Sunday, November 21, 2010

Have We Created New Fiduciary Standards?

I am fortunate to be a member of various non-profit investment committees along with a number of very keen investors. In these settings we are able to share our experiences and relevant readings. I hope that this blog community benefits from these associations. An off-setting disadvantage is that perhaps I read too much.

This week I read an excellent review by the renowned law firm Milbank, Tweed, Hadley & McCloy on the enactment by the State of New York of the “Prudent Management of Institutional Funds Act.” All too often laws and regulations have the impact of lowering the investment returns of sophisticated investment institutions. This is not the case this time, at least through my interpretation of the fine Milbank Tweed article.


Diversification or “diworsification” as it is known in some circles, is addressed intelligently in the new regulation. The law appears to require a written investment policy statement to demonstrate compliance with the diversification directive unless the institution determines that it would be better served without diversification. If the institution deems that it would be better served without diversification, that policy needs to be affirmed each year. Mathematically oriented investors might point to the anomaly that if one could find the single best investment, adding a second investment (which by definition would not be as good as the first) would lower the average investment return.

The uncertainty of determining the best possible return suggests that a number of alternatives could improve the potential return over a single investment. For some institutions a thorny issue may be encountered when an over-sized position occurs due to an extra large gift of a security or perhaps more intriguing, a stock position that disrupts diversification due to its way above average performance and expected future growth. Thus, there may be a conflict between diversification and expected benefit to the institution. As an investment advisor as well as a member of various investment committees, I believe the mere fact that the issue of diversification should be regularly reviewed is a breath of fresh air.

The act, and there are similar acts in most states, does not define diversification. In the past, the laws governing investment relied on the 1830 dictate of Judge Putnam, deciding against Harvard College as to what was required to be considered prudent. In effect, he created the whole performance measurement sub-industry that clearly benefited me and perhaps investors, by requiring the prudent investor do those things that other intelligent and prudent investors do with their own money. The recently enacted New York State law appears to define “prudent” as actions that consider eight factors without specific reliance on what others are doing. Thus, trustees need to make their own decisions as to what prudence requires without necessarily being led by others. In many ways this may liberate investors from slavishly following the current popular policies, e.g. emerging markets, private placements or ETFs. At the same time, this freedom is frightening to the less-knowledgeable investment committees. In determining the prudence required, some institutions may want to review the makeup of their investment committees and/or consider the addition of one or more external investment advisors.

The role of each investment

The act, or at least Milbank Tweed’s interpretation, appears to drill down to the individual security position. Apparently each position has to be an integral part of the portfolio. Portfolios can no longer be a mere collection of assets without relation to one another. From my viewpoint, this focus can be extremely useful in the long run. All too often a security that is down in price significantly is an immediate candidate for sale for many investment committees. I believe that all positions should be reviewed for their potential to add, or in the case of down markets, stabilize the future value of the portfolio. One of the ways I and others build portfolios is to include investments that are likely to do well under a certain investment climate. Almost by definition some or all of these “hedges” will do poorly under other market phases. When they do poorly I am reluctant to remove them if I still consider that there is a reasonable chance that the investment wind will shift in their direction. I get extremely nervous when all the securities in appropriately balanced portfolios are going in one direction. At a recent client meeting, I commented that all of our fund investments were producing positive returns for the first ten months of the year, and that I was nervous as there were no losers. In the future this would unlikely be the case.

Spending rate

Perhaps the most significant element in the article is the following quote: “….spending in excess of 7% of the fair market value of a fund (calculated based on quarterly estimates averaged over a five year period) will be presumed imprudent, which presumption may be rebutted.”

There are several important elements to the quote. The first is the identification of an imprudent level. Second, the use of a twenty quarter average return. Third, that the imprudence contention can be rebutted. That the law (or at least Milbank Tweed) is, in effect, rate-setting, goes beyond the normal principles-based regulation. (I find it perhaps ironic that the level chosen is one percent above the old impermissible level of usury at six percent.) The rate chosen is below numerous pension assumptions, thus could be a cause of concern in the business and labor communities.

The suggestion of a five year rolling quarterly measurement device is a step in the right direction. In the institutional community, three years is the most popular measurement period. The cynic in me believes that three years is the shortest period that many consultants use to urge the replacement of a manager and the initiation of another fee generating search. The analyst in me objects to using three years, as often the market can move in one direction for the entire period, which is not representative of longer periods. The SEC appears to agree with me in requiring performance calculations within fund prospectuses to include one, five and ten years along with since-inception reporting. Market historians and at least one major investment management group have found that the best single fit to the statistics is four years. I suspect in part this works because of the US presidential election cycle that some market pundits use.

What is refreshing is while the lawyers have gotten deep into the weeds of setting investment policies, they have accepted that these views can be rebutted successfully.


As investors and investment managers, we must be aware of changes that lawyers and regulators force on the artform of investing. In the case of the Prudent Management of Institutional Funds Act, some of the clarifications are positive and far reaching. As fiduciaries, all involved are going to be held to a higher standard of prudence not just copying what others are doing.

What are your views?
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