Safeguarding the Future: Effective Investment Strategies for Private Foundations

by: Kyle Anderson
October 31, 2023

In an ever-changing economic landscape, private foundations face the formidable challenge of strategically managing their investments to secure long-term financial sustainability. This guide, specifically tailored for private foundations, explores many essential principles that that underpin a solid investment strategy including risk management, asset allocation, and common pitfalls that can hinder a foundation's progress. By thoughtfully balancing these investment considerations, foundations can chart a course towards fulfilling their mission, protecting their endowment, and amplifying their social impact.

Diversification, Risk Management, and Preservation of the Corpus: A Blueprint for Effective Investment

Implementing a well-designed asset allocation plan is crucial for effectively managing investment risk while maximizing returns. Diversification, the cornerstone of this approach, plays a vital role in mitigating portfolio volatility and enhancing risk-adjusted returns. It is not enough to focus solely on asset classes; comprehensive diversification necessitates considering geographic and sector diversification, growth versus value investments, and other relevant categories. By carefully evaluating alternative investments, foundations can ensure a well-rounded approach to diversification that aligns with their long-term goals.

Implementing a well-designed asset allocation plan is crucial for effectively managing investment risk while maximizing returns. Diversification, the cornerstone of this approach, plays a vital role in mitigating portfolio volatility and enhancing risk-adjusted returns. It is not enough to focus solely on asset classes; comprehensive diversification necessitates considering geographic and sector diversification, growth versus value investments, and other relevant categories, including well-known alternative investments such as private equity, real estate, hedge funds, and venture capital. By carefully evaluating these investments, foundations can ensure a well-rounded approach to diversification that aligns with their long-term goals.

When formulating their investment policy, foundations must address the fundamental risk of inadequate funds to achieve their objectives. Preservation of assets, particularly in the face of the long-term erosion of real value due to inflation, requires proactive measures. It is crucial to protect the foundation's endowment against the corrosive effects of inflation to maintain its purchasing power over time. Additionally, fluctuations in assets can significantly impact the stability of grant programs, making it essential to develop strategies that account for these potential fluctuations.

While evaluating investment performance relative to benchmarks is an important consideration, foundations must avoid blindly following popular trends. Succumbing to the temptation of chasing short-term gains may compromise long-term financial sustainability. Moreover, private foundations should recognize that a risk-free investment strategy is unattainable unless they intend to rapidly deplete their endowments. The 5% distribution obligation generally exceed the returns offered by risk-free government bonds, highlighting the need for foundations to earn an average return that surpasses the distribution rate plus expected inflation.

The understanding of risk has evolved beyond a simplistic concept of the possibility of financial loss. Sophisticated measures like "beta" and standard deviation provide a more nuanced assessment by considering portfolio volatility as a measure of risk. However, it is important to acknowledge the limitations of these academic risk measures. While they capture certain aspects of risk, they do not directly address the risk of insufficient funds to achieve the foundation's goals. Therefore, foundations must consider alternative considerations that encompass a broader perspective.

Quantitative risk modeling can be a valuable tool for foundations to make informed estimates and evaluate potential outcomes. By utilizing historical data and employing models like Monte Carlo analysis, foundations can simulate various scenarios and gain insights into specific risks and trade-offs. These models, while powerful, should be viewed as tools that complement subjective human risk analysis and decision-making. They provide practical guidance, but they are not infallible predictors of the future.

Furthermore, risk management should not be viewed as a static process but as an ongoing endeavor. Foundations should establish a robust system for monitoring and reviewing their investment strategy. Regular assessments of performance, risk exposure, and alignment with objectives enable foundations to identify areas for improvement and make necessary adjustments to their investment approach. Continual monitoring and review ensure that the foundation remains responsive to changing market conditions and evolving goals, thereby enhancing its ability to navigate uncertainties successfully.

To navigate uncertainties and make prudent investment decisions, foundations must adopt a diligent and informed approach to risk management. This entails clarity in defining goals, consistency in adhering to guidelines, and a data-driven process that leverages historical data and quantitative analysis. By implementing these practices, foundations can preserve their corpus, withstand market fluctuations, and make decisions that support their long-term objectives.

The Art and Science of Asset Allocation

Asset allocation, defined as the distribution of an investor's portfolio among different asset classes, is a fundamental aspect of modern financial theory. Renowned scholar Harry Markowitz, a Nobel laureate and influential economist, made significant contributions to the field by introducing Modern Portfolio Theory (MPT). Markowitz emphasized the importance of asset allocation and diversification as key factors in achieving optimal investment outcomes. Numerous academics and practitioners agree that asset allocation is the most critical investment consideration, outweighing other decisions in long-term performance. Their research and insights have shaped the investment landscape, highlighting the benefits of allocating assets across various classes with distinct behaviors and correlations.

Developing an effective asset allocation strategy involves evaluating the expected returns and risk levels associated with different asset classes in a portfolio. By comparing the risk and return characteristics of each class and considering their interrelationships, a thorough analysis can be conducted. This analysis lays the foundation for a mathematical optimization process, generating a range of correlations for each combination of assets. Using this information, an optimal portfolio can be calculated, aiming to maximize returns while managing the desired level of risk. One valuable insight that may not be immediately apparent is the ability to reduce overall portfolio risk without sacrificing expected returns. This can be achieved by including assets that are considered risky or even highly risky.  However, it's important to acknowledge that investing also entails a level of uncertainty and unknowns, which is where the "art" of asset allocation comes into play. Experienced investors understand that despite the scientific principles underlying asset allocation, factors like market dynamics and unforeseen events add a subjective element to decision-making.

When considering whether to modify the asset allocation policy over time, it becomes crucial to assess how asset classes are defined and to stay vigilant in recognizing shifts in their relative financial attractiveness. Adjustments should be made when an asset class becomes excessively expensive or remarkably inexpensive. However, determining the optimal frequency of adjustments is subjective, as too frequent changes may undermine the effectiveness of rebalancing. Finding the right balance between adherence to a strategic asset allocation plan and the flexibility to adapt to changing market conditions is a key challenge for all investors including private foundations.

Choosing Wisely: The Benefits of Indexing in Asset Allocation

When it comes to asset allocation policy, one of the crucial decisions is choosing between active management and the passive, indexed-investment approach. This debate has been fueled by the efficient market hypothesis, stirring up lively discussions among proponents and critics alike. Supporters argue that securities are rarely mispriced based on publicly available information, making the index the optimal strategy. However, skeptics have raised valid concerns, highlighting the limitations of the efficient market view.

While the efficient market hypothesis generally holds true, it's important to recognize that market outperformance is possible. Over time, certain investors, like the renowned Warren Buffet, have consistently outperformed indexes. Armed with thorough research, analysis, and market expertise, active managers can identify mispriced securities and generate superior returns. By deviating from the index constituents, they have the flexibility to seize opportunities and strategically position their portfolios. This active approach allows for potential outperformance and capitalizing on market inefficiencies.

However, caution is necessary when approaching active management. While some actively managed funds may outperform the index, it's challenging to identify such managers in advance. Studies have shown that most active managers fail to consistently beat their benchmarks in the long term. The unpredictability of outperformance, combined with higher fees, poses a significant challenge for investors. Differentiating between skilled managers and those who may have relied on luck or randomness in the past becomes a daunting task.

One of the key advantages of indexing is its ability to provide broad diversification across a market or asset class. By holding a representative sample of securities in a specific index, investors gain exposure to the overall market's performance, reducing reliance on individual stocks. This diversification helps mitigate the impact of specific company or industry fluctuations and contributes to a more stable investment experience. Additionally, indexing tends to be more cost-effective compared to active management. Passive strategies avoid the higher fees associated with active funds, including expenses related to research, trading, and portfolio management. Lower fees lead to higher net returns over the long term, enabling investors to grow their wealth more effectively. Moreover, indexing offers simplicity and transparency. By tracking a specific index, investors have a clear benchmark against which they can evaluate their portfolio's performance. This transparency facilitates effective monitoring, enables easier comparisons, and simplifies the evaluation of investment results.

It's important to acknowledge that not all asset classes are well-suited for the index approach. For instance, private equity investments, which involve privately held companies, are not conducive to indexing due to their illiquidity and unique deal structures. Other alternative investments such as venture capital, hedge funds, managed futures, and real estate also present complexities and unique strategies that are not easily replicable through indexing. These asset classes often require active management to navigate their intricacies, seize specific opportunities, and achieve superior returns. As a result, investors seeking access to these alternatives typically opt for active management approaches instead of indexing.

While it is undeniable that skilled active managers have the ability to surpass market performance, the compelling array of benefits associated with indexing makes it a very appealing choice for a wide range of asset classes where it is well-suited. Ultimately, the decision between active management and indexing should be grounded in careful consideration of individual circumstances, investment objectives, and risk preferences.

The Benefits of Partnering with Investment Professionals

When it comes to managing the endowment of a foundation, taking advantage of professional guidance is a prudent choice. Unless the foundation leaders involved possess expertise in investment management, relying on professionals is crucial for making informed decisions. Investing is a complex and intricate process that requires specialized knowledge and experience. Opting for professional assistance empowers foundations to leverage the expertise of financial advisors who can provide comprehensive financial planning, mitigate risks, offer unbiased advice, and facilitate continuity planning.

Common Pitfalls in Foundation Asset Allocation Policy

Effective asset allocation is crucial for foundations, yet many common errors can hinder their financial success. By understanding and avoiding these pitfalls, foundations can make informed decisions for optimal asset allocation:

Ignoring the Impact of Inflation:

It is crucial for foundations to consider inflation when making long-term plans and crafting their asset allocation strategies as the detrimental effects of inflation erodes the purchasing power value of the foundation’s endowment over time. Foundations must prioritize the consideration of inflation in their long-term planning and asset allocation strategies, as the detrimental effects it can have on the purchasing power of their endowments should not be underestimated.

Let's delve into a scenario that illustrates the impact of inflation on the value of grants for a foundation with a significant starting endowment. Imagine that this foundation is committed to distributing $500,000 in grants annually, both presently and in the future. What becomes apparent over time is how the value of these grants diminishes, even with a seemingly modest 3 percent inflation rate.

Let's fast forward 10 years into the future. Despite the nominal value of the grants remaining unchanged at $500,000, the relentless influence of a persistent 3 percent inflation rate has significantly eroded their purchasing power. In fact, assuming a cumulative inflation rate of 3 percent per year, the real value of the grants would be reduced to approximately $391,000 in today's dollars. This substantial decline serves as a stark reminder of the hidden impact of inflation, quietly eroding the foundation's ability to support its intended beneficiaries effectively. To provide further perspective, let's extend the time horizon to 50 years. Astonishingly, even though the nominal value of the grants continues to stand at $500,000, their real value has experienced a drastic decline. In today's dollars, the grants' purchasing power would be reduced to approximately $97,000. This staggering 80 percent decrease underscores the relentless erosion caused by low and stable inflation over an extended period.

Neglecting Strategic Asset Allocation Foundation Asset Allocation Policy is an essential element of long-term investment planning. However, some foundations make the mistake of failing to adequately consider their strategic asset allocation. They may overlook the importance of diversifying their portfolio across different asset classes and investment strategies. By neglecting strategic asset allocation, foundations expose themselves to unnecessary risk and limit their potential for long-term growth. A well-thought-out asset allocation strategy, based on the foundation's goals, risk tolerance, and time horizon, is crucial for achieving sustainable returns and protecting the foundation's resources for future generations.

Excessive Cash Holdings:

While cash may provide a sense of security, holding too much cash can be costly. Bank savings accounts and money market funds typically offer low returns. Foundations should aim for efficient cash management, typically allocating no more than a few percentage points to cash. Holding excess cash hampers the potential for higher returns without commensurate benefits.

Misguided Perception of Risk:

Misunderstanding risk can lead foundations to overly conservative investment strategies, such as excessive cash holdings and fixed-income securities. While risk aversion is understandable, foundations must strike a balance between risk and return. A narrow focus on minimizing volatility can hinder the foundation's ability to generate sufficient returns, keep pace with inflation, and meet distribution requirements.

For instance, foundations may exhibit an excessive reliance on cash holdings and fixed-income securities, driven by a perception that these assets provide stability and security. While these investments may offer a lower level of risk, they often generate modest returns that may not keep pace with inflation or meet the foundation's distribution requirements over the long term.

Another misguided perception of risk pertains to alternative investments. Foundations may shy away from considering alternative asset classes like private equity, venture capital, or managed futures due to a perception of higher risk. However, these alternative investments have the potential to deliver attractive risk-adjusted returns over the long term and can provide diversification benefits to a foundation's investment portfolio.

Insufficient Diversification:

Insufficient diversification of a foundation's investment portfolio can expose it to significant risks. Over-reliance on a single company's stock or limited investments can lead to unnecessary volatility and potential losses. The case of Sears serves as a prime example of the consequences of concentration. Once a retail giant, Sears failed to adapt to the changing retail landscape and the rise of e-commerce. The company struggled with declining sales, increased competition, and outdated business strategies, ultimately filing for bankruptcy in 2018. Any investors heavily invested in Sears suffered catastrophic losses. This serves as a stark reminder of the importance of diversification to safeguard against the complete downfall of a single company.

Overreliance on Income-Producing Investments:

Foundations often gravitate towards investments that generate a steady distribution of income, such as bonds. However, relying solely on income-producing investments can present challenges in maintaining long-term growth and meeting distribution requirements. To address this, foundations should consider adopting a more comprehensive cash management strategy that encompasses a broader range of assets. By solely focusing on immediate income, foundations may overlook investment opportunities that have the potential for higher returns over time. Striking a balance between income generation and capital appreciation is crucial to optimizing the foundation's financial sustainability and enhancing its ability to fulfill its philanthropic mission.

One effective strategy that private foundations should explore is yearly asset sales. By strategically selling assets to raise funds and meet distribution requirements, foundations can gain access to a wider universe of investment opportunities. While these opportunities may not provide immediate income, they offer the potential for greater long-term growth. It is important to note that these investments may exhibit higher short-term volatility, but they can significantly contribute to the foundation's overall portfolio performance and growth.

Failing to Rebalance the Portfolio:

Many foundations overlook the importance of regularly rebalancing their investment portfolios, which can result in overexposure to certain assets and an under-allocation to others. Implementing a disciplined rebalancing strategy ensures that portfolios align with desired asset allocation and risk profile, leading to consistent and controlled long-term performance. Furthermore, regular and systematic portfolio rebalancing creates a rebalancing bonus, generating additional returns over time. This bonus allows foundations to "buy low and sell high" by keeping assets allocated according to predetermined targets.

Let's consider a hypothetical example to grasp the concept of the rebalancing bonus. Suppose a portfolio has a target asset allocation of 60% stocks and 40% bonds. If a significant market event causes a 30% decline in the stock market, the value of stocks in the portfolio would also drop by the same percentage. As a result, the portfolio would become overweighted in bonds and underweighted in stocks. Through rebalancing, the portfolio automatically adjusts by selling bonds and buying more stocks at lower prices. This approach enables the portfolio to benefit from potential future gains as the stock market recovers. When the stock market eventually returns to its initial level, the rebalanced portfolio not only recovers its losses but also generates a profit due to the rebalancing bonus.

t's worth noting that taxable accounts may incur negative tax impacts from rebalancing, which can outweigh the benefits. However, private foundations benefit from their exemption from income taxes, allowing them to focus on investment strategies that aim to maximize returns without being restricted by tax considerations. Although there is a nominal 1.39 percent excise tax on net investment income for foundations, it is typically insignificant in the context of investment decision-making. As a result, rebalancing offers a significant and valuable advantage for foundations.

Portfolio rebalancing can be implemented at regular intervals, such as quarterly or annually, or can be based on specific deviations from the target allocation. Determining the ideal frequency of rebalancing is subjective, as there is no universally optimal strategy. However, it is worth considering that when foundations must sell assets to meet the required annual distribution of 5%, it is prudent to prioritize selling securities from asset classes that exceed their target allocation. Irrespective of the chosen rebalancing approach, the substantial impact of the rebalancing bonus warrants deliberate attention in the investment policy and should be consistently evaluated.

Performance Chasing:

Chasing performance and succumbing to the allure of recent top-performing assets can have detrimental effects on long-term investment results. One common manifestation of performance chasing is the tendency to select funds based solely on their recent performance or to allocate more funds to the "best" fund, primarily driven by its recent growth. However, this approach overlooks an important historical trend known as "reversion to the mean." In statistical terms, this refers to the tendency for above-market performance to be followed by a subsequent period of below-market performance.

Investors often mistakenly assume that a fund with an impressive track record over the past year, three years, or five years is inherently a "good fund." Consequently, they pour significant investments into the fund precisely when its likelihood of underperforming is highest, immediately after a phase of consistent overperformance.

To avoid the perils of performance chasing and make sound investment decisions, it is essential to prioritize a disciplined, long-term investment approach that transcends short-term performance trends. By focusing on the fundamentals of asset allocation, diversification, and rebalancing, investors can navigate market fluctuations with confidence and increase their potential for sustainable, favorable outcomes.


In conclusion, navigating the path to successful investment management for private foundations is a complex and intricate balancing act. A myriad of factors must be considered and balanced to pave the way towards stability and success. By applying the principles outlined in this guide, foundations can solidify their financial footing and ensure the continuation of their charitable endeavors.

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