Non-Profit Fiduciaries Must Consider Passive Investing

An individual serving as a director of a non-profit has been given a role of significant trust, and has a duty to donors, beneficiaries, officers, employees and the public at large. Directors have broad management authority over the practices of an organization, specifically concerning management, strategy and finance. The two primary fiduciary obligations of a director are a duty of care and a duty of loyalty (not to underscore the duty of obedience, which has less weight in this discussion).

A simple take on the duty of loyalty is this:  treat the organization and its finances as if they were your own.  The organization must come first, and any conflicts of interest must be disclosed and considered.  A director cannot allow personal benefit to play a role in organizational decisions or strategies.

A duty of care requires that the director exercise the care of a prudent person and with the belief that the action is in the best interest of the organization.  A director has a responsibility to make fully informed decisions and pay a high level of attention to matters concerning the organization. This “ordinary prudence” does not require that all directors be well versed in management, business strategy or finance, but the duty does require that the director take a proactive approach to the oversight of the organization’s activities.

It is not unusual for directors or organizations to hire third party consultants for a variety of tasks, not the least being the management of the organization’s endowment.  The duty of care requires that directors be well informed to consider the opinions and advice of an outside consultant, and that the organization is not exposed to unnecessary risk.  This advice from the DOL is specifically directed to ERISA retirement plans, but certainly applies in spirit to all fiduciaries:

“Hiring a service provider in and of itself is a fiduciary function. When considering prospective service providers, provide each of them with complete and identical information about the plan and what services you are looking for so that you can make a meaningful comparison.”

Financial obligations are a source of frequent director and organizational liability.  The prudent care of stakeholder assets requires a high level of due diligence and ongoing oversight. Mismanagement and neglect of organizational assets can end in directors being held liable for failure to exercise due care.

The board must protect the assets of the organization, and simply hiring an outside investment consultant does not fulfill a director’s obligation of due care.  The majority of cases in which directors have been found liable has been as a result of a failure of the director to supervise and provide oversight to an outside financial consultant.  Directors cannot unilaterally grant authority to any individual or third party consultant without providing necessary oversight.  Directors should expect and demand that their outside investment consultants provide regular reports concerning investment performance and asset allocation and measure these data against the targets outlined in their Investment Policy Statement (IPS).

The IPS will have stated goals for asset allocation and target risk/return characteristics. It would be stated in most Investment Policy Statements that the investment portfolio of an organization will have its performance regularly benchmarked to appropriate market indices.

As discussed above, the duty of care a director owes to the organization requires that the director make well informed decisions regarding the finances of the organization. Any brief academic study of actively-managed fund performance will inform the director that the majority of these investments regularly fail to match the performance of their respective benchmarks.  Such studies would include Michael Jensen’s 1965 work on actively managed mutual funds, Standard & Poors’ ongoing research of fund performance, Morningstar’s evaluation of past-and-future correlation of returns and William Sharpe’s Arithmetic of Active Management.

Given that most Investment Policy Statements will state a performance objective (either on absolute terms or relative to market indices), the director should consider if the additional management costs and specific active management risks will help the organization meet its stated goals.  In many cases the director can arrive at the conclusion that a simple portfolio of broad based passive investment strategies will have a higher probability of success than a high turnover, expensive active management strategy.

If a director has been well informed (as he or she is asked to be) and must consider the best interests of the organization, the data obligate the director to consider the use of a passive investment strategy for at least some of the organization’s assets in an effort to increase the probability of reaching the objectives stated in the IPS. The evidence is clear that the use of such passive strategies over actively managed investments are in the organization’s best interests.


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