Diversifying Nonprofit Investment Portfolios: Balancing Risk and Return

Nonprofit organizations need to grow investments for the future, but they also have to manage risk carefully. Diversifying investments can help your organization manage market changes. It can also cover spending needs and keep you focused on your mission. 

We provide a practical framework for nonprofit investment diversification in this article, drawing on best practices and actionable insights from our experience. 

Starting with purpose, time horizon, and spending needs

Every nonprofit’s investment strategy should begin with a clear understanding of its mission, liabilities, and spending policy. These all inform the risk budget — the amount of risk the portfolio can prudently take. Linking these elements helps ensure that investment objectives and decisions align with the organization’s goals and obligations. 

A clear spending policy, like a total return spending policy, helps boards decide how much risk is suitable. For example, endowments and foundations may adopt a policy that balances current spending with the need to preserve capital for future generations.  

Stress testing and scenario analysis can help boards understand how different asset allocations might impact their ability to meet spending needs under various market conditions. 

Building a diversified core

The foundation of a nonprofit portfolio is a diversified core, typically composed of global equities and high-quality fixed income. Global diversification reduces concentration risk and provides exposure to a broad range of economic drivers. 

High-quality bonds are important for stability and liquidity. They help meet short-term needs and reduce portfolio volatility. 

Boards should consider the role of bonds in nonprofit portfolios carefully. Bonds offer predictable income and serve as a buffer during market downturns. The right mix of stocks and bonds will depend on the organization’s risk tolerance, spending needs, and investment timeline. 

Asset allocation for nonprofits and regular rebalancing ensures that the portfolio remains aligned with target allocations, especially as market conditions change. 

Looking beyond with selective alternative investments

For organizations seeking additional diversification and potential for enhanced returns, you might consider selective alternatives for nonprofits. Real assets, private equity, and private credit for nonprofits can be valuable additions. These asset classes provide access to investments that do not move in sync with traditional stocks and bonds. This can help improve risk-adjusted performance. 

Accessing alternatives requires careful due diligence and an understanding of investor qualifications. Nonprofits may need to determine whether they qualify as a “qualified purchaser” vs. “accredited investor,” as these designations affect access to certain private funds. 

Boards should also consider liquidity constraints, as some alternatives may have limited redemption options or “gates” that restrict withdrawals.

Setting guardrails in the Investment Policy Statement (IPS)

A robust Investment Policy Statement for nonprofits is essential for guiding portfolio decisions and managing risk. The IPS should establish target ranges for asset classes, benchmarks for performance, and rules for rebalancing and liquidity. Fee transparency and manager oversight are particularly important. They help make sure costs are fair and that investment managers are responsible. 

Boards should regularly review the IPS. They should update it as needed to reflect changes in the organization’s mission, finances, or market. Clear guardrails help define risk management nonprofit investments and ensure that the portfolio remains aligned with strategic objectives. 

Managing liquidity and drawdowns

Liquidity management and reserves are key considerations, especially if the organization has ongoing spending needs. Establishing reserve tiers and cash ladders can help organizations meet short-term obligations while maintaining investment flexibility. Stress testing and downside scenario analysis allow boards to evaluate how the portfolio might perform during periods of market stress or unexpected cash needs. 

Nonprofits should think about interval funds and redemption gates. These can affect how easily they can access capital when needed. Maintaining adequate liquidity ensures that the organization can fulfill its mission, even during turbulent financial markets. 

Choosing how to implement strategies

There are several options for implementing an investment strategy, including Outsourced Chief Investment Officer (OCIO) vs consultant for nonprofits. Each approach has pros and cons. OCIOs provide comprehensive portfolio management and can respond quickly to market changes and help manage potential risks. Consultants typically offer strategic advice and oversight. 

Boards should look at which option works best for them. They should think about their resources, governance structure, and how much control they want. 

Monitoring results

Effective oversight requires regular monitoring of key portfolio metrics. Boards should review risk metrics, dispersion, tracking error, and costs each quarter. This helps ensure that the portfolio remains within established guardrails and that performance is consistent with expectations. 

Transparency and accountability are essential. Boards should ask questions such as: How much risk are we taking? What is our risk-adjusted performance? Are costs reasonable? How often are we rebalancing? What role do bonds play in our portfolio? Can we access private equity or other alternatives? 

Checklist for diversifying investment portfolios

1. Define mission, time horizon, and spending needs 
2. Establish a total return spending policy 
3. Build a diversified core of global equities and high-quality bonds 
4. Consider selective alternatives for additional diversification 
5. Set guardrails in the IPS: targets, benchmarks, rebalancing, liquidity 
6. Ensure fee transparency and manager oversight 
7. Manage liquidity with reserve tiers and cash ladders 
8. Conduct scenario analysis and stress tests 
9. Evaluate OCIO vs consultant implementation options 
10. Monitor risk metrics, dispersion, tracking error, and costs quarterly 
11. Review and update the IPS regularly 
12. Educate board members on investment best practices 

From helping you diversify your nonprofit’s investment portfolio to becoming an integrated fiduciary partner, discover all the ways Mercer Advisors supports nonprofits. Contact our endowments and foundations team to learn more.