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Fiduciary Focus: Non-Profits Get Their Day (Part 3)

Ignorance and conflict of interest: Welcome to the world of non-profits.

W. Scott Simon, 12/07/2006

Among other kinds of clients (e.g., retirement plans such as 401(k) plans and individuals), my investment advisory firm invests and manages money for non-profits. When we are retained by fiduciaries responsible for a non-profit pool of money to replace an existing investment advisor, it never ceases to amaze me what outright awful (and costly and underdiversified) portfolios the advisor had foisted on the hapless fiduciaries.

A recent example concerns a non-profit that employed a national broker-dealer as its investment advisor. The advisor broker-dealer had an alliance with a local community foundation whereby the advisor supplied the investments through which the donors could make donations to the foundation. Correction: The advisor didn't actually make the investments itself. Instead, it handed off that task to a third-party "wrap manager" that invested the portfolio in a mishmash of individual stocks and mutual funds. As a result, the non-profit portfolio was burdened with the broker-dealer's fee, the third-party wrap manager's fee and (let's not forget) the community foundation's fee for a total annual fee of 4% to 5% of the value of the portfolio. The Web site of the advisor broker-dealer that quarterbacked this wonderful (for the advisor) arrangement, of course, assures all that its fees are "reasonable."

Marion Fremont-Smith, a legend in the field of nonprofit law and regulation with over a half-century of experience working with non-profits of all kinds, noted in an interview recently that "one of the strengths of the nonprofit sector, the reason that we revere it and support it, is.its ability to respond.to society's problems." The word "respond" in the preceding sentence is a code word for "giving" (another important word in the non-profit world), and giving largely means giving money.

But when the total investment fees involved in placing a non-profit in an awful (or, for that matter, even a stellar) portfolio can reach 5% annually--the same minimum percentage of principal which must be distributed (that is, "given") annually from a non-profit's portfolio to charitable causes--something is rotten in Denmark. In cases such as this, sometimes you have to pay dearly for bad advice.

Welcome Inside the World of Non-Profits
Non-profits are a major component of the U.S. economy. This trillion-dollar industry has addressed implications of Sarbanes-Oxley voluntarily and maintains an ongoing dialogue with Congress and the Internal Revenue Service. Non-profits have been successful historically in raising money and have continued to perfect their development models. The way in which those dollars have been invested, though, has all too often been done in an imprudent and haphazard way.

I will assume that any trustee or other fiduciary of a non-profit cares deeply about its charitable mission. Call me crazy, but I cannot imagine that anyone associated with a non-profit in any position of authority would want to do anything other than what's best for the non-profit. (There are, of course, members of non-profit boards that don't have any particular passion for non-profit missions, yet they continue to serve so that they can represent their employers and keep their names prominent in the local media.) There are, nonetheless, a number of real-world factors that keep fiduciaries responsible for non-profit pools of money from doing their best as responsible stewards. Two of these factors are ignorance about fiduciary standards and practices, and blatant conflicts of interest.

Ignorance about Fiduciary Standards and Practices
Many members of nonprofit boards of directors are volunteers with little knowledge of investing. These fiduciaries are often busy people, so board meetings have to be kept relatively short leaving scant (or no) time for education about fiduciary duties. In such cases where this kind of education isn't regarded as a priority, the inevitable result is widespread ignorance among board members about even the most basic principles involved in overseeing a non-profit investment portfolio. I have seen situations (whether involving a $7 million portfolio or one with $70 million) where a non-profit, for example, had no Investment Policy Statement (IPS) or, where one was present, the IPS was canned and therefore totally inadequate in helping carry out the non-profit's mission.

Many investment advisors to boards are all too glad to take advantage of the ignorance shared by many board members. Advisors often attend board meetings, leaving board members with little chance to have an honest dialogue about, for example, the true, all-in costs charged a non-profit portfolio, an issue that advisors would rather avoid. These advisors generally control the flow of information, and board members--well meaning but often so uninformed that they don't even know what issues are involved much less what questions to ask about those issues--sit idly by and rubberstamp whatever the advisors want.

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