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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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The old fixed ideas of how foundations and endowments should manage their moneyNO FOUNDATION, FOUNDATIONS, AND ENDOWMENT FUNDS Two members picked themselves up off the floor and called our office after the bomb had been dropped. They were new to the board of this popular foundation, and like many volunteers who generously give their time and their talent to jobs for which they do not get paid, they found themselves thinking that they may have bitten off more than they could chew. The bomb was figurative, but it was as destructive as a real one would have been. The new building that the foundations paid staff had to occupy in 30 days had no roof, no drywall, no plumbing, and no electricity. The assets of the foundation had sunk to a level so low that feeding cash into the building project was no longer possible without permanently depleting the corpus of the foundations assets. Subcontractors were not getting paid, and construction stopped. We were asked to figure out what happened. Statements were faxed and projections reviewed. In just 15 minutes it became clear how a prominent charity, supported by a constant flow of money from societys upper crust, could regress into a downhill slide toward the financial equivalent of homelessness. Between 1998 and 2000 the money that poured in from fundraising efforts during a booming economy was invested 60% in so called blue-chip growth stocks and 40% in bonds. This allocation was arrived at so arbitrarily that no one could recall its source: Langford C. may have told Bentley R., Thats how this other organization in town does it. While no one will admit to it, this approach is so ubiquitous that what we found on a deeper inspection of the portfolio did not surprise us. Frightened by the market declines of 2000 and 2001, donations received by the foundation were put into bonds that then declined in the fourth quarter of 2001 and dropped further in the first quarter of 2002.9 This exacerbated the foundation losses by another $720,000. Another emotional, knee-jerk reaction was the doubling up on posi tions in the companies just listed and those like them. The justification for this was that they were supposedly cheap because the price per earning ratios were low, and history was thought to prove that they would soon bounce back. Large profits would be achieved with little risk by buying Merck at 50 and watching it soar back to 90. This panicked effort to make up for losses only drove the portfolio further into a hole. The situation with this foundation is not unlike that of many others. The contributions of donors are going toward subsidizing an old dominant investment system, and a shrinking piece of the pie remains to do the work of the charity. Had the same situation occurred in the 1950s, 1960s, or even 1980s, reliance on the historic performance of socalled blue chips would have paid off. But the ending of an old investment culture also ended the effectiveness of the old fixed ideas of how foundations and endowments should manage their money. When, in an effort to learn how best to guide boards in the handling of the money to which they have been entrusted, we ask members to explain the basis on which decisions have been made in the past, someone usually points toward the prudent man rule. This can be a solid basis on which to build an investment strategy, as long as one recognizes that what is prudent today is not what was prudent 20, 50, or 100 years ago. Here is Justice Samuel Putnams definition of the prudent man rule: All that can be required of a trustee to invest is that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of the capital to be invested.10 Putnams original statement has been amended and enhanced, but the key word prudent has stuck. This is peculiar in that prudent is a fluid concept. Proof that any definition of a prudent investment cannot be an enduring proposition lies in the fact that Putnam wrote his opinion in 1830. No doubt, in 1830 Justice Putnams idea of a prudently managed portfolio would have been one that consisted of bonds, predominately railroad bonds. So who were the more prudent fiduciaries in 1903? Those who kept buying railroad bonds, or those who adopted a methodical approach to investing in a new dominant investment? The only prudent course that a twenty-first century fiduciary can follow when making decisions on money that does not belong to them is to adopt the investment methodology outlined in Chapter 3. The process should begin with an investment policy statement spelling out whether the funds primary goal is to last into perpetuity, provide bequests (and if so, to whom), or provide cash flow for projects, operations, or emergencies. A liability analysis should be performed much like that which is required for a defined benefit plan. After this is completed, the optimal portfolio can be prescribed and the rebalancing technique employed. The unique dynamics at work on the boards of charitable or nonprofit organizations can turn the collective best intentions of its members into a formless, makeshift affair unless the methodology we outlined to manage money is employed. The rotation of board members interrupts continuity as experienced members are replaced by new ones. Big donors may get a prestigious board seat in exchange for the tacit approval to make the decisions like directing the investments to the bank that just agreed to some personal financing. Deference may be given to a celebrity or high-powered business executive who neither wants nor asks for it, resulting in the investment strategy of the funds shooting off in a new direction, out of context with arrangements that were just beginning to come together. In this way ambitious plans are continuously recycled but seldom achieved. The investment committee of Denison University included some high-powered financial people: John Lowenberg, a former Robinson Humphrey fund manager; John Canning, president of the Chicago private equity firm Madison, Dearborne Partners; and Mark Dalton, a Connecticut financier. In 1999 they permitted 12% of the Universitys endowment fund to be invested solely in Cisco stock. Half of the endowment was invested in illiquid funds with no disclosure or investment return requirements. Long periods went by when no one knew how much money they had or what it was invested in. On the assets to which they could assign a value, they lost $105 million in six months.11 The reason for this gross mismanagement? We decided it was time to get some decent returns here, and that meant being a little more aggressive,12 says Jim Oelshlager, an alumnus of the University and a principal of Oak Associates, a mutual fund company that no surprise here was given a large chunk of the endowments money to manage. The word in Oelshlager s sentence that gives weight to our contention that boards and finance committees have a dynamic all their own is we. The fact that Oelshlager was not a member of the finance committee but was permitted to weigh in on asset allocation decisions that would directly benefit him and his firm shows the willful disregard for even the appearance of propriety that exists. That Oelshlager does not seem embarrassed by this since his quote using the we appeared in a nationally distributed magazine points to the shortage of regulations and surplus of ego that can meet around the conference tables of certain organizations. Denison University did have an investment policy. This is of no use if it is carelessly enforced. They had high-profile investment people making decisions. This is of no use if none of them has any sense of discipline or are ill informed about basic investment methodology, as the committee members at Denison seemed to be. Those who are concerned with what happens to their charitable donations should ask to see an investment policy statement that governs the pool of money into which their contribution will go. The document should outline clear objectives, spending policies, liabilities, and investment guidelines. A composite statement should be available listing all the endowments assets and how they are broken down by percentages. This should be accompanied by comments on why each manager was selected. This should include not just performance numbers but qualitative issues as well. Things like the size of the firm or their unique research methods might be included. The composite statement should be compared to the investment policy statement. In this way one can determine whether the policy is being followed. A potential donor may prefer to give the information to his or her financial advisor. An experienced person can size up the situation quickly to determine whether the charity in question is worthy of a donation. The board or finance committee that adheres to the investment policy mandate has a much easier job. Their task becomes simply to ensure that stated guidelines are being met. Those with minimal investment experience do not need to be intimidated by those who lay claim to knowledge of finance (less experienced investors have no need to be intimidated anyway; a case in point is Denison University). The committees job is to see that objectives are being met and that guidelines are being honored. If they are not, ask why not. If a suitable answer is not delivered, refer to the investment policy statement for direction. The answers to how and why to remove a board member, fire a money manager, or amend an asset allocation strategy should have already been spelled out. There is bound to be a flaw in the participants perception of the fundamentals. The flaws may not be apparent in the early stages but it is likely to manifest itself later on. When it does, it sets the stage for a reversal in the prevailing bias. George Soros 13 George Soros has been described by the New York Times as the most powerful and profitable investor in the world today. Soross success comes from finding the flaw in the prevailing perceptions about the financial markets and then backing up his convictions with large sums of money. The flaw in perceptions that prevails in the markets today is the disregard for the fact that a new investment culture has replaced an old one. It is those who participate in the early stages before there is a reversal in the prevailing bias that will be most successful. Those entrusted with the responsibility of making decisions for pension plans, 401 (k) plans, foundations, and endowments can accomplish this in an orderly and business-like fashion by adopting the methods set down in the book. The management of money, as we describe it, operates no differently than that of any other profitable business. Aplan should be realized, capitalized, and customized. If its conception is realistic and it is executed with a military discipline, it will work. As the assets of their large pools of money fall in step with the new dominant investment system, the beneficiaries can feel confident that promises made to them will be kept. Those willing to recognize and act on the reversal in the prevailing bias that is occurring will be naturally led into it. Those unwilling to adapt to the new investment culture will be dragged along, fulfillment of expectations always just out of each. Then, somewhere near the end of the acceleration phase, they will decide, Its time to get some better returns here. As impulsive as two-year-olds, they will try to accomplish this by being a little more aggressive with their makeshift plans and arbitrary decisions. As they indulge old habits and rationalize away the inevitable losses, they will take comfort in the fact that, Oh well, at least it wasnt my own money. NOTES 1. Kenn Tacchino and David Littell, Planning for Retirement Needs (Bryn Mawr, PA: American College, 1997). 2. Ibid. Here the term cost means the amount of money that a plan sponsor has to contribute to the plan so that it can pay its promised benefits. 3. Courtesy of Ryan Research, Ryan Labs. 4. Ibid. 5. FAS 106, paragraph 186. 6. SEC Guidelines on FAS 87 (June 1993 letter to all corporations). 7. FAS 87 Transition Amortization, courtesy of Ryan Labs. 8. Plan Sponsor Defined Benefit Plan Survey, 2000. Plan Sponsor Mag azine, March 2001. 9. The Lehman Brothers Government Corporate Bond index return in the first three months of 2002 was -1.2%. 10. Consulting Group, Endowments and Foundations, 2000. 11. Ron Suskind, On Dangerous Ground, Smart Money (2001, Septem ber), 117-124. 12. Ibid., p. 120. 13. George Soros, The Alchemy of Finance (New York: Wiley, 1994). |
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