The level of risk an endowment fund may experience is viewed from the perspective of the Prudent Person Rule, which has the purpose of testing whether investments made by board members are reasonable. The Prudent Person Rule is part of the Uniform Prudent Management of Institutional Funds Act (UPMIFA) and is the legal basis that underlies endowment investment management policies and practices. UPMIFA regulations require that, in the absence of a clear donor restriction in the gift instrument, the following factors must be considered when investing institutional funds:
The requirements of California’s UPMIFA statute need to be clearly understood by the governing board of each CSU auxiliary organization.
- General economic conditions.
- The possible effects of inflation or deflation.
- The expected tax consequences, if any, of investment decisions or strategies.
- The role that each investment or course of action plays within the overall investment portfolio of the fund.
- The expected total return from income and the appreciation of investments.
- Other resources of the institution.
- The needs of the institution and the fund to make distributions and to preserve capital.
- An asset’s special relationship or special value, if any, to the charitable purposes of the institution.
Using the legal framework of UPMIFA, the development of a strong investment policy should include discussion of the risks that impact the investment performance of an institution’s portfolio. Many types of risk exist including: volatility, inflation, deflation and underperforming one’s peers.
The proper time horizon for most college and universities is long-term, at least ten to fifteen years. Often, however, the effective time horizon becomes much shorter, to the detriment of the endowment, because of an investment committee’s inclination to take action (usually resulting in a change in strategy) in order to minimize any negative outcomes during its watch. It is important to note that the longer the time horizon and the lower the propensity to panic, the more risk an endowment can assume, and therefore the greater the returns it can achieve over the longer term.
The most relevant and comprehensive definition of risk is “failing to achieve one’s policy objectives.” Anything that increases the likelihood of failing to achieve one’s objectives can be accurately defined as “risky.” Therefore, it is necessary for policy objectives to be clearly articulated and agreed upon before board members talk about what is “risky.”
All actions, strategies and asset classes should be considered or reviewed in this light: Will they enhance or erode the chances of achieving the objectives of the investment policy? Those that increase the probability of attaining goals should not be considered risky.
Individuals and institutions will assign different priorities to different types of risk, depending on their views on risk and risk tolerance. That is why a strong investment policy will explicitly describe and define the risks that the committee and staff believe are most relevant. The remaining portions of the policy – especially asset allocation – can then be structured accordingly.
- Has your governing board studied the requirements of California’s UPMIFA statute and understand its relevance to the investment policy?
- Does your institution’s investment policy have a discussion on risks and their impact on investment portfolio performance?
- Has the long-term horizon of the investment strategy been clearly stated?
- Is there a clear link between the institution’s views on risk and its policy on asset allocation?
1 California Probate Code at Sections 18501 – 18510. 1 UPMIFA applies to institutional funds existing or established after January 1, 2009, and governs decisions made after that date.