Who is Managing Your Investment Process?

Puzzle PieceWhile the ultimate fiduciary responsibility lies with the Board of Directors, most organizations seek professional help to manage the investment process. There are a number of different approaches to the mechanics of investing, most of which are blurred by the many different actors and the confusing array of role titles, platforms and regulators. We begin by listing some of the possible scenarios.

  • In House Portfolio Management
  • Broker-Dealer Transactional Relationship
  • Investment Manager
  • Investment Management Consultant

Given that these are all existing business models, each of these approaches have some appeal to investors. Which one, however, is right for your organization? For fiduciaries, there are several key questions.

  • Which of these approaches best fulfills the fiduciary duty to invest prudently in the sole interest of the organization?
  • Which approach allows fiduciaries to focus on important decisions related to investment policy, broad asset allocation and risk tolerance in the context of the organization’s mission?
  • Which approach is fee transparent and lowers costs?

Let’s take a look at each of these approaches.

In House Portfolio Management

Harvard, Yale and other large institutional investors have formed their own management companies, as you should if you want to do this right. The problem is that it is awfully hard to justify the cost of staffing this kind of expertise unless the portfolio is in the billions. This is not really an option for the vast majority of non-profits.

Broker Dealer Transactional Relationship

What exactly is a “financial advisor” or a “financial consultant”? How about “wealth manager”? Most of the times we encounter these titles, we are dealing with what we used to call “registered representatives” of brokerage firms. Clients may be more familiar with the terms “broker” or “customer’s man” if of a particularly fine vintage. Whether this individual or team of individuals is employed by a FINRA licensed broker dealer or a bank, the role is the same. These are commissioned sales agents whose business model is to generate profitable transactions. The business model has evolved to now include asset based fees. In other words most “financial advisors” are now licensed both to make commissions on transactions and to collect fees on assets managed. Most reputable broker dealers do not allow the reps to “double dip” or earn both commissions and fees from the same client. Most of the advisers we have seen in the non profit space have wisely chosen to present the asset based approach as it is more appealing to fiduciaries.

Fiduciary Duty, FINRA Regulated
Brokers or financial consultants etc. are regulated by FINRA and are required to “know” their customer, a requirement most often fulfilled by a suitability questionnaire which is part of the account opening paperwork. Once the broker or advisor is familiar with a client’s circumstances, the recommendations they make must be “suitable” given the client information submitted in the account opening form. Importantly, the advisor is not required to act only in the best interest of the client, as entities regulated by the SEC must.

There are several other problems in dealing with “financial advisors” or brokers, most of which relate to conflicts of interest and fee levels. Most broker dealers have proprietary products such as in house mutual funds, for which there is a higher level of compensation for the adviser. Many broker dealers have constructed asset based investment “platforms” that allow clients to invest with a variety of “selected” outside managers. This is generally referred to as a form of “open architecture “. The problem here is that quite often managers are selected on the basis of undisclosed fee splits. In other words a mutual fund manager may be willing to cut their fee in order to be included on a large visible platform, allowing more of the fee to be awarded to the platform sponsor and its employee…your advisor. True open architecture allows advisers to choose from thousands of managers using criteria that are unrelated to their own compensation.

Investment Advisors

Investment advisors, unlike financial advisors employed at a broker dealer or bank, are not transactionally oriented. They charge an investment management fee, most often based as a percentage of assets managed.

Fiduciary Duty, SEC Regulated
Investment advisors are regulated by the SEC and have a higher fiduciary standard than FINRA regulated (broker-dealer) financial advisors. Investment advisors have a fiduciary duty to put their clients’ interests first and must always act in the best interests of their clients. This is a much higher standard than the financial advisor’s duty to recommend suitable investments while not necessarily placing the client’s interests first.

Investment managers manage portfolios of stocks, bonds, ETFs and mutual funds and have full discretion to manage client assets. As in many walks of life, investment managers tend to specialize in market segments, such as fixed income, large cap growth stocks, small cap value stocks, international stocks etc. While some managers offer a full suite of investment products, some of their products are better than others.

Investment managers are key to implementation of the investment strategy that the organization has decided upon. Can investment managers help develop that investment strategy? Yes, but there are inherent conflicts.

  • If they are fixed income specialists or large cap value gurus, will this affect their judgment in allocating assets?
  • If there is a superior product offered by another firm, will they send assets away to that firm?
  • If they use mutual funds to diversify into categories such as emerging markets or global bonds, will they reduce their fee for that portion of the portfolio?

Investment Management Consultants

Investment management consultants are the next best thing to in-house portfolio management used by large institutions.

Regulated by the SEC, the fiduciary duty is the same as for investment advisors; they must always act in the best interest of clients. Unlike investment managers, they should have no conflicts of interest in development of Investment Policy, Asset Allocation, Manager Search and Selection and Portfolio Monitoring. Importantly, they offer independence and objectivity in Performance Reporting and evaluation of results. The consultant’s purpose in life is to help fiduciaries manage the investment process. This allows fiduciaries to focus on high level decisions.

Investment management consultants help organizations assemble teams of investment managers for the purpose of implementing an investment strategy that has been developed without conflicts of interest and is transparent with regard to fees. The process becomes more efficient, using managers who have been thoroughly vetted for performance and fees. Speaking of fees, consultant fees are generally a fraction of investment management fees and because the consultant is charged with finding efficiencies in developing the process, total fees can actually decrease when using a good consultant.

About Jim Jeffery, CFA

Jim Jeffery, the founder and principal of Jeffery Asset Management has joined Solaris Advisors LLC as Managing Director where he will lead the non profit senior living effort. Jim is a Chartered Financial Analyst (CFA) with more than 20 years experience in the financial services industry. Have a question about your financial plan? ASK JIM

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