Finance and investments can be daunting. The “financial world” has its own terminology, conventions, and complexities. Because of this, it can be intimidating to nonprofit board members across all walks of life, even for those with deep expertise in other professional areas. And it can be even more intimidating to non-financial professionals who have oversight responsibility, in some form, for an organization’s assets.
Of course, participating in the oversight process doesn’t necessarily mean playing a leading role in determining what types of investments a nonprofit should be holding. Many organizations partner with consultants to help in making these decisions and provide valuable advice along the way.
With that said, regardless of whether an organization is working with a consultant, and even if they are not financial experts, board members can bring more to the table than may seem at first blush. Below are three best practices for those who participate in the management of their organization’s assets.
Build an effective board
First things first. Oversight-related decisions will only be as good as the people in charge of making them. Every organization has its own unique set of needs, so it’s difficult to broadly prescribe guidelines about an appropriate board size, tenure, professional experience, etc. With that said, striking a balance across all of the above is often a strong approach.
Take experience as a starting point. Some organizations will stock boards with professionals that work in the same or a highly-related industry under the idea that such individuals will understand the operations and needs of an organization most intimately. For example, a hypothetical hospital foundation with an investment committee comprised almost entirely of doctors and other medical professionals. While this logic is sound, it’s clearly harder to obtain diversity of thought with a homogenous board.
The example above is more glaring for illustrative purposes, but the bigger point is that board composition should be a topic for discussion at committee meetings. It’s important for a board to periodically assess its current size and the background and tenure mix of its members. It’s also important to think about how to identify a pipeline of professionals for the future who would be a welcome addition to the team.
Diverse perspectives often lead to more robust discussion and analysis at meetings, and in turn, can help improve decision-making. Investment committees often come to truly appreciate this when market environments, and subsequently investment decisions, become particularly challenging.
Assess with art and science
Many nonprofit organizations invest their assets using diversified products like mutual funds and ETFs. Though blending quantitative analysis (science) and qualitative assessment (art) is highly important in evaluating any product, to the extent that an organization is investing in actively managed mutual funds in particular (relative to index funds), using a mix of both is even more critical.
A given investment product’s track record can provide important insight into its strategy and risk characteristics, but past performance is no guarantee of future returns. With this in mind, supplementing quantitative analysis with a qualitative review can strengthen a board’s assessment of a given actively managed strategy and improve confidence in its decision to either retain or terminate a given fund in the portfolio.
Qualitative assessment itself is highly subjective and should vary depending on the nature of a given fund, but a few important questions to thoroughly assess include the following. How consistent has a product’s strategy been through time and if a lack of consistency appears, why is that the case? How are the portfolio managers and analysts associated with the fund compensated and is their compensation structure aligned with investor outcomes? And lastly, how strong are the set of risk management protocols that ensure the fund remains within its stated mandate and who is responsible for overseeing them?
Obviously this is not a comprehensive list of qualitative due diligence topics, but the three above are important. If possible, these questions can be addressed effectively via a site visit to a manager’s headquarters or primary area of operation. And to the extent that board members are working with an advisor or a consultant who is performing much of this work on behalf of an organization, these are appropriate questions to ask those who are conducting initial product due diligence or ongoing oversight.
Be patient over the long haul
Focusing on the long-term is one of the most common pieces of investment advice broadcasted throughout the industry. Admittedly, it’s also one of the hardest tenets to follow. For nonprofit committees managing assets for indefinite-lived institutions, short-term performance pressure still often exists in some form. This is particularly true when spending needs from the portfolio are material.
There are two angles from which to address patience. First, more broadly, investment committees should generally avoid the urge to time the markets in an attempt to opportunistically add value. It’s a powerful calling. However, the markets are extremely difficult to predict over the short-term, and it’s far easier to destroy value than add value by doing so. Instead, assuming a nonprofit organization has an appropriate long-term investment strategy already in place, sticking with the plan is generally a better path to success.
Second, more specifically related to using actively managed mutual funds, these types of strategies typically need to be assessed over long-term horizons that encompass full market cycles. Though a three-year period may feel like enough time for a thorough evaluation, it’s just a blip in the investment management industry.
When assessing the hire-fire decision for an active manager where the investment objective is benchmark outperformance, historical returns should certainly be an important input. But performance for active strategies truly needs to be assessed over 10-year (and greater) horizons to, for example, determine whether a portfolio manager’s track record is the result of skill rather than luck. Instead, to the extent board members are assessing managers over shorter-term horizons, just as much emphasis should be placed on other important qualitative factors including some of the topics discussed above.
Daniel Berkowitz is an investment director at Prudent Management Associates, which manages assets for a variety of nonprofit institutions.