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.