Beyond the Blueprint: Why Nonprofits Need an Investment Philosophy Statement

Nonprofit organizations are the bedrock of our communities, providing vital services and improving countless lives through generous donations and taxpayer dollars. Yet, despite their crucial role, many nonprofits across the country, and even locally, are missing out on significant financial resources due to systemic investment underperformance. Studies show that endowments often underperform market benchmarks, sometimes by as much as 5.5 percentage points annually. This translates to millions of dollars left on the table each year, funds that could be channeled directly into charitable causes.

While the causes of this underperformance are complex—ranging from market conditions to the challenges of attracting seasoned investment professionals to volunteer committees—a critical underlying issue often lies with the very documents intended to guide investment decisions: traditional Investment Policy Statements (IPS).

The Limitations of Standard IPS Documents

Almost all nonprofit organizations have an Investment Policy Statement. These documents typically lay out basic investment considerations, including time horizon, liquidity needs, asset allocation targets and ranges, and performance benchmarks. They serve as a crucial framework for managing a nonprofit’s assets, ensuring alignment with the organization’s mission and objectives.

However, in their current form, many IPS documents fall short of expectations. They often leave a significant amount of discretion to outsourced investment managers. While flexibility might seem beneficial with a “smart” manager, academic data overwhelmingly suggests that most managers underperform their benchmarks, and tactical timing decisions often destroy value.

This lack of explicit philosophical guidance can lead to a detrimental cycle. Investment committees, particularly those without a deep bench of investment professionals, might feel compelled to react to short-term market fluctuations, hiring and firing managers based on recent results. This can lead to the unfortunate practice of “selling low and buying high,” locking in long-term underperformance. Committee turnover further exacerbates this issue; without a documented philosophy, new members can easily pivot from one investment trend to another, hindering long-term consistency.

How Philosophy Drives Consistency and Resilience

To break free from this cycle of underperformance, organizations need to adopt a deliberate, long-term investment philosophy. Next to asset allocation, a clearly defined investment philosophy will largely drive the long-term return characteristics of a portfolio.

The key to success is a deep commitment to a “proven” philosophy, understanding its pros and cons to stick with it over the long haul, especially during periods of market stress when emotional reactions are most tempting.

An Investment Philosophy Statement moves beyond merely outlining rules; it articulates the core beliefs and principles that will guide all investment decisions. This philosophical anchor provides:

• Consistency: It ensures that investment decisions remain aligned with the organization’s long-term goals, even as market conditions shift or committee members change. The investment horizon for most nonprofits is essentially infinite, so short-term considerations should not derail a sound long-term plan.
• Resilience: By establishing a clear philosophy, committees are better equipped to weather market downturns without making impulsive, detrimental changes. It helps frame discussions about manager performance, allowing committees to discern whether underperformance is due to a “bad” manager or simply a strategy temporarily out of favor.
• Reduced Conflicts: A well-articulated philosophy can help mitigate perverse incentives, such as committee members directing management work to their friends.

Furthermore, considering the organization’s revenue sources, such as grant revenue and donations, and their susceptibility to recessions, a philosophy statement can guide the inclusion of counter-cyclical components within the portfolio. This ensures that specific types of alternative investments, chosen for their low correlation to traditional stocks and bonds and their ability to hold up in downturns, are strategically integrated, rather than just allocated blindly.

Examples of Investment Philosophies in Practice

Different investment philosophies offer varied approaches to achieving long-term goals, each with its own set of considerations. A brief overview of a few potential philosophies includes:

• Active management is generally more expensive than indexing and is therefore unlikely to generate above-benchmark returns. It is also unlikely to be a specific enough philosophy to be useful.
• Active value (or some other factor) would be more specific and could outperform over the long term but will likely still have a large expense headwind and will suffer long periods of underperformance.
• Passive/indexation addresses the cost and underperformance issues, but there could be long periods of time when performance is not enough to meet the required returns to keep up with the spending policy. That was true during the 2000s, which was one of several “lost decades” that appear in the historical data.
• Factor investing can benefit from some of the best aspects of indexing, such as lower costs and broad diversification. It may also keep up with required returns better during flat or down markets, but expect significant tracking error to the benchmark.
• Alternative investments could include hedge funds, private investments, liquid alternative funds, and a wide array of underlying asset classes and investment strategies. It is important to understand the return characteristics, as almost all will come with significantly higher costs than simple stocks and bonds. Committees need to make sure the extra expense is worth it.

Regardless of the chosen philosophy, nonprofits must define and commit to a long-term investment philosophy, understanding its pros and cons to maintain discipline during market fluctuations. The key to long-term success for nonprofits lies in selecting an investment philosophy that aligns with their mission and financial goals, focusing on factors like cost control, broad diversification, and a steadfast commitment to the strategy, rather than chasing short-term performance or reacting to market noise. This deliberate approach can help break the cycle of underperformance that has cost many nonprofits significant annual gains.

To explore the key factors that contribute to underperformance in nonprofit investment portfolios, take a look at our in-depth article on this topic.

If you would like to learn more about Armbruster Capital’s institutional investment services or speak with one of our registered investment advisors, call # (585) 381-4180 or contact us through our website.

Disclaimer: Armbruster Capital Management’s views as portrayed in this post are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Investing involves risks and the value of your investment will fluctuate over time; as a result, you may gain or lose money. Past performance is no guarantee of future results.