W. Scott Simon
I described, in last month’s column, the dominant approach used by many investment advisors in providing advice to fiduciaries responsible for the investment of non-profit assets. That approach, which I term “imprudent speculation,” ensures that charitable assets are invested by those advisors in such a way as to favor their interests over those of charitable beneficiaries and the fiduciaries that are responsible for protecting them. This outcome is inevitable since the business model followed by such advisors legally requires it.
Many of the fiduciaries responsible for the investment of charitable assets think that this approach by which they receive investment advice is the only one open to them. That just isn’t so. Another, but less-well-known approach, which I term “prudent investing,” focuses on what’s best for charitable beneficiaries of non-profits. My five-part series on non-profits will now conclude with an examination of this approach, which stands in stark contrast to that of imprudent speculators who focus on what’s best for their own business model.
I’ve tried to show fiduciaries in my series on non-profits the importance of understanding the differences between these two very different approaches of providing investment advice to them. Many (perhaps most) may dismiss what I’ve tried to convey. It may be more difficult, however, to dismiss what The Panel on the Non-Profit Sector (convened by the Independent Sector) recommends:
“Charitable organizations should work with their state legislatures to amend state laws to ensure that the prudent investor standard of care for investment decisions, as set forth in the Restatement of Trusts (Third) and the Uniform Prudent Investor Act, is made applicable to all charitable organizations, whether formed as trusts or corporations.” These bodies of modern prudent fiduciary standards require ideally a legally sound, academically based and cost efficient investment process. A prudently investing advisor incorporates this process.
Prudence as a Legally Sound, Academically Based, and Cost-Efficient Investment Process
Prudence as process is one of the overarching themes emerging from the landmark reforms of American trust investment law that culminated in 2006 with publication of the Uniform Prudent Management of Institutional Funds Act (UPMIFA). The investment standards of modern prudent fiduciary investing, as set forth by UPMIFA, require fiduciaries of non-profits to establish and follow a prudent investment and management process. An investment advisor who engages in prudent investing provides advice to such fiduciaries through a process that ideally is legally sound, academically based, and cost efficient.
1. Legally Sound
A Fiduciary Mindset
The Prudent Investor. The legally sound aspect of the investment process followed by a prudently investing advisor focuses on what’s best for the interests of charitable beneficiaries. Indeed, every body of fiduciary law requires placing the interests of beneficiaries first; that, after all, is the very essence of prudence. A prudently investing advisor legally assumes fiduciary status to the non-profit fiduciaries it advises and, by implication, their beneficiaries. Providing investment advice grounded firmly in the law is also beneficial to fiduciaries because they are assured of greater protection from liability. It’s pretty difficult for a fiduciary to incur liability if it’s focused first on doing what’s prudent legally for its beneficiaries.
The Imprudent Speculator. An imprudently speculating investment advisor engages in its own kind of “process” in providing investment advice to fiduciaries of non-profits. That process, however, tends to have a focus on the advisor’s business model in order to enrich the advisor, not on the protection of beneficiaries (and fiduciaries) of non-profit portfolios. Imprudently speculating advisors consciously choose a business model that won’t allow them to be fiduciaries simply because they don’t want to be fiduciaries. The typical result of this approach is a toxic brew of poor diversification and high costs–both of which damage return–as well as bad service, which is an inevitable consequence of the imprudent speculator’s business model. Needless to say, none of this is in accord with a legally sound investment process.
The Central Consideration
The Prudent Investor. The legally sound aspect of the investment process followed by a prudently investing advisor also incorporates the “central consideration” of investment fiduciaries under the Uniform Prudent Investor Act (UPIA): determine the tradeoff between risk and return in a portfolio. Prudently investing advisors consciously take both risk and return into consideration when building portfolios. This approach helps create portfolios that are prudent and broadly diversified, both of which tend to increase portfolio return.
The Imprudent Speculator. The central consideration of investment fiduciaries under the UPIA isn’t even on the radar screen of imprudently speculating advisors. There are at least three reasons for this, and each reason creates a problem for fiduciaries of non-profits who rely on the advice of these advisors. First, such advisors are focused solely on past (through track record investing) and present (through stock picking and market timing) investment returns of individual stocks and bonds, mutual funds and other investments (or their managers). That is an outright violation of the UPIA’s central consideration: determining the optimal tradeoff between the return and risk of a given portfolio. This central consideration–the goal of which is to obtain the highest return for a given level of risk or the lowest risk for a given level of return—comes straight from Modern Portfolio Theory 101.
In reality, many experienced imprudent speculators know that there’s no dependable way to identify today–based on readings of the past or predictions of the future–which investments (or managers) will turn out to be the winning entries in the investment race. After all, no one knows on, for example, Jan. 1 who (or what) will win the race on Dec. 31, but we all know that someone will win. The reason why no one knows is that the return on an investment is simply a random variable which, by definition, is unknowable in advance. (It is only inexperienced imprudent speculators who actually believe that they create value added with their stock picking, et al. but they too will eventually come to realize that it just ain’t so.)
Imprudent speculators focusing solely on return define investment prudence in terms of portfolio performance, not fiduciary conduct. This is a second problem for fiduciaries of non-profits who rely on the advice of such advisors because it’s directly opposite of how the UPIA defines prudence: in terms of fiduciary conduct not portfolio performance. That is, the prudence of a process is determined by the fiduciary’s conduct, not the performance of the portfolio for which the fiduciary is responsible.
A third problem for fiduciaries of non-profits who rely on the advice of imprudently speculating advisors is that such advisors simply ignore the existence of investment risk. The reason is obvious: in the sales-oriented advisory profession through which most financial products are distributed, the “good news” of an investment product’s superior return sells while the “bad news” of that product’s risk doesn’t.
While the failure to account for risk is yet another violation of basic standards of modern prudent fiduciary investing, it isn’t just a Sunday school transgression. Ignoring the existence of risk when building portfolios can have a huge impact on return–both in the short run and long run. This translates into (sometimes a lot) fewer dollars that would otherwise be available for carrying out charitable missions.
That’s why, to be prudent, fiduciaries of non-profits must be careful to retain investment advisors that consciously take both return and risk into consideration when building portfolios. The hundreds of law school professors, prominent attorneys and judges that labored on the UPIA and UPMIFA over the years didn’t place this requirement into those model acts for their health; they did so because it is legally sound–not to mention academically based.
The Primacy of the Portfolio
The Prudent Investor. A basic tenet of modern portfolio theory is the primacy of the portfolio, not just its individual parts. This tenet, which is contained in every body of fiduciary law, instructs investment fiduciaries to incorporate investments with risk and return parameters that have a rational relation to each other within the context of a portfolio. Prudently investing investment advisors think in terms of “the whole,” thereby exhibiting a portfolio mindset. The goal is to build portfolios that will have the highest return for a given level of risk or the lowest risk for a given level of return, which is in accord with the central consideration of the UPIA.
The Imprudent Speculator. Imprudently speculating investment advisors tend not to give any thought as to how their (or third party) guesses about the future (i.e., stock picking and market timing) or the past (i.e., track record investing) will impact the risk and return parameters of a portfolio. They think more in terms of “bits and pieces,” by providing discrete, stand-alone investments with risk and return characteristics that have little relation to each other within the context of a portfolio. Such advisors with a non-portfolio mindset add investments to, or delete them from, portfolios willy-nilly based on, for example, the need to unload excess inventory of illiquid, high cost investments on unsuspecting fiduciaries or the desire to invest in the latest investment fads because they fear being left out.
No Need for 20/20 Hindsight
The Prudent Investor. Section 7 of UPMIFA reads: “Compliance with this [act] is determined in light of the facts and circumstances existing at the time a decision is made or action is taken, and not by hindsight.” Commentary to section 8 of the UPIA explains: “Trustees are not insurers. Not every investment or management decision will turn out in the light of hindsight to have been successful. Hindsight is not the relevant standard. In the language of law and economics, the standard is ex ante, not ex post.”
This language means that investment fiduciaries aren’t required to correctly predict future events such as forecasting which financial market, investment or money manager will be superior (or inferior). While a fiduciary can’t be second-guessed with 20/20 hindsight about portfolio performance, this prohibition applies only if its investment conduct has been prudent. And prudent conduct, according to standards of modern fiduciary investing, ordinarily includes broad diversification of portfolio risk. So in return for excusing fiduciaries from having to make accurate predictions of the future, the law requires them ordinarily to diversify portfolio risk broadly.
It’s probable that very few fiduciaries of non-profits understand or even know that the notion of “broad” diversification of risk occurs at two different levels: (1) across all the investments in a portfolio (which can be termed “horizontal” diversification) and (2) within the asset class corresponding to each such investment in the portfolio (which can be termed “vertical” diversification).
The broad diversification requirement of modern prudent investing calls for fiduciaries to adopt a “prospective” view of investment risk. This obliges a fiduciary to recognize consciously–before designing a portfolio’s asset allocation and implementing it with an investment strategy–the fundamental problem encountered by all investors and identified by the father of Modern Portfolio Theory, Nobel laureate Harry Markowitz: Decisions about selecting investments for portfolios are made under conditions of uncertainty. Such uncertainty implies investment risk, which is why in order to manage this problem the law requires ordinarily that a prudent investor diversify portfolio risk broadly.
The Imprudent Speculator. Imprudently speculating advisors have a “retrospective” view of investment risk: only after their portfolios have been decimated in value, do they think about risk: “Gosh, I guess that I shouldn’t have loaded up on those high technology stocks (or equity-linked notes or.).” They just don’t have the mindset to think–in advance–about risk as they go about stuffing their portfolios willy-nilly with investments.
It’s probable that to the extent imprudently speculating investment advisors actually think about standards of modern prudent investing, they believe mistakenly that they’re required to see into the future and achieve superior returns in order to be prudent. That’s one reason why such advisors focus solely on return and outright ignore risk. These advisors, of course, also think that they’re prudent even when they turn in poor performance. It’s not their fault, they say, that the economy, financial markets or sunspots interfered unpredictably with their otherwise sound investment strategies. If the law were to allow fiduciaries to escape liability by always pleading the unpredictably of financial markets, there would be no brake on legally goofy fiduciary investment conduct. That’s why the law governing fiduciary investment conduct normally won’t give a pass to any fiduciary that fails to diversify broadly and, as a result, pleads the unpredictability of financial markets. After all, financial markets and the investments that comprise those markets are always unpredictable.
2. Academically Based
Dr. Markowitz, as noted, states the fundamental problem encountered by all investors: decisions about selecting investments for portfolios are made under conditions of uncertainty. In this academically based aspect of the investment process, much of that uncertainty has to do with the fact that the return generated by any given investment over any given period of time is a random variable, which can result in significant volatile change such as a $20 stock that unpredictably becomes a $12 stock, then a $34 stock, and so on. This unalterable fact of investing is captured perfectly by a warning from the Securities and Exchange Commission: “Past performance is no indication of future results.” In addition, virtually every reputable study of mutual fund performance over the last 40 years finds that there’s no reliable way to predict when–or which, or even if–winners from the past will win again in the future. Reporter’s General Note on Restatement 3rd of Trusts Section 227, reflects this finding: “Evidence shows that there is little correlation between fund managers’ earlier successes and their ability to produce above market returns in subsequent periods.”
Diversifying Risk or Ignoring Risk
The Prudent Investor. A prudently investing investment advisor knows that broad stock asset classes will outperform broad bond asset classes over the long run because the stock market has greater risk than the bond market. Such advisors also know, however, that there’s no way to know in advance which individual stock or bond, or particular mutual fund or other investment, or money manager will, over the long (or short) run, reign supreme.
These advisors realize that the best they can do in the face of the uncertainty associated with selecting investments for portfolios is to diversify risk broadly. Broad diversification of a portfolio reduces its risk, yet doesn’t reduce its return. Indeed, prudently investing advisors can actually increase portfolio return by managing risk through broad diversification. This phenomenon occurs as a result of a mathematical rule known as “variance drain.” “Variance” is a measure of portfolio risk; reducing the variance in returns of portfolio investments–that is, keeping the size of fluctuations in such values low–increases portfolio compound return and therefore portfolio dollar wealth.
The Imprudent Speculator. The value of imprudently speculating advisors, as they see it, is to wrestle superior returns into non-profit portfolios through stock picking, market timing and track record investing. The “evidence” that such advisors use to “prove” this value turns up every time they drag out a mountain chart (which, by definition, can show only past performance) purportedly showing the superior return (which is nearly always short term) of a given investment. There’s no way to know, of course, whether such “superior” performance is repeatable for any period of time in the future. The reason for this is that imprudently speculating advisors engage in an activity–focusing solely on the random variable of returns generated by investments–over which they have no control to achieve superior returns. This “process,” which is even more unpredictable than a game of coin-flipping, also can have a significantly negative impact on return since it ignores risk.
Passive Investing and Active Investing
The Prudent Investor. The academically based aspect of the investment process incorporates the “passive” investment philosophy into portfolios. The Restatement 3rd of Trusts (Prudent Investor Rule) (Restatement) indicates that passive investing is the “default” standard of modern prudent fiduciary investing. Prudent and broadly diversified passively managed portfolios capture financial market-level returns and incur market-level risk. Passive investing, of course, is not the only way to invest prudently–but it is the best way. This is true whether a financial market is “efficient” or “inefficient” since all financial markets are zero sum games. Prudently investing investment advisors focus on financial markets, not on just investments products or the managers that manage them.
The Imprudent Speculator. The “process” that imprudently speculating investment advisors follow incorporates the “active” investment philosophy. These advisors are interested in finding the next hot stock tip, identifying the next winning mutual fund and crowning the next guru. Such attempts to “beat the market” take the form of stock picking, market timing and track record investing. In providing investment advice to fiduciaries of non-profits, these advisors invest in each time period in those investments they believe offer the best odds of maximizing portfolio return. Dr. Markowitz suggests that such advisors are not investors, but speculators since they fail to consciously take risk into consideration.
Imprudently speculating investment advisors give little thought as to how their (or third party) guesses about the future (i.e., stock picking and market timing) or the past (i.e., track record investing) will impact the risk and return parameters of a portfolio. Nor do they care that virtually all academic articles (not to mention widespread empirical evidence taken from financial markets) over the past 40 years have concluded that active investing is often inferior which is why it can be quite harmful to portfolio wealth.
3. Cost Efficient
The Prudent Investor. The cost efficient aspect of the investment process eliminates visible costs such as commissions and 12b-1 fees and minimizes invisible costs such as trading costs, bid-ask spread costs and market impact costs. Cost efficient portfolios incur no revenue-sharing or hidden fees of any kind. The UPIA and Restatement place great emphasis on the virtue of keeping portfolio costs (and taxes) low and the critical role this plays in assessing fiduciary conduct.
The Imprudent Speculator. The cost efficient aspect of the investment process is not on the radar screen of imprudently speculating investment advisors. These advisors typically offer portfolios bearing 12b-1 fees, commissions, trading costs, bid-ask spread costs, market impact costs, manager drift and cash drag. Commentary to the UPIA warns, however: “Wasting beneficiaries’ money is imprudent.” Undisclosed revenue-sharing that’s inherent in these portfolios offered by such advisors can create conflicts of interest and cost transparency problems that may expose fiduciaries of non-profits to liability. The active investment philosophy incorporated into the portfolios offered by imprudently speculating advisors also generates unnecessary risk which can reduce return significantly.
The legally sound, academically based, and cost-efficient process of prudent investing is the best way for fiduciaries that are responsible for the investment of charitable assets to invest. This process, which focuses on what’s best for charitable beneficiaries of non-profits, is counterintuitive: The conscious management of risk rather than attempts to score big in the random game of identifying investment winners through stock-picking, market-timing, and track-record investing is actually the most effective way to enhance portfolio wealth. This process is also fully in accord with the principles of modern prudent fiduciary investing.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.