Relevant Risks

The level of risk an endowment fund may experience is viewed from the perspective of the Prudent Person Rule, which has the purpose of testing whether investments made by board members are reasonable. The Prudent Person Rule is part of the Uniform Management of Institutional Funds Act (UMIFA)¹ and is the legal basis that underlies endowment investment management policies and practices. The Uniform Act codifies the following key aspects of endowment investment management:

1. A standard of prudent use of appreciation in invested funds;
2. Specific investment authority;
3. Authority to delegate investment decisions;
4. A standard of business care and prudence to guide governing boards in the exercise of their duties under the Act; and
5. A method of releasing restrictions on use of funds or selection of investments by donor acquiescence or court action.

Using the legal framework of UMIFA, a strong investment policy should include a discussion of the risks that impact the investment performance of an institution's portfolio. Many types of risk exist, including: volatility, inflation, deflation, and underperforming one's peers.

The proper time horizon for most colleges and universities is long-term, at least ten to fifteen years. Often, however, the effective time horizon becomes much shorter, to the detriment of the endowment, because of investment committees' natural inclination to take action (usually resulting in a change of strategy) in order to minimize any negative outcomes during its watch. It is important to note that the longer the time horizon and the lower the propensity to panic, the more risk an endowment can assume and, therefore, the greater returns it can achieve over the long term.

The most relevant and comprehensive definition of risk is "failing to achieve one's policy objectives." Anything that increases the likelihood of failing to achieve one's objectives can be accurately defined as "risky". Therefore, it is necessary for policy objectives to be clearly articulated and agreed upon before board members can talk about what is "risky".

All actions, strategies, and asset classes should be considered or reviewed in this light: Will they enhance or erode the chances of achieving the objectives of the investment policy? Those that increase the probability of attaining goals should not be considered risky.

Individuals and institutions will assign different priorities to different types of risk, depending on their views on risk and risk tolerance. That is why a strong investment policy will explicitly describe and define the risks that the committee and staff believe are most relevant. The remaining portions of the policy-especially asset allocation-can then be structured accordingly.

Checklist Questions

1. Has your governing board studied the requirements of California's UMIFA statute and understand their relevance to its investment policy?
2. Does your institution's investment policy have a discussion on risks and their impact on investment portfolio performance?
3. Has the long-term horizon of the investment strategy been clearly stated?
4. Is there a clear link between the institution's views on risk and its policy on asset allocation?

¹  The National Conference of Commissioners on Uniform State Laws promulgated UMIFA in 1972 for consideration and ultimate adoption by the states. UMIFA has been modified and adopted by at least 46 states and, in most cases, is the controlling governing statute with regard to management of endowment funds, absent a contrary provision in a gift instrument.