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| Path: Main Street > Resources/Library > Research Articles > Feature Article |
Investing for the longer term
By David Michaels
April 7, 2008
In February, we looked at some basics of investing and discussed short-term strategies that charitable organizations can use to realize better returns on their funds. In March, we turned our attention to more specific investment considerations, such as time horizons, asset classes, and risk and return. This article looks at investing over a longer term and includes approaches for long-term operating funds and endowments.
Long-term investment considerations
On the balance sheet, long-term investment assets are classified as anything that matures in excess of one year. However, for the purposes of investing for the long term, we should consider a time horizon of five to ten years.When a longer term time horizon is available, the investment alternatives and the opportunities to diversify among asset classes become greater. It is widely accepted that, over a 10-year horizon, returns from equities will outperform other asset classes (cash and fixed income). This becomes especially important when considering how to handle endowments (discussed below).
While equities are considered to be the asset class that exhibits the greatest volatility, this can be mitigated by investing in equities that have low levels of volatility over a long term. Research is required to determine which equities are most appropriate, but the first step is to develop an Investment Policy Statement (IPS), which each organization should have, regardless.
An IPS sets out the organizational rules for investing, including objectives, allowable investment vehicles, responsibilities of the board and board finance committee and senior staff, the type of firm to be engaged, and reporting requirements.
In Canada, there are a number of sources of information that can help an organization determine which specific investments are most suitable, but professional assistance is likely the best course. A professional will work with an organization to help determine risk tolerance and create a portfolio that is most suitable to the organization’s goals, as reflected in the IPS. An investment advisor will help the organization decide among investment alternatives. For example, when it comes to equities (stock), preferred shares - which pay dividends but usually don’t exhibit the volatility of common shares (which may or may not pay dividends) - might be more suitable for the equity portion of the portfolio.
Another important consideration is that often, as mentioned above, common shares do pay dividend income; this is typical with bank stocks, for example. So, while the underlying investment may be subject to the ups and downs of the market, a steady flow of dividend earnings not only provides an income stream, but is part of the total return calculation.
Where do long-term investments come from?
Generally, there are two sources of funds that may allow for long-term investment opportunities: long-term operating funds and endowment funds.1. Long-term operating funds
In the March 3, 2008 article that appeared here, we used a hypothetical example of a charity receiving annual operating grants that have, due to timing differences between receipt and use, resulted in an amount of $200,000 being recorded as Deferred Revenue on the balance sheet. Upon examining its balance sheets over the last number of years, the charity saw that this $200,000 was relatively constant, so there was an opportunity to invest this $200,000 in a bond or series of bonds with maturities ranging between one and five years and at rates higher than the going rate for a GIC.
Now, assume that another charity had the same situation, but instead of going back five years, when they looked back ten years, this same $200,000 was on the balance sheet as a deferred revenue item. Under this circumstance, the potential investment time horizon is longer and the chance to invest in a more diversified way is increased. This charity decided that, consistent with its IPS, it would use 25% of the $200,000 to purchase common shares in a Schedule I Canadian bank, with a dividend of $2.80 per common share, resulting in a current annual yield on the dividend, of over 5.9%! And, since the common shares were anticipated to be held for a long time, it was reasonable to assume that capital appreciation would significantly add to total returns over the holding period.
2. Endowment funds
While the potential benefits, disbursement requirements, and other mechanics related to endowments are beyond the scope of this article, it should be noted that endowments typically arise in one of two ways:
- A charity may establish an endowment fund to further its mission;
- A donor may specify that his/her gift be held as an endowment.
In either case, once an endowment has been established, there will be a long-term hold of capital that is invested, with all or a portion of the annual income from the investment flowing back to the charity to support its activities.
When a charitable organization has an endowment fund, regardless of how the fund came to be, there is an understanding that generally accepted investment risks will be part of how the charity handles those funds. Endowments are expected to grow in value over the holding period and, since equities are the asset class that historically offer the best returns over a longer time horizon, a charity with an endowment fund should reasonably be expected to invest at least a portion of an endowment fund in equities.
But, as we’ve discussed before, equities are the “riskiest” asset class so the organization has to balance risk and return. This can be accomplished by diversification, investing in relatively safe equities, and taking other strategic approaches. For example, assume a donor has given your charity a gift of $100,000 and signed a designation that the gift is to be an endowment and held for ten years. Under the Income Tax Act, such a gift is generally excluded from the charity's disbursement quota.
At this point, the charity may choose to protect the capital of $100,000 by purchasing a zero-coupon bond to mature in 10 years at $100,000. A zero-coupon bond pays no interest, is sold at a discount and at maturity is redeemed for its full face value. Assuming a 4% interest rate, the charity would pay just over $67,500 for this bond and would be certain that, in ten years, it would receive the equivalent amount of the capital portion of the gift - $100,000. At the time of purchase of the bond, it would also have the difference between the gift and the cost of the bond, (about $32,500), to invest. An investment decision would be made, consistent with the organization’s IPS. A well-diversified portfolio could be established to take advantage of the long-term superior returns that can be expected from having a portion of that $32,500 invested in equities. And remember, the principal (original gift) is protected.
Successful investing for the long term may be more easily accomplished than seems apparent. It can begin by doing a trend analysis of certain balance sheet and other operating items over a number of years. If endowments are part of your organization’s funds, the long-term investing opportunities will be that much more available and diverse strategies should definitely be explored.
David Michaels is an Investment Advisor with BMO-Nesbitt Burns, Exchange Tower branch, in Toronto. Before joining Nesbitt-Burns, David was in charge of the finances of three legally separate but related medium-sized charitable organizations in Toronto where he used a cash management and fixed income strategy to significantly improve interest earnings.
David can be reached at (416) 365-6038, or via his website at www.davidmichaels.ca.
Opinions are those of the author and may not reflect those of BMO Nesbitt Burns. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. BMO Nesbitt Burns Inc. is an indirect wholly-owned subsidiary of Bank of Montreal. Member CIPF.
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