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| Fiduciary Focus: It's Process, Stupid! |
| by
W. Scott Simon
| 01-08-04 |
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Last month in this column, I suggested how you may want to use the Uniform Prudent Investor Act to help build your practice. This month, I'll describe and explain some of the process found in the act.
Prudence as Process
During Bill Clinton's 1992 presidential campaign, his campaign workers were instructed to attack President Bush incessantly on an issue that he was most vulnerable to by chanting a simple mantra: "It's the economy, stupid!" In a similar vein, my advice (with all due respect) to investment fiduciaries and their advisors that really want to help and protect their beneficiaries (and themselves): "It's process, stupid!"
Prudence as process is one of the overarching themes that emerged from the landmark reformation of U.S. trust investment law in the 1990s. The standards of modern prudent investing require a fiduciary, in appropriate situations, to establish and follow a prudent investment and management decision-making process.
A fiduciary's conduct is reflected in its investment and management decision-making process. This is important to understand because the determination of prudence centers on fiduciary conduct, not portfolio performance. That is, the prudence of fiduciary investment decisions and actions is determined not by a portfolio's results but by the soundness of the decision-making process that led to those results.
While the loss of portfolio values is what usually triggers lawsuits and arbitrations, a fact-finder is not allowed under standards of modern prudent investing to focus on portfolio performance in determining whether a breach of fiduciary duty has occurred. When I am asked to provide consulting or expert witness services in a case, I don't even look at the portfolio's performance.
Instead, I focus on the fiduciary's conduct as it is reflected in its investment and management decision-making process to determine whether or not it was prudent. It could very well be that a fiduciary's conduct in managing a portfolio that lost 50% of its value was prudent as long as that conduct reflects a sound decision-making process.
A prudent process can immunize you against liability when you get into hot water for poor portfolio performance.
Sometimes portfolio performance is relevant--but only insofar as once a fiduciary's conduct is determined to be imprudent and liability ensues, the performance may be helpful in fixing monetary damages.
It is also impermissible under the Uniform Prudent Investor Act to judge a fiduciary's conduct with 20/20 hindsight. A fiduciary cannot be expected to predict future events; it is not an insurer of ensuing portfolio performance.
Instead, the prudence of fiduciary conduct is determined in light of the facts and circumstances existing at the time of the fiduciary's decisions or actions. This means that a fact-finder cannot look back in time and find a fiduciary imprudent solely because a portfolio's performance for, say, 2001 turned out to be minus 35%. On the other hand, a fact-finder cannot find a fiduciary prudent based solely on the defense that declines in values of the stock market during, say, 2000, 2001, and 2002 were unpredictable.
Risk and Return: The "Central Consideration" of Process
Plato observed in The Republic: "The most important part is the beginning." Any examination of the process described in the Uniform Prudent Investor Act should begin by citing certain language from its Prefatory Note: A fiduciary's central consideration when investing and managing the assets of a trust portfolio is to determine the tradeoff between portfolio risk and return. The following historical detour is necessary to provide the context of this duty.
It is rare in the history of human thought that the origin of an idea be identified with precision, but in this case it can. The notion of determining tradeoffs between portfolio risk and return emanated in the mind of a 23-year-old graduate student one day in 1950 as he was reading a book in the library at the University of Chicago graduate school of business. The book was The Theory of Investment Value by John Burr Williams.
Williams maintains that investors should seek to maximize the expected returns of their portfolios. In Williams' view, diversification is equivalent to holding a large number of stocks that are anticipated to maximize expected return. It strikes the student, Harry Markowitz, that Williams' approach is one-dimensional. Seeking only to maximize return doesn't take into account the element of risk.
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| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
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