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| Fiduciary Focus: It's Process, Stupid! (Part 2) |
| by
W. Scott Simon
| 02-05-04 |
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In last month's column, I described and explained some of the investment and management process found in the Uniform Prudent Investor Act. I emphasized the "central consideration" of fiduciaries under the act: making tradeoffs between portfolio risk and return.
In response to that column, John H. Langbein, the Reporter for the Uniform Prudent Investor Act and the Chancellor Kent Professor of Law and Legal History at Yale University Law School, wrote me: "In drafting the Uniform Prudent Investor Act, we went to extraordinary lengths to remind courts that the standard of prudence is not outcome but process." (Emphasis added.)
And when noted attorney Fred Reish, the nation's foremost authority on the duties--and liabilities--of ERISA fiduciaries, was asked recently about what 401(k) plan sponsors should do with the scandal-tainted mutual funds in their 401(k) plans, his response was: "The answer is always the same--engage in a prudent process."
Given the importance of process in fiduciary investing, I thought that it would be useful in this month's column to touch upon two other major areas of the investment and management process found in the Uniform Prudent Investor Act: diversification and costs.
Diversification: The Antidote to Uncertainty
The word "diversification" is used a lot in investment articles and marketing literature. But what is its meaning within the context of the Uniform Prudent Investor Act and what implications does that hold for the investment conduct of fiduciaries?
Nobel Laureate Harry Markowitz, the father of Modern Portfolio Theory, identifies the fundamental problem all investors face: Selections of portfolio investments involve making decisions under uncertainty. This leads to the observation that uncertainty--or risk--is the central factor at work in financial markets. To see how true Markowitz's observation is, we need look no further than the plunge in value of many high-flying technology stocks in 2000, 2001, and 2002.
Restatement commentary acknowledges that there is no such thing as a "safe" investment or investment strategy. For example, all investments involve risk in the comprehensive sense of loss of inflation-adjusted value. Because it isn't possible to avoid risk, Restatement commentary requires fiduciaries to manage it. Modern Portfolio Theory posits that risk can be managed through diversification. (Stop-loss orders, collars, and other techniques can also be used to manage risk.)
The act ordinarily mandates diversification of risk. (Prudent fiduciary investing doesn't prohibit underdiversified portfolios. Instead, it shifts the burden of proof to the fiduciary to demonstrate its reasonable determination that "under the circumstances, it is prudent not to [diversify].") This enhanced duty is so central to modern concepts of prudence that the act integrates the diversification requirement into the very concept of prudent investing. Commentary to the Restatement 3rd of Trusts (Prudent Investor Rule) notes that the duty to diversify risk is based on principles of Modern Portfolio Theory.
As discussed in last month's column, principles of modern prudent investing don't require fiduciaries to predict future events. That is, a fiduciary isn't expected to have to forecast which financial markets and/or which investments within those markets will perform well or poorly. In short, fiduciaries aren't insurers of portfolio performances.
But wait, there's a "catch" to this. In return for the "pass" of excusing fiduciaries from having to forecast the performances of particular investments and/or particular financial markets, the standards of modern prudent investing require fiduciaries ordinarily to diversify portfolios--preferably broadly--as part of a prudent process.
If the law governing prudent conduct didn't provide for this "catch" to the "pass" given to fiduciaries, fiduciaries could always escape liability by arguing, for example, that declines in value of the stock market during 2000, 2001, and 2002 were unpredictable. Of course they were unpredictable! Financial markets and the investments that compose those markets are always unpredictable! That's what puts the "R" in "Risk!" Because of this, the law normally won't give a "pass" to a non-diversifying fiduciary that pleads the unpredictability of financial markets.
The "catch" of requiring fiduciaries to ordinarily diversify broadly means that they should adopt a view of investment risk that's prospective.
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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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