W. Scott Simon
In last month’s column, I discussed the all-too-common situation where a large portfolio (whether involving a private family trust, an individual, or a non-profit) is concentrated in one stock or a very few stocks. I noted that investment fiduciaries cannot sit by passively and ignore the existence of this kind of risk in the portfolios for which they are responsible.
All bodies of fiduciary law–including the 1974 Employee Retirement Income Security Act (pertaining to private retirement plans such as 401(k) plans), the 1994 Uniform Prudent Investor Act (pertaining to private family trusts), the 1997 Uniform Management of Public Employee Retirement Systems Act (pertaining to public employee retirement plans), the 2006 Uniform Prudent Management of Institutional Funds Act (pertaining to non-profits such as foundations and endowments) as well as modern investment theories–require fiduciaries to take affirmative steps to diversify risk broadly as part of a prudent investment process.
While trying to minimize taxes is a worthy objective in general, that objective should never be allowed to override a prudent risk management strategy. That’s why I suggested that a fiduciary just sell off a portfolio concentrated in one stock (or a relative few stocks), pay the 15% long-term capital-gains tax, then prudently and efficiently mitigate risk through broad diversification, and be done with it. That way, the fiduciary has largely eliminated the risk of a plunge in portfolio value and the possibility of losing some much larger amount due to the portfolio’s poor diversification.
Now let’s suppose that there’s some fiduciary out there responsible for, say, a $10 million portfolio invested in just a few stocks that, gasp, would actually follow my advice to bite the bullet and fork over 15% of the value of the portfolio to the government. Now what?
Well, the first thing is to congratulate the fiduciary for having the fortitude to overcome the almost pathological aversion to paying taxes that many such fiduciaries (and their beneficiaries) have in this situation. It’s critical, however, that this fiduciary not then turn around and negate its so-far prudent conduct by investing the after-tax balance of the portfolio with some investment advisor who refuses to be a fiduciary (such as, say, someone who owes fiduciary duties to the firm he or she works for, and not to clients) and, what’s worse, invests the portfolio in narrow industry sectors rather than broad asset classes. Let’s see why that’s not a very smart way to invest.
Back to the (Fiduciary) Basics Once Again
Commentary to the Restatement 3rd of Trusts (Prudent Investor Rule) (Restatement) explains:
“Asset allocation decisions are a fundamental aspect of an investment strategy and a starting point in formulating a plan of diversification. Basic asset classifications might begin with cash equivalents, bonds, asset-backed securities, real estate, and corporate stocks, with both debt and equity categories further divided by their general risk-reward or income/growth characteristics, by the domestic, foreign, tax-exempt, or other characteristics of the issuers, and the like.”
Note that the commentary uses asset class terms such as “cash equivalents” and “bonds”–not industry sector terms such as “financials,” “health care,” “telecommunications,” or “technology” that many investment advisors use on the account statements they issue to their clients. No doubt these advisors would contend that their portfolios are “broadly” diversified because they’re invested in, say, 10 or 12 different industry sectors. That contention is incorrect as a matter of investment theory and practice, as well as a matter of modern prudent investing standards.
Financial economics (including modern portfolio theory) posits that portfolios should ordinarily be built on the basis of broad asset classes. An asset class is composed of stocks with comparable risk and return characteristics according to an identifiable factor such as the size of the market capitalization of each stock. (Bond asset classes have their own unique risk and return characteristics.) An asset class with its own specific risk and return characteristics is helpful in contributing to the creation of broadly diversified portfolios. In fact, asset classes are much broader than industry sectors.
An industry sector such as energy, industrials, or consumer staples is simply the industry in which a company–and by extension its stock–is classified. The non-fiduciary investment advisor investing in narrow industry sectors under examination here is in business to pick “good” or “safe” stocks. It does this by identifying such stocks through proprietary asset valuation models based on earnings or profit consensus forecasts, technical trends, relative valuations (price/book, price/sales, price/earnings), competitive advantage analysis, or other “fundamental” asset valuation models.
Many such investment advisors stuff their portfolios with 20 to 150 stocks simply because their “fundamentals” make them appear, at the moment, to be safe, promising, and appropriate. The problem with building a portfolio this way is that, given the climate of a particular economy, an advisor using such an approach may purchase stocks sharing the same accounting, economic, and statistical relationships. These stocks often have high covariance to each other. (Covariance describes how the market prices of investments move relative to each other in reaction to any information about the investments that may have an impact on their prices.)
What the advisor has really done is to make highly concentrated bets on a relatively few stocks in a relatively few industry sectors. That’s not a good thing, particularly when stock prices start sinking faster than the Titanic, as they did this week. Portfolio construction is not optimal when an advisor merely bundles together stocks which exhibit strong current financial statements and favorable accounting ratios. Identifying and investing in good or safe stocks unfortunately cannot reduce portfolio risk.
Stock analysts are fond of talking about what companies produce and how that affects the prospects for the companies’ stock prices. The reality, though, is that the industry sector (e.g., energy, industrials, consumer staples) in which a company is classified has no bearing on the company’s expected return. Differences in the expected returns on company stocks are related to certain risk factors such as the health of a company and the size of its market capitalization rather than to whatever the company produces (e.g., oil, cars, diapers).
These risk factors seem to account for many of the differences in expected returns among industry sectors. The greater the exposure a stock has to these risk factors, the greater its expected return. After all, it’s been known ever since the year of our nation’s founding when Scottish classical economist Adam Smith published The Wealth of Nations–the linchpin of the economic theory of capitalism–that the industry in which a company is classified has no direct relation to the flow of capital.
An industry sector, then, is not an asset class because it doesn’t have common risk and return characteristics. Each of the major asset classes available to investors can be subdivided into a number of industry sectors. The prudent way to build, for example, a growth portfolio is to include whatever industry sectors can fit into the asset class of growth stocks. After all, industry sectors drift in and out of different asset classes. They get bigger and smaller and healthier and more distressed over time. High technology stocks might be growth stocks today, but more earnings disasters could turn them into value stocks tomorrow. Investing in stocks based on secondary criteria such as industry sectors can cause a portfolio to drift in and out of different asset classes.
Investment advisors that focus on industry sectors instead of the risk and return characteristics of different asset classes when investing portfolios are focused on the wrong thing. The difference between a collection of good or safe stocks and the implementation of a portfolio based on conscious decisions about the level of risk appropriate to the “terms, purposes, distribution requirements and other circumstances” of a portfolio is mighty. After all, the “central consideration” of every investment fiduciary under the UPIA is to determine the tradeoff between the risk and return of the portfolio for which it is responsible.
Not the Only, Just the Best, Way to Build a Prudent Portfolio
Not the only, just the best, way to build a prudent portfolio is with broad asset classes using passively managed mutual funds. It just is. This allows a fiduciary to manage risk (which is possible) in order to both reduce losses and increase returns–since otherwise the risky volatility in a portfolio eats up returns. If a fiduciary prefers to manage risk by using the active approach to investing, it is free to do so, but it must justify the particular investment strategy it wishes to implement in accordance with the two-pronged test found in Restatement commentary. In any event, fiduciaries must realize that such an approach is decidedly a less efficient and effective way to manage risk. It just is.
The other half of the risk-return equation–return–is a random variable which means that no one (despite the billions of dollars spent by money managers to convince investors otherwise) can manage the return of any given investment product. They just can’t. Trying to manage return is like trying to herd skunks, which is even more impossible than trying to herd cats because, well, cats ignore you, just wander off or keep sleeping while skunks pose the very real risk of a very aggressive reaction.
Many fiduciaries (and investors in general), of course, simply won’t believe or don’t understand what the standards of modern prudent fiduciary require. Some prefer, for example, to let their non-fiduciary investment advisor invest the portfolio for which they’re responsible in the advisor’s proprietary mutual funds (uh oh, my blood pressure is starting to spike). Other fiduciaries will let such advisors invest in wrap accounts and incur high risk while having the pleasure of paying high fees (quick, Melba, get me my blood pressure medicine).
Before I expire of a burst blood vessel as a result of this kind of “fiduciary” conduct, let me leave you with what Paul Samuelson (the second person, and first American, to receive the Nobel Prize in economic sciences) says about that kind of investing: “Every departure from indexing that you hope will put you ahead–as when you give eight money managers with different styles one-eighth each of your portfolio to manage–when the resultant ends far from diversification agreement with the overall index, your risk-corrected long-run performance is in jeopardy to a degree that you are not able even to estimate.” (Oh boy, that feels much better; I won’t be needing my medicine after all.)
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™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.