DATELINE: June 25, 2009, Chicago
The National Committee for Responsive Philanthropy (NCRP) released a study claiming losses by charities in the Madoff Ponzi scheme are explained by small and homogeneous boards. When we see anyone talking about diversity and foundation boards these days, we see a hidden agenda. So we want to set the record straight: There is...
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insufficient evidence to support the claim that board size or lack of diversity was a significant factor in the losses incurred by charities as a result of their decisions to invest with Madoff.
We agree in principle with the portion of the NCRP study concluding the Madoff losses are most likely due to a faulty investment decision-making process. We strongly suspect the discussion at many of the foundations that suffered losses sounded something like this: “I was talking to Fred at the country club after playing a round of golf today and he told me that Bernie Madoff has made him good money for years. I think we should invest with Bernie. I've know Fred a long time and he is a shrewd operator.” It was for that reason, that we wrote early on and told both charity regulators and state attorneys general that they should at a minimum consider opening investigations into whether foundations and charities that invested with Madoff undertook sufficient due diligence. By and large, that appears not to have happened.
We strongly disagree with NCRP’s notion that larger boards are the solution to the problem. In researching a portion of a book on investment policies and committees, we reviewed a number of articles and books by investment professionals with extensive experience in advising large endowments, pension funds, and other institutional investors. To an expert, the consensus is the smaller the investment committee, the better. The experts are in agreement that as committee size grows, the committee comes captive to the herd mentality that plagues investors as a whole. Decision-making regresses to the mean. There is the related problem of groupthink, a phenomenon that discourages creative thinking. The solution is anything but more people involved in the process.
We strongly recommend that the authors of NCPR’s study read the Independent Fiduciary by Russell L. Olson, the Handbook for Investment Committee Members by Russell Olson, and Foundation & Endowment Investing by Lawrence Kochard and Cathleen M. Ritterreiser. All prefer smaller investment committees to larger ones. These folks are writing largely for college and university investment committees. The consensus varies a bit, but these and other investment professional recommend no more than 5 or 6 members on an investment committee for institutions that often have 30 or 40 trustees. We acknowledge that in those cases, the experts warn against investment committees of just two or three, but we don't think they would advise family foundations to increase board size to address the potential problems.
The authors of NCRP’s study also should review the second edition of David Swensen’s landmark book Pioneering Portfolio Management, An Unconventional Approach to Institutional Investment. Mr. Swensen is Yale University’s Chief Investment Officer. He argues that smaller endowments should adopt an indexing strategy. The nature of many of the foundations that invested with Madoff makes them the perfect candidates for such a strategy. What is appealing about an indexing strategy is its simplicity, which means fewer people are necessary to implement and monitor it. This leads us to believe that a family foundation should be able to make adequate investment decisions with just two or three people on its board.
The committee makes reference to the Picower and Chais Foundations, noting that each had at least 5 directors. The report observes:
A mere 16 (15 percent) of these 105 foundations had boards comprising five or more individuals, the minimum board size recommended by NCRP.
The use of the word “mere” is indicative of the belief that there would have been far fewer charitable victims of Madoff had more of the victims had larger boards. X does not follow from Y. In fact, the Picower and Chais Foundations are hardly stellar examples for supporting the proposition that increasing board size improves investment performance. Irving Piccard, the bankruptcy trustee handling the Madoff liquidation, has filed suit against the people behind those two foundations, alleging that they knew or should have known about the scandal. If the allegations turn out to be true, no conclusion can be drawn from the size of the Picower or Chais Foundation boards. To their credit, the authors of the NCRP study do acknowledge the allegations by Piccard.
So why did charities lose money in the Madoff scheme? Until someone reviews minutes and investment policies, and interviews directors and trustees, we and NCRP can only speculate on whether there was adequate due diligence on the part charities that invested with Madoff. We strongly suspect that if these charities had done even a modicum of due diligence on Madoff, they probably wouldn’t have invested. The lack of a reputable auditor and the inability to use custodial accounts were all that many investors who steered clear of Madoff needed to know. A review of Barons also would have provided another clue. Most important, common sense, something that doesn’t require a large group, should have carried the day. Nobody consistently returns 10% to 12% returns for 15 or 20 years running.
In some cases, we suspect that Madoff investors, including charities, got what they deserved. There have been reports that some of those investors suspected Madoff of either insider trading or front running. As long as these investors could benefit from what they thought might be Madoff’s illegal activity, they were happy to go along for the ride. What they apparently failed to recognize is that criminals sometimes double cross their own friends—as anyone who has watched a Jean Pierre Melville movie knows all too well.
NCRP also should get realistic about its push for diverse boards. We understand their concern, but don’t believe diversity is relevant to investment decision-making. Investment is about process, due diligence, risk assessment, asset allocation, monitoring, and evaluation. Economic, ethnic, or religious background provide absolutely no additional insight into what largely should be a mechanical and objective process. NCRP might disagree, arguing that diversity might lead to different stock selection. The problem with that argument is that the investment process is not really about individual stock selection. There are some cardinal rules that need to be adhered to when overseeing an endowment and most problems arise when people deviate from those rules. If you want to argue that diversity can positively impact grantmaking, maybe. But investing, no.
To suggest that family foundations be subject to some sort of diversity requirement is to inappropriately interfere with private philanthropy. The law permits families to use foundations to make what are private allocations of resources. The law shouldn’t force families to open up what are often very personal decisions to outsiders, whether or not those outsiders add diversity to the process. Our many foundations provide sufficient diversity, with each choosing the interests of its funders and board members. Moreover, even if family foundations sought diversity by adding a few slots for outsiders, most would retain sufficient board slots to provide them with veto power. More importantly, what is wrong with unilateral decisions by the people who are funding the charitable gifts? Nobody tells individuals that they must make charitable donations in accordance with the guidelines developed by NCRP’s Philanthropy at Its Best project. So why should we impose that requirement on what are incorporated family pocketbooks? Seems like a rather artificial distinction to us.
Even if NCRP could wave a wand and require outside directors for family foundations, it would not achieve the goals it has previously outlined for grantmaking foundations. Many families then would choose to give directly to charities, use donor-advised funds, or establish funds with community foundations. Some people want to give their money to medical research, the arts, or their college. Not every dollar of private philanthropy need go to aid low-income communities. It is rather paternalistic of NCRP to try to dictate how resources should be allocated. Why are their preferences any more legitimate than anyone else’s?
At the end of the day, the trouble with NCRP’s Madoff study is that NCRP tries to use Madoff to support its long-term agenda. This is unfortunate because we need to determine what investment and governance practices led to the bad decision-making. It wasn’t board size or lack of diversity. NCRP forgets that Madoff only represents one aspect of the problem of poor investment practices—performance problems linked to fraud. The other aspect is poor investment performance. This comes about because investment committees fail to properly assess the organization’s risk tolerances and to construct asset allocations that maximize returns for a given risk tolerance. Many big foundations, colleges and universities, and other institutions with large endowments screwed up badly in terms of assessing investment risk, alphas, betas, and appropriate asset allocations. These organizations often do have the large boards and investment committees, as well as a more diverse group of directors and trustees. The diversity and size that NCRP demands didn’t seem to prevent these institutions from driving over the cliff. In short, NCRP’s study proves nothing.
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