Fiduciary Investing Made Easy

Every so often a client or colleague would seek my advice about what is really a very simple problem. They served on the board of their alma mater or a local charity. They had been tasked to help select an investment advisor for the endowment. They usually find themselves in this position because they know something about investing. Frequently it is because they handle their own portfolio through one of the discount brokerage firms.

But that is not the same as evaluating a professional investment advisor to handle other people’s money.  They want to find a good advisor for the fund and they do not want to make a mistake.

The same methodology that I am going to suggest would be appropriate for a business owner or investment committee seeking an advisor for a corporate pension plan.  The money in the plan belongs to the employees. They are counting on that money to fund their retirement.

The Department of Labor (DOL) has proposed new regulations that will shortly become effective and will hold all stockbrokers that handle pension or retirement accounts to a fiduciary’s standard of care. Registered Investment Advisors have been held to this standard for decades and if you are overseeing a pension plan or endowment you should hold yourself to the same standard as well.

The DOL regulation deals primarily with the costs or fees of the investments. It targets high commission investment products like private placements, hedge funds and variable annuities that are also high risk. I find it amazing how many large pension funds have allowed themselves to “diversify” into these alternative investments that they know very little about.

You should know that there are significant shortfalls in a great many large pension funds both public and private.  By shortfall, I mean that they do not have enough money to pay out the benefits that they have promised to their employees.

In many cases, this is a result of the managers trying to “do better” than the market to get higher returns for the fund.  Seeking higher returns means that they took higher risk and got burned.  Getting an underfunded pension fund back to par is very difficult without taking on even more risk.

Pension fund managers do get sued by plan participants for losing money. Corporate executives who oversee the advisors do as well. A good perspective for anyone who is sitting on a committee overseeing investments for a pension fund or an endowment is to adopt the same rule that doctors apply to their practice: first, do no harm.

You should also know that asset allocation for a pension plan or endowment may be a little different than you might think.  For a purely long term portfolio, funds are allocated between stocks, bonds and cash according to a pre-determined risk profile and re-balanced as market conditions shift.

If the pension plan is already paying out benefits or the endowment is being tapped to cover operating expenses or grants, then the fund must have enough income producing investments to cover the cash outflow. It is never appropriate to selloff portfolio securities to fund expenses. This is a mistake that a lot of individuals make in their own retirement accounts.

That leaves the selection of the equities that the fund will hold for the long term, stocks that will appreciate over time and allow the fund to grow. It is at this point that the investment committee is likely to have the most difficulty.

Many people believe that the cost of an investment advisor to help select the investments in the fund should be a determining factor. People seem to think that no-load mutual funds or ETFs are the way to go because an annual fee will diminish their returns.

At best you will get returns that are average, because you are investing in the good stocks in the sector or index along with the poorer stocks. You can and should hire a good advisor who does their own research to select a portfolio that will do better than the index.

There is an ongoing discussion regarding the merits of using a passive investment strategy (index funds or ETFs) versus using an active portfolio manager. In addition to higher costs, there are studies that suggest that the average investment advisor does no better than the indexes and many do worse. In my mind, it begs the question: why would you hire an average investment advisor in the first place?

So the real problem is to identify an investment advisor who is better than most or at least can reasonably be expected to get better results than an index.  If there are 30 airline stocks in an airline sector fund or ETF, then you would want an advisor who could research and rank those stocks and buy not all, but only the best.

A really good research shop is a rarity. All of the large brokerage firms and investment banks have research departments. Many of the analysts are excellent and insightful. But the research department is still often an adjunct to the firm’s investment banking operation and may be conflicted.

There are, of course, independent research reports that are provided by discount brokers who have no investment banking operations and others that are available by subscription that are used by many advisors. But none of these can be called anything but middle of the road and may be the reason that many active advisors get average results.

There is, in my opinion, a research based investment advisory firm that rises above the rest.  It is called Dimensional Fund Advisors (DFA).  You will not find their ads on most financial websites. They do not fill your e-mail account with spam or pop-ups. They do not write magazine articles aimed at mom and pop investors.

They actually do not even employ relationship managers (salespeople) in the traditional sense. You can only approach DFA to manage your funds through a limited group of pre-screened independent advisors.

I have known about DFA for decades. Several years ago I attended a presentation by one of their analysts and came away very impressed. They employ a bottoms-up, book value versus market value approach with the goal of picking the best stocks, one at a time.

This type of text book, academic approach to portfolio management is not that easy to find. The primary principals of the firm, Ken French and Eugene Fama are academics. Prof. Fama won the 2013 Nobel Prize for Economics.

Even if you are a DIY investor managing your own modest portfolio at a discount brokerage firm, I would encourage you to visit the DFA website, search out some articles and learn their approach to stock selection. Knowledge, after all, is powerful. I actually shudder when someone managing a few million dollars of their own money has never read a textbook on fundamental securities analysis.

If you have a larger account or find yourself in the position of overseeing a pension fund or endowment and would like more information or an introduction to DFA, I can refer you to one of the independent advisors who has a relationship with them. It is the same gentlemen who secured me a seat at their analyst’s presentation

Understand that I receive no compensation for this in any way.  If you follow my blog, you know that I routinely point out foolishness in the marketplace. I have written several articles on why people are foolish to manage their funds with robo-advisors.  This article, I hope, provides some balance.

It is the methodology employed by DFA that puts them above other advisors. It is the same methodology that you  should employ in your own account and seek out in an advisor for yourself or if you are asked to find an advisor for an endowment or company pension plan.

And telling your employees that you value their contribution to your company so much that you hired a Nobel Prize winner to manage their retirement funds, in my opinion it is not likely to get you sued.


Making the new capitalism efficient

Economic theory teaches us that capital in a perfect world would always be allocated to its best use. The best use is always viewed from the perspective of the person or entity that is deploying the capital. Consequently we normally calculate the best use as the highest rate of return that the capital can reasonably achieve. The object is always to use money to make money.

To further this goal, capital has always been deployed to companies that have had the best chance of success. A due diligence process is employed to separate the best companies from those that the market deems less worthy. While far from perfect, this system has historically worked well enough to create our modern society with few truly innovative ideas left by the wayside, meaning unfunded.

In the last 20 years, some people with capital have been content to deploy it for other, more altruistic reasons. Specifically, they want to make capital available to people who have no access to the mainstream capital markets and others who for a variety of reasons could not get funded.

This new capitalism has taken two innovative forms, micro-lending and crowdfunding. Each has the potential to put capital into the hands of people who otherwise would never have access to it. Both have the potential to be transformative at the lowest tier of the global economic system. Neither is focused on highest rate of return as its primary goal.

In its purest form a micro-loan is very small and will often help a subsistence level individual transform into a capitalist. Micro-loans are frequently used to purchase one sewing machine to create a manufacturer; one shipment of goods at wholesale to create a merchant. Some micro-loans are used by a rural community to purchase one used truck or tractor. The benefits of these loans are obvious.

As originally envisioned, micro-loans were often interest free or loaned at an interest rate low enough to cover only the lender’s overhead and the costs of defaults. Even though no one who gets a micro-loan has a FICO score, statistics show the rate of default worldwide to be very low. As much as 97% of the loans are repaid. As conceived, micro-lending is a model of market efficiency.

Unfortunately, as this industry has developed and matured, there are some places where micro-loan programs are managed by bloated bureaucracies. There are stories of interest rates that would make loan sharks blush, corruption and exploitation in the lending process and misappropriation of funds intended for borrowers.

Crowdfunding, which is still in its infancy, is still remarkably inefficient. Fraud is prevalent because no one really vets the companies that seek funding. Far too many companies sell products that they can never deliver. The process itself can be expensive and is often hit or miss. Only about 30% of the rewards based crowdfunding campaigns successfully raise the funds that they seek.

Investors who buy into the equity of a small company on a crowdfunding platform must understand they may take a total loss. Even if the company is initially successful, there is no liquidity for the equity that investors purchase. Despite all of the enthusiasm for crowdfunding, this much risk and inefficiency cannot be sustainable.

There is, I would think, a way to combine the micro-loans with crowdfunding in a way that would remove much of the inefficiency, at least in the developing world.

In most developing countries there are universities whose students are  themselves often making the transition to the middle class. They should appreciate that strengthening the underclass will provide a greater market for the products and services that they themselves will eventually make and/or sell.

What I would propose is that each university creates a crowdfunding platform to enable students to fund micro-loan programs in their own communities.

Most peer-to peer lending platforms allow companies in need of loans to borrow from multiple individuals, essentially syndicating each loan. I envision the university students creating a single fund from which to make micro-loans to many borrowers.

I would ask the students to fund the program by purchasing shares in the fund with a small yearly tithe for the 4 years that they are students and for a few years after they graduate. Call it a 10 year voluntary commitment to purchase shares.

Additional funds would come from sale of shares to faculty, alumni, local banks, businesses and importantly, each country’s expatriate community. University students in western countries could partner with university students in developing countries. All anyone need do to participate is buy one share.

I have intentionally left out any local government involvement or participation. Direct government participation rarely adds efficiency to anything.

Business students and volunteer faculty at each university would administer the fund. This would remove much of the costs and corruption. It would give these students valuable experience evaluating business proposals and detailed knowledge about the local economy that will not be found in their textbooks.

Borrowers would pay a fixed interest rate. A rate of 6% might be sufficient to cover the risk of defaults and provide some amount of internal growth. Real growth will come from new students who will join the program each year as they enter college.

At some point each fund would reach a predetermined principal amount and be closed. In the US and elsewhere a closed-end mutual fund can become registered and be listed and traded in the regulated securities markets. This would provide liquidity to these crowdfunded investments where none exists.

Even after it is closed, a fund can continue to collect payments on existing loans and make new loans year after year. There would be no reason or requirement for it to liquidate. As the fund grows after it is closed the per-share value will continue to appreciate. Providing for growth and a liquid market would mean that shareholders could expect to make a profit from their investment.

The closing of one fund will be followed by the opening of a new fund to replicate the process. Over time, multiple funds will exist in every country that wants them, sponsored and funded by university students and others who will see both the benefits of the program and the potential for their own modest profit.

Replicated university to university and country to country a program like this would have a demonstrable effect within a decade. On a continuing basis it has the ability to transform communities and economies in the developing world from the bottom up.

It is an opportunity to demonstrate that altruism and capitalism are not mutually exclusive.