Commonfund Institute Online

Welcome to Common Fund Institute Online, dedicated to the advancement of investment knowledge and the promotion of best practices in financial management. In this program, the investment policy statement, what it is for, what belongs in it, and how to make it serve the institution over the long term. The IPS is often described as both a sword and a shield. It is a sword because it supports the fulfillment of the institution's mission and lets the board adapt to changing needs and conditions. And it is a shield because it guards trustees against misguided decisions made in response to short term or transitory pressures. Done well, it reflects the board's best thinking, developed in a time of calm through a deliberate drafting process. It is reviewed every year or two and changed only with care. That protection matters most in a crisis, when strong opinions in the room or human emotion push toward rash decisions. In 2008, the S and P 500 fell 37%. Many individual investors moved to cash and then missed much of the recovery. They had to get the decision right twice, when to get out and when to get back in. Institutions with a long time horizon and a policy that sets ranges around a target allocation, with minimums that cannot be breached, are protected from that. They can stay invested, adjusting tactically within the bands. The IPS is also a governance tool. Boards may delegate investment functions to outside advisors, provided they act prudently in choosing and overseeing them, but responsibility for overall strategy and policy stays with the board and the investment committee. So what belongs in the policy? Five key points. They are return objectives, spending, asset allocation, risk management, and liquidity. First, return objectives. State the return the endowment needs to maintain its purchasing power, given the spending rate, inflation, and investment costs. Second, spending. Document the rate and the formula, and revisit them as often as asset allocation. Third, asset allocation. Specify the policy portfolio, target weights for each asset class with ranges around them, and be explicit about what is permitted and what is prohibited. Putting numbers to the first two points, spending rates typically average between four and a half and five and a half percent. With inflation near 2% and investment costs near one, a return of about 8% is often cited as necessary to maintain purchasing power. Spending formulas generally fall into three categories: simple, inflation based, and smoothing or hybrid. Spending policy may be the most overlooked part of endowment management and it is closely linked to asset allocation, so consider them together. Fourth, risk management. Treat risk as a primary input, not a byproduct of investment decisions. For a mission based organization, risk is best defined as the inability to meet its financial objectives, not simply volatility. Measurable examples: large declines followed by long recoveries, too little liquidity to meet obligations, and not understanding how the portfolio behaves under stress. Fifth, liquidity. Address the institution's liquidity needs in the context of its balance sheet and long term strategic plan. Liquidity is typically grouped in three categories: liquid, convertible to cash within a month semi liquid, within a month to a year and illiquid, more than a year. Beyond these five points, the IPS should also say who does what, the roles and responsibilities of the board, the committee, staff, consultants, and any outsourced chief investment officer. One of the most common mistakes is inconsistency within the document itself. Return objectives should match the asset allocation, because the allocation is how the endowment earns its return. If the two don't align, something has to give: spending, the return objective, or the risk the board is willing to take. Consider a hypothetical foundation that says it needs a 5% real return, yet its sixtyforty allocation, using its own return assumptions, is expected to deliver about 3.4. Left alone, that gap erodes purchasing power year after year, and the shortfall falls on future generations. Risk limits should match reality. Consider a hypothetical policy that capped losses at 10% in any twelve months. In the year ending June 2009, the average endowment lost more than 18%, nearly twice that limit. Why did it happen? The financial crisis hit markets all at once, assets that normally move independently move together, and liquidity dried up, forcing some institutions to sell. Why does it matter? A limit that is breached this far is not working as a limit. A policy written in calm and never tested against a crisis can fail when it is needed most. And the consequences reach beyond the portfolio: a long recovery, less capacity to support the institution, and hard choices under pressure. Hold the policy, reduce risk or change spending, often just as the needs of the people it serves are rising. So set risk limits against realistic stress scenarios, such as a sustained equity bear market of 30 to 40%, and test them at least once a year. Make sure the committee actually agrees, surface disagreement early, and educate. Set rebalancing bands thoughtfully, too tight and the portfolio is constantly trading, too wide and the door opens to emotional decisions, and evaluate over the right timeframe. A one year return is the least important number in the book, Longer records, three, five and ten years, or a full market cycle, show whether purchasing power is being maintained. That is the investment policy statement, the central governing document for the endowment, a living document that keeps the institution's investment decisions tied to its mission. To go further, see the Common Fund Institute Guide, Principles of Investment Stewardship for Nonprofit Organizations, the Investment Policy Statement white paper and its template to help you start crafting your own, and the other programs in this series. Thank you.