 |
| > Investing > Fiduciary Focus |
 |
| Fiduciary Focus: Non-Profits Get Their Day (Part 4) |
| by
W. Scott Simon
| 12-07-06 |
|
|
In this month's column, I'll explore the approach used by most investment in providing investment advice to fiduciaries of non-profits.
In the non-profit world, there are two starkly different approaches to providing investment advice. Those that follow the dominant approach, which can be thought of as "imprudent speculation," focus on what's best for the business model they follow. Those that follow the other, less well-known approach, which can be thought of as "prudent investing," focus on what's best for beneficiaries of non-profits.
Imprudent Speculation
It's important for fiduciaries of non-profits to understand how the dominant approach to providing investment advice--imprudent speculation--can, in many instances, undermine the long-term interests of their beneficiaries and what a threat it can be to their charitable missions.
I've discussed in previous columns that those investing in stocks believed to offer the best odds of maximizing expected return--without consciously taking risk into consideration--are speculators, not investors, according to Nobel laureate Harry Markowitz, the father of modern portfolio theory. The fundamental value that imprudent speculators say that they bring to the table is the ability to tell their clients today which investments will be winners in the future, whether through stock picking, market timing or track record investing.
Part of the problem with imprudent speculation is that those engaged in it simply don't want, legally, to be fiduciaries to the non-profit fiduciaries (and by extension, the beneficiaries of such fiduciaries) they advise. That's why they consciously choose a business model that prevents them from doing so. An investment advisor such as a registered representative following this model is required to swear fealty to its broker-dealer master, the only entity that the stockbroker owes any duties. Non-profits better duck if they get in the way of this principal-agent relationship because when push comes to shove, their interests will always be subordinated to those of the registered representative's broker-dealer.
Another problem with the dominant approach to providing investment advice is that it's designed to maintain the often outrageous (i.e., "inappropriate" and "unreasonable" in fiduciary legal-speak) profitability of the business model upon which it's based. That's why I've called stock brokerage firms and other entities that adopt this model "non-fiduciaries" in my series on non-fiduciary investment consultants. What many of these advisors want, such as charging high, hidden costs, is very different from what best serves the interests of beneficiaries of non-profit portfolios, such as low, transparent costs.
Many fiduciary board members of non-profits have no understanding of these problems for the simple reason that they are not even aware that they exist. Those fiduciaries that do understand them often look the other way. Many of them just will not admit that they're wrong in the choices they have made--even in the face of overwhelming evidence showing that those engaged in imprudent speculation have led such board members to invest in costly and underdiversified portfolios over, say, the last five years, 10 years, or 20 years. In such situations, the usual outcome is for the board members to circle the wagons, and refuse to change.
The Attraction of Imprudent Speculators
Investment advisors that engage in imprudent speculation are very attractive to many fiduciaries of non-profits. First of all, many of them work for entities such as stock brokerage firms, insurance companies, banks, trust companies, and others. These entities often are prestigious and some of them are huge, employing thousands, managing billions and safekeeping trillions. They provide good cover to fiduciaries who believe that if they hire them, they will help make the fiduciaries look good--or at least they won't make them look bad.
A second reason why investment advisors engaged in imprudent speculation are very attractive to fiduciaries of non-profits is that they are always very personally likable. The affability of these salespersons is what makes it so difficult to dislodge them as advisors to fiduciaries of non-profits--even in cases where they have inflicted disastrous results on non-profit portfolios. That emotional attachment can be very hard to break. Sometimes, of course, the issue is even deeper: the emotional inability, as I've noted, to admit a mistake. People generally resist change, but to convince them to change because of a mistake they have made (even one they acknowledge) is really difficult.
Many investment advisors to non-profits engaged in imprudent speculation attempt to portray themselves as "institutional" advisors to avoid being thought of as advisors to mere individual retail investors. An example of this that I ran across recently involved a non-profit with more than $50 million in its portfolio. The "institutional" investment advisor involved was a group of five people at a branch office of a well-known stockbrokerage firm. The head of this group attempted to sell the baffled fiduciaries of the non-profit a complex, illiquid investment product that, no doubt, was burning a hole in the pocket of the stock brokerage firm's inventory. (If you take away nothing else from this article, remember that complex, illiquid investment products are always very expensive.)
If the head of this group really thought that he was in an institutional relationship with the non-profit, he would never have dared attempt to fob off this surplus inventory on the fiduciaries. What was really happening in this example was that even though the group at the stock brokerage firm posed as an institutional advisor, it treated such non-profit clients as retail investors that wouldn't (and didn't) squawk when they were charged retail rates. Investing and managing over $50 million at retail rates instead of institutional rates, of course, is in the best interests of the stock brokerage firm, not the beneficiaries of this non-profit. This happens, incredible as it may seem, in many such situations involving non-profits with up to $100 million or even more in their portfolios.
In any event, no fiduciary of a non-profit should ever be under the illusion that the kind of investment advisors I have just described reached their station at their respective employers on the basis of much more than their sales abilities. Silver tongues and gold wristwatches are not necessarily good indicators of the worth that such advisors bring to beneficiaries of non-profits. In fact, people like the head of the group in this example are little more than extremely likable backslappers. They receive marching orders to hawk the latest investment products to non-profit fiduciaries, products that institutional investors savvy to the ways of such imprudent speculators have already rejected.
|
|
1
|
2
 |
|
|
|
| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
|
|
|
|
|
 |
|
Manager's View Participants
|
|
|
|
|
|
|
Follow us on Twitter
