Institutional and nonprofit investors have seen a lot of changes in the past few years that make navigating their investment issues a challenge. The bear market of a few years ago may have disrupted plans, and services and new legislation have set forth a host of different investing rules. These factors have combined to make many institutional investors more needful of quality investing assistance than ever before.

Advisors have numerous opportunities to serve these clients. The key to serving institutions is to understand their specific needs. Before diving into the specifics of serving institutional investors, it's helpful to understand how institutions differ from individuals when it comes to investing. Here are just a few of the main differences:

Time Horizons
The time horizons of institutions and nonprofit organizations are very long, with many investing in perpetuity. The long time horizon to invest and generate income is a benefit when it comes to riding out volatile markets, but it also means that growth must keep pace with or exceed inflation to preserve buying power.  

Intergenerational Equity
With individual investors, the main goal is typically to provide for the individual and spouse, with thoughts of leaving something to heirs being secondary. Intergenerational equity is a concept that refers to the equal treatment of present and future recipients. In other words, for institutions, an asset allocation and spending policy should be designed with equal emphasis on or benefit to current and future beneficiaries.

Tax-Exempt Status
Tax-exempt status means ordinary income and capital gains no longer cause friction for an organization's investment portfolio, opening up institutions to asset classes that may not be as prudent for individual investors. The barrier to investing in tax-inefficient asset classes such as REITs, commodities or taxable bonds is not an issue, and the additional cost of tax management is eliminated.

Regulations
The most widely adopted guideline for institutions and nonprofit organizations is the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which has been enacted in every state except Pennsylvania. By incorporating modern investment theory and practice, UPMIFA replaces the 1972 Uniform Management of Institutional Funds Act (UMIFA).

Fiduciary Responsibility
One of the biggest items set forth by UPMIFA is that institutions and nonprofit organizations have a fiduciary responsibility when it comes to investing and handling endowments, meaning the staff, board and committee members have a legal obligation to do only what is in the organization's best interest. UPMIFA permits board members to delegate their investment management responsibilities to one or more investment advisors if they do so with prudence. This also means that any advisors acting on behalf of such an organization must uphold the same fiduciary requirements as board members.

For advisors, recognizing the differences between serving institutional and individual investors is only a starting point for effective investment management. Guiding an investment or finance committee through the investment management process can be complicated, depending upon the range of experience and personalities of committee members. Careful planning and active communication between the organization and the investment advisor not only simplifies the process but also reduces the number of conflicts that may arise.

First, the board must agree to the overall mission and goals of the organization. Next, they should create a written investment policy statement (IPS) that governs the funds that will fuel the mission. This goes beyond simply serving as a blueprint for investing. The IPS ensures that future board members, staff and advisors understand why endowment funds are invested in the manner they are, helping mitigate confusion and potential conflicts down the road. An experienced investment advisor can help with that process, providing an outline of an appropriate IPS and helping with recommendations.

The IPS not only outlines the mission, but also prioritizes objectives, defines responsibilities of the investment committee and investment advisor, and sets the investment parameters. For example, a comprehensive IPS will state acceptable and prohibited asset classes, target asset allocations, rebalancing guidelines and methodologies for measuring performance. An IPS should cover all the funds of an organization, especially those with differing objectives. A general operating fund and an endowment fund may have different priorities, asset allocations and spending policies, which should be clearly outlined in the organization's IPS. Alternatively, a board could create a separate IPS for each specific fund.

After the IPS is set, the board's next task is setting a spending policy and sharing it with all parties involved. The spending policy sets the guidelines for spending each year and also provides guidance for committee members to be more flexible in certain years when necessary. For example, the board may determine that a specific endowment should spend between 4% and 6% of the total assets. However, such distributions may not be appropriate during difficult market times, so the flexibility to scale back distributions may be needed.

UPMIFA provided seven factors for board members to take into account when determining year-to-year spending:
1. The duration and preservation of the endowment fund.
2. The purposes of the institution and the endowment fund.
3. General economic conditions.
4. The possible effect of inflation or deflation.
5. The expected total return from income and appreciation of investments.
6. Other resources of the institution.
7. The investment policy of the institution.

This is an important departure from previous law, which stated that underwater endowments (that is, endowments with a total value less than the original gift) weren't allowed to make distributions. During the most recent financial crisis (prior to UPMIFA's widespread adoption), many endowments, especially recently established ones, had the necessary assets to fund programs, but were prohibited from spending them because they were underwater.

For example, at the beginning of 2008, the North Carolina Symphony's endowment was worth $9.3 million, well above its historic dollar value of $7.25 million and enough to allow the organization to make a $600,000 withdrawal to cover salaries and concerts. By March 2009, the fund had dropped to $6.9 million, meaning the symphony was restricted from touching the endowment and needed to find other ways to make up the revenue. (North Carolina has since adopted UPMIFA.)

It is important to know that spending policy and asset allocation are dependent on each other and cannot be determined in isolation. A perpetual endowment with an expected investment return of 3% per year can't be expected to distribute 7% each year. To achieve intergenerational equity, the portfolio must take enough risk to sustain spending while not taking on so much risk that the corpus is unduly jeopardized.

To strike this optimal balance of allocation and spending, advisors should conduct an asset allocation and spending policy analysis. Because each institutional fund is unique, a properly run study can show the impact of spending changes, smoothing formulas, inflation and other assumptions.

Once the IPS, spending policy and asset allocation are finalized, the investments of the funds can be implemented according to the board-approved documents of the organization and the investment guidelines of UPMIFA. UPMIFA incorporates several key concepts from the Uniform Prudent Investor Act and Modern Portfolio Theory (MPT), including the concept that investment decisions should be made in the context of the portfolio as a whole (a total-return approach) and should take into account the funds' risk and return objectives.

Several leading financial economists, three of whom received the 1990 Nobel prize for their contributions, conducted research resulting in the formulation of MPT. One strategy that strongly follows the spirit of UPMIFA and MPT is passive investing. By broadly diversifying equities through low-cost, passively managed mutual funds, managers fulfill their obligation to minimize costs, provide transparency of underlying assets and deliver a prudent investment strategy backed by academic and real-world evidence.

Even David Swensen, chief investment officer of Yale University's $19.4 billion endowment, would agree that for most institutions, passive management is the right approach. A recent article from Financial Advisor magazine reported David Swensen addressing an audience at a conference:

Unless an investor has access to "incredibly high-qualified professionals," they "should be 100% passive-that includes almost all individual investors and most institutional investors," he said.

UPMIFA clearly states that those who manage funds for a charity should adhere to the following guidelines:
Give primary consideration to donor intent as expressed in a gift instrument.
Act in good faith, with the care an ordinarily prudent person would exercise.
Incur only reasonable costs in investing and managing charitable funds.
Make a reasonable effort to verify relevant facts.
Make decisions about each asset in the context of the portfolio of investments, as part of an overall investment strategy.
Diversify investments unless, due to special circumstances, the purposes of the fund are better served without diversification.
Dispose of unsuitable assets.
In general, develop an investment strategy appropriate for the fund and the charity.

Following these guidelines allows advisors to add tremendous value to institutional and nonprofit clients and help ensure the organizations they work with will be providing services for many years to come.

Tiya Lim is director of institutional advisory services for BAM Advisor Services, which provides back-office services to RIA firms across the country.