Oversight – Part 2: Common Investment Mistakes of Trustees

This is the second of a two-part series about the most common mistakes nonprofit organizations make when considering their investment portfolio. The previous article discussed four common mistakes; this article covers three more that fiduciaries should examine. Being informed of these costly errors will pay off in the overall growth of your portfolio, and in turn, your organization’s financial well-being.

Mistake # 5: Not Fully Understanding the Risk of Alternative Investments

Generally, there are two types of alternative investments. The first type includes illiquid alternative investments, such as hedge funds, private equity, venture capital, hedge fund-of-funds, etc. The second type of alternative investment includes liquid, marketable securities, such as Real Estate Investment Trusts (REITs), commodities, etc.

In addition to the availability of an exchange or marketplace, the ability to sell alternative investments differs from traditional investments in the existence of information necessary to determine value. Unlike traditional equities, for example, private equity investments are not traded on an exchange and are rarely traded over the counter. Investors in private equities are willing to eschew a readily available market in exchange for the hope for greater returns. The lack of available information significantly reduces the pool of willing buyers, negatively affecting the holder’s ability to sell.

However, purveyors of alternative investments, including fund managers and fund-of-fund managers, market the benefit of being opaque in the identified strategy. Namely, the ability to operate in secrecy ostensibly allows the fund manager to capitalize on opportunities before they become known to other investors. The logic is that the earliest investors generate the highest returns.

While the end game is the search for higher returns, the pitch behind many alternative investments must include the prior returns of the strategy. This is ironically juxtaposed to the lack of transparency in the investment. The returns, it is believed, are the direct result of the inability to look into the tactical maneuvers of the fund managers, thereby limiting the knowledge of the maneuvers. Without other funds or managers duplicating the activity, the investor should see a very unique result. Without transparency however, it is more difficult to define the strategy and the probability to continue the past performance without giving up too many of the managers’ secrets. In essence, the less we know about an investment, the less confident we can be of the result.
This issue is not lost on auditors. In fact, the publication Alternative Investments – Audit Considerations: A Practice Aid for Auditors, issued by the American Institute of Certified Public Accountants (AICPA) in 2006 states that “management is responsible for making the fair value measurements and disclosures included in the financial statements” and further states that “this responsibility cannot, under any circumstances, be outsourced or assigned to a party outside of the investor entity’s management.” For fiduciaries, understanding alternative investments goes beyond a boardroom discussion and falls squarely on the shoulders of management.

Mistake #6: Blindly Investing in an Advisor’s Proprietary Vehicles

It is not uncommon for client portfolios to contain a mutual fund that is managed by the bank or brokerage firm that is also functioning as advisor to the client. These “proprietary” mutual funds generate fees that are a great source of income to the bank or brokerage firm, with many firms relying on their in-house advisors to distribute the funds, (i.e., selling the funds to their clients.)
There is nothing illegal about using proprietary mutual funds in a bank or broker portfolio. But the existence of proprietary mutual funds in client portfolios poses conflict of interest and self-dealing issues. The Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and the Federal Deposit Insurance Corporation (FDIC) have all commented about the existence of such issues and the need to recognize a fiduciary obligation (where one exists) to act in the best interest of the client.

Fiduciaries should be sensitive to the existence of proprietary mutual funds in portfolios under their watch. The obvious issues include fees and performance. For example, the fees of proprietary funds should be market-based and in line with similar non-proprietary mutual funds. Before any commitment to proprietary funds, fiduciaries should know how the fees compare to median fees of similar strategies and non-proprietary alternatives. And there are many issues regarding performance analysis that should be reviewed, including returns, volatility, tracking-error to the relevant benchmark, and capture ratios to name a few. Of course, performance issues should be reviewed over a long-term horizon and should include multivariable peer analysis (i.e., the source of risk and returns).

Mistake #7: The Advisor Is Not Independent

Arguably, independence is one of the best ways to describe an advisor’s ability to represent the interests of the client, free of potential conflicts. It is sometimes curious to see an existing conflict of interest policy that is written to address board member conflicts, but not necessarily vendor/provider conflicts. For example, an investment committee member may be subject to a formal conflict of interest policy, such as: “A conflict of interest, whether actual or perceived, is defined as any event in which a covered party may personally benefit from knowledge of, participation in, or by virtue of, an investment decision or holding in the portfolio.”

One of the primary filters of a conflict is the source of compensation of the advisor. For example, does the application of the above language introduce an “actual or perceived” conflict of interest for an investment advisor that utilizes proprietary mutual funds? Introducing conflict of interest language in an advisor’s contract may result in a different kind of relationship and might even change the recommended investment vehicles as advisor incentives (i.e., compensation) are examined. Certainly, regulations are being written to facilitate fee transparency requiring service providers, including advisors, to disclose expense and fee information. Examples include recent regulations written by the Department of Labor concerning participant-directed defined contribution plans subject to the Employee Retirement Income Security Act of 1974 (ERISA), such as 403(b) and 401(k) plans. The regulations require fiduciaries to discharge their duties prudently and solely in the interest of plan participants and beneficiaries; the investment of plan assets is a fiduciary act subject to these fiduciary standards. As such, knowledge of provider fees and expenses has become a regulatory requirement of fiduciary oversight for these plans. And while not currently required of non-ERISA plans, such expense and fee disclosures could become the standard of best practices in the industry.

Independence also provides a platform for specialization. In order to properly assess the risk profile of an organization, an advisor must fully understand three essential elements: the source of the funds, the purpose of the funds and the risk propensity of the fiduciaries. In addition to being different for each client, each element is subject to change. For example, a decline in contributions or investment markets could lead to change in strategy. And the arrival of a new board member may change the risk profile of the organization and therefore the portfolio, resulting in changes in potential returns.

Because of the differences between organizations, including unique portfolio needs, a specialist tends not to use “model” portfolios, which are developed to replicate a single risk/return profile across all participating accounts. If the advisor truly understands the client and the essential elements, it is hard to imagine a model portfolio that is applicable to all fiduciary accounts.

Although contract language can vary from one advisor to the next, many advisors use a standardized contract. Fiduciaries may be asked to sign a contract that is used for both individuals and institutions. In it, it is important to note the ability to incorporate the organization’s unique investment restrictions (i.e., the board-adopted Investment Policy Statement), while not granting broad discretionary powers to the advisor. Both model portfolios and standardized contracts are a great benefit to the advisor, as it makes the administration of the portfolio much simpler. An independent advisor specializing in your industry tilts the benefit to your favor.
It is more important than ever for nonprofit board members to be knowledgeable of their organization’s mission, policies and investment risk as well as understanding their responsibilities as fiduciaries. In today’s uncertain investment environment, fiduciaries must apply these tenets to reduce organizational risk and maintain financial stability as they work to ensure the institution remains viable for years to come.

William M. Courson is the president of Lancaster Pollard Investment Advisory Group in Columbus. He may be reached at wcourson@lancasterpollard.com.

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