The preamble to the Uniform Prudent Investor Act notes, “The tradeoff in all investing between risk and return is identified as the fiduciary’s central consideration.” For most trustees determining the return that was produced by the assets held in trust is a fairly straightforward exercise.
Most investment managers are required to produce performance data that is compliant with SEC standards. However, defining whether the return was appropriate for the level of risk taken is more complicated.
The Bogert treatise states, “The trustee cannot assume that if investments are legal and proper for retention at the beginning of the trust, or when purchased, they will remain so indefinitely. Rather, the trustee must systematically consider all the investments of the trust at regular intervals to ensure that they are appropriate” (A. Hess, G. Bogert, & G. Bogert, Law of Trusts and Trustees §684, pp.145–146 (3d ed. 2009)).
To fulfill this duty to monitor the risk and return of the trust assets, a prudent trustee acting in good faith will make the following inquiries:
The manager’s actual return will initially be compared to the trustee’s stated return objective. This begs the question whether the trustee has taken steps to define a targeted rate of return for the assets of which they are responsible. If they have not, they are encouraged to do so. The Target Return is stated as an absolute number (e.g., 7.0%) or as a real, inflation-adjusted number (e.g., Inflation + 4.0%).
No single benchmark can precisely measure the acumen or shortcomings of the investment manager. The most prudent approach is to compare the risk and return of the actual portfolio against several key performance indicators to judge whether the client’s investment objectives are being accomplished. It is rare that a benchmarking study would ever conclusively prove that the manager was either exceptional or incompetent. More often, such a study would conclude that the manager’s performance was or was not within a reasonable range of return and risk outcomes. Common benchmarks that are used in a benchmarking study are: 1) the benchmark suggested by the investment manager; 2) a Strategic benchmark which has very little sub-asset class detail; 3) a Tactical benchmark that is designed to exactly match the sub-asset class allocation of the actual portfolio; and 4) a Peer Group benchmark which is a compilation of the actual return and actual risk of an investment manager the incumbent competes against. (Download Benchmarking White Paper)
In addition to measuring the manager’s performance against several benchmarks, there must be an evaluation of the risk that has been accepted by each manager. Some forms of risk can be discovered through statistical analysis. Often used statistical risk measures include Standard Deviation, Value-at-Risk, Beta, Sharpe Ratio, M-Squared, et cetera. This type of analysis for a marketable portfolio can be easily done by the software the current investment manager has access to. (If they cannot do this analysis it should put doubt in their ability to balance risk and return since they are not able to monitor the risk of the portfolio.)
Other types of risk cannot be deduced from statistical inquiry and require a more subjective analysis.
Lack of Liquidity: The % of the trust that cannot be liquidated within 5 business days
Concentration: The % of the trust held in the single largest security
Leverage: The % of leverage used by the trust as reflected in a debt-to-equity ratio
Lack of Valuation: The % of the trust assets that do not have daily valuation
Most investment managers, if provided with this overview, can help the trustee create a record that these factors have been considered and documented. If the investment manager is unable to help the trustee develop such a record, a prudent trustee will take steps to independently evaluate these factors or find an investment manager that is willing and able to do so.
Ask for Help: Most investment managers, if provided with this overview, can help the trustee create a record that these factors have been considered and documented. If the investment manager is unable to help the trustee develop such a record, a prudent trustee will take steps to independently evaluate these factors or find an investment manager that is willing and able to do so.
Anodos helps trustees develop, maintain, and manage their governance processes. Our support helps trustees and plan committees save time, reduce their personal risk, and fulfill their duties of care. What makes us unique is that providing fiduciary governance support is all that we do. We don’t manage money, sell insurance, or accept revenue sharing fees. We don’t have a horse in the race.
Josh Yager, Esq., CFP®, ChFC®
Anodos helps individual trustees save time, reduce their personal risk, and fulfill their fiduciary duties. We do this by helping trustees develop and maintain a series of governance documents which demonstrates they have fulfilled each of their duties of care. We also will act as an expert witness to defend our clients’ findings in court. What makes us unique is that trustee governance support is all we do. We do not manage money, sell insurance, or accept referral fees. We don't have a horse in the race.
We help trustees save time, reduce risk, and fulfill their fiduciary duties. What makes us unique is that trustee governance support is all we do.