May 15, 2009 |

Board & Investment Committees: Madoff Lessons

How Can Nonprofits Avoid Bad Investments

Like everyone in the non-profit community, I’ve been horrified by the Bernie Madoff scandal and its impact on so many non-profits and foundations. Most of what I’ve read has focused on the magnitude of the fraud, how it could go undiscovered for so long, and the impact of this massive loss of resources on the nonprofits affected.

There’s no doubt that the charities and foundations that lost money will suffer in some immediate and unfortunate ways, but I’m worried that non-profit boards and investment committees could take the wrong lessons from this scandal and make decisions that will impose additional financial hardship on their organizations.

To me the lessons from the scandal are really these:

Use common sense

If something seems to good to be true (e.g. an investment strategy that always yields positive results), it probably is. Certainly there are a few (very few) talented investors like Warren Buffet, who have outstanding investment records, but unlike Madoff, Buffett makes no secret of his investment strategy and has results that are easily analyzed and validated.

Don’t invest in what you don’t understand

There is simply no good reason for a non-profit to incur the costs, risk, and liquidity associated with hedge funds, private-equity and money managers with complex investment strategies. I doubt their ability to consistently produce superior returns, particularly after fees, and its unlikely that non-profit boards have the time or expertise to evaluate and oversee such investments.

Diversify Your Endowment’s Investments

The fact that some of these nonprofits had all or most of their investments with a single money manager and investment strategy violates the first principal of sound investing. Depending on the amount of assets, investment committees should try to not have more than 5% of their assets in a single investment, unless it is a mutual fund that is already providing a diversified portfolio — in which case it may be appropriate to have as much as 25% in such a fund.

Understand Investment Risk

It’s ironic that the appeal of investing with Madoff was the idea that the investment would provide consistent & attractive returns — making it “safe” from periodic losses. The real and under-appreciated risk was from the possibility that these results would not continue or as it turned out weren’t real — and the resulting lack of diversification and due diligence.

Don’t over-react

My fear is that in the wake of this scandal (and the significant decline in the stock market), non-profit boards & investment committees will decide to keep all or most of their funds in “ultra-safe” investments like treasury bills, money market or bond funds. These are low-yielding investments and although they may reduce the risk of direct loss of asset value, they virtually guarantee a slow but steady loss in the buying power of the nonprofits savings due to inflation. Just review any long-term inflation-adjusted graph of investment returns such as this one and note the negative “real” (after inflation) returns for Treasury Bonds, and T-Bills during the 60’s & 70’s.

Slow and Steady

My view is that unless your non-profit has a near-term plan to use the money that is invested for a particular project, your objective should be to take a long-term view toward preserving the assets while providing income and/or appreciation that exceeds inflation by a realistic amount (historically 3.5% is pretty realistic). This income/appreciation can then be used to fund operations or larger one-time projects or saved to provide additional financial stability in case of financial crisis.

Achieving this doesn’t require much time, expertise, or cost. It can be as simple as investing in four or five no-load mutual funds like those offered by Vanguard. I favor index funds and would recommend that at least one of them be Internationally oriented.

My intent is not to criticize the decisions of non-profit boards or investment committees, but simply to share my observations from many years of successful investing. Non-profit boards have a real challenge — striking the right balance between risk and return. It is just important that they consider that being too cautious has the potential to hurt the organization as much as being too aggressive.