Wednesday, February 27, 2008

Should Fiduciaries Invest Like Warren Buffet?

The duty to act prudently is one of a fiduciary’s primary responsibilities under ERISA. With this fiduciary responsibility, there is also potential liability. Fiduciaries who don’t adhere to the basic standards of prudent fiduciary conduct may be organizationally and personally liable for Plan losses. Fulfilling these responsibilities requires expertise, particularly in an area such as investments. Lacking the expertise, fiduciaries should employ professional investment strategies.

In a February 15, 2008 interview with students from Emory's Goizueta Business School and McCombs School of Business at UT Austin, Warren Buffet remarked on investing and the value of diversification.

“If investing is your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. If you have a harem of 40 women, you never really get to know any of them well. Charlie (Munger)and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest.”
Unfortunately, ERISA fiduciary prudence requires diversification to minimize the risk of large investment losses to a retirement plan. Though adequate diversification is not specifically spelled out in ERISA, it would be determined on a facts and circumstances basis using recognized generally recognized investment standards. By example, the Investment Company Act of 1940 provides some guidance on legal diversification and industry concentration. Section 5 of the 1940 Act requires that mutual funds elect to be classified as either "diversified" or "non-diversified". As a diversified fund, the Fund is limited as to the amount it may invest in any single issuer. Specifically, it provides that “with respect to 75% of its total assets, a diversified fund may not invest in a security if, at the time of purchase and as a result of such investment, (1) more than 5% of the fund's total assets would be invested in securities of the issuer of such security, and (2) the fund would hold more than 10% of the outstanding voting securities of such issuer” exclusive of cash and Us government securities. In contrast, a "non-diversified" fund is defined by the 1940 Act to be any fund that is not a "diversified" fund.

This implies that a "diversified" fund would have a minimum holding of at least 20 investments. Other studies suggest that 90% of the benefit of diversifying against unsystematic or stock specific risk would be derived from portfolios holding 15 – 20 stocks.

“Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet”
Good investment governance relies on establishing investment performance benchmarks. However, fiduciary benchmarking processes can serve to “pull the rug out from under the feet of fiduciaries”, turning quotational or unrealized losses into realized losses. This happens on a fairly regular basis as fiduciaries exit investments for not meeting performance benchmarks. The reference benchmarks are often not reflective of the nature of correlated investment. Benchmarking is particularly ineffective for concentrated portfolios which contain substantial unsystematic risk such as WB's. In these cases, fiduciaries are forced to choose between either not employing a significant procedurally prudent process or ignoring its results. Neither option would be very defensible in the event of a poor investment outcome.

Despite his extraordinary success, fiduciaries would have to think long and hard about their exposure before singularly employing Warren Buffet's unique investing strategies.

“If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.”

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