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The Rules for Nonprofit-Portfolio Fiduciaries (Part 2)

It's important for fiduciaries to undestand the risks behind investments.

W. Scott Simon, 02/04/2010

Last month, I described the legal framework within which fiduciaries responsible for nonprofit pools of money must operate. (For further reference, please see the five-part series on nonprofits that I wrote in 2006.) This month, I'd like to discuss some investment issues facing many fiduciaries responsible for nonprofit pools of money.

Many Investment Fiduciaries at Nonprofits Have Constraints
In my experience, I've found that the vast majority of fiduciaries responsible for nonprofit pools of money truly care about carrying out the mission of the institution they serve. The values of nonprofit portfolios, of course, have been subjected to the gyrations (more or less, depending on the nature of their investments) in financial markets over the last few years just as other portfolios outside the nonprofit community.

The results of these gyrations are often not "losses" as the media usually likes to describe them. There's a big difference between a loss and a decline in value. A real blood-and-guts loss occurs only when an investor actually sells holdings in its portfolio for less than what they were purchased for, thereby locking in actual losses. When an investor does that, it has forfeited forever the ability to recover what had been only "paper" losses (declines in value). Retaining a portfolio holding that has experienced a decline in value means that the bet is still on the table that it will recover its prior value--and potentially even more.

This is not a Pollyanna-like view of investing to minimize the trauma of extreme downturns in financial markets and investment portfolios. It is, rather, a reminder that advisors who consult with and/or advise nonprofit fiduciaries (or any other types of investors) should be precise in analyzing and describing the nature of investing to them, thereby conveying as accurate a picture as possible.

Fiduciaries who are responsible for nonprofit portfolios are generally not investing experts. In addition, they often lack a good understanding of fiduciary principles, and many don't have a large amount of time to devote to the mission of their institution because they are among the leading lights in their communities and are involved in many other activities. Given such constraints, these fiduciaries are often hard-pressed to understand the true nature of the investments that they are asked to assess and approve for inclusion in nonprofit portfolios.

Beware of Alternative Investments
It's not the Easter Bunny engaged in such asking; it's advisors and/or consultants to nonprofit boards. Some of them come bearing proposed investments for nonprofit portfolios known as "alternative investments." These can include, for example, hedge funds using long/short strategies, private equity (for example, limited partnerships), private real estate and hedge funds using leveraged fixed-income strategies. The basic idea of alternative investments is that they can zig in times when more traditional investments such as open-end mutual funds can only zag, and, in doing so, they can make money in both in both up markets and down markets.

It is true that, in the years before the downturn in 2008, some alternative investments actually did quite well. How well is often open to interpretation, however, since the values--and therefore the returns--of alternative investment are usually only estimates provided by their providers. These estimates can often be six months old or older by the time they are reported. Even when the returns of alternative investments are audited in a quest for great accuracy, it's difficult to ascertain which of the audits are truly independent and which are biased. This can make it impossible for investment fiduciary decision-makers at nonprofits to either trust the reported performances of alternative investments or verify the real performances.

In the recent downturn, of course, many alternative investments declined in value just as did traditional investments in the stock and bond markets--and some of them declined by a lot more. In fact, it appears from performance data that many nonprofits with smaller portfolios invested in more-traditional stock/bond asset allocations actually outdid much larger portfolios invested in alternative investments. The reason why is that smaller nonprofit portfolios, which didn't have the money to retain "sophisticated" (and therefore expensive) consultants who may have, say, touted timberland in Timbuktu as a new asset class to large nonprofits, were "condemned" to invest only in traditional asset allocations, which actually did better.

Back to the Basics: The "Central Consideration" of Investment Fiduciaries
While writing my most recent book, The Prudent Investor Act: A Guide to Understanding, I contacted Nobel laureate Harry Markowitz, the father of modern portfolio theory, to review my chapter on, well, modern portfolio theory. I knew that there was a lot of misinformation circulating out there on modern portfolio theory and I wanted to find out from the horse's mouth, so to speak, whether or not what I was conveying in my book was correct.

One thing in particular that Markowitz told me has really stuck in my mind: Always remember that standard deviation is a mirror image. That is, even when an investment's return is skyrocketing ("risk" in the "positive" sense on one side of the mirror), the possibility is always present for its return to plummet ("risk" in the "negative" sense on the other side of the mirror). It seems, of course, as if risk is not present when we are in euphoric markets, and it seems like it's everywhere when we are in pessimistic markets. Neither condition is true. In fact, risk (as is expected return, by the way) is always present in any given investment--whether or not we are actually aware of it.

The drafters of the 1994 Uniform Prudent Investor Act were influenced mightily by this kind of thinking. As a result, they identified risk as one of the two elements that comprise the "central consideration" of investment fiduciaries under UPIA: determine the risk/return trade-off of the particular portfolio under consideration.

The 2006 Uniform Prudent Management of Institutional Funds Act, which governs  the conduct of fiduciaries of nonprofit pools of money, largely incorporates UPIA. Such fiduciaries must therefore be vigilant about the risks inherent in any investments that are served up to them by their advisors and/or consultants for possible inclusion in their non-profit portfolios. This is particularly true of alternative investments, since many of them are so difficult for any normal human being to understand.

It appears from widespread commentary, both outside and inside congressional committees, that even the experts don't understand alternative investments very well. Many of those in the alternative investments food chain, ranging from salespeople in the trenches who sell them directly to investors, to levels of supervisors back at the main office and all the way up to CEOs, simply have no idea how these instruments work. They do know, however, that they are paid scads of money to sell them. Even the quants who design such investments from the ground up and do actually know how they work don't appear to have thought through the ramifications of how they might (or might not) affect entire financial systems.

Investment fiduciaries at nonprofits have been under pressure during the recent market downturn to continue the same levels of outlays to the organizations they help support as they did before the downturn. This is difficult given both the declines in values of their portfolios and the fact that the amounts of charitable contributions they receive from the public have been in decline.

It's appealing for investment fiduciaries to look at the track records of many alternative investments--always the good part of the story told to them--and believe that they will be repeated in the future so that nonprofits can maintain their outlays. But the bad part of this story--many alternative investments exhibiting huge declines in value (which are often actually worse than they are reported to be, given the self-valuing process by which their performances are reported)--is almost never told to fiduciaries.

Fiduciaries must understand, though, that the quest for greater returns always carries the prospect of greater risks. The eye-popping returns generated by some alternative investments in the market upturn hid the risk of their illiquidity and extreme leverage that manifested itself in the shattering declines in value that occurred in the market downturn. Illiquidity in a market downturn means that unloading, timberland in Timbuktu is impossible because no wants to buy it, and extreme leverage means that investments which would otherwise not be sold must be sold at low prices to satisfy margin requirements.

Investment fiduciaries at nonprofits cannot fall for the good part of the story. They must instead understand that risk is risk, and that risk is always present in all investments in order to grasp the meaning of the bad part of the story.

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