Fiduciary Focus: Active vs. Passive Investing (Part 3)

Morningstar Advisor Magazine August/September 2010 Issue

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Fiduciary Focus: Active vs. Passive Investing (Part 3)

by W. Scott Simon | 04-07-05

Continued from page 1.

Because the range of potential returns on either side of the overall stock market's return can vary substantially from year to year, a portfolio of even 50 "carefully" selected stocks in Prof. Lorie's example fails to achieve the potential of fully reducing the portfolio's uncompensated risk. Even the expected return of a portfolio containing as many as 200 stocks can deviate one percentage point on either side of the stock market's expected return.

Other academics cite similar data: Diversification of a randomly selected portfolio shows that a 20-stock portfolio has 21% more risk than a portfolio holding 100 stocks, and a 100-stock portfolio still has 5% more risk than a portfolio of 1,000 stocks. The diversification effect of a non-randomly selected portfolio is even greater.

Although the one percentage point differential on either side of the market's expected return in Prof. Lorie's example or the 5% additional risk that exists in a 100-stock portfolio as compared to a 1,000 stock portfolio may not seem like much, when the dollars represented by such percentages are negatively compounded over long periods of time they can result in enormous differences in accumulated wealth.

A Little Means a Lot

So while it's accurate to say that a substantial amount of risk can be diversified away in portfolios that hold, say, 10 to 50 stocks, fiduciaries should understand the potential consequences when not all (or nearly all) risk is eliminated.

That "not all (or nearly all)" is what active money managers (even--and maybe particularly--those even at the largest, most prestigious money management institutions that typically hold portfolios of only 20 to 40 stocks for high-net-worth clients) "leave on the table" as seemingly small amounts of uncompensated risk. Uncompensated risk for which investors receive no return (that's why it's called "uncompensated") can also lead to less return--sometimes a lot less.

It's crucial for fiduciary investors (as well as non-fiduciary ones) to understand that in this context "a little means a lot." Underperforming the market by even one percentage point on an average annual basis can, over time, result in large amounts of dollars left on the table. The flipside of this, of course, is the enormous wealth added to the table by Sir John Templeton and John Neff, who each outperformed the market by two to three percentage points on an average annual basis over more than 30 years.

Those investing for themselves can freely hold portfolios with whatever amounts of uncompensated risk they desire. Some of these investors, rather than underperforming the market by, say, two percentage points on an annualized basis, may outperform it by that much.

Those investing for others--fiduciaries--generally do not have such luxuries. Fiduciaries are required by principles of modern prudent investing to consciously assess portfolio risk. That ordinarily includes minimizing uncompensated risk to avoid leaving large amounts of dollars on the table. The most efficient and effective way to avoid that risk is to invest in a passively managed portfolio.

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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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