W. Scott Simon
Last month’s column dealt with a question often asked in a Request for Proposal. An RFP is a formal document in which an employer, such as the sponsor of a 401(k) plan that’s governed by the Employee Retirement Income Security Act of 1974, or ERISA, solicits proposals from qualified firms to perform third-party services such as investment management, recordkeeping, or other plan administration.
Nonprofits, including endowments and foundations as well as other pools of money subject to fiduciary edicts, may also choose to issue an RFP, and requirements for those RFPs should not be any less exacting than for ERISA plans. According to best practices, a requestor should go to market and issue a new RFP every three to five years in order to ensure that its plan is receiving services that, among other things, are cost-effective.
Last month’s column identified the question that a plan sponsor always asks respondents answering an RFP for investment management services in a 401(k) plan: What’s your investment philosophy?
This month’s column identifies another question often found in RFPs issued by nonprofits, including endowments and foundations. More particularly, this question asks respondents for their philosophy regarding alternative investments.
One of the tenets of modern prudent fiduciary investing–originating with the 1992 Restatement (Third) of Trusts and subsequently codified in the 1994 Uniform Prudent Investor Act and its various progeny, including the 2006 Uniform Prudent Management of Institutional Funds Act (or UPMIFA)–is that no investment is considered imprudent per se to include in a portfolio.
However, any given investment can become imprudent when its inclusion in a portfolio is considered unreasonable or inappropriate within the context of a particular set of facts and circumstances.
I don’t favor the use of alternative investments (including, say, hedge funds and private equity) for a whole host of reasons.
- Alternatives are usually complex investment products and therefore difficult to understand by both buyers and sellers. Buyers–usually highly successful community leaders who, for that very reason, are recruited to sit on the board of a nonprofit–are often at sea when it comes to assessing the prudence of such products. This is especially true when they face off against sellers–those touting alternatives–who are very highly financially motivated to make a sale.
- Fiduciary board members rarely raise questions about even the basics of complex investments, because they don’t wish to appear ill-informed in front of their equally successful fellow board members. Often the outcome from this all-too-human impulse is little understanding of alternatives, which makes many members putty in the hands of skilled salespeople. In cases where board members raise pointed, well-informed questions, they are often outvoted by other members who much too often “trust” the salespeople peddling alternatives partly because, well, those salespeople use trust-based selling techniques.
- But perceptive, well-informed board members who ask deep, probing questions of salespeople pushing alternatives will often find that a salesperson’s understanding of their own investment products is relatively shallow. When faced with this kind of inquiry, the typical response will be: “I’ll have to get back to you on that one.“
- Alternatives generally lack transparency. Their holdings are opaque and may even include those held offshore beyond the reach of American law. This is forbidden under all bodies of fiduciary law, including UPMIFA, which governs nonprofits.
- Alternatives often generate mediocre investment performance. Even when a performance is (seemingly) excellent, it remains suspect because such performances are usually self-reported with no independent third-party check on the veracity thereof.
- Alternatives can be quite costly. But how costly is often difficult (more like impossible) to establish given the generally hidden nature of all the costs involved. These costs are usually not even spelled out in the contract entered into by a nonprofit and a seller of alternative investments.
- Alternatives are often illiquid. They are valued at the beginning of their investment life and until their cash-out–which may be up to a decade or more in the future–they continue to carry that initial valuation through the years. But it may very well be that at the end of such a “lockup period” an alternative may be valued less than its initial valuation. And yet an investor in the alternative investment is often required to pay fees that are based on its initial value. Sometimes an alternative is completely worthless at the end of a lockup period. What a deal–for sellers of alternatives–because nonprofits hand over fees based on the initial value of the alternative. Akin to the Roach Motel where you check in but you don’t check out, investors in alternatives have to keep forking over fees over the course of an alternative’s lifetime–and they cannot stop doing so nor do they get any refund.
- Alternative investments are frequently impossible to value given the lack of secondary markets to establish their fair market value.
- All the foregoing factors, of course, make it impossible for board fiduciaries to carry out their monitoring duties prudently.
It is a truism of Wall Street that the more complex an investment product and the more difficult it is to truly understand the product (including all its hidden costs and conflicts of interest), the greater the compensation that will be paid to the salesperson peddling it. And alternative investments are almost always very complex. Fiduciaries, especially those responsible for pools of assets at nonprofits, must be alert to this–but ideally will retain an advisor wise to the ways of sellers of alternatives.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as written opinions, which are described here [https://www.fiduciary-experts.com]. Simon also serves as a discretionary fiduciary investment advisor to retirement plans at Retirement Wellness Group [https://www.retirementwellnessgroup.com/]. For more information, email Simon at email@example.com or firstname.lastname@example.org. The views expressed in these articles do not necessarily reflect the views of Morningstar.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.