Tuesday, January 29, 2008

Fiduciary Challenges II

Market events in 2007 reinforced that simplicity can be a valuable attribute of an effective fiduciary investment strategy. In today’s capital markets virtually any income stream can be transformed into an asset class. Financial engineers have found it lucrative to reformulate and leverage common risks into complex alternative asset structures with supposedly superior investment characteristics. The complexity of these structures leads to information asymmetry which is an uneven distribution of information to the parties at risk. This enables risk premiums to be transmogrified into much more attractive “alpha”.

The current mortgage credit crisis is an obvious example of how complexity and information asymmetry worked against investors. The “excess” return in structured mortgage products was, in fact, compensation for the unlikely event that the mortgages would default. As it turns out , the cost of this uncompensated tail risk could be quite high. Investor’s faith that sophisticated global banks and money managers properly understood and were managing these risks was obviously misplaced. Moody’s Investor Services warned that “the complexity of the global financial system and the imbalance of information available to market participants means the ability to track risk has declined, probably forever”.

Fiduciary responsibility and prudence has long required a detailed evaluation of under-performance. In the future, fiduciaries may have to be just as vigilant about examining the true nature of out-performance. Despite all the financial innovations, the most significant risk and return generator for most portfolios remains common stock. Managing the extent and concentration of that exposure is still one of the most important and consequential fiduciary responsibilities. The single strategic decision about how much stock to have in a portfolio should occupy the majority of an investment fiduciary’s consideration since it alone can determine much of the outcome of the portfolio.

Investors who understand and implement a prudent investment process will be sucessful, in at least a relative sense, in part because the utilization of a disciplined process will help them take advantage of the benefits available to long termism and escape some of the pitfalls inherent in investment complexity. While this seems simple…it is not easy. It requires patience, self restraint and the discipline necessary to overcome strongly ingrained instinctive behaviors.

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