Answering a Key Question in a Request for Proposal

Contributor Scott Simon argues that investment managers have clearly articulated investment philosophies. Here’s why.

W. Scott Simon

 

‘Tis the season–in the investment industry, the season of Requests for Proposal (or RFPs) by, for example, sponsors of retirement plans subject to the Employee Retirement Income Security Act of 1974 (also known as ERISA). An RFP is a formal document in which a sponsor solicits proposals from qualified firms to perform third-party services such as investment management, record-keeping, or plan administration.

Retirement plans not subject to ERISA and non-profits including endowments and foundations, as well as other pools of money subject to fiduciary precepts, may also choose to issue an RFP, and its requirements should not be any less exacting than for ERISA plans. According to best practices, a sponsor should go to market and issue a new RFP every three to five years in order to ensure that its plan is receiving services that, among other things, are cost-effective.

A Request for Information (or RFI), in contrast, is a much less formal process in which the requestor of information might simply contact a number of providers to get updates on, say, the current costs of services. This requestor is often the incumbent provider of the service which presents, at the very least, the appearance of a conflict of interest. To avoid this, it’s advisable to retain another party for such tasks.

One question that a plan sponsor always asks respondents to an RFP for investment management services is to describe their investment philosophy. Many such advisors don’t have a set investment philosophy. They often simply defer to the wishes of the sponsor and are willing to provide just about anything the sponsor asks for.

My view is that any plan sponsor going to the trouble and expense of issuing an RFP deserves an answer to this question from a respondent that is forthright, commonsensical, and well thought-out. A fiduciary should be the leader of the pack in its relationship with a plan sponsor, especially in cases where an RFP calls for the services of a discretionary fiduciary, such as an ERISA section 3(38) investment manager.

Litigation filed against even very large 401(k) plans over the last decade or so demonstrates in most cases that companies with untold resources have 401(k) plans that are not much better (and often worse) than those sponsored by mom-and-pop operations.

A sponsor ideally should retain an investment manager wise in the ways of ERISA to help it establish a prudent retirement plan that gives plan participants a reasonable chance of achieving successful retirement outcomes. The investment options offered by such a manager should be low-cost, and broadly and deeply diversified to reduce risk–both of which can enhance return. Simple factors such as reducing cost and risk can help give participants confidence that they are in the right investment option(s).

The key to all this, of course, is to establish from the start–and maintain over time–a well-documented process that is prudent. After all, prudence under ERISA (as well as under any body of fiduciary law) is defined as process, process, process–not investment returns.

Here is an example of how I (as a respondent) answer a plan sponsor’s question about my investment philosophy.

Any discussion of the respondent’s process for selecting, monitoring and replacing investment options as an ERISA section 3(38) investment manager must begin with an explanation of its investment philosophy. Since the beginning, the respondent has employed a structured passive asset class investment strategy that is in accord with the ever-expanding body of Nobel Prize-winning academic research dating back more than 50 years.

The respondent rejects as suboptimal any investment philosophy based on the very popular–yet ultimately fruitless– ongoing search for the “nirvana” of investment management: attempting to identify in advance those managers (or investments) that consistently generate market-beating performance (properly adjusted for risk and costs).

There has been no empirical or academic evidence to date to support the notion that professional money managers can consistently beat any stock or bond market (or any sub-sector or asset class of a market, for that matter).

This is not to say that there are not “winning” investment managers or investments even after their risks and costs are taken into account; indeed, they must exist in the zero-sum game that characterizes any financial market. It is to say, however, that such winners cannot be identified in advance before their track record performances show up from the past and, in any case, they end up being few and far between.

The respondent, in contrast, believes that investing is deceptively simple. The essential variables of investing are return, risk, and costs. Return, however, which receives the most attention from investors by far (for example, “What was your return over the last three years, one year, one quarter?”), is a random variable subject to inherent uncertainty. Translation: No one has any idea–in advance of when it happens–what the return will be for a stock/bond/mutual fund/asset class/financial market over any given time period, whether it’s a decade/year/month/day/hour/minute. Many, however, will profess with great confidence that they do know–which is often conveyed through endless amounts of advertising, for example.

Because the return on any investment or manager is uncontrollable in advance of its realized occurrence–and therefore unknowable–it makes no sense to pick a relatively few investments out of the thousands of investments available in financial markets in the hope that they will turn out to be winners that will beat the market. The odds against being successful at such attempts (after appropriate adjustments for risk and costs) are extremely daunting, as shown by empirical and academic evidence over the last half-century. It’s just a wild (and unnecessarily costly) goose chase to undertake such attempts in the first place.

Instead of focusing on a variable of investing over which investors have no control–return–the respondent’s investment philosophy is to invest in thousands of investments in a way that focuses on the two other essential variables of investing over which investors do have control: controlling costs and managing risk.

That’s why all the investments used by the respondent are low-cost (resulting in higher net return compared with higher-cost investments which ordinarily are actively managed investments but can also include certain passive investment products), and broadly and deeply diversified to reduce risk (which can lead to higher net return due to decreased portfolio volatility).

More particularly, the respondent believes that, in managing investment assets, it is prudent to establish and follow a legally sound, academically based, and cost-effective investment process. The respondent’s investment process is designed to give investment fiduciaries an extra layer of protection. By focusing on getting it right for ERISA fiduciaries, the respondent can get it right for plan participants (and their beneficiaries) whose well-being is, after all, the focus of the ERISA universe.

The respondent’s investment process is legally sound because it focuses on how fiduciaries must carry out their duties prudently under the law of ERISA. For example, reducing the risk of ERISA fiduciaries through use of risk-mitigation techniques can help protect them legally. That, in turn, helps protect plan participants.

The respondent’s investment process is academically based, because the menu of investment options that it selects for a 401(k) plan is designed in accordance with leading academic research to be in alignment with the tenets of Modern Portfolio Theory, which provides the investment underpinnings of ERISA. In addition to helping legally protect ERISA fiduciaries, this focus can also enhance the wealth of participant account balances.

The respondent’s investment process is cost-effective because it has eliminated altogether explicit “visible” costs such as commissions and revenue-sharing/12b-1/sub-TA fees, and it has minimized implicit “invisible” costs such as trading costs, bid-ask spread costs and market impact costs from its menu of investments.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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