March 23, 2006 | Read Time: 7 minutes
Foundations control more than $600-billion in assets, but they put only a tiny amount — less than 1 percent — into investments designed to help them further their missions. That is a massive lost opportunity for the nonprofit world. And it is caused, in part, by a misperception of the bounds of fiduciary duty.
We tend to think of fiduciary duty as a fixed concept, but, over the past 125 years, the permissible boundaries of investment by trustees and directors of nonprofit institutions keep getting wider. Sixty years ago, the standard of fiduciary duty we so assiduously follow today would never have withstood judicial review, and, 100 years ago, it would probably have landed many trustees in prison.
The original legal doctrine, dating from a case involving Harvard College in the late 1800s, imposed the standard that any trustee act as a “prudent man” would in investing his own funds. (The term has since been gender-corrected to “prudent investor.”)
The prudent man started off as a very conservative guy.
He was concerned about preserving principal, obtaining a predictable stream of income, and avoiding risk at any price. He made his own investment decisions, unable to delegate responsibility to other money managers, and he worried about personal liability for any investment that went bad.
As a trustee, he could be forced to reimburse the endowment from his own pocket for any “imprudent” loss, regardless of how well the portfolio as a whole performed.
That’s why many foundations and universities invested almost exclusively in bonds or mortgages. When authorized to spend income, they spent only the actual interest or rental fees they received.
Over the years, this prudent man became more and more uncomfortable.
Inflation threatened to undermine the preservation of principal. The stock market offered a better opportunity to preserve the purchasing power of the endowment, but dividend income alone could not meet current spending needs.
At the same time, the investment world grew immensely more complex. Money managers and mutual funds proliferated, new and complex financial instruments were continuously being created, and the prudent investor was overwhelmed trying to keep up with every investment decision himself.
Then it got even worse.
“Modern portfolio theory” emerged, asserting that risk could never be avoided altogether but merely had to be balanced against the potential rewards. Risky investments could actually be “prudent” if the prospective profit was large enough, or if they were hedged by countervailing risks within the overall portfolio.
What’s more, the most attractive financial returns seemed to be going to those who took the most risk, such as venture-capital or international-hedge-fund investors.
All of this became very confusing for the poor prudent man. He had trouble sleeping and his hair began to fall out. Things became so bad, in fact, that the prudent man began to question whether it was at all prudent for him ever to serve on a nonprofit board. After all, he was rarely compensated for his time and he could be held personally liable for losses incurred in the massive endowment funds for which he was assuming fiduciary responsibility. And so the Ford Foundation stepped in.
In the mid-1960s, the Ford Foundation financed research on the investment responsibility of nonprofit board members. Researchers determined that most of the limitations trustees feared were more myth than reality, but they also discovered that the law had not caught up with the modern world, and greater clarity was needed.
Ultimately, this research resulted in the Uniform Management of Institutional Funds Act, now accepted by most states as the legal standard.
The new law did away with that poor burned-out “prudent man,” and instead imposed a more reasonable standard of good business sense.
It acknowledged that risks could be incurred — in fact, they could never be avoided — and it considered these risks acceptable as long as they brought commensurate profits and the endowment portfolio as a whole wasn’t placed in jeopardy. It authorized the delegation of investment responsibility to outside managers, and it eliminated the literal distinction between “income” and “principal.”
Endowment funds could now be invested in stocks or other assets, and the appreciation — not just dividends — could be distributed as income.
In short, the law brought institutional investing into the modern world. It is now commonplace for large foundations and nonprofit groups to keep a modest percentage of their funds in risky investments that were previously unimaginable, such as private equity, venture capital, hedge funds, international investments, and on and on.
No investment is beyond consideration, as long as the risk-reward ratio is reasonable, and the portfolio as a whole is not endangered. The prudent investor could finally relax. His blood pressure returned to normal, and he began to spend more time with his family.
The only problem is that the law applies a blanket standard to all institutional endowments, from pension funds to foundations. It does acknowledge that the trustee’s responsibilities depend on the purpose of the organization, but without explicitly considering the dissimilar purposes of charitable foundations.
Consider the difference, for example, between a pension fund and a foundation.
Both are nonprofit entities managed by fiduciaries. The sole purpose of the pension fund, however, is to provide financial benefits to its beneficiaries. A pension-fund trustee might take reasonable risks to increase these financial returns, but would not be justified in accepting a lower return or greater risk because of the trustee’s personal values or charitable objectives.
The same is true of any private trust fund or corporate asset with the sole purpose of maximizing the financial returns to a limited group of beneficiaries or stockholders.
The beneficiary of a foundation, however, is the public. Its guiding principle is the intent and values of the donor, and its entire purpose is to achieve charitable objectives for the public good. If an investment furthers the donor’s intent and provides benefits to the public, then unlike the private trust or pension fund, that may be reason enough to accept a lower return or greater risk — especially if the entire portfolio is not placed at undue risk.
Of course when the Uniform Management of Institutional Funds Act was first drafted decades ago, the concept of social investing was at best nascent, just as portfolio theory was unknown when the original definitions of fiduciary duty were formulated. But legal concepts always evolve over time to keep pace with changing realities.
A proliferation of new approaches are available now to make it easier for investment dollars to achieve social impact and solid financial returns, including screened investment portfolios, certificates of deposit in community-development finance institutions, microfinance funds, and venture investments that back social entrepreneurs. Virtually any foundation today can find investment opportunities that advance its mission and match its tolerance for financial risk.
One highly sophisticated grant maker, the FB Heron Foundation, in New York, has invested 24 percent of its total assets in a diverse range of social investments that match — or in some cases outperform — traditional benchmarks of financial risk and return. Yet this is extremely rare, and the far larger foundations that would readily invest 10 percent of their assets in risky private equity or other alternative investments rarely put more than 1 percent to 2 percent in program-related or other social investments.
Not only is it permissible for foundations to consider the social impact of their investments under current law, but as the field of social investment expands and the concept of fiduciary duty continues to evolve, foundations may eventually be required to factor in the social dimension of their investments.
In short, if they are truly to fulfill their fiduciary duties, foundation trustees today must move beyond the traditional trade-off of financial risk and reward to consider balancing risk, financial reward, and the advancement of their missions when they make investment choices.
Mark R. Kramer is a senior fellow at Harvard University’s John F. Kennedy School of Government, a founder of the Center for Effective Philanthropy, a nonprofit research organization, and managing director of the Foundation Strategy Group, a consulting firm. He is a regular contributor to these pages.
