Should foundations invest in ETFs?

Adaptive ETF strategist Jeff Black spent eight years chairing the Oakville Community Foundation’s investment committee, helping the committee with asset mix, strategy, and manager search and selection. In this article, Jeff shares some of his insights on ETFs. Should foundations use them? And if so, how? Read on for the answers.

Q: How do you describe the work of community foundations?

A: Community foundations connect agencies that are doing work on the ground with donors who want to contribute to their communities. They marry financial resources to a knowledge and understanding of needs to get maximum impact.

Q: What factors influence a foundation’s approach to investing?

A: Every foundation has twin objectives: to grow the capital long term so there’s financial sustainability, and to generate some current income to fulfill obligations for distribution and support why it exists in the first place.

Environment, social and governance (ESG) factors have been important to community foundations for a long time and some foundations will preclude certain types of investments or areas because they aren’t aligned with their philosophy or mandate. At the Oakville Community Foundation, we made sure any new investment managers we worked with were signatories to the UN Principles for Responsible Investment (PRI)—it became part of the selection criteria for the firms we worked with.

Q: Should foundations use ETFs?

A: Absolutely. For any pool of capital, you’re not optimizing the management of risk and returns if you’re ignoring the ETF space. ETFs are the fastest growing segment of investment management precisely because of what they bring to the table in terms of reducing cost, adding diversification, mitigating risk and more.

At the end of the day, though, ETFs are just another arrow in a foundation’s investment quiver and can be used in a variety of ways to meet different objectives. It all comes back to the core debate in the investment management world: what’s better, active vs. passive management? There’s room for both. While an ETF may be passive in terms of the securities held within it, because it is replicating an index, it still requires active management when used in a portfolio to minimize risk and optimize return.

Q: What are other important advantages of ETFs for foundations?

A: Diversification is an important advantage of ETFs. No one should be putting all their eggs in one basket. When you invest using an ETF, you’re buying a fund that represents a broader index. It is less vulnerable to extremes and what is referred to as company-specific risk.

Another advantage of ETFs is low cost. You pay more for active management, but you have to ask if there’s value to that cost or if you could achieve the same or better results for lower fees with ETFs.

ETFs are also a prudent way to “go global”. For some investors, it’s hard to get to know the companies and do the research from afar, but there’s merit to getting exposure to emerging economies. One of the ways to achieve that exposure without the risk of buying individual stocks is through ETFs.

Q: How can foundations use ETFs?

A: A foundation that has existed for many years likely has an active management strategy—in the early days of the Oakville Community Foundation, for example, few people had even heard of ETFs. Older foundations can ease into ETFs when they’re switching investment managers and want to maintain exposure to the particular area that manager was responsible for during the transition period. A young, growing foundation today could start with ETFs and add in active management over time.

Q: What are some concerns with foundations using ETFs?

A: There aren’t any. With so many ETFs available now, they can be core long-term exposure for foundations. You can even get specific exposure to social, environmental and governance-oriented indices through an ETF.

Q: Are there any ETFs that are a poor fit for foundations?

A: There are a lot of esoteric funds now, which can introduce unnecessary risk into your portfolio. ETFs that are focused exclusively on water conservation or cannabis, for example, will include a limited number of companies and could have huge volatility.

Q: How should foundations go about investing in ETFs?

A: It comes back to your investment policy statements—what’s your asset mix, time horizon, risk, the strategies employed in each asset class; what assets are eligible; what can the weights of exposure be. There’s a potential ETF solution for each one. The next step is to decide how you’re going to use ETFs. Domestically? To get exposure to foreign markets? To bifurcate a market into large cap and small cap by using a passive ETF strategy on one and active management on the other?

Q: What should a foundation look for in an ETF advisor?

A: There are a few key things to look for. What’s their depth of knowledge and experience in ETFs? What’s their track record? Do they use ETFs themselves—in other words, are they eating their own cooking? Are they using what’s available to optimally meet the investment objectives and risk tolerance of clients? If the advisor’s answers to those questions give the investment committee confidence, they’re probably a good choice.

Q: Any last words of advice on ETFs for foundations?

A: At the end of the day, ETFs are only a structure. What matters is the strategy that’s used to determine which ETFs are chosen for a portfolio. Are you getting the diversification, quality, liquidity, fidelity to the mandate and, ultimately, the results you need? Not every ETF will deliver that to you, so you need an advisor with a rigorous, repeatable strategy to make the right selections.

Are ETFs right for you?