The board of directors needs to make two critical decisions with regard to investment policies relative to their reserve fund: asset allocation (commonly referred to as diversification) and spending or liquidation needs. These decisions will provide insights into an organization’s investment practices, its historical return on the investments, its asset allocation, and its need for future funds.
The following is a list of initial questions the board of directors should answer in setting investment policies for your organization:
  • Does your organization have an investment policy statement? If so, when was it last updated? Does it meet your objectives and needs? What is your return goal over the period of your plan?
  • What is your current spending rate, if any (percentage of reserve funds transferred to operating fund)?
  • What is your projected contribution level and liquidity needs?
  • Is there a finance committee responsible for investments? How often does it meet?
  • How do you currently monitor investment performance? What investment performance benchmarks are used?
  • Have you evaluated the cost of your investment managers?
  • What is your current asset allocation in the reserve fund’s portfolio?
  • What are the organization’s attitudes toward risk and return within the portfolio?
  • Are your investments subject to any unusual regulations?
  • Have you adopted a policy regarding investments in companies that may conflict with your mission?
  • Who manages the portfolio and are any unique skills required of the portfolio manager?

Successful investing for long-term defined reserve funds requires a strategic plan. This is true because of the fact that the future is unknowable. The plan must be specific, embodying in concrete terms the best thinking of the Board about the investment pool, its goals and purposes; but it also needs to be sufficiently flexible to guide the Board through environments that may be very different from those prevailing at the time of its adoption.

For institutions with a segregated reserve fund, one of the gravest risks is that, in periods of economic turmoil, crucial investment decisions may be made in haste, under pressure, and without adequate consideration of the long-term consequences. All must realize that market crises have occurred at a rate of around two per decade. In such cases, the temptation to listen to urgent voices claiming that ‘this time is different’ has been very difficult to resist. For the Board, the risk to the Reserve fund of a permanent loss as a result of poor investment decisions is compounded by the potential for after-the-fact second-guessing and possible legal challenge by others.

The investment policy statement sets forth in writing the operating plan of the Board for the management, investment and spending of the investment pool. While strategic in approach and long term in scope, the investment policy statement also sets forth parameters or ranges within which more tactical actions may be taken.

The investment policy statement should also contain descriptions of permitted and prohibited asset classes, investment strategies and instruments. The purpose of this list is to enable the board or committee to focus on the role of the various strategies in the context of the portfolio and its goals. To this end, it should include not only strategies that the institution intends to use immediately, but those that it may use in the future. For example, the statement might permit certain classes of alternative investments while assigning them a weighting of zero in the current portfolio.

The question of permitted and prohibited investment strategies and instruments has gained importance because the complex nature of many investment products can make it difficult for a client to understand clearly what investment practices are being employed by a manager. Many disclosure documents and offering memoranda are lengthy and densely written, and can be difficult to understand even if the information is accurate. The Board should not find itself in a situation where, as a result of this complexity, the language in the investment policy conflicts with decisions actually taken. If, for example, an investment policy statement prohibits instruments such as derivatives or strategies such as short selling, the committee should be careful not to invest with a hedge fund that uses derivatives and routinely goes short unless it has first inserted language in the investment policy statement to allow for the use of derivatives and short-selling as part of a hedging strategy. The institution should know what it is investing in and be sure that permissions and prohibitions in the investment policy statement reflect the reality of the decisions being made for the portfolio.

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