You may have heard that the outlook for traditional stocks and bonds is bad. You’re told that the 2008/2009 financial crises has brought about a ‘new normal’ of slow growth and below average stock market returns. Interest rates are at all time lows and the bond bubble that we’ve enjoyed for 20 years is due to burst. Either your organization or your peers have moved a portion of the organization’s investment portfolio into “alternative assets”. If you haven’t yet moved into alternatives – should you? If you have, how do you know if it was a good decision?
This article seeks to further the understanding of alternative investing in the nonprofit sector and move you closer to making the right decision with your organization’s investments. The article defines alternative investments and then seeks to answer if making such investments is defensible, necessary, and/or beneficial for a nonprofit. An excerpt from the AICPA’s “Practice Aid for Auditors” is included as well.
Description and Risks of Alternative Assets
Alternative assets, by definition, are any investment that is an alternative to traditional stocks and bonds. Many consider real estate and commodities to be alternative assets but hedge funds are the primary “alternative” that organizations struggle with. Hedge funds are limited partnerships that maintain complete flexibility in the strategies they execute in pursuit of superior market returns. While there are dozens of different ‘hedge fund strategies’ most employ either leverage, short selling, or indirect investment through derivative contracts. Each strategy contains an additional element of risk beyond traditional market and interest rate risks – such as counter-party risk, legal risk, risk of high concentration, and the risk of fraud due in part to a lack of transparency.
The lack of liquidity inherent in limited partnerships increases a hedge fund managers’ flexibility but at the expense of investor flexibility. As the hedge fund industry evolves many of these risks are being addressed. Fund of fund hedge fund structures, for example, address risks related to concentration and fraud. “Liquid alternatives” (access to hedging strategies through mutual funds) address the liquidity challenge. This evolution, however, seems to have come at the expense of performance as either higher fees or reduced flexibility have reduced return expectations.
So, what’s a nonprofit to do?
Is it defensible? Certainly.
With respect to the oversight of a nonprofit investment portfolio, the primary role of the Board is to follow a prudent process in evaluating, hiring, and monitoring the investment professional whose role it is to manage the organization’s investments and to outline clearly in the investment policy statement the organization’s investment objectives, cash flow expectations, and risk tolerance.
The Fiduciary Handbook (Prudent Practices for Investment Stewards written by Fiduciary 360) references a number of “Safe Harbor” provisions(1) that, when adopted, may reduce liabilities associated with the Investment Steward’s management of the portfolio. Among the provision sited is “give the prudent expert discretion over the assets”. By delegating discretion of investment management decisions, Trustees may not ultimately be responsible for the decision to use or not use alternative investments. This assumes, of course, that there was a thorough due diligence process followed in hiring the advisor/manager and that the reasonable conclusion of this process, conducted by a reasonably informed Board/Finance Committee, was such that the selected manager maintains the expertise necessary to prudently invest in hedge funds. This also assumes that the organization’s internal management maintains a level of understanding sufficient to verify the valuation of any alternative investments.
Clearly the burden of oversight and continuous monitoring by the Board is increased, but the management decision (within the confines of the policy) may be made by the professional. This moves the challenge related to alternatives from one of inclusion/exclusion to one of oversight/monitoring. The key to oversight going forward, assuming the manager maintains expertise in this area, is proper benchmarking. See the article ‘Benchmarking Alternatives’ in the Dollars and Cents archive.
Is it necessary? No.
It’s important to understand that the global capital markets are highly efficient and that there is a direct and inextricable relationship between investment risk and investment return. The implication of this to those considering investing in alternatives is that you will not be circumventing the relationship between risk and return – but rather choosing to take risk in a different way.
Typically, the objective of an association’s long term reserve or investment portfolio is to support the long term health of the organization. Most policies seek growth without undue risk and are balanced with some allocation to stable fixed income investments. An organization seeking greater return expectations needs to know that this can only reliably come by assuming greater investment risk. And while seeking greater returns is perfectly reasonable, organizations should first considering increasing their allocation to stocks.
Is it beneficial? Maybe.
While you may have heard that the outlook for stocks and bonds is bad – you can be sure that such market outlooks have been wrong at least as often as they’ve been right. The outlook first began to worsen just after (key word after) the 2008 collapse. The outlook was at its most bleak in March of 2009 – just in time for a rally that brought all of your portfolios back over their previously set high water mark (assuming you maintained your policy). Current market prices reflect the future outlook. Market prices will change as the future outlook changes. The future outlook will change based on events that have not yet occurred. Moving to alternatives may be appropriate – but it won’t be because your investment advisor/manager knows how the economy’s future outlook is going to change tomorrow.
A recent article in the NY Times points out that pension funds that have stuck to more traditional investments have outperformed pensions that have a higher concentration of alternative investments like private equity, hedge funds and real estate.
Alternative investments have received a great deal of attention from the American Institute of Certified Public Accountants (AICPA) due to the inherent challenges of accounting for these investments. A recent pronouncement by the AICPA addresses alternative investments and states that an organization’s internal management (investor entity management) is responsible for the fair value measurements and disclosures included in the financial statements.
“This responsibility cannot, under any circumstances, be outsourced or assigned to a party outside of the investor entity’s management. Although the investor entity’s management may look to the fund manager for the mechanics of the valuation, management must have sufficient information to evaluate and independently challenge the fund’s valuation. The underlying investments generally are measured at estimated fair value by the fund manager in accordance with its stated valuation policies for determining net asset value.”2
Taking responsibility for the valuation of the alternative investments will necessitate that the management of the investor entity has a sufficient understanding of the nature of the underlying investments, the portfolio strategy of the alternative investments, and the method and significant assumptions used by the fund manager to value the underlying investments. The nature and extent of management’s process for valuing investments, and the related internal controls, are particularly important when the investor entity invests in securities for which readily determinable fair market values do not exist. In these instances, management should have in place a process and internal control over that process to ensure that its alternative investments are recorded at amounts in accordance with its stated accounting policies.
Our firm spent the better part of the last year working internally and with our external investment committee to get to a place where we can recommend a specific approach to investing in alternatives. Despite our best efforts to identify a solution, and regardless of the challenges related to valuation, we remain confounded by the data indicating that our nonprofit client objectives will be met more reliably with traditional assets. The hedge fund industry is rapidly evolving, however, and the market is forcing greater transparency and lower fees. It’s entirely possible that the current barriers to prudently accessing certain hedging strategies get removed.
The answer for nonprofits then and now is good governance. Specifically, draft clear policies that reflect both your objectives and your capacity for oversight, delegate discretionary authority to your managers to make investment decisions, and follow your due diligence procedures closely.
Raffa Wealth Management is an independent investment advisor providing nonprofit organizations with a full range of investment consulting services. We were established to fill the need for transparency, clarity, and accountability in the professional management of investment assets. Visit us at www.raffawealth.com.
Raffa Wealth Management is not a law firm and any statements made in this article should not be construed as legal advice.
- Prudent Practices for Investment Stewards (The Fiduciary Handbook) Written by Fiduciary 360, 2006; Technical Review by American Institute of Certified Public Accountant; Legal substantiations by Reish, Luftman, Reicher, & Cohen
- ALTERNATIVE INVESTMENTS – AUDIT CONSIDERATIONS A PRACTICE AID FOR AUDITORS Copyright © 2006 by American Institute of Certified Public Accountants, Inc.