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As nonprofits accumulate financial assets for specific purposes or from budget surpluses, a variety of issues arise as to optimal investment options. Factors that dictate an association's investment posture for strategic assets include

• Association ownership. While all association assets must be handled with due care, strategic assets generated by the association differ from assets that are bequested to the association by third parties for specific use. Third-party bequests typically have instructions as to their deployment, with endowment assets being the most perpetual. Internally generated assets are typically seen as an enhancement of member benefits as well as a hedge against future lean periods.

• Time frame. Assets invested toward a particular goal differ from assets invested for ongoing benefit. Assets accumulated for a specific purpose are usually expended once the financial goal has been reached or after a specific time frame has elapsed. In general, a shorter investment time frame dictates a more conservative posture due to the potential inability to make up for adverse returns in future time periods.

• Risk level. Within the parameters of prudence there should be an understanding that risk taking is rewarded by higher investment returns across time. The range of risk that an association can tolerate is dictated by the association's dependency on the return. For example, incorporating a projected return into the association's budget would call for a more predictable return than a decision to spend a portion of the return after it is realized.

  Bond assets as a class have more predictable returns in the short run, especially from the standpoint of cash flow. Stocks will give higher returns across time but less predictable returns in any one year.

Common mistakes in strategic asset investing

• Not enough consideration of association's tax status. While most people grasp that cash flow and appreciation are tax-exempt for a nonprofit, there is sometimes a tendency to become more aggressive in the pursuit of short-term gains and overlook the benefits of cash flow.

  In theory, an association's strategic investments should be impartial from a tax standpoint as to whether gains come from appreciation or cash flow, especially because there is usually no allocation of the two as in endowment fund investing. In reality, cash flow is more certain while appreciation can be greater but is less certain. Some investments, such as convertible securities, can offer income and appreciation in the same investment.

• Excessive portfolio turnover. The purchase and sale of securities entails several costs of which commissions is but one, albeit the most visible. Thus, a high-turnover investment strategy must return more gains to pay for the various transaction costs in order to net as much as a low-turnover strategy. Associations that have invested in mutual funds with high portfolio turnover are engaging in a high-turnover strategy, often without being aware of it.

• Over-reliance on long-term data in making asset allocation decisions. Historically, across long periods of 50 years or more, stocks outperform bonds and bonds outperform cash. However, within long periods there are times lasting as long as a decade when the performance of the asset classes are reversed. Usually this reversal is precipitated by the excessive valuation of an asset class by its historic yardsticks.

  The best way to capitalize on variations in valuations is to have a range of asset allocations rather than a rigid percentage formula. This permits the investment manager to use his or her discretion in capitalizing on such valuation discrepancies to the advantage of the fund being managed.

• Use of mutual funds instead of individual assets. Mutual funds are appropriate investments for relatively small amounts of money and are often the only way an association can obtain diversification and professional management.

  With larger amounts of funds, individual issues become more appropriate. A layer of management fees is eliminated, as only one manager handles the funds. With a mutual fund there are often two management fees: one for the mutual fund company and one for the investment manager who chooses the funds for the association.

  In seeking individual account management, an association should be sure that it is receiving such and not a formalistic reconstitution of a mutual fund in the form of individual issues. (This is sometimes the strategy of the wrap fee approach.) Firms that use questionnaires to invest all accounts the same way in a given risk category are mutual funds in all but name. In addition, their fees are sometimes higher than the mutual funds that they replace.

Warren M. Barnett is a certified financial adviser and president of Barnett & Company, Chattanooga, Tennessee.

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