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Investment Management Best Practices For Nonprofit Foundations & Endowments

Scott A. Schropp, CIMA, CAP, CTFA The Iles Wealth Management Group

&Paul DeRoche, CIMA, CFP, MBA

The DP GroupMerrill Lynch

February 2008

Presented to:

Michigan Hospital Association

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What we will cover during today’s call:

•New: Uniform Prudent Management of Institutions Fund Act (UPMIFA) expected to be adopted by Michigan in 2008

•UMIFA verses UPMIFA

•Investment Policy Statement (IPS) Audit Issues

•Spending Policies

•Addendums to IPS

•Allocation Trends for Foundations

•Due Diligence Issues

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UMIFA vs. UPMIFA

1. Updates a 1972 law and theory governing endowments.

2. Initiates the era of modern portfolio theory.

3. Allowed all classes of investments, pooling of investments and delegation of investment management to professionals.

4. UPMIFA updates the experience learned over 35 years and addresses issues such as:

• Investment costs and fees

• Effects of inflation

• Total portfolio level decision making

• Outlines risk and return strategies

• Updates modern portfolio theory standards and practices

4

Trends in Foundation Investment Practices

• UPMIFA changes the landscape of former “best practices” utilized.

• Scope is “all encompassing” not just “charitable organizations” in general.

• Heightened awareness now from Sarbanes-Oxley spills over on Audits.

Three main components of UPMIFA:

1. Investment Conduct

2. Expenditures of Funds

3. Delegation of Investment Management

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UPMIFA

1. Investment Conduct:• Express duty of loyalty

• Express cost management obligation

• Whole portfolio management standard of performance

• Express diversification requirement: (correlations)

• Portfolio balancing required: (calendar, market or liquidity event)

• Special skills standard of performance

Historical Snapshot of Asset Class Returns

Worst

Best

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Intern’l Stocks 56.72%



Small Value

Stocks 29.47%

Large Growth Stocks 36.40%

Bonds 8.96%

Small Growth Stocks 51.19%

Small Value

Stocks 29.14%








Small Value

Stocks 22.83%

Small Value

Stocks 14.02%

Bonds 10.25%


Small Value

Stocks 22.25%





Large Value

Stocks 21.67%



S&P 500 31.63%


Small Stocks 46.04%

Small Stocks 18.41%

Small Value

Stocks 23.77%


S&P 500 37.53%

S&P 500 22.95%

S&P 500 33.35%

S&P 500 28.58%


Bonds 11.63%

Bonds 8.44%

Small Value

Stocks -11.42%

Small Stocks 47.2%

Intern’lStocks 20.07%

Large Value

Stocks 6.33%

Small Value

Stocks 23.48%


S&P 500 31.73%

S&P 500 18.67%

S&P 500 5.25%

Small Stocks 25.02%

Large Value

Stocks 26.13%

S&P 500 -3.11%

Small Value

Stocks 41.70%

Large Value

Stocks 10.52%

Small Stocks 18.88%

S&P 500 1.32%

Large Value

Stocks 37.00%

Large Value

Stocks 21.99%

Small Value

Stocks 31.78%



Large Value

Stocks 6.08%

Small Stocks 2.49%

Intern’l Stocks -15.66%

Small Value

Stocks 46.0%

Small Stocks 18.33%

S&P 500

4.89%

Large Value

Stocks 20.80%


Small Stocks 31.05%

Bonds 15.26%

Large Value

Stocks 3.68%

Large Value

Stocks 21.67%


Large Value

Stocks -6.85%



Large Value

Stocks 18.60%

Large Value

Stocks -0.64%


Small Value

Stocks 21.37%

Large Value

Stocks 29.98%

Large Value

Stocks 14.67%

Small Stocks 21.26%

Small Stocks -3.02%

Small Growth Stocks -9.23%

Small Stocks -20.48%


Large Value

Stocks 15.71%

Small Value

Stocks 4.71%

Small Stocks 18.37%

Bonds 6.97%

Small Value

Stocks 31.01%


Bonds 2.76%


Small Stocks 16.26%

Small Growth Stocks

-17.41%

S&P 500 30.40%

S&P 500 7.61%


Small Value

Stocks -1.54%

Small Stocks 28.45%

Small Stocks 16.49%

Small Stocks 22.36%

Bonds 8.69%

S&P 500 21.04%

S&P 500 -9.10%

Large Value

Stocks -11.71%

Large Value

Stocks -20.85%

Large Value

Stocks 31.8%


Small Stocks 4.55%

S&P 500

15.79%

S&P 500

5.49%


Small Value

Stocks 7.41%

Small Value

Stocks -7.11%

S&P 500 16.56%

Bonds 14.53%

Small Stocks

-19.48%

Large Value

Stocks 22.56%

Bonds 7.40%

S&P 500 10.06%

Small Stocks

-1.82%

Small Value

Stocks 25.75%




Large Value

Stocks 12.72%


S&P 500

-11.83%

S&P 500

-22.10%

S&P 500

28.7%

S&P 500

10.88%



Large Value Stock 1.99%

Large Value

Stocks 29.68%

Small Stocks 5.68%

Small Stocks

-8.80%


Small Value

Stocks 12.43%

Small Value

Stocks -21.77%

Bonds 16.00%


Bonds 9.75%

Small Growth Stocks

-2.43%

Bonds 18.47%


Bonds 9.65%

Small Stocks

-2.55%

Bonds -0.82%

Large Growth Stocks

-22.08%

Large Growth Stocks -12.73%

Large Growth Stocks -23.59%





Small Stocks -1.57%

Bonds 22.10%


Small Growth Stocks

-10.48%

Bonds 7.89%






Bonds -2.92%


Bonds 3.63%


Small Value

Stocks -6.45%

Small Value

Stocks -1.49%

Small Growth Stocks

-22.43%


Small Growth Stocks -30.27%

Bonds 4.1%

Bonds 4.34%

Bonds 2.43%

Bonds 4.33%

Small Value

Stocks -9.78%

Annual Total Returns of Key Asset Classes (1985 to 2007) Ranked In Order of Performance (Best to Worst)

Large Stocks are represented by the S&P®500

Large Growth Stocks are represented by the S&P®500/CITI Growth Index*

Large Value Stocks are represented by the S&P®500/CITI Value Index*

Small Stocks are represented by the Russell 2000® Index

Small Growth Stocks are represented by the Russell 2000® Growth Index

Small Value Stocks are represented by the Russell 2000® Value Index

International stocks are represented by the MSCI® EAFE® Index

Bonds are represented by the Lehman Brothers Aggregate Bond Index

The Iles Group of Merrill Lynch (989)791-8401 or (888) 835-3192

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HedgeFunds

Managed Futures Funds

PrivateEquity

Exchange Funds

There are four major investment categories of alternative investments:

The Universe of Alternative Investments

A hedge fund is a private pool of assets that may invest in a diverse array of investments, from basic stocks and bonds to complex derivatives.

A managed futures fund is a professionally managed portfolio typically trading in a wide range of markets via futures, forward and options contracts through a

Commodity Trading Advisor (CTA).

Private equity funds are pools of actively managed capital organized to invest in privately held and certain public companies. These funds share the common goal of supporting companies as they

create value and, ultimately, deliver substantial returns to investors.

Exchange funds are limited partnerships that provide the opportunity to “exchange” a large, highly appreciated single-stock position

for shares in a diversified private fund while deferring capital gains taxes.

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Hedge Fund Styles

Market Exposure High

ArbitrageDirectional /

TacticalEvent Driven

Low

ConvertibleArbitrage

Fixed IncomeArbitrage

Equity MarketNeutral

Source: Standard & Poor’s

Special Situations

Distressed Securities

Merger Arbitrage

Long/Short Equity

Managed Futures

Macro

There are three broad categories of hedge funds (and 9 sub-strategies) that provide varying levels of market exposure.

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Management Fees

Easily found in the prospectus

Cover portfolio research and management

12B-1 fees

Easily found in the prospectus

Cover marketing expenses of the fund

Transaction costs

Hard to find – in Statement of Additional Information

Variable trading costs in addition to the management fee

Advisory fees (in some cases)

Additional fees charged for Advisory/Consulting Services

Fee Components becoming critical

PRICE IS FRIGHT

Annual costs of running the average U.S. stock fund

Source: “Scale Effects in Mutual Fund Performance: The Role of Trading Costs”

1.44%

2.85%

1.73%

0.77%

1.21%

1.34%

1.30%

1.12%

All funds

Small-cap

Mid-cap

Large-capTrading CostsExpense ratio

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UPMIFA

2. Expenditure of Funds• Express prudent total return standard, 7 factors:

1. Fund duration

2. Fund purpose

3. General economic conditions

4. Effects of inflation/deflation

5. Expected total return

6. Other resources

7. Investment policy statements

Optional: over 7% of total return presumed imprudent

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Spending Policy – 3 types

1. Spending policy-foundations: 5% required at minimum.

2. Cash Flow and Spending for a Public Support Organization:

• IRS Reg. 1.509(A) – “substantially all of its income” policy. This means 100% interest income + dividend income + 85% of short-term capital gains. Can be set to max out at 4% or 5% of annual portfolio value.

3. Rolling/Moving Average spending policy: most common

• 3 year moving average of quarterly portfolio market values.

• Calculated one-year prior to distribution date.

• 12 quarters X spending rule of 4% or 5%

• Provides more consistency & predictability on spending and allows the Board to design allocations to be more aggressive than if just based on the annual performance of the portfolio.

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Spending Policy Examples: NACUBO 2006

1. Clark University: Moving Average Policy: 5% of a 20-quarters moving average of market values.

2. California State University: Prudent Total Return Policy: UMIFA allows “total return” concept. Income to projects, capital appreciation to special needs. No cap.

3. Stanford University: Smoothing Rule Spending Policy: a model based on 4.75% of expected return or budget needs.

4. Yale University: Smoothing Rule Spending Policy: long-term spending at 4.75% to reduce volatility. Spending equal to 30% of the long-term spending rate of 5% of current endowment values plus 70% of spending in the previous year adjusted for inflation.

5. Wellesley College: Wide Range Spending Policy: spending shall be between 4.5% and 6% of moving average of endowment market value.

6. Northwestern University: CPIU Spending Policy: spend last year’s total increased by the Consumer Price Index, unless that exceeds 6%, or less than 3.5% of a three year moving average of the portfolio.

7. Harvard University: The None of Your Business Spending Policy.

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UPMIFA

3. Delegation of Investment Management• Prudent delegation in good faith, care standard of prudent person

• Agent has duty of reasonable care

• Agent subject to court jurisdiction

• Delegation to committees, officers or employees as authorized by other law

Investment Policy Statements are required to satisfy this requirement of delegation of investment management. Does your IPS accomplish this?

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Professional Money Managers

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Investment Policy Development For Foundations: The IPS Audit

Identifying IPS Gaps in the following:

Investment Duration, liquidity needs & events

Return and Volatility Ranges: allocation modeling

Asset Class & Style Allocation Parameters

Social, Religious & Legal Restrictions

Investment criteria including active or passive guidance, investment selection/replacement process, implementation & monitoring

Reporting/Review Frequency & Rebalancing regimen

Detect Gaps & Remedy Variance, if any, in IPS and Current Allocation

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IPS Audit Issues

Uniform Prudent Management of Institutional Funds Act and Revised Uniform Prudent Investors Act heightened due to Sarbanes-Oxley trends.

Complexity of Global Capital Markets and complicated investment programs impact on the traditional IPS

Major accounting firms introduce new audit programs for IPS included in annual financial audits for tax exempt qualifications

AICPA issues Audit Section AU 9328 Fair Value Measurement and Disclosure and AU 9332 Derivative Instruments, Hedging Activities and Investment in Securities where readily determinable fair value does not exist: Alternative Investments

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IPS Audit Issues

Auditors are suggesting several key recommendations:

•Confirmation from Foundation’s money manager on valuation of manager’s fund is insufficient evidence for certification of a funds value.

•The Foundation is responsible for making the fair value measurement and disclosures in financial statements.

•Auditor must understand the Foundation’s valuation methodology and conform to GAAP and test the valuation measurements and disclosures.

•If auditor is unable to qualify these issues, auditor should consider the qualifying opinion in the form of a “scope limitation” suggesting the auditor cannot claim comfort with financial statements relating to AI.

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Critical Issues for IPS

1. Nonprofit audits now requesting IPS evaluations: risk analysis at security level and measuring Ratings and BETA.

2. Increased difficulty meeting client objectives in a lower return economic environment: Behavioral finance impacts IPS and radical changes.

3. Market trends toward absolute return alternative investment programs. Due diligence, increased costs, manager talent & accessibility, offerings & participation and historical performance vs. forward looking estimates.

4. Market trends toward more dynamic asset allocation modeling: traditional allocations, tactical allocations and allocations with alternative investments.

5. More sophisticated analytical tools available: Monte Carlo probabilities and cash-flow simulations on spending policy.

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IPS Structure (17 Components)

Main body of the IPS adopted by the Board:

• Executive Summary

• Mission & Purpose

• Scope of Investment Policy

• Delegation of Authority

• General Investment Principals

• Goals of Institution

• Attitudes toward Gifts

• Spending Policies

• Investment Objectives

• Definitions: risk, volatility, liquidity and marketability

• Guidelines on Restricted and Unrestricted Assets

• Selection of Alternative Investments

• Asset Allocation Guidelines

• Investment Manager Selection, Evaluation and Removal

• Policy Monitoring and Frequency

• Investment Decision History

• Fees and Operating Costs

• Investment Policy Review: frequency

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IPS Addendums vs. Amendments

Addendums can be structured so the Investment Committee can amend and approve changes to the IPS through the use of Addendums without the need for full Board of Trustees formal action.

Types of Policy Addendums:

•Investment Manager Addendums: hires and fires

•Asset Allocation Addendums: tactical allocation changes

•Investment History: logs of strategic and tactical decisions and frequencies

•Service Provider Addendums: consultants, custodians, legal, accounting

•Fees and Compensation Addendums: disclosure logs on each hire

•Gift Acceptance Addendums: changes and exceptions for Donors

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Recent Trends in the

Asset Allocation Models

for Endowments and Foundations

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Zephyr AllocationADVISOR: Merrill Lynch

Efficient FrontierCase: Pre-Tax CMA Case Return vs. Risk (Standard Deviation)

11 12 13 14 15 167.5

7.6

7.7

7.8

7.9

8.0

8.1

8.2

8.3

8.4

8.5

8.6

Risk (Standard Deviation)

Re

turn

Mix 1

Mix 2

Mix 3

Mix 4

Mix 5

Sample Current

Allocation Mixes 1-5 have risk/return efficiencies i.e highest

return/lowest risk

Generating Optimal Asset Allocation Mixes

Typical Foundation

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Risk-Reduction via Non-Correlated ASSET CLASSES

* Private Equity, Commodities, Hedge Funds, Real Estate, Currency Allocations

* Geographic, Sector, Thematic, Tactical Allocations - widens diversification, reduces risk

- increases non-correlation of investments - elevates portfolio risk/reward efficiency

AI

Equities

Fixed Income

Cash

AI

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Trends in Foundation Asset Allocation

Greenwich Associates study of 1,113 Endowments/Foundations shows:

* Increasing allocation to Private Equity (9.8%) Real Estate (6%) and Hedge Fund (15%) in Foundation asset allocations

* Expected Increases next 3 yrs. in P.Equity (41% of Foundations) Hedge (33%) R.Estate (30%) and expected Decreases in U.S Equity (23%) and Bonds (14%)

* International stocks/Intl. bond allocations up

* Alpha-hungry Single Manager Hedge Funds up vs Fund of Funds

* Actively managed, high conviction styles are being included

* Heavily concentrated, non-correlated styles are being added

* Strategic mix of indexing for Beta with active mgmt. for Alpha

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Greenwich & NACUBO Studies point to increased AI by Foundations

Over $1BB $250-$500 Overall - DW Over $1BB $100-$500 Overall - DW Overall - EWDomestic Stocks 39.10% 43.70% 40.10% 25.70% 45.10% 31.70% 45.90%International Stocks 14.40% 13.80% 14.30% 16.20% 11.80% 16.60% 12.60%Fixed Income 22.30% 20.50% 22.30% 16.20% 18.40% 17.20% 21.50%Equity Real Estate 4.50% 3.80% 4.10% 5.30% 4.00% 4.40% 3.10%Private Equity 8.50% 4.20% 7.40% 9.30% 3.90% 7.10% 2.40%Hedge Funds 9.80% 11.80% 10.00% 19.90% 11.90% 16.60% 8.70%Natural Resources 5.40% 1.40% 3.60% 0.90%Other (Mostly Cash) 1.40% 2.20% 1.80% 2.00% 3.50% 2.80% 4.90%

100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

2005 Increase in Assets 11.86%

2005 Investment Return 13.80% 9.60% 13.90% 9.30%2005 Spending 4.70%

2005 Imputed Contributions 7.26%

Note: DW refers to Dollar Weighted averages, EW refers to Equal Weighted averages.

NACUBO DataGreenwich Data

Larger portfolios take more aggressive positions, not only because they have the size to invest in more complicated instruments with higher minimum investments, but also because they have more sophisticated internal portfolio managers.

The more aggressive positions lead to greater returns, especially given the economies of scale with respect to fees.

The net additions observed in college/ university endowments allows the portfolios to invest in more aggressive and less liquid investments that may have more return potential than investments subject to the need for more liquidity in the average endowment (Greenwich Data) that does not necessarily have dependable inflows.

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Typical Roadblocks To Adopting AI By Foundations

* Too much money chasing too few opportunities (30% of Foundations)

* Poor credibility, transparency and reporting of AI sources (27%)

* Does not fit Investment Policy risk mandates (23%)

* Boards uncomfortable with Risk (22%)

* High Leverage (21%)

* Illiquidity, & insufficient regulation (14%)

* Short track records (13%)

Source: Greenwich Associates

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Foundations Should Embrace AI for Creating “Generational Equity”

Generational Equity = future purchasing power of the foundation’s spending funded by portfolio growth plus inflows minus annual spending

* Foundations’ Average spending rate was 5% approx last 5 years

* Mean expected return next five years U.S stocks (7.3%) and actively managed bonds (4.6%) alone without AI exposure may be ‘tight’ in creating generational equity after a 5% spending rate.

* Mean expected return of other alpha sources-P.Equity (10.5%), H.Funds (8.4%), Real Estate (8%) and Int’l equity (8%) may be needed.

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A Strategic Allocation Model for Foundations

* Understanding the mandates of the Investment Policy Statement (IPS)

* Determining variances between mandates and actual portfolio

* Reconciling the Foundation’s IPS with Best Practices

* Getting Investment Committee’s buy-in to new Best Practices by partnering with Foundation’s Investment Team

* Creating different Asset Allocation scenarios combining traditional and alternative asset classes

* Testing allocation scenarios with two-prong deterministic (standard deviation & expected returns) and probabilistic (Monte Carlo simulation) tools

* Populating selected allocation with investments after extensive Due Diligence

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Due Diligence & Portfolio Construction For Foundations

Sleeve or Whole

Portfolio?New or

Replace?Manager

Due Diligence:Qualified Candidates

Sleeve/PortfolioConstruction

Monitoring

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Quantitative Due Diligence For Foundations

Total Return: Peer universe & benchmark comps

Risk: SD, Beta, Worst Performance Period

Efficiency: Sharpe, Treynor & Information Ratios

Consistency: Tracking Error, R squared, Bat Avg.

Symmetry: Up & Down market capture ratios

Attribution: Returns, Holdings, Multi-factor

Confirmation from multiple and divergent sources increases accuracy of judgment

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Qualitative Due Diligence For Foundations

ResourcesResources

FirmFirm

Organization

•Ownership•Infrastructure•Breadth of products

•Client base

Organization

•Ownership•Infrastructure•Breadth of products

•Client base

Progress

•Ownership Changes

•Adaptability• Growth• Product additions

Progress

•Ownership Changes

•Adaptability• Growth• Product additions

People

•Team stability•Key decision makers

•Incentive comp

•History

People

•Team stability•Key decision makers

•Incentive comp

•History

Product

•History•Investment vehicles

•Client types

Product

•History•Investment vehicles

•Client types

MethodologyMethodology

Philosophy

•Manager’s beliefs

•Clear game plan

•Risk/ return•Value added

Philosophy

•Manager’s beliefs

•Clear game plan

•Risk/ return•Value added

Process

•Clear/ understandable

•Data sources•Communication

•Repeatable

Process

•Clear/ understandable

•Data sources•Communication

•Repeatable

Investment ResultsInvestment Results

Portfolio

•Construction•Risk mgmt process

•Characteristics

•Consistent

Portfolio

•Construction•Risk mgmt process

•Characteristics

•Consistent

Performance•Representative

•AIMR compliant

•Consistent w/ process

•Performance vs. risk

Performance•Representative

•AIMR compliant

•Consistent w/ process

•Performance vs. risk

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Customizing Portfolio Construction For Foundations

One size does not fit all!

* Understanding the Foundations spending rates and inflow projections

* Allocating a combination of beta sources for funding liabilities and alpha sources for “generational equity’

* Adjusting to Foundation peculiarities like stock concentration issues in the allocation mix

* Factoring in cultural, regulatory, social and religious restrictions, if any, in portfolio construction.

* Implementing, quarterly reviewing and systematic rebalancing to be consistent with IPS mandates

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On behalf of MHA and

The Iles Group&

DP Group

Thank You

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DISCLAIMER

This presentation contains information on wealth management principles and is for informational purposes only. It should not be construed as investment advice and is not intended to be a specific offer by Merrill Lynch to sell or provide, or a specific invitation to apply for, any particular product or service that may be available through the Merrill Lynch. In particular, this presentation is not intended as a recommendation that any investor pursue investment strategies involving listed options, high-yield bonds or alternative investments. All investment recommendations are made by Merrill Lynch Financial Advisors only after individual consultation and in consideration of an individual client's financial goals, investment objectives and risk tolerance.

Diversification does not assure a profit or protect against a loss in declining markets.

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