a private foundation) and whether it wants to grow its endowment or maintain the endowment at current levels (inflation-adjusted).

Performance Objectives: The policy may include a statement of long-term investment performance objectives, including a goal for the minimum annual total return the foundation hopes to achieve over a specific period of time. The return objective for most foundations is the amount needed to maintain the value of the endowment while also meeting the foundation's spending objectives and the expected rate of inflation.

Strategic Statement: The policy may include a statement of the foundation's philosophy regarding the use of fixed-income and equity securities.

Allocation Formula: The policy may provide an asset allocation formula, including target percentages of total investments in fixed-income versus equity securities, and target percentages in various types of equity holdings.

Manager Guidelines: The policy may include guidelines on how much managers can invest in a single stock, maximum percentage of a company they can own, minimum number of positions they can have in a portfolio, maximum percentage any one company can have in the manager's total portfolio, and areas determined off-limits (commodities, art objects, real estate, gold, etc.). Equity managers also may be told when they can invest in fixed-income securities, how much they can have in cash, and the minimum investments quality levels (AA or A bonds, no junk bonds, no derivatives, etc.).

Mission-Related Investing

Some foundations are exploring the concept of "mission-related investing," sometimes known as "socially responsible investing." The Foundation Partnership on Corporate Responsibility defines mission-related investing as an integration of the relationships among a foundation's asset management and charitable purpose. Mission-related investing could include:

Portfolio Screening: A foundation may screen portfolios to include best-in-class corporations or avoid corporations that have poor records on social issues, environmental issues or other issues of interest to the foundation.

Proxy Voting: Shareholder activity may include voting proxies on a company's proxy statement, or developing a set of proxy voting guidelines covering issues of concern to the foundation. These activities could also include engaging corporations in dialogues on issues of concern, and filing and co-filing shareholder resolutions.

Early Investment: Mission-related venture capital uses the foundation's assets for early-stage investment in companies that are seeking solutions to the problems that the foundation is seeking to solve through its grantmaking.

Community Investing: Community investing assists underserved communities in meeting their development needs. There is disagreement in the foundation field about the use of mission-related investing. Some would argue that the board's primary fiduciary responsibility is to ensure the maximum return on the foundation's investment assets, so that the foundation has the largest amount of financial resources possible to fulfill its mission. Others would argue that in order to fulfill its fiduciary responsibilities, a board has a duty to consider whether the foundation's investment decisions will further its charitable purposes — or at least not run counter to them.

For More Information

See also Frequently Asked Legal Questions: Investment.