Endowments can provide a long-term source of financial stability and growth for a nonprofit organization. Nonprofit boards and endowment committees don’t have to be experts in investing to successfully manage an endowment. There are a few key terms and concepts that every stakeholder should know to make informed decisions and maximize the potential performance of your endowment.
This is a hot topic all over the world and has a major impact on how far funding can take a nonprofit. Inflation refers to the general increase of prices over time, and results in a decrease in purchasing power. In the context of a nonprofit, stakeholders may feel the impact when it comes to the organization’s immediate needs, like the cost of services, supplies, and the rising needs of employees.
The rate of inflation fluctuates in accordance with the global economy. If an endowment is left idle in a bank account, there’s a good chance that the interest rate for the account is lower than the rate of inflation. This means that inflation may outpace the returns, which leads to an overall reduction in the endowment’s value. Endowment committees have to consider investment options that grow at a pace consistently higher than the rate of inflation to protect the organization’s long-term viability.
Time-Weighted Return vs. Internal Rate of Return
Time-weighted return measures the performance of an investment portfolio over a specific period of time. It doesn’t measure the impact of external factors that cause the ebb and flow of cash, like additional investments or withdrawals. To calculate a time-weighted return, the investment period is divided into smaller sub-periods. The return for each of these sub-periods is calculated, then combined for a mean average. This accurately measures the portfolio’s performance, and investors can gauge the success of the investment manager in generating returns.
The internal rate of return (IRR) is the rate at which an investment breaks even. Calculating IRR can be complex, but provides a percentage that can be used to determine the overall profitability of an investment. Like time-weighted returns, IRR uses specific periods of time within the calculation, however, it differs in that it accounts for all forms of cash flow.
Understanding both measures will help compare the performance evaluation of the endowment’s investments over time to predetermined benchmarks. If the calculations result in returns over the benchmark, then the investment is considered profitable.
Fixed Income (Bonds) vs. Equity (Stock)
Fixed income refers to investments that provide a predictable stream of income. A bond is essentially a loan made by an investor to a borrower. The borrower makes interest payments, then pays the full amount to the investor at the end of the predetermined time period. Bonds are often used as a fixed income investment because the interest rate is predetermined at the time it’s issued, which gives investors a clearer picture of the rate of return.
In the context of investing, equity refers to the different types of ownership interests in a company. Stock is a form of equity and can be purchased for shares in a company. The potential returns are calculated by the company’s growth, which increases the value of the stock. Market fluctuations can impact stock values, so it carries a higher risk than bonds. The tradeoff is that it has the potential to provide much greater returns. It’s important to diversify endowment portfolios with a balance of fixed income and equity investments to manage risk and strategically enhance returns.
Managing an Endowment with Confidence
Understanding these investment terms is essential for nonprofit board and endowment committee members to make informed decisions while managing endowments. Nonprofits can utilize measures like time-weighted return and internal rate of return to accurately assess the success of the endowment’s investment portfolio.
It’s important for nonprofits to find a balance between consistent income and growth potential to make sure the organization can continue funding its mission effectively. Fairlight Advisors offers consulting and investment management services as well as educational opportunities for nonprofits. If your organization is ready to harness the power an endowment has to offer, reach out for a consultation by calling 1-844-309-6248.
Talk to the financial experts at Fairlight Advisors to learn more about managing your nonprofit’s investments. Schedule a free consultation today!