Nonprofits and the ‘Central Consideration’ of Fiduciaries

A continued examination of issues in the world of nonprofits.

W. Scott Simon


This month’s column will continue an examination (first covered in my last two columns) of some of the issues in the world of nonprofits within the context of a trio of foundations that I ran across recently. Each foundation, with a portfolio valued in excess of $100 million, has retained the same nationally known advisor/investment consultant.

The ‘Central Consideration’

The Prefatory Note to the 1994 Uniform Prudent Investor Act (UPIA) states that the “central consideration” of a fiduciary responsible (and liable) for a pool of money under the UPIA is to determine the risk/return trade-off of the portfolio selected. But that process would occur in a vacuum–indeed, it would simply be an exercise in futility– without identifying the portfolio’s primary objective.

This process should ideally include a modeling of any number of possible portfolios and their various iterations in which the fiduciary would consider investing in order to increase the chances of achieving the identified objective. Given that the 2006 Uniform Prudent Management of Institutional Funds Act (UPMIFA) is an off-spring of the UPIA, it’s reasonable to assume that the fiduciaries (for example, directors and trustees) serving as stewards of the portfolios (that is, institutional funds) of charitable organizations would likewise be required to engage in this central consideration.

The Return Side of the Equation

The return side of the risk/return trade-off equation is by far where many investors (fiduciary or otherwise) place the most emphasis; it’s often where the only emphasis is placed. It’s always: “What’s your return?” It’s never: “What’s your risk?” And yet, the rate of return on any given investment (whether an individual stock or bond, a mutual fund, or whatever the investment may be) is simply a random variable subject to inherent uncertainty.

This is consistent with what Nobel laureate Harry Markowitz identifies as the essential problem faced by all investors: Decisions about portfolio selections are made under uncertainty. This derives from Dr. Markowitz’s simple yet fundamental idea–surely ranking as one of the most crucial investment insights of the 20th century–that investors must think consciously about risk as well as return. Others would add: Those who invest in each time period in those stocks (or any investment) it is thought will produce maximum expected returns–without taking risk into consideration–are speculators, not investors. Fiduciaries can never be speculators.

Saying that any given investment’s return is a random variable subject to inherent uncertainty is stated more simply this way: No one can know in advance which investments will turn out to be winners–or losers, for that matter. That is, no one today can know future returns, whether that future extends out a year, a month, a week, a day, or even an hour. Many will say they do know but none, in reality, can know. That “many” includes Wall Street and the billions upon billions of advertising dollars it spends each year to convince us to the contrary.

This is not to say, of course, that the return side of the risk/return trade-off equation is unimportant or irrelevant. In fact, it is critical–as part of the “central consideration” process when modeling different possible portfolios in order to arrive ultimately at the one that’s selected–to look at return in order to determine if the overall level of potential risk of a given portfolio as well as the myriad types of potential risks inherent in that portfolio are worth it. In short: determining the risk/return trade-off of a portfolio. The failure to incorporate returns in this process results eventually in the elimination of all risk, which leaves available essentially only one investment: Treasury bills with their risk-free rates of return.

The financial models favored by my RIA firm eliminate those risks that do not generate expected return (that is, holding too few securities, betting on countries or industries through stock-picking, following market predictions, track-record investing, market- timing, relying on analysts’ forecasts, and so on) and maximize exposure to those risk factors that do. Ultimately, however, because the return on any investment is an unknown variable, most of the time spent on modeling risk involves gaining a better understanding of the expected (but not guaranteed) returns that might be generated as a byproduct of the risk incurred by the different portfolios under consideration. This is what is meant when it’s said that “risk drives return.”

Although the return side of the risk/return trade-off equation is critical to the central consideration process, at the same time it is a fundamental, underlying fact that the directors and trustees serving as stewards of the institutional funds at charitable organizations (or any other investor) have no power to control return. They do, however, have the power to manage risk and control costs. And the very best way to do that is to ensure that the pools of money for which they are responsible (and liable) are broadly (that is, across the assets classes of a portfolio) and deeply (that is, within each asset class of a portfolio) diversified–and are low-cost to boot.

Ideally, then, the central consideration to be followed by all fiduciaries under the various model acts of modern prudent fiduciary investing, including UPMIFA (and the Employee Retirement Income Security Act of 1974 (ERISA) by the way) will incorporate a process that focuses on risk and costs (see section 404(a) of ERISA)– factors which can be managed by fiduciaries. This would include the understanding that any returns generated by the portfolio selected will be a byproduct of the risk incurred by that portfolio. Fiduciaries must look at both sides of the risk/return equation; they cannot have one without the other. The Road to Investment Nirvana leads through that process.

The Risk Side of the Equation

It is highly doubtful that one in 10 fiduciaries at charitable organizations has ever heard of the “central consideration” of determining the risk/return trade-off in a portfolio. A factor largely contributing to this state of ignorance is that the investment consultants hired by many nonprofits (such as the one retained by all three charitable organizations referenced previously) are also lacking in such awareness. That’s bad enough, but in certain instances there’s something even worse: when consultants are fully aware of this fiduciary decision-making framework and choose consciously not to disclose it to their nonprofit clients. After all, to educate their clients about it could possibly ensnare such consultants in, say, the fine mess of assuming fiduciary status themselves. A perusal of the conflicts of interest policy statement of the investment consultant at the three charitable organizations reveals that the word “fiduciary” was used only once–and that likely was merely a scrivener’s error.

And how does this highly regarded, well-known, sophisticated investment consultant describe to its clients how it assesses risk? Well, it certainly uses all the right, soothing language: “Investment Strategy. The X Foundation has adopted an investment strategy emphasizing broad diversification and consistency of returns. Diversification reduces portfolio volatility (variability of returns) while maximizing investment returns at appropriate levels of risk over time. Donors to the X Foundation can be assured that their funds are prudently and professionally managed.”

This smooth talk continues: “Investment Management. With the assistance of [the investment consultant], the X Foundation strives to identify “best-in-class” investment managers to carry out the investment strategy . . . Use of multiple investment managers contributes to effective diversification of the portfolio. The performance of each investment manager is measured against a benchmark appropriate to the managers’ asset class as well as a peer group of managers with like investment styles. Each manager is also monitored closely to assure that returns are achieved without unexpected levels of risk.”

Now compare the foregoing verbiage with what the late Paul Samuelson, the second (and first American) recipient of the Nobel Prize in economics (1970), wrote in a 1994 article for The Journal of Portfolio Management: “Every departure from indexing that you hope will put you ahead–as when you give eight money managers with different styles one eighth each of your portfolio to manage–when the resultant ends far from diversification agreement with the overall index, your risk-corrected long-run performance is in jeopardy to a degree that you are not able even to estimate.”

Investment consultants retained by charitable organizations that, for whatever reason, do not bring to the attention of their clients the central consideration of modern prudent fiduciary investing do them a real disservice in my view. However, in any event, their attempts to identify “best-in-class” investment managers or investments through stock-picking, market-timing, track-record investing, and so on, are a demonstrably suboptimal way to get on the Road to Investment Nirvana.

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™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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