FIDUCIARY RESPONSIBILITY IN TODAY S INVESTMENT ENVIRONMENT

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1 FIDUCIARY RESPONSIBILITY IN TODAY S INVESTMENT ENVIRONMENT Donald B Trone, AIFA don@fi360.com

2 FOUNDATION MISSION Develop and promote Practices that define a prudent process for investment fiduciaries. The Practices impact the more than 5 million men and women who 1 2 Have the legal responsibility for managing investment decisions (trustees, executors, and members of investment committees) Provide comprehensive and continuous investment advice (investment advisors).

3 THE NECESSITY FOR DEFINED FIDUCIARY PRACTICES Society depends upon professionals to provide reliable fixed standards in situations where the facts are murky or the temptations too strong. Their principal contribution is an ability to bring sound judgment to bear on these situations. They represent the best a particular community is able to muster in response to new challenges. - Dr. Robert G Kennedy, Why Military Officers Must Have Training in Ethics

4 LEGISLATION ERISA UPIA MPERS Employee Retirement Income and Securities Act (Qualified retirement plans) Uniform Prudent Investor Act (Private trusts, foundations/endowments) Uniform Management of Public Employees Retirement Systems Act (State, county, and municipal retirement plans)

5 UNIFORM FIDUCIARY STANDARDS OF CARE 1. Know standards, laws, and trust provisions. 2. Diversify assets to specific risk/return profile of client. 3. Prepare investment policy statement. 4. Use prudent experts (money managers) and document due diligence. 5. Control and account for investment expenses. 6. Monitor the activities of prudent experts. 7. Avoid conflicts of interest and prohibited transactions.

6 FIVE-STEP INVESTMENT MANAGEMENT PROCESS Analyze Current Position Step 1 Diversify Allocate Portfolio Step 2 Formalize Investment Policy Step 3 Implement Policy Step 4 Rebalance Monitor and Supervise Step 5

7 CONSTRUCTING THE PRACTICES MATRIX UNIFORM FIDUCIARY STANDARDS OF CARE STEPS IN THE INVESTMENT MANAGEMENT PROCESS 1. Know standards, laws, and trust provisions. 2. Prepare investment policy statement. 3. Diversify assets to specific risk/return profile of client. 4. Use prudent experts money managers and document due diligence. 5. Control and account for investment expenses. 6. Monitor money managers and service vendors. Analyze Current Position Step 1 Design Optimal Portfolio Step 2 Formalize Investment Policy Step 3 Implement Policy Step 4 Rebalance Monitor and Supervise Step 5 7. Avoid conflicts of interest and prohibited transactions. Copyright 2001, Center for Fiduciary Studies PRACTICES MATRIX Steps Standards The Matrix is constructed by using the five Steps of the Investment Process as the horizontal axis, and the seven Uniform Fiduciary Standards of Care as the vertical axis. 7

8 LEGAL CITATIONS, REFERENCES AND SUPPORT Each Practice is substantiated with a reference to: ERISA UPIA MPERS When applicable: Case Law and Regulatory Opinion Letter(s)

9 BENEFITS OF HAVING PRACTICES Reduce fiduciary liability by uncovering omissions. Provides educational outline. Should improve long-term performance. Enable fiduciaries to compare practices and procedures. Assist in prioritizing projects. Establish benchmarks to measure progress. Negotiate lower E&O premiums.

10 ALTERNATIVE INVESTMENTS FIDUCIARY ISSUES Practice 1.1 a prototype IPS may have exclusionary language Practice 1.2 forget they are still a fiduciary Practice 1.3 failure to confirm there are no conflicts of interest ( pay-to-play ) Practice do not understand the risks involved Practice 2.4 allocation is consistent with risk/return profile

11 ALTERNATIVE INVESTMENTS FIDUCIARY ISSUES Practices 3.4, 3.5, 4.1 and 5.1 no defined or consistent due diligence and monitoring criteria Practice 4.3 investment vehicle inappropriate given portfolio size Practice 5.3 fiduciary is not tracking the use of the soft dollars Practice 5.4 performance-based fees are based on an appropriate benchmark Practice 5.5 finder s fees are not disclosed

12 PRIMER ON PAY-TO-PLAY 1. Broker Pay-to-Play: SEC charges against Morgan Stanley s Partner s List Important to distinguish between paying for shelf space and undisclosed compensation 2. Politician Pay-to-Play: Contributions to politicians in exchange for access to public funds Watch also 529 Plans and Tobacco Settlement 3. Consultant Pay-to-Play: Selling services to money managers Most egregious because consultant is hired to be an objective source

13 INDUSTRY SCANDALS: PAY-TO-PLAY Through the lens of fiduciary practices 1.2 Fiduciaries are aware of their duties and responsibilities. 1.3 Fiduciaries and parties in interest are not involved in self-dealing. 3.6 The IPS defines procedures for controlling and accounting for investment expenses. 4.1 The investment strategy is implemented with the required level of prudence. 5.1 Periodic reports compare investment performance. 5.2 Periodic reviews are made of qualitative and/or organizational changes. 5.3 Control procedures are in place to periodically review policies for best execution, soft dollars, and proxy voting. 5.5 Finders fees, 12b-1 fees, or other forms of compensation that may have been paid for asset placement, are appropriately applied, utilized, and documented.

14 INDUSTRY SCANDALS: MUTUAL FUNDS Through the lens of fiduciary practices 1.1 Investments are managed in accordance with applicable documents 1.2 Fiduciaries [fund directors] are aware of their duties and responsibilities. 1.3 Fiduciaries and parties in interest are not involved in self-dealing. 1.4 Contracts do not contain provisions that conflict with fiduciary standards. 3.4 The IPS defines due diligence criteria for selecting investment options. 3.5 The IPS defines monitoring criteria for investment options and service vendors. 4.1 The investment strategy is implemented with the required level of prudence. 4.2 The fiduciary is following applicable Safe Harbor provisions. 5.1 Periodic reports compare investment performance. 5.2 Periodic reviews are made of qualitative and/or organizational changes.

15 WHAT TO DO WHEN YOUR FUND IS IMPLICATED IN A SCANDAL 1. Fiduciary duty to take info in to consideration. 2. Who s implicated staff, portfolio managers, or management? 3. What is the organization s response, including restitution? 4. Check overall fiduciary ranking of fund family. 5. Other considerations: ability for record keeper/ custodian to change options; retail clients - tax status; liquidity of fund (small cap more sensitive)

16 MANAGER DUE DILIGENCE Performance relative to peer group. Performance relative to assumed risk. Inception date of product. Correlation to peer group. Assets in the product. Holdings consistent with style. Expense ratios or fees. Stability of the organization.

17 FIDUCIARY SCORE Each field is given a numerical value and then ranked against other funds in its peer group. Passed No fiduciary due diligence shortfalls. (Top Percentile) Appropriate Shortfalls, but still ranks in Top Quartile. Watch (2) (3) and (4) There are shortfalls; the fund may not be the best choice if being considered in a search, but may not need to be replaced (2 nd and 3 rd Quartiles).

18 MUTUAL FUND FAMILY FIDUCIARY RANKINGS An overlay to the mutual fund scandals: strong correlation to rankings Rankings* based on percentage of funds that have a Fiduciary Score of Passed or Appropriate Vanguard 88% T. Rowe Price 79% American Century Investments 56% * As of March 31, 2004

19 YOU ARE A STEWARD OF THE NATION S WEALTH The nation s wealth is a finite resource, as finite a resource as our air, water, and other natural resources it warrants comparable attention, discipline, and rigor.

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