Sunday, November 23, 2008

Investment Fiduciaries - Living in the Left Tail

Investment fiduciaries have developed a set of historically biased, analytically oriented and rules based approaches to support their investment decision making. This governance process is largely predicated on assumptions about the past cyclicality of capital markets, their reversion to the mean and a relatively normal distribution of economic and market events. This process, slavishly executed, may be insufficient in the face of today’s unique market losses and the almost unprecedented level of uncertainty.

It is not clear to what extent these drastic times call for drastic fiduciary measures. It is certain however, that an enhanced level of fiduciary judgment and decision making is required to accommodate today’s markets. Simple rote execution of fiduciary processes established in normal times may not be considered fully sufficient. Investment fiduciaries should re-examine their investment policies and investment review process to ensure they address the unique characteristics, risks and uncertainties implicit in the current markets.

The majority of investment policies are largely descriptive and rules based. Rules based investment policies are easy to execute and provided a simple demonstration of fiduciary governance. However, the rules and assumptions that work in normal market environments (and are reflected in most investment policies), may not work in today’s markets. Many fiduciary committees are uncomfortable departing from strict compliance with investment policy rules since it is a fiduciary breach under ERSIA not to comply with Plan documents. However, rules based investment policies are rarely comprehensive enough to address every critical investment characteristic through every market. Therefore, a prudent fiduciary process requires the consideration of all relevant facts and circumstances, even those that may not be explicitly defined in an investment policy statement. Some of these alternative standards may produce alternative investment conclusions. These might include:

Active/Passive – There is a pronounced investment trend towards the separation of core low cost investment beta returns from higher cost active alpha. Investment fiduciaries should have substantial principles based support for not providing/utilizing a passively managed investment alternative for all core asset classes. To the extent passive managed alternatives are made available, the ability to select/offer higher potential, though more volatile, actively managed funds may be better justified than without index funds. This also substantially reduces plan sponsor liability. When using active funds, Plan fiduciaries should be careful to avoid, to the extent possible, over-concentration or overlap (see below).

Strict Reliance on 3-5 year Investment Performance Standards - Strict fiduciary reliance on historically normalized market performance standards could cause fiduciaries to overreact to today’s performance. Many best of breed investment manager have fallen out of compliance with a standard market cycle (3 and 5 year) view of comparative performance. Relying more on qualitative investment factors and “life of fund”, rolling period and longer term comparative performance measures can provide other important performance perspectives. However, fiduciaries should not freeze up over investment manager changes. A record of properly evaluated prior fund underperformance that continues through the current markets, still presents an fiduciary obligation and an opportunity for plan sponsors to offer a better alternative.

Investment Characteristics –The nature of performance oriented investment selection virtually guarantees that investments with the dubious qualities so well rewarded over the last 5 years are well represented in today’s plan investments. Plan fiduciaries should review investments and policy criteria with a specific eye toward principles such as; level of structuring, transparency and clarity of underlying investments, complexity, fees levels and disclosures and leverage.

Investment Diversification – Investment funds within a plan should be reviewed to ensure they contribute towards investment diversification and not mistakenly expose investors to over-concentrated exposures. Fiduciaries attempting to provide diversification by offering broad asset class funds and overlapping sectors funds can mistakenly expose the plan or its participants to unexpected levels of over-concentration or high risk sector exposure. For instance, offering an international equity fund with a broad mandate to invest in emerging markets along side an emerging markets fund has the potential to create an exposure to emerging markets beyond many investors risk appetites. The utilization of both hybrid high yield bond funds and core plus bond strategies has created similar unintended levels of credit risk in some Plans. Hybrid asset don't usually add much value in a balanced portfolio anyway. Similarly, within an investment style, care should be taken to offer different investing strategies. For instance, using 2 deep value manager’s may provided less diversification benefit than having a deep value total return strategy with a dividend oriented income strategy.

ERISA 404(c) Compliance - Broadly speaking ERISA 404(c) compliance requires that Plans offer at least 3 distinct investment alternatives, each of which is diversified, each of which has materially different risk and returns characteristics and each of which when combined with investments in the other alternatives tends to minimize through diversification the overall risk of a participant's or beneficiary's portfolio. In today’s world, a Plan with a money market account and all equity funds may not, arguably, meet the criteria since all equity funds have been highly correlated in this bear market. Such Plan sponsor’s might reasonably consider adding a market value bond account. 404c compliance further requires diversification so as to minimize the risk of large losses. Traditionally money market funds or stable value funds have provided a safe option for participants. Recent credit market events and liquidity conditions require that fiduciaries examine these products and re-evaluate how comfortable they are with their safety. Given the markets extraordinary volatility, fiduciaries might also consider whether 404 (c) trading requirements can be met given the emergence of redemption fees and trading restrictions in many funds.

Investment fiduciaries should consider a principles based overlay for their investment policies and additional topics for evaluation in their investment reviews. A simple shift in perspective from "what did" to "what if" should provide a broader context for investment decision making and greater depth of support for a plans investment positions in todays markets.