Fiduciary Focus: The 12 Days of Christmas of a Modern Prudent Fiduciary

The following article from fiduciaryadvisors.org is an excellent read for those still in the Christmas spirit!

Fiduciary Focus: The 12 Days of Christmas of a Modern Prudent Fiduciary  

by W. Scott Simon

On the first day of Christmas my true love said to me: According to Nobel laureate Harry Markowitz, the father of modern portfolio theory, the fundamental problem faced by all investors (including fiduciaries that are responsible for other people's money) is that any investment decisions they arrive at are made under conditions of uncertainty.

On the second day of Christmas my true love said to me: The "central consideration" of fiduciaries under the Uniform Prudent Investor Act (as well as the variations thereof adopted by 44 states, the District of Columbia and the U.S. Virgin Islands) and the Employee Retirement Income Security Act is to determine the trade-off between risk and return in a portfolio. 

On the third day of Christmas my true love said to me: The relevant unit to which fiduciaries must pay attention is the investment portfolio, not the individual components that comprise a portfolio.

On the fourth day of Christmas my true love said to me: Investment prudence, according to standards of modern fiduciary investing, is measured by process. Process is how a fiduciary does something, not what happened (i.e., good or bad investment performance) after the fiduciary did it. The prudence of that process is determined by reference to fiduciary conduct, not the investment performance of the portfolio for which the fiduciary is responsible. Stated more expansively, the prudence of fiduciary investment decisions and actions is tested not by the investment performance of a portfolio but by the soundness of the decision-making process that led to the performance.

On the fifth day of Christmas my true love said to me: Focusing solely on return - as most active investors that are stock pickers, market timers and track record investors attempting to beat the market are wont to do - violates the "central consideration" of all modern prudent fiduciaries: determine the tradeoff between risk and return in a portfolio.

On the sixth day of Christmas my true love said to me: It's silly to think that active investors can achieve investment returns superior to that of the market when any investment return is nothing more than a random variable and therefore subject to inherent uncertainty, over which no one has any control. My true love reminded me that focusing solely on return defines investment prudence in terms of portfolio performance, not fiduciary conduct which is directly opposite of how standards of modern fiduciary investing define prudence: in terms of fiduciary conduct not portfolio performance.

On the seventh day of Christmas my true love said to me: Broad diversification of the risk in a portfolio increases return. To enhance that return, diversification should occur at two levels: both across (i.e., horizontally) the asset classes that comprise the portfolio and within (i.e., vertically) each such asset class.

On the eighth day of Christmas my true love said to me: Prudent fiduciaries should adopt a prospective view of risk which obliges them to recognize consciously - before implementation of a given portfolio investment strategy - the fundamental problem identified by Professor Markowitz on the first day of Christmas. Because uncertainty implies risk, a common way of managing the problem described by Professor Markowitz is to diversify the risk in portfolios as broadly as possible.

On the ninth day of Christmas my true love said to me: The certain, intelligent management of investment costs and taxes (for taxable investors), and risk (through broad diversification) goes much further in generating increased return than the uncertainty of stock picking, market timing and track record investing.

On the tenth day of Christmas my true love said to me: Focus on the importance of broad financial markets, not the unimportance of actively-managed mutual funds and their inherent evanescence, or money managers and the soap operas at their firms in which many of them find themselves.

On the eleventh day of Christmas my true love said to me: It's a basic mathematical fact that all financial markets are zero sum games. This is true whether a market is thought of as "efficient" or "inefficient." Even many proponents of active investing admit that passive investing (i.e., index mutual funds and asset class funds) has the advantage over active investing in efficient financial markets because of the low costs of passive investing, plus investment skill doesn't matter as much in efficient markets. Yet passive investing has the advantage over active investing even in inefficient financial markets, since the high costs of active investing usually swamp any investment skill that active investors may have.

On the twelfth day of Christmas my true love said to me: Fiduciary conduct cannot be judged with 20/20 hindsight. So looking backward is not permitted. Section 8 of the UPIA states: "Compliance with the prudent investor rule is determined in light of the facts and circumstances existing at the time of a trustee's decision or action and not by hindsight." Reciprocally, fiduciaries aren't expected to be able to forecast which financial markets and/or which investments comprising those markets will perform well or poorly. Since a fiduciary is not required to accurately predict future events, it cannot be an insurer of portfolio performance. So looking forward is not required.