Nonprofits and the 'Central Consideration' of Fiduciaries

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.

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.