MAINSTREET ADVISORS THE PRUDENT INVESTOR RULE PLACING RESPONSIBILITY BEFORE RETURNS

Transcription

1 MAINSTREET ADVISORS THE PRUDENT INVESTOR RULE PLACING RESPONSIBILITY BEFORE RETURNS

2 FIDUCIARY RESPONSIBILITY IS NOT DETERMINED BY INVESTMENT PERFORMANCE, BUT RATHER BY WHETHER PRUDENT INVESTMENT PRACTICES WERE FOLLOWED. IT IS NOT WHETHER YOU WIN OR LOSE, IT IS HOW YOU PLAY THE GAME.

3 DEFINING ROLES THE PRIMARY DUTY OF THE FIDUCIARY IS TO MANAGE THE INVESTMENT PROCESS WITHOUT WHICH THE COMPONENTS OF AN INVESTMENT PLAN CAN NOT BE DEFINED, IMPLEMENTED OR EVALUATED. In 1994, the National Conference of Commissioners on Union State Laws adopted the Uniform Prudent Investor Act (UPIA) in order to promote uniformity of state laws governing the trust and investments field. According to the UPIA, a trustee, investment advisor and other fiduciaries that invest and manage trust assets on behalf of their beneficiaries must adhere to the Prudent Investor Rule. The Prudent Investor Rule defines a standard of care and the process, that fiduciaries must follow when making investment decisions. This standard demands the implementation of reasonable care, skill and caution when choosing an investment strategy. As such, it imposes a number of general duties that fiduciaries must perform during the investment process. Under these standards, trustees have to consider needs of trust beneficiaries, preserve assets, minimize risk, generate realistic amount of income, and invest for the long term. The Prudent Investor Rule only applies to the investment decision-making process. Thus, investment decisions being made are considered prudent as long as the investment process followed is prudent, regardless of the investment outcome. The prudent investment process is based on the Modern Portfolio Theory, (MPT) which emphasizes the risk and expected total return of the entire portfolio. Accordingly, no single investment decision should be judged in isolation but rather as part of the entire portfolio. Additionally, the rule mandates fiduciaries apply the principle of diversification when constructing portfolios. Diversification is the process of spreading an investment across multiple asset classes as well as within a single asset class in the portfolio. DEFINING ROLES TRUSTEE An individual or organization which holds or manages and invests assets for the benefit of another. The trustee is legally obliged to make all trust-related decisions with the trustee s interests in mind and may be liable for damages in the event of not doing so. Trustees may be entitled to a payment for their services if specified in the trust deed. FIDUCIARY An individual, corporation or association holding assets for another party, often with the legal authority and duty to make decisions regarding financial matters on behalf of the other party. INVESTMENT ADVISOR As defined by the Investment Advisors Act of 1940, any person or group that makes investment recommendations or conducts securities analysis in return for a fee, whether through direct management of client assets or via written publications. An investment advisor who has sufficient assets to be registered with the SEC is known as a Registered Investment Advisor, or RIA. Investment advisors are prohibited from disseminating advice known to be deceitful or fraudulent and from acting as a principal on their own accounts by buying and selling securities between themselves and a client without prior written consent. Source: UPIA MAINSTREET ADVISORS PRUDENT INVESTOR 3

4 THE EVOLUTION OF THE PRUDENT INVESTOR RULE THE PRUDENT INVESTOR RULE HAS EVOLVED THROUGHOUT ITS EXISTENCE IN RESPONSE TO THE GENERAL ECONOMIC AND INVESTMENT APPROACH OF ITS DAY. IT HAS GONE FROM INITIALLY PERMITTING ONLY RELATIVELY SECURE, GOVERNMENT-BACKED INVESTMENTS TO ENCOURAGING THE USE OF WELL-DIVERSIFIED MULTI ASSET CLASS PORTFOLIOS. The first mention of the rule in common law courts dates back to eighteenth century England. As a response to the collapse of a large private investment, the British courts mandated that fiduciaries could invest only in securities backed by their government. Initially, U.S. courts rejected this highly restrictive stance and held a position that an investment in private securities was permissible as long as the fiduciary invested in good faith in exercising a sound plan. Nearly forty years later, in 1869, this decision was overturned when a New York Court reverted to a more restrictive standard of generally prohibiting trust investments in private securities. Furthermore, the State Legislature created a list of legal investments, which was adopted and applied by the majority of states until 1930s with the introduction of the Prudent Person Rule. Under this rule, there are no legal investment lists and fiduciaries are expected to invest the portfolios as a prudent person would invest their own property. The rule stressed the needs of beneficiaries, capital preservation, and regularity of income. The passage of the Employee Retirement Income Security Act in 1974 instituted a prudent expert rule which sanctioned diversification of investments and therefore, by implication, Modern Portfolio Theory (MPT). During the 90 s the existing standard of prudence was designed by the Uniform Prudent Investor Act (UPIA). These current guidelines regarding the fiduciary role in the financial planning and investment management are based on the MPT. TIMELINE Common law courts place a great premium on insuring the safety of principal. This risk-averse approach was in partial response to the catastrophic collapse of a large private investment. Consequently, fiduciaries could invest only in securities backed by the British government New York State Legislature codified the investment standard which subsequently became known as the New York or legal list rule for its enumerated list of legal investments Classic and landmark case of Harvard College v. Amory, a Massachusetts court ruled that a trustee s investment in private securities was legal as long as the trustee invested in good faith In the landmark case of King v. Talbot, New York Court of Appeals adopted the more constraining English standard, which resurrected the position of generally prohibiting investments in private securities. Source: Poon, Percy S. The new Prudent Investor Rule and the modern portfolio theory: a new direction for fiduciaries. American Business Law Journal. 9/22/ MAINSTREET ADVISORS PRUDENT INVESTOR

5 1890s-1930s Majority of states applied the legal list rule while a minority incorporated the Harvard College rule The Uniform Prudent Investor Act (UPIA), developed by the National Conference of Commissioners on Uniform State Laws, sets out the guidelines for financial planning as a fiduciary. The UPIA incorporated the tenets of modern portfolio theory by shifting the focus away from individual investments to the more modern approach of looking at the portfolio as a whole. Circa 1940 The collapse of bond values during the depression led to a reconsideration of the implicit prudence of fixed income investment strategies and a return to the Prudent Man standard s Various concerned parties, particularly bankers, fought to eliminate the legal list approach. Studies revealed that trusts in states, like Massachusetts, utilizing the Harvard College standard earned a four percent return while legal list jurisdictions earned only two percent American Law Institute s Restatement (Third) of Trusts by the National Conference of Commissioners on Uniform State Law s Uniform Prudent Investor Act A Second Restatement added the requirement that a trustee must use caution in making investments which are used by prudent men who have primarily in view the preservation of their property, of men who are safeguarding property for others. also established universally accepted investments, such as government and high quality corporate bonds, as well as prohibiting aggressive techniques, such as margin trading Passage of the Employee Retirement Income Security Act (ERISA) in ERISA instituted a prudent expert rule. The statute also sanctioned diversification of investments, and therefore, by implication, the modern portfolio theory view in which investors are encouraged to consider total return and total portfolio performance in governing pension plans. MAINSTREET ADVISORS PRUDENT INVESTOR 5

6 UNIFORM PRUDENT INVESTOR ACT ACCORDING TO THE FDIC, THERE ARE TWO FIDUCIARY STANDARDS GOVERNING THE PRUDENCE OF THE INDIVIDUAL INVESTMENTS SELECTED BY A FIDUCIARY. THEY ARE THE PRUDENT INVESTOR ACT AND THE PRUDENT MAN RULE. The Prudent Man Rule is based on common law - the 1830 Massachusetts court s decision in Harvard College v. Armory which directed the trustees to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regards to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested. This rule also limited investment choices by forbidding the use of certain investment assets. Since its last revision in 1959, numerous investment products have been introduced and widely accepted by investors. This combined with investors becoming more sophisticated in their investments has made the Prudent Man Rule less relevant. The Uniform Prudent Investor Act (UPIA) was drafted by the Uniform Law Commissioners in The Act brought about major changes to the process utilized by trustees and other fiduciaries to guide investment decisions for trusts. The changes were a result of a generally accepted knowledge about the behavior of financial markets and largely based on the Modern Portfolio Theory. As a result, the new approach permits fiduciaries to invest portfolios according to the most effective portfolio management techniques. Consequently, the Uniform Prudent Investor Act differs from the Prudent Man Rule in following four major ways. - The standard of prudence is applied to entire portfolio instead individual investments. - The prudent fiduciary must diversify the portfolio unless special circumstances exist and the trust s interests are served better without it. - The Act does not label any category or type of investment as inherently imprudent. As long as the investment choice meets other requirements of prudent investing, a trustee can invest in anything deemed appropriate to achieve the risk/return objectives defined in the Investment Policy Statement. - Delegation of investment and management functions is permitted as long as a fiduciary exercises reasonable care, skill, and caution during this process. To date, it has been fully adopted in 41 states and the District of Columbia. UNIFORM PRUDENT INVESTOR ACT (UPIA) VS. PRUDENT MAN RULE (PMR) UPIA - Entire portfolio considered when determining prudence - Diversification is explicitly required * - No category or type of investment is deemed inherently imprudent - A fiduciary is permitted to delegate investment management and other functions to third parties PMR - Each investment is judged on its own merits - Diversification is recommended as an informal technique - Speculative or risky investments must be avoided - Prohibits the delegation of investment management and other functions to third parties who are still required to exercise a reasonable degree of skill in choosing investments *Certain terms of the trust agreement may affect this requirement. Source: The Uniform Prudent Investor Act; Prudent Man Rule 6 MAINSTREET ADVISORS PRUDENT INVESTOR

7 INVESTMENT POLICY STATEMENT THE FIRST STEP ON EVERYONE S INVESTING HORIZON OUGHT TO BE A WELL WRITTEN PLAN. An Investment Policy Statement (IPS) is typically a document drafted between a client and fiduciaries (i.e. trustee, investment advisor, portfolio manager, etc.) that outlines general rules and duties for all parties involved in the investment process. An IPS is not a contract but rather a written investment plan that effectively communicates which investment strategy a trustee should pursue over explicitly stated time horizon. The purpose of an IPS is not just to provide a road map of investment parameters to fiduciary but also serves as a guide for evaluating and monitoring the overall performance of investment portfolio. Besides providing a written investment strategy, an IPS states client s goals and objectives, risk tolerance, return expectations, asset allocation ranges, eligible investments, portfolio review frequency, any constraints and any other material investment facts and assumptions. In effect, an IPS forces all parties to commit to a disciplined investments approach. This is particularly important during turbulent times when it is crucial to maintain focus on the disciplined investment process and the long term goals. 1. FACTUAL DATA - Location of client s assets - Amount of assets under management - Identification of the trustees - Interested parties to the account 2. DISCUSSION AND REVIEW 3. LIQUIDITY AND MARKETABILITY REQUIREMENTS 4. TRANSACTION PROHIBITIONS 5. THE MONITORING AND CONTROL PROCEDURES - Investment objectives - Time horizon - Anticipated withdrawals/deposits - Need for reserves or liquidity - Tolerance for risk and volatility - Constraints and restrictions on assets - Diversification concentrations - Advisor s investment strategy (including tax management), - Locations of assets by account type (taxable versus tax-deferred) - How client accounts that are not being managed (if any) will be handled - Security types and asset classes - Included in or excluded from the portfolio - Basic allocation among asset categories - Variance (rebalancing) limits for this allocation. - Responsibilities of each party - Timeframe for meetings Source: MainStreet Advisors, Morningstar MAINSTREET ADVISORS PRUDENT INVESTOR 7

8 PRUDENT INVESTMENT PROCESS THE PRIMARY DUTY OF A FIDUCIARY IS TO MANAGE A PRUDENT INVESTMENT PROCESS. TO ACCOMPLISH THIS DUTY, A FIDUCIARY MUST HAVE AN EXCELLENT KNOWLEDGE OF PREVAILING TRUST INVESTMENT LAWS, ESTABLISHED STANDARDS OF CARE AND ACCESS TO A WIDE RANGE OF INVESTMENT PRODUCTS. Generally, in order to exercise reasonable care, skill and caution in managing trust portfolios, the fiduciary must adhere to the following five step investment management process (as defined by the Handbook for Investment Fiduciaries). STEP 1: ANALYZE CURRENT POSITION The starting point for a fiduciary is to ensure that investments are managed in accordance with applicable laws, trust documents, and written Investment Policy Statement (IPS) with clearly defined goals, objectives and restrictions. STEP 2: ALLOCATE PORTFOLIO & EMPHASIZE DIVERSIFICATION The fiduciary s role is to identify tax status, appropriate asset classes, investment time horizon, risk tolerance, and anticipated capital gains and income in order to select an appropriate asset class mix. The fiduciary should focus on the overall portfolio risk/ return trade off. STEP 3: FORMALIZE INVESTMENT POLICY The fiduciary is required to manage investment decisions with a reasonable level of detail. As a result, a well written IPS that defines the duties and responsibilities of all parties involved helps avoid unnecessary difference in opinion and possible conflict. It also defines diversification and rebalancing parameters and criteria for selecting investment options and subsequent monitoring. STEP 4: IMPLEMENT POLICY The fiduciary s responsibility is to ensure that the investment strategy is implemented according to the IPS and applicable laws. It is here that the fiduciary decides which investment vehicles are appropriate based on the portfolio size. STEP 5: MONITOR AND SUPERVISE The fiduciary is obligated to provide periodic reports comparing investment performance against an appropriate benchmark and client s objectives. Specific measures regarding soft dollars, management fees and applicable proxy voting should be in place as well. Source: A Handbook for Investment Fiduciaries 8 MAINSTREET ADVISORS PRUDENT INVESTNG

9 MODERN PORTFOLIO THEORY THE MODERN PORTFOLIO THEORY IS AN INVESTMENT DISCIPLINE WHICH SEEKS TO MAXIMIZE RETURN AND MINIMIZE RISK BY CAREFULLY DIVERSIFYING AMONG DIFFERENT ASSET CLASSES. The theory was first introduced by the Nobel Prize laureate Dr. Harry Markowitz in It was later expanded by James Tobin (1958) and William Sharpe (1964). Since its introduction the MPT has become the most dominant model for investment professionals for measuring risk/return prospects in a portfolio setting. Prior to MPT, investors focused on evaluating the risk/return characteristics of individual securities in constructing their portfolios. This pre-mpt approach has also been mandated by the Prudent Man Rule (PMR) since the1930s. Following the PMR approach usually steered portfolio allocation toward being highly concentrated, creating unnecessary risk to investors. To avoid this, Markowitz introduced the idea of diversification among a group of non correlated asset classes. This, at least in theory, produces a portfolio with lower risk than most individual securities bear on standalone basis. Put simply, when one asset class drops in value, a broad diversification into other classes should help hold the value of the overall portfolio steady. Ultimately this meant that investors should focus on selecting portfolios based on their overall risk/return characteristic. The MPT models an expected portfolio return as a weighted return of individual assets comprising that portfolio. It also defines risk as the standard deviation of returns which, in turn, is a function of the correlation of individual assets. The efficient frontier (the concave lines shown below) represents the set of portfolios with a maximum return for a given standard deviation. A portfolio that offers the highest return for a given level of risk is said to be an optimal efficient portfolio. Any portfolio mix that plots below the efficient frontier is considered suboptimal because for the same risk there is another portfolio positioned on the frontier. MODERN PORTFOLIO THEORY, EFFICIENT PORTFOLIOS LESS RETURN RETURN MORE RETURN LESS RISK RISK MORE RISK DIVERSIFIED PORTFOLIO EFFICIENT FRONTIER COMPRISED OF ADDITIONAL ASSET CLASSES. TRADITIONAL PORTFOLIO EFFICIENT FRONTIER COMPRISED OF TRADITIONAL ASSET CLASSES ONLY. SUBOPTIMAL SAMPLE PORTFOLIOS THAT PLOT BELOW THE CORRESPONDING EFFICIENT PORTFOLIO. This illustration is solely for information purposes and does not reflect the performance of any MainStreet Advisors portfolio or recommendation. Source: C. Corrado & B. Jordan. Fundamentals of Investments: Valuation & Management. MAINSTREET ADVISORS PRUDENT INVESTING 9

10 INVESTMENT EXPENSES THE FIDUCIARY MUST ESTABLISH PROCEDURES FOR CONTROLLING AND ACCOUNTING FOR INVEST- MENT EXPENSES IN ORDER TO FULFILL THE OBLIGATION TO MANAGE INVESTMENT DECISIONS WITH THE REQUISITE LEVEL OF CARE, SKILL AND PRUDENCE IN ADDITION TO FULFILLING THE SPECIFIC OBLIGATION OF THE FIDUCIARY TO PAY ONLY REASONABLE AND NECESSARY EXPENSES. Investment costs drive down the net portfolio performance since they translate to less dollars compounding over time. Every dollar paid to cover fees and/or taxes for investment management, custodian, trading and trusts is a dollar that lowers the net portfolio return. Attuned investors know that keeping investment cost and taxes low is crucial to reaching their financial goals. Investors should also be aware of a number of investment-related costs charged by different investment products. It is difficult to navigate the fee structure of mutual funds and exchange traded funds. The expense ratio, the percentage of the fund s total assets deducted from its return each year, includes fees for management, custody, trading, and administration to name a few. EXPENSES $1,000,000 $750,000 $500,000 $250,000 $100,000 $0 Costs count: After 30 years FUND A gives you almost $250,000 more than FUND B FUND A (expense ratio 0.2%) FUND B (expense ratio 1.19%) The UPIA states that wasting beneficiaries money is imprudent. In devising and implementing strategies for the investmentand management of trust assets, trustees are obliged to minimize costs. Here s an example. Let s say you have $200,000 to invest and you decide to split it evenly between two mutual funds that are identical in every respect except one: Fund A has an expense ratio of 0.20%, and Fund B has an expense ratio of 1.19%. Assuming an 8% annual rate of return for both funds, after 30 years, Fund A would net you an extra $242,079 all because of that seemingly minor difference in expense ratios YEARS This hypothetical illustration is solely for information purposes and does not represent any particular investment, nor does it account for inflation. There may be other material differences between investment products that must be considered prior to investing. All investments are subject to risk. Please see a fund s prospectus for more detailed information about its risk, expenses and fees. Source: MainStreet Advisors, Vanguard, UPIA 10 MAINSTREET ADVISORS PRUDENT INVESTORS

11 EVERY INVESTOR HAS UNIQUE CIRCUMSTANCES THAT PLAY AN IMPORTANT ROLE IN THE DEVELOPMENT OF A CUSTOM TAILORED PORTFOLIO. With MainStreet Advisors you get the tools you need to build the right portfolio. Our Investment Team uses a proven process to identify opportunities, analytical skills to build efficient portfolios, and a rigorous monitoring system to keep portfolios vibrant. With MainStreet Advisors you can expect: - Disciplined process with a long-term focus - Outstanding client service - Sound advice based on proven investment models - Highly motivated and experienced group of investment professionals

12 The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. This presentation is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations, and makes no implied or express recommendations concerning the manner in which any client s account should or would be handled, as appropriate investment strategies depend upon the client s investment objectives. The portfolio risk management process and the process of building efficient portfolios includes an effort to monitor and manage risk, but should not be confused with and does not imply low or no risk. Traditional and Efficient Portfolio Statistics include various indices that are unmanaged and are a common measure of performance of their respective asset classes. The indices are not available for direct investment. Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and a loss of principal may occur. Investing for short periods may make losses more likely. The opinions expressed are those of MainStreet Advisors. This information is subject to change at any time, based on market and other conditions. The information presented has been obtained with care from sources believed to be reliable, but is not guaranteed. Member and/or officers may have material ownership interest in investment mentioned. Any investments purchased or sold are not deposit accounts and are not endorsed by or insured by the Federal Deposit Insurance Corporation (FDIC), are not obligations of the Bank, are not guaranteed by the Bank or any other entity and involve investment risk, including possible loss of principal. MainStreet Advisors and Bank are independently owned and operated. MainStreet Advisors Form ADV Part II is available upon request. BRPIR001_ MAINSTREET ADVISORS 120 N LASALLE, 33RD FLR CHICAGO, IL MAINSTREETADV.COM