The question of what investments are suitable for funds held in trust for the benefit of private persons or corporations is a topic that has engaged the legal and financial communities for centuries. In the United States, the legal framework defining the manner in which funds held in trust for a finite period or in perpetuity can be invested has followed a general trajectory best characterized as a continual expansion of the discretionary powers bestowed upon the trustee and, by extension, the professional investment counselor.
The oft-cited “prudent man rule” originated in a seminal court case, Harvard College v. Amory (1830), involving Harvard College and Jonathan and Francis Amory, both trustees of a fund of $50,000 established by their brother and cousin, John McLean. The fund was to distribute current income to the late Mr. McLean’s wife, Ann, and upon her death the residuum, or corpus, of the trust was to be given to Harvard College and Massachusetts General Hospital.
The trustees selected what many fiduciary advisors would view as an inappropriate weighting towards equity securities (100%) and no allocation to fixed-income instruments. After the passing of Mrs. McLean, just over $29,000 remained in the trust. Harvard sued the remaining living trustee, Francis Amory, and argued that placing the entirety of the trust’s assets in common stock, which offered no security of principal – a government guarantee or backing of a real asset – jeopardized the interests of the ultimate beneficiaries of the trust, Harvard College and Massachusetts General Hospital. In conclusion, the court sided with the defendants and decided that the trustees had acted as any prudent person would in a like position, given their skill level in the context of the economic backdrop at that time.
This legal precedent established a wide scope of discretion in which trustees could operate when constructing and managing portfolios. Thirty years later, in King v. Talbot (1869), the New York Court of Appeals greatly narrowed the list of acceptable investments that would be permitted under the prudent man rule.
In essence, government bonds and notes backed by a pledge of real estate (mortgage securities) were designated as the only acceptable investment for funds held in trust. The Vanguard Group’s A Guide to Best Practices for Nonprofit Fiduciaries (2014), includes a brief history of fiduciary case law. They track the evolution of acceptable portfolio management practices dating back to 18th century events surrounding the collapse of the South Sea Company: “Judicially created restrictions based on English common law have mandated that fiduciaries be judged on an individual investment basis rather than on the overall performance of a well-diversified portfolio.” This thinking stands in stark contrast to today’s modern portfolio management techniques.
Nearly a century after King v. Talbot, Harry Markowitz, in 1952, introduced to the world Modern Portfolio Theory (MPT). MPT postulates that when a portfolio blends securities that lack strong correlations, security-specific, nonsystemic risk can be neutralized and “diversified away.” Thus volatility originating from any one security or sector or asset class is dampened, and returns attributed to the overall market can be captured. William Sharpe, in 1966, built on the MPT foundation by focusing not just on the directional price relationship of combinations of securities in a portfolio (co-variance) but also on the aggregate risk-return characteristics across a portfolio. Managers desire to construct portfolios that optimize the risk-adjusted return, garnering the largest possible return over the risk-free rate, per unit of “risk” as measured by standard deviation. Visually, this concept is depicted by graphing the efficient market frontier.
The work of Markowitz, Sharpe, and others, paired with two studies published by authors working under the Ford Foundation, elevated the importance of capital appreciation to the same level as principal preservation and current income. The resulting approach, dubbed “total return investing”, is intended to preserve the real purchasing power of endowments for the benefit of current and future generations. The codification of these related concepts – MPT, the efficient market frontier, total return investing, intergenerational equity – is represented, in its most current form, by the 2006 Uniform Prudent Management of Institutional Funds Act (https://www.cumber.com/intergenerational-equity/).
So, with the flood gates now open, large institutional pools with infinite lifespans, such as university endowments, have allocated a sizeable percentage of their assets to hedge funds, funds of hedge funds, private equity, and venture capital. An industry publication covering trends in institutional investment management, Pensions & Investments, follows the returns of 31 large university endowment funds. As reported by James Comtois, for fiscal year 2017 ending June 30th, “The average 12-month return for the large US endowments in P&I’s universe … was 13.2% vs. 1% for the prior year.” The range of returns among the 31 universities was wide, with Grinnell College clocking in at 18.8% ($1.9 billion endowment) and Harvard’s $37.1 billion pool returning 8.1%. For FY 2016, Harvard lost 2%. We note that Harvard’s fund has been undergoing a significant restructuring involving the shuttering of internally managed funds, with a shift toward external managers. Harvard excluded, the other 30 higher-education endowments on P&I’s radar saw returns averaging in the low-to-mid teens for FY 2017.
At Cumberland Advisors, we are not exuberant supporters of “2-and-20” hedge funds, funds of hedge funds, and other alternative investments. Multi-year lock-out periods, the relinquishing of custody of donor funds to general partners, onerous fee structures, and lack of real-time reporting and transparency inherent in these partnerships all provoke a healthy dose of skepticism. We express this reservation particularly in regard to the lack of public oversight in the management of 501(c)(3) monies. In contrast to the near total transparency involved in the selection and monitoring of managers for state and local government pools, the public has little access to the inner workings of investment committees of community foundations, colleges, and other not-for-profit organizations.