By Ellie Winninghoff

How do you invest in high-risk, proof-of-concept approaches to solving environmental and social problems if you are risk averse? Gift it.

Foundations have long been a way to funnel charitable dollars into investments targeting a specific mission. Indeed, impact investing arguably got its start in the late 60s with the creation of program-related investments, or PRIs, which are investments foundations make to target their philanthropic missions. Since the main purpose of the investment must be charitable, most PRIs (which can be structured as debt or equity investments) have been designed as low-interest loans.

But while PRIs are an exciting tool that can function as social venture capital, they are available only for foundation purposes. Donor-advised funds, on the other hand, can offer an intriguing alternative for individual investors. "Donor-advised funds are the secret sandbox of impact investing," says Tim Freundlich, president of Impact Assets, a nonprofit financial services firm and spin-off of the Calvert Foundation, who says it's a lot easier to do impact investments in DAFs than in the real world.

The story begins about 70 years ago when community foundations first introduced donor-advised funds, or DAFs. In this early iteration (which still exists,) DAFs usually required $500,000 to $1 million. The idea was to co-mingle the funds of several donors with those of the foundation's endowment, which would be managed by investment professionals. Then, if a donor wanted to make a gift to a charity, the foundation would first make sure the charity was in good standing. Once so satisfied, it would then liquidate the funds from its endowment and send a check to the charity in the donor's name.

In the late 90s, financial services firms realized they could use the technology and infrastructure for brokerage accounts and mutual funds to facilitate on-line DAFs. These DAFs, which usually require a minimum of $5000, are electronic versions of foundations. Foundations, though, are stand-alone corporations. DAFs, in contrast, are a conglomeration of individual accounts held under one administrative umbrella, itself a charity that provides DAF services. These on-line DAFs are invested individually.

"[An on-line DAF] is almost like a charitable savings account," Kim Wright-Violich, former president of Schwab Charitable, told FA Green last January.

How does an on-line DAF work? Take an individual who has a capital gain of $3,000 on $5,000 worth of stock that she wants to liquidate. She can avoid the capital gains tax hit by transferring the $5,000 in stock to a DAF that she has established at a place such as Schwab Charitable. This locks in a charitable deduction for the entire $5,000, which she can take as a credit against her ordinary income.

The next step is for the DAF (which the donor controls) to sell the stock, leaving $5,000 in the DAF account. The donor has committed to giving it away, but can do so at her own pace. (Private foundations, on the other hand, are required to make 5% minimum distributions each year.)

On-line DAFs, which have arguably democratized philanthropy, have been extraordinarily popular. Schwab Charitable, for example, in ten years has grown from a start-up to become the 10th largest charity in the U.S. with assets of $3 billion. Its donors typically give away 20% to 25% of total assets each year.

The question arises: What do you do with DAF funds while they are waiting to be granted? After all, these are monies the donor will never get back but for which she already has received a tax credit in exchange for making charitable donations. "Donors are always in this dilemma," Wright-Violich pointed out. "Do you maximize your investment return to get the most money out of charity--or do you invest in a way that is consistent with your charitable giving?"

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