How University Boards Work - The Investment Committee and Invested Funds

Over the past year, I have issued short descriptions of the topics covered in How University Boards Work: A Guide for Trustees, Officers, and Leaders in Higher Education. In this post, I summarize the role of the Investment Committee.

The institutional Investment Committee, like the Finance Committee, should include at least a couple of members who are professionally competent in the subject matter. Nevertheless, it is often beneficial to have members who will ask “naive” questions about topics that professionals take for granted.

While the Finance Committee enjoys full committee status, the Investment Committee is sometimes a sub-committee to the Finance Committee. Under this arrangement, the Finance Committee deals with investment policies, procedures, and guidelines, including ethical issues and a spending policy, as part of its portfolio. Nevertheless, most Investment Committees will have independent committee status and be guided by a Charter drawn from the institution’s by-laws.

In addition to some professionally competent members, the institution will probably engage a consulting firm that will manage the relationships with the various fund managers. A university or college might have a different manager for each type of investment, including (1) equities, (2) fixed income, and (3) alternatives such as lumber and commodities (hedge funds), etc. There are large cap and small cap equity funds specializing in domestic, international, and emerging markets both generally and specifically.

Invested funds are also of three main types: “restricted” by a donor; “designated” by board action; and “unrestricted funds serving as endowment”. The latter may be from unrestricted gifts or excess income during the year. 

The Investment Committee will be aided by the Chief Financial Officer (CFO). The CFO will probably be the routine contact person for the investment consultant. A wise president will also attend Investment Committee meetings and seek to understand its responsibilities and opportunities.

At smaller institutions, the CFO may be the sole contact for the consulting firm and the board might limit the number of managers. In larger, more sophisticated investment programs, the primary contact will be the Chief Investment Officer (CIO). Depending upon the size of an investment staff, there may also be heads of various asset class categories, like equities and fixed income.

The full board of trustees should adopt a set of policies and procedures to guide the actions of the Investment Committee. Committee decisions include the selection of a consultant, selection of fund managers, the percentage allocations of funds across different types of asset classes, and the level of investment in each. This gives the Investment Committee guidance but also some latitude in managing the asset allocations of the fund. For example, the Committee might have authority to increase an investment in an approved manager from $3 million to $5 million, but not over an approved threshold of $5 million.

In addition, the board will adopt a policy regarding the use of investment returns. A standard for many institutions is to use 4% to 5% of the three-year rolling market value of investments as income for operations. As is readily apparent, problems can arise if the value of the stock portfolio declines or inflation increases. A restricted gift will have specified funding for scholarships or a professorship, for example. If an institution has come to rely on this steady stream of revenue to honor these commitments and the approved percentage does not yield the anticipated income, budget pressures can result. This is why it is prudent to stick to a percentage even if the yield is higher than the expected amount. The balance should be reinvested for a darker day or, if unrestricted, used for a one-time expense.

The Committee members should become familiar with UPMIFA, the Uniform Prudent Management of Institutional Funds Act. This Act applies to permanently restricted assets provided by a donor and specifies the goals of maximizing “total return”, that is the total return of interest, dividends, and net capital gains.

Just as for individuals, the allocations between and among fund types are dictated by the degree of risk the institution can tolerate. For many institutions, a 60% equity-40% fixed income ratio would be the norm. As prudent diversification of the equity portion of the fund became better understood, the asset mix at many institutions changed to include an increasingly larger percentage of equities.  Today, there are endowments that have just 10% to 15% of the total fund in fixed income investments, with an allocation of 75% - 80% in the equity portion of a fund.

Furthermore, some institutions with large endowments will tolerate even greater risk by putting a sizable percentage of funds in illiquid, so-called “alternative” assets, like timber and commodities. The theory underpinning this approach is that the characteristics of certain alternative investments cause them to act in a complementary fashion in relation to mainstream equity investments over longer time periods. Thus, in theory at least, they help in achieving adequate diversification and risk management within the equity portion of a fund.  

Over shorter time periods, though, such as the Great Recession of 2008, even some of the largest and most sophisticated endowments found that they could experience a significant, absolute loss of value.  The liquidity risk of alternatives forced one Ivy League School’s board chair to report that, because the University had invested some operating funds in the alternative investment category, it needed to borrow funds to meet short-term cash needs.

Other forms of risk to be considered are more philosophical than financial. One is the potential or actual conflict of interest that can arise when a board member has a relationship with a proposed investment firm or manager. Such conflicts of interest must be made known to the board, discussed, and decided upon according to the duties of care, obedience, and loyalty.

Another form of risk is related to controversial investment options such as alcohol, tobacco, and fossil fuels such as oil and gas. The types of investment should be consistent with the college or university’s mission, programs, and priorities as well as financial goals.

Still another risk is that donors will think the institution is engaging in unreasonable practices with their endowments. Good stewardship requires that the university or college act to preserve the gifts and report to donors on the status of their funds. This not only can satisfy the donor about the condition of a past gift but also can serve as an encouragement to give again.

The campus audit firm can be a source of advice about the degree of risk that would be prudent. However, prudence is to some extent in the eye of the beholder. The prudent investor rule requires that a fiduciary, as in trustee, should invest the entrusted assets as he or she would invest family assets by considering the needs and interests of the trust’s beneficiaries.

Nevertheless, I recall an Investment Committee discussion of a particular hedge fund candidate when a trustee said that this was the kind of “black box” investment opportunity he would take for himself, but would not recommend for the university. Echoing David Riesman’s assertion that the role of the board is to save the university of the future from the actions of the present, he said that the committee should remember the 100-plus year timeframe of the institution.

The principles of good governance apply to the Investment Committee and its members as they do to the board as a whole. The role of the committee chair is important to the fulfillment of the committee’s charter.

Robert A. Scott is the former president of Adelphi University and of Ramapo College of New Jersey. He is the author of How University Boards Work: A Guide for Trustees, Officers, and Leaders in Higher Education.

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I am grateful to Timothy P. Burton and Richard Moreland for reviewing my understanding of some of the technical aspects of this text.