Boards of directors are required to exercise prudent fiscal management in maintaining the integrity of the reserve account. (Civ. Code § 5515.) HOA funds accepted or received by a managing agent (as defined in Civ. Code § 4158) must be deposited in accounts that protect the principal and covered by insurance provided by an agency of the federal government or a guaranty corporation. In no event may those HOA funds accepted or received by a managing agent be invested in stocks or high-risk investment options. (Civ. Code § 5380.)
Managing Agents. Managing agents who receive HOA funds must deposit them (i) into an escrow account with a bank, savings association, or credit union or into an account under the control of the association, (ii) into a trust fund account maintained by the managing agent in a bank, savings association, or credit union in this state. All funds deposited by the managing agent in the trust fund account shall be kept in this state in a financial institution insured by the federal government or is a guaranty corporation, and shall be maintained there until disbursed in accordance with written instructions from the association entitled to the funds. (Civ. Code § 5380(a).) The managing agent cannot commingle the funds of the association with the managing agent’s own money or with the money of others. (Civ. Code § 5380(d).)
Investment Strategy. Prudent investments of reserve monies should focus on the following parameters in their order of importance:
1. Safety. A board's primary goal should be the preservation of the association's reserves against loss. Sometimes an association's governing documents may limit investment opportunities by requiring that funds be kept in FDIC insured accounts. Following is a hierarchy of risk to the principal:
- Stocks and non-government bonds (high risk)
- Mutual funds
- Money market funds
- Municipal bonds
- Treasury money funds (medium risk)
- Certificates of deposit
- Treasury bills
- Ginnie Mae securities
- Bank savings accounts (low risk)
2. Liquidity. Liquidity refers to the ability to quickly convert investments into cash. If reserves are tied up on long-term investments, they will not be available in the event the association needs to (i) use funds for emergency repairs, (ii) borrow for short-term operating expenses or (iii) repair or replace large common area components that reach the end of their useful life earlier than expected. Accordingly, investing all of an association's reserves into a jumbo 3-year CD would not be prudent. A more prudent strategy is to invest in smaller CDs and stagger them to mature every six months.
3. Yield. Yield is the return received on an investment. Boards should seek a reasonable return on the association's reserve accounts but should never adopt a strategy that emphasizes return over preservation of capital (as occurred with Orange County in the 1990s and resulted in bankruptcy when the investments collapsed). Bank savings accounts may be too conservative due to their low rates of return. Using non-interest bearing accounts is viewed by some as mismanagement because the funds are not earning any income at all. The most common form of investment used by homeowner associations is the certificate of deposit.
Certificates of Deposit ("CDs") are interest-bearing, FDIC insured investments offered by banks and savings & loans. CDs are known as "time deposits," because the account holder has agreed to keep the money in the account for a specified amount of time, anywhere from three months to six years. In exchange for tying up principal, the association earns a guaranteed return at a set percentage rate locked in at the time of purchase. A CD's return is payable when the CD matures, i.e., at the end of a predetermined period of time. In exchange for higher rates of return, CDs do not have the liquidity of other investments. Cashing the CD early results in penalties. A prudent policy is to make sure money is reasonably available for emergencies. For example, associations that invest in CDs should stagger them so they mature every few months. That way, the association is never more than 90 days from funds it might need for unexpected repairs. If associations need immediate access to funds, some banks will allow borrowing against the CD if the association pays the interest above what the CD is earning.
Jumbo CDs. A jumbo CD is a certificate of deposit in a very large denomination, usually at a minimum of $100,000. Like a traditional CD, a jumbo CD is a low-risk investment, provided the amounts are within FDIC limits. Jumbo CDs typically deliver a higher rate of return than comparable cash investments such as money market accounts or savings accounts.
CDARS Program. For convenience, many associations participate in a program called "Certificate of Deposit Account Registry Service" (CDARS). Boards can deposit amounts that exceed FDIC limits in a single bank and have their funds dispersed into individual CDs up to FDIC limits in member banks across the country. This allows boards to deal with one bank, receive a single statement summarizing all their CDs, and remain fully insured by the FDIC. For more information, check the CDARS website at www.cdars.com. 
A video on how it works.
Mutual Funds. Mutual funds are operated by investment companies that raise money from shareholders and invest in a group of assets, such as stocks, bonds and money market instruments. Investors in the fund receive an equity position in the fund. Mutual funds offer liquidity and convenience, but charge fees and often require a minimum investment. There are many types of mutual funds, including aggressive growth fund, asset allocation fund, balanced fund, blend fund, bond fund, capital appreciation fund, clone fund, closed fund, crossover fund, equity fund, fund of funds, global fund, growth fund, growth and income fund, hedge fund, income fund, index fund, international fund, money market fund, municipal bond fund, prime rate fund, regional fund, sector fund, specialty fund, stock fund, and tax-free bond fund.
Money Market Funds. Money market funds are mutual funds that invest only in money markets. These funds invest in short term (one day to one year) debt obligations such as Treasury bills, certificates of deposit, and commercial paper. Unlike bank accounts and money market accounts, most deposits are not FDIC insured.
Money Market Accounts. Unlike money market funds or mutual funds, a money market account is a type of savings account offered by banks and credit unions. Like other savings accounts, money market accounts are insured by the Federal government. They generally pay higher interest than regular savings accounts, have higher minimum balance requirements, and only allow limited withdrawals per month.
Municipal Bonds. Municipal bonds are issued by cities, counties, states, and school districts. The bonds are used to fund projects such as highways, new schools, etc. "General obligation bonds" are unsecured municipal bonds that with maturities of at least ten years and are paid off with funds from taxes or other fees. The interest on municipal bonds are usually exempt from federal taxes, state and local taxes. However, capital gains that occur when the bond is sold or at the time of maturity (if the bond was bought at a discount) are taxable. Municipal bonds are considered safer than corporate bonds because a local government is less likely to go bankrupt than a corporation, but there are no guarantees. Also, the bonds are not FDIC insured.
Treasury Bills. "U.S. Treasury Bills" are debt obligations issued by the U.S. government and backed by its full faith and credit. T-Bills have a maturity of one year or less and are exempt from state and local taxes.
Brokerage Accounts. Brokerage accounts allow investment brokers to manage the association's funds for a fee. using a brokerage firm can have several advantages:
- Some brokerage firms have a large inventory of CDs from banks across the country. This saves boards from going from bank to bank, shopping rates and filling out bank signature cards. The brokerage firm acts as a custodian of the funds so associations can hold several million dollars’ worth of CDs in a single account while keeping everything within the $250,000 FDIC limit.
- They provide more competitive yields than would be available through local banks.
- Brokerage firm financial advisers with experience with community associations provide investment continuity from board to board.
Ginnie Mae Securities. Ginnie Mae securities are secure investments that are mortgage-backed securities. Mortgage-backed securities are pools of mortgages used as collateral for the issuance of securities in the secondary market. Ginnie Mae securities carry the full faith and credit guaranty of the United States government, which means that regardless of whether the mortgage payment is made, investors in Ginnie Mae securities receive full and timely payment of principal as well as interest.
Investment Advisor. For associations with large reserve deposits, using an investment adviser to develop a written investment policy is a good idea. Do NOT pay a board member to manage your funds. Instead, use an independent third party professional to develop a sound investment policy. Also, have your attorney review your governing documents to see if there are any restrictions on how monies can be invested. Following is an example of what not to do:
Paid Board Member. A homeowners association in Northern California received millions from a construction defect claim. The board paid a fellow director $75,000 to manage the funds. In addition, the director was allowed to receive commissions and trading fees on the funds. The paid financial adviser did not resign from the board--he continued as a board member and voted on matters directly affecting his control of the funds. Because he financially benefited from the use, management, and spending of the settlement funds, his votes ceased to be arm’s-length. This created a glaring conflict of interest.
Accountability. Another problem with the arrangement was the director's unwillingness to follow the board's instructions. While an independent, third party financial manager will follow instructions (or face potential liability and loss of business), interested directors often do not feel such constraints. They sometimes feel it is "their" money and will act outside the scope of their authority both as a director and a money manager. That occurred in this case.
Stock Market Losses. Without board approval, the director invested $3 million in the stock market. His investments resulted in losses of $400,000 before the board took steps to regain control of the situation. Before it was all over, the amount of lost principal was close to $1 million.
Crime Insurance. As a further protection of the association's funds, the the association shall maintain crime insurance, employee dishonesty coverage, fidelity bond coverage, or their equivalent, for its directors, officers, and employees in an amount that is equal to or more than the combined amount of the reserves of the association and total assessments for three months. For more information, see Fidelity Bond - Crime Insurance.
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