Chapter 13: Investment Strategies Flashcards
Fidicuary
Individual or organization holding assets for another party
Investment Policy Statement
Key document the board creates to discharge its fiduciary responsibility in nonprofit investment
Operating Reserve
A “rainy day” fund for unexpected events
Liquidity Reserve
Financial resources set aside to smooth out operations and provide a cushion against cash-flow fluctuations
What are 3 objectives to consider in managing investment programs?
- Safety - getting the principal back
- Liquidity - ability to convert investment back to cash in a timely manner
- Yield - return on investment
What is the highest priority objective for a fiduciary managing the investments of a nonprofit?
Safety (protection of principal invested)
What is the lowest priority objective for a fiduciary managing the investments of a nonprofit?
Return
Safety and liquidity are more important
What are the two risk sources for nonprofit investment?
Default Risk
Market Risk
Default Risk
Safety of the security or to the company that issues the security
Market Risk
Risk of interest rate changes in the marketplace
Investment Grades
Rating used by security rating agencies
AAA grade securities
Top credit quality rating
C grade securities
Speculative credit quality rating
D grade securities
Default (bad) credit quality rating
CDO
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.
What are the safest investment instruments?
US Treasury securities
Laddering
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.
Hedging
Strategy used to reduce market risk.
Takes an offsetting position in a related security, to protect against potential loss caused by interest rate change.
What reduces market risk - short or long investment terms?
Short
What are a safe, liquid investment for nonprofits?
High-quality, short-maturity, fixed income instruments
Fixed Income Investments
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.
FDIC
Federal Deposit Insurance Corporation
Insures investments up to a certain amount, with money available on demand
CDs
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.
US Treasury Secuities
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.
3 Types of Treasury Securities
- Treasury Bills (T-Bills)
- Treasury Notes
- Treasury Bonds
Treasury Bills
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.
Treasury Notes
Type of US Treasury Security. Mature in 1-10 years. Can be obtained from Federal Reserve Bank or security dealers.
Treasury Bonds
Type of US Treasury Security. Mature up to 30 years.
What is true about the interest rate of a tax-exempt bond?
Interest rate tends to be lower because the investors do not have to pay federal taxes (and sometimes state taxes) on the earned interest
Commercial Paper
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.
Repos/Repurchased Agreements
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.
Money Market Mutual Funds
Mutual funds that invest in short-term, safe investment vehicles. Liquid. Convenient. Small investments available - good for small nonprofits.
Long-Term Investment Strategies
- Endowment Funds
- Pension Funds
- Self-Insurance Funds
Endowment Funds
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
3 Types of Endowment Funds
- True endowments
- Term endowments
- Quasi or Board-Designated endowments
True Endowments
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.
Term Endowments
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.
Quasi or Board-Designated Endowment
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.
“Underwater”
When endowment funds fall below their historical dollar value. Steps must be taken to limit further deterioration of the fund principal.
2 Key Elements of Endowment Fund Management
- Spending Policy
2. Investment Policy
Is an increase in the interest rate good or bad for an investment?
Bad
Is risk higher or lower, when investing at low interest rates?
Higher, because of the risk that interest rates rise over time (riskier the longer the investment)
What is the downside to extremely low-risk investments?
The lower the risk, typically the lower the returns. If returns are too low, they cannot even offset inflation, let alone support programs.
Total Return
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.
Real Total Return
Total return after adjustment for inflation
What is the most significant way to affect endowment total returns in the long run?
Asset allocation, or composition of assets between bonds (safer) and stocks (higher returns)
Systematic Risk
Market risks wherein the prices of all securities decrease or increase simultaneously (such as the Great Depression)
Nonsystematic Risk
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.
