Chapter 13: Investment Strategies

Question 1

Fidicuary

Answer 1

Individual or organization holding assets for another party

Question 2

Investment Policy Statement

Answer 2

Key document the board creates to discharge its fiduciary responsibility in nonprofit investment

Question 3

Operating Reserve

Answer 3

A “rainy day” fund for unexpected events

Question 4

Liquidity Reserve

Answer 4

Financial resources set aside to smooth out operations and provide a cushion against cash-flow fluctuations

Question 5

What are 3 objectives to consider in managing investment programs?

Answer 5

1. Safety - getting the principal back
2. Liquidity - ability to convert investment back to cash in a timely manner
3. Yield - return on investment

Question 6

What is the highest priority objective for a fiduciary managing the investments of a nonprofit?

Answer 6

Safety (protection of principal invested)

Question 7

What is the lowest priority objective for a fiduciary managing the investments of a nonprofit?

Answer 7

Return

Safety and liquidity are more important

Question 8

What are the two risk sources for nonprofit investment?

Answer 8

Default Risk

Market Risk

Question 9

Default Risk

Answer 9

Safety of the security or to the company that issues the security

Question 10

Market Risk

Answer 10

Risk of interest rate changes in the marketplace

Question 11

Investment Grades

Answer 11

Rating used by security rating agencies

Question 12

AAA grade securities

Answer 12

Top credit quality rating

Question 13

C grade securities

Answer 13

Speculative credit quality rating

Question 14

D grade securities

Answer 14

Default (bad) credit quality rating

Question 15

CDO

Answer 15

Collateralized Debt Obligations. Complex structured finance product backed by a pool of loans/assets, and sold to institutional investors. Large driver of the “crisis carnage” due to exposure to subprime mortgages.

Question 16

What are the safest investment instruments?

Answer 16

US Treasury securities

Question 17

Laddering

Answer 17

Strategy used to reduce market risk. Structures security terms so a certain proportion of the investment matures every year, over a few years. Mature investment is then reinvested, laddering behind the last one to mature. Mitigates the impact of interest change on security value.

Question 18

Hedging

Answer 18

Strategy used to reduce market risk.

Takes an offsetting position in a related security, to protect against potential loss caused by interest rate change.

Question 19

What reduces market risk - short or long investment terms?

Answer 19

Short

Question 20

What are a safe, liquid investment for nonprofits?

Answer 20

High-quality, short-maturity, fixed income instruments

Question 21

Fixed Income Investments

Answer 21

Investments that obligate the borrower or the issuer to make fixed-amount payments on a fixed schedule. Less affected by the performance of the issuers, as income is guaranteed. Debt holders take precedence in asset claims.

Question 22

FDIC

Answer 22

Federal Deposit Insurance Corporation

Insures investments up to a certain amount, with money available on demand

Question 23

CDs

Answer 23

Certificates of Deposit
Safe Short-Term investment vehicles that are FDIC insured. Less liquid than some other options. Requires a minimum investment size, that may be too much for a small nonprofit.

Question 24

US Treasury Secuities

Answer 24

Obligations of the US government, backed by the full faith and credit of the gov’t for timely repayment of principal and interest. Safest investment vehicle. Highly liquid. Low returns.

Question 25

3 Types of Treasury Securities

Answer 25

1. Treasury Bills (T-Bills) 2. Treasury Notes 3. Treasury Bonds

Question 26

Treasury Bills

Answer 26

Type of US Treasury Security. Offered in 4-week, 3-month, and 6-month terms. Can be obtained from Federal Reserve Bank or security dealers.

Question 27

Treasury Notes

Answer 27

Type of US Treasury Security. Mature in 1-10 years. Can be obtained from Federal Reserve Bank or security dealers.

Question 28

Treasury Bonds

Answer 28

Type of US Treasury Security. Mature up to 30 years.

Question 29

What is true about the interest rate of a tax-exempt bond?

Answer 29

Interest rate tends to be lower because the investors do not have to pay federal taxes (and sometimes state taxes) on the earned interest

Question 30

Commercial Paper

Answer 30

Relatively safe, liquid, and efficient investment vehicle. Issued by high-quality industrial and financial institutions. Minimum investment is typically $1 million, out of reach for small and medium nonprofits.

Question 31

Repos/Repurchased Agreements

Answer 31

Contractual agreements between investors and security dealers, commercial banks, or the Federal Reserve. Issuers sell investors securities, while agreeing to purchase securities back at predetermined dates and prices. Safe and liquid. Large minimum investment required.

Question 32

Money Market Mutual Funds

Answer 32

Mutual funds that invest in short-term, safe investment vehicles. Liquid. Convenient. Small investments available - good for small nonprofits.

Question 33

Long-Term Investment Strategies

Answer 33

1. Endowment Funds 2. Pension Funds 3. Self-Insurance Funds

Question 34

Endowment Funds

Answer 34

Restricted funds in which principal is invested for perpetuity and part of the fund is used regularly to support the operation of the nonprofit and sometimes for donor-designated programs

Question 35

3 Types of Endowment Funds

Answer 35

1. True endowments 2. Term endowments 3. Quasi or Board-Designated endowments

Question 36

True Endowments

Answer 36

Restricted by the donors in perpetuity. Invested for the purpose of producing present and future returns that may be distributed or reinvested with the original gift.

Question 37

Term Endowments

Answer 37

Limited by terms. The gift as well as the investment returns can be spent after a stipulated passage of time, or upon occurrence of some specified event.

Question 38

Quasi or Board-Designated Endowment

Answer 38

Designated by the board. Principal as well as the income of the fund can be used at the discretion of the nonprofit. Legally not an endowment fund.

Question 39

"Underwater"

Answer 39

When endowment funds fall below their historical dollar value. Steps must be taken to limit further deterioration of the fund principal.

Question 40

2 Key Elements of Endowment Fund Management

Answer 40

1. Spending Policy | 2. Investment Policy

Question 41

Is an increase in the interest rate good or bad for an investment?

Answer 41

Bad

Question 42

Is risk higher or lower, when investing at low interest rates?

Answer 42

Higher, because of the risk that interest rates rise over time (riskier the longer the investment)

Question 43

What is the downside to extremely low-risk investments?

Answer 43

The lower the risk, typically the lower the returns. If returns are too low, they cannot even offset inflation, let alone support programs.

Question 44

Total Return

Answer 44

Sum of investment income and capital appreciation over a period of time. Income includes interest from fixed-income investments, distributions, or dividends. Capital appreciation represents the change in the market price of an asset.

Question 45

Real Total Return

Answer 45

Total return after adjustment for inflation

Question 46

What is the most significant way to affect endowment total returns in the long run?

Answer 46

Asset allocation, or composition of assets between bonds (safer) and stocks (higher returns)

Question 47

Systematic Risk

Answer 47

Market risks wherein the prices of all securities decrease or increase simultaneously (such as the Great Depression)

Question 48

Nonsystematic Risk

Answer 48

Default risk of a specific corporation or institution. For example, an investor's loss when a company goes bankrupt. Not dependent on ebb and flow of overall market, so risk can be reduced by diversification.