Financial advisors who work with investment committees of foundations, endowments, and other philanthropic entities find the fiduciary standard an important component of their work. But many are actually not fiduciaries. In fact, the Dodd–Frank legislation of 2010 required the SEC to study the fiduciary standard, because there is a good deal of confusion among investors as to what it really means.
Why is the fiduciary standard such an important area of discussion? What does it mean for the portfolio and the ultimate outcome for the charitable entity? To demystify this issue and provide a glide-path to charitable boards who are making important decisions about the advisors mandated to watch the organization’s most important asset—its portfolio, let’s begin with a definition:
Fiduciary: an individual in whom another has placed the utmost trust and confidence to manage and protect property or money; the relationship wherein one person has an obligation to act for another’s benefit
This appears to be a simple principle, and most readers might be thinking, “I already have a fiduciary managing my foundation’s portfolio, right?” But do you?
To get to the bottom of this issue, we need to start with the differences between broker-dealers and investment advisors.
Although both assist individuals and institutions in making financial decisions, and charge fees or commissions on the investments they execute, they are not the same—although most people believe they are.
A broker is defined by the SEC as “someone who acts as an agent for someone else” and a dealer as “someone who acts as a principal for their own account.” So a broker acts as an intermediary between an investor and a product, and a dealer may actually be that product. Broker-dealers must follow the suitability standard, meaning an investment simply needs to be suitable for that investor’s situation. There can be conflicts (like higher fees for one investment over another), but, as long as the investment meets the suitability standard, the broker is in compliance.
- Works for a firm; duty to broker-dealer
- Suitability standard
- Overseen by FINRA (a self-regulatory agency) and defined by The Securities Exchange Act of 1934
- Assists individuals and institutions in making financial/investment decisions
- Not required to disclose conflicts
- Not required to place trades under “best execution” standard
- Fees on assets or fees based on time spent or commissions
Investment advisors are bound to the fiduciary standard that was established by the Investment Advisors Act of 1940, requiring them to put their client’s interest above their own—period. There also is a key distinction in what loyalty is owed to whom: the broker has a duty to the broker-dealer firm he works for; the investment advisor has a loyalty only to his client.
- Independent; allegiance to clients only
- Fiduciary standard
- Overseen by the SEC and guided by the Investment Advisors Act of 1940
- Assists individuals and institutions in making financial/investment decisions
- Must disclose any conflicts of interest
- Trades must be placed under “best execution” standard
- Fees on assets or fees based on time spent or commissions
But how does this difference affect portfolios of foundations and endowments? What do investment committees of these philanthropic entities need to worry about?
Fees are one of the biggest determinants of long-term investment growth; the lower the fees, the greater the returns. Among portfolios composed of individual equities and bonds, the fees are simply a calculation of the fully disclosed management fee plus any drag due to trading costs and turnover. But among portfolios allocated toward ETFs, closed end funds, hedge funds, alternatives, and the like, the fee issue is much more pervasive. This brings us back to the fiduciary standard. If your investment professional doesn’t put the portfolio’s interests above his, he may populate it with products that generate greater fees for his firm.
Philanthropic portfolios have the ultimate objective of making a difference to the nonprofits they support. Charitable entities must ensure their portfolios are being managed in a fashion akin to their own fiduciary responsibilities.
Peter J. Klein, CFA, CRPS, is president of The Claire Friedlander Family Foundation and managing director/partner of Klein Wealth Management at HighTower Advisors, a recognized authority in security analysis, investment management, and philanthropic services. Klein Wealth Management, one of Exponent Philanthropy’s Platinum Sustaining Partners, puts its extensive knowledge to work for affluent individuals, retirees, corporations, and private foundations—seeking to create and fulfill legacies its clients can be proud of for generations.