Foundation Investments 101: What You Need to Know and Why

1. May 5, 2011 Foundation Investments 101: What You Need to Know and Why Presented by: Jennifer Christian Murtie Director of Foundation Services Federal Street Advisors jmurtie@federalstreet.com

2. Agenda • Who are the players in the investment industry? • How are these companies compensated? • What are different Investment Structures and Approaches? • Active vs. Passive Management • What is an Investment Policy Statement? • What is the relationship between Risk and Return? • How do we evaluate Investment Performance? • What are Indexes? • What are the major Investment Asset Classes? • What are Socially Responsible Investments?

3. Who are the players in the investment industry? • Investment Consultants • Custodians • Money Managers • Separate Accounts • Mutual Funds • Other Pooled Funds • Brokerage Firms • Banks

4. How are these companies compensated? • Fixed Fee • Percentage of Assets • Commissions • Revenue Sharing

5. What are different Investment Structures and Approaches? • Mutual Funds • A regulated investment “company” that brings together a group of people and invests their money in stocks, bonds, and other securities for a common goal. • Separate Accounts • A privately or separately managed investment account for a given client. • Limited Partnerships • Two or more partners united to conduct a business jointly. Limited partners do not receive dividends, but enjoy direct access to the flow of income and expenses.

6. Active vs. Passive Management • Active Management • The use of a human element, whether a single manager or a team of managers, to buy and sell securities based on quantitative and qualitative analysis. • Examples: Peter Lynch, Bill Gross • Passive Management • Also know as indexing, it is a pure quantitative approach to money management where the goal is to mirror a market index. • Example: Vanguard 500 Index Fund

7. What is an Investment Policy Statement? • Foundation Goals • Spending Requirements • Target Rate of Return • Risk Tolerance • Asset Allocation • Any other restrictions or requirements

8. What is the relationship between risk and return?

9. How do we evaluate investment performance? • Benchmarks for Portfolios and Managers • Absolute – Target Rate of Return • Relative – Index Return • Manager Performance Evaluation • Consistent risk adjusted outperformance • Organization stability • Stable investment process • Style consistency • Ultimate assessment of luck vs. skill

10. What are Indexes? • Bond Index: Barclays Aggregate Bond Index • Domestic Equity Indexes: • Large-Cap Indexes • S&P 500 Index • Russell 1000 Growth Index • Russell 1000 Value Index • Small-Cap Indexes • Russell 2000 Index • Russell 2000 Growth Index • Russell 2000 Value Index • International Equity Index: MSCI EAFE Index

11. What are the major Investment Asset Classes? • Hedge Funds • Directional Hedge Funds (Equity Risk Reducers) • Absolute Return Hedge Funds (Fixed Income Alternatives) • Private Equity (Return Enhancers) • Venture Capital • Buyouts • Real Assets • Real Estate • Timber • Commodities • Precious Metals • Cash and Cash Equivalents • Fixed Income • Bonds • Domestic Equities • Large-Cap Equities • Mid-Cap Equities • Small-Cap Equities • International Equities • Developed Markets • Emerging Markets • Non-U.S. Small-Cap

12. Types of Fixed Income and Equities • Bond (fixed income) Examples • Government Bond – 10 Year U.S. Treasury • Corporate Bond – General Electric (GE) • Stock (public equity) Example – Exxon Mobil (XOM) TYPES OF STOCKS • Growth Stocks (Sectors: Technology, Health Care) Example – Google • Value Stocks (Sectors: Transportation, Financials, Industrials) Ex. – Caterpillar • Large-cap Stocks: Example – Microsoft ($212 Billion) • Small-cap Stocks: Example – Peet’s Coffee & Tea Inc. ($452 Million) • U.S. Stocks: Domestic Example – Delta Airlines, Inc. • International Stocks: International Example – BMW AG

13. Types of Alternative Investments • What is a Hedge Fund? • Hedge Fund Manager Example – George Soros • Hedge Fund Index Example – FSA Long/Short HF Index • What is Private Equity? • Private Equity Manager Example – Mitt Romney, Bain Capital • Private Equity Index Example – Venture Economics

14. Hedge Fund Terminology • What is shorting? • The sale of a borrowed security with the expectation that the asset will fall in value. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short. Opposite of traditional investing or going long. • What is a long/short fund? • Hedge fund managers who combine purchasing securities that they feel are undervalued and selling short others they deem to be overvalued. • What is leverage? • Typically the borrowing of capital from a bank or brokerage firm to be able to invest more and increase the opportunity for return.

15. What are Socially Responsible Investments (SRIs)? • Shareholder Advocacy • Proxy Voting • Screens (exclusive) • Sustainable Investing (inclusive) - ESG • Mission Related Investing • Private Equity

16. Glossary of Terms

17. Glossary of Terms • Absolute Return Target –An absolute return target is the annual rate of return an investor needs to meet its objectives. It typically includes a provision for inflation, expenses, and a desired real return.  For instance, if inflation is expected to be 3% per year, and a foundation’s expenses represent 1% of its assets each year, that foundation’s absolute return target might be 9% to cover these and provide a 5% “real” return. • Alpha –In its simplest form, alpha is the value added by an active manager over the benchmark return, or “beta”.  For instance, if a large-cap stock manager returns 10%, and the S&P 500 returns 7%, we would say that the alpha generated by the manager was 3% (10% minus 7%). • Beta – The market return, as represented by an active manager’s benchmark index.  A passive investment strategy (holding the index) earns only beta, whereas an active strategy (picking stocks from the index) attempts to generate “alpha”.

18. Glossary of Terms (continued) • Blended Benchmark – A blended benchmark is used to measure the relative performance of an entire portfolio against a similarly allocated blend of indices.  To take a simple example, if an investor’s assets are allocated to 70% stocks and 30% bonds, the portfolio’s performance would be measured against a blended benchmark consisting of 70% in a stock index, and 30% in a bond index. • Bonds – When a company or government borrows money, it issues bonds representing a claim on repayment, much like an IOU.  These bonds can then be traded in the public or private markets. • Cost vs. Market Value – The cost value is what an investor paid to purchase an asset.  The market value is the price at which the asset is currently being exchanged in the market. • Domestic Stock – Stock of a company whose operations are located primarily in the U.S.

19. Glossary of Terms (continued) • Duration - A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. • Efficient Frontier - Different combinations of securities produce different levels of return. The efficient frontier represents the best of these securities combinations -- those that produce the maximum expected return for a given level of risk. • Gross Exposure – The total of long and short positions in a hedge fund portfolio. Represents absolute level of investment bets. • Growth Stock – Stocks of companies that are expected to grow rapidly are called growth stocks, and typically trade at higher valuations.  These higher prices reflect the anticipation that the company will generate higher cash flows in the future.

20. Glossary of Terms (continued) • Hedge Fund – A hedge fund is a lightly-regulated, private manager of capital that can engage in a wide variety of investment strategies, including short-selling (betting on stocks to go down) and arbitrage (taking advantage of small price discrepancies between two securities), amongst many others.  Hedge funds can use borrowed money to enhance their returns.  They typically charge a management fee of 1-2% of assets under management, plus an “incentive fee” of 20% of profits made. • Incentive Fee – Most, if not all, hedge funds charge an incentive fee of anywhere between 10-20% of fund profits, and some hedge funds have even gone as high as 50%. The idea of the incentive fee is to reward the hedge fund manager for good performance, and if the fund's performance is attractive enough, investors are willing to pay this fee.

21. Glossary of Terms (continued) • Index – An index is a grouping of securities intended to represent a broad segment of the market: for instance, the S&P 500 index is composed of the stocks from the 500 largest companies in the United States, while the Barclays Aggregate Bond Index contains a wide selection of investment-grade bonds.  Active investment managers are commonly measured against the index which corresponds to their respective universe. • Index Fund – A passively-managed fund which holds all the stocks in an index (such as the S&P 500) or is designed to mimic an index. • International Stock –Stock of a company whose operations are located primarily outside the U.S. • Investment Policy Statement –A document which outlines the investor’s return target, comfort level with regard to risk, broad guidelines for asset allocation and/or specific investment mandates (social, etc.).  Before implementing an investment plan for a client, the advisor first works with the client to create an IPS to serve as a basis for that plan.

22. Glossary of Terms (continued) • Large-Cap Stock – Stocks of companies with high market capitalizations (in other words, the total value of the company) are called large-cap stocks.  Typically, a company with a market cap above $10 billion is considered large cap. • Leverage – Typically thought of as the use of borrowed capital to increase the potential return of an investment. • Long (or Long Position) –The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value. • Net Exposure – Market position defined by long exposure minus short exposure. A portfolio with a 120% long position (using leverage) and 50% short position would be “net” 70%.

23. Glossary of Terms (continued) • Private Equity – Much like hedge funds, private equity groups are lightly-regulated.  They pursue opportunities outside of the public markets (hence the “private” in their name). Within this category, buyout groups purchase all of a company’s stock on the public markets and take that company private, looking to re-sell the shares at a later date for a profit, typically after making operational improvements at the company.  Venture capital groups invest in small, start-up companies (typically in technology); this is a high risk-reward strategy that aims to make a large profit on a handful of successes that outweighs the larger number of failures. • Relative Benchmark – Active managers are typically measured against the index which best represents the stock universe from which they are choosing their investments.  For instance, a manager that invests in large, U.S.-based companies will usually be measured against the S&P 500 index, which is an index of the 500 largest companies in the U.S.

24. Glossary of Terms (continued) • Short (or Short Position) – The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value.   • Small-Cap Stock – The stocks of companies with market capitalizations below $1 billion are typically considered small cap. • Stocks – A stock is a share of ownership in a company, and represents a claim on the cash flows generated by that company. Stocks are also referred to as equities. • Target Rate of Return –The annual percentage rate of return targeted by the investor.

25. Glossary of Terms (continued) • Total Return – The return on an asset due to price appreciation plus any dividends paid.  For example, say an investor buys a stock for $10.  If the investor later sells that stock for $12, and received a dividend of $2 while holding the stock, the total return is 40% ($2 gain from price appreciation, plus $2 gain from dividend, divided by the $10 purchase price). • Value Stock – Stocks of companies that are not expected to grow more rapidly than the average, on a year by year basis, typically carry lower valuations and are called value stocks.