It's important for advisors to understand the foundations of prudent investing and other principles that guide investment fiduciaries, and how they are designed to lead to long-term success.

In 1992, the American Law Institute created the Uniform Prudent Investor Act in an effort to apply modern portfolio theory to fiduciary investment practices. The act was viewed as a model that states could enact to provide a new "safe harbor" process for fiduciaries, thus enabling fiduciaries to employ diversification and risk management. It has been adopted as law in most states.

The Prudent Investor Rule, which is part of the act, contains five basic principles:
Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees.
Trustees have a duty to avoid fees, transaction costs and other expenses that are not justified by needs and realistic objectives of the trust's investment program.
Risk and return are so directly related that trustees have a duty to analyze and make conscious decisions concerning the appropriate levels of risk, distribution requirements, and other circumstances of the trusts they administer.
The fiduciary duty of impartiality requires a balancing of the elements of return between production of income and the protection of purchasing power.
Trustees may have a duty as well as having the authority to delegate as prudent investors would.

The Prudent Investor Rule is a legal standard used by investment managers to manage investment portfolios in a legally satisfactory manner. In the context of the rule, prudent investing is a process that an investment advisor uses to manage client funds.  If the process followed in making investment decisions is prudent based on accepted investment theory, then the decisions being made are prudent irrespective of their outcomes.  

For example, it would be imprudent to have clients invest in only large-cap U.S. stocks. Even if this strategy worked, the client should own a combination of large-cap, mid-cap and small-cap and international equities.  The prudence of the decision is not affected by the fact that a large-cap strategy may outperform a diversified portfolio in a given year. Such an outcome would be viewed as luck, and the use of only large caps would still be considered an imprudent action by the investment manager. Decisions not based on sound financial theory will always be deemed "imprudent."  The most important thing to understand is that prudent investing is a standard for the design of the investment process and not a guarantee of future performance.

Why Invest According To The Rule?
Investing in this manner gives you a structured process for considering all of the relevant factors that should be part of the investment decision-making process.  If you follow the basic principles outlined in this article, you will be well on your way to developing a sound long-term investment strategy.

Advisors who are investment fiduciaries will be held to a higher standard and are legally required to use a process that provides clients with fundamentally sound advice.  Many clients end up getting into trouble when they take advice from a commission salesperson or broker.  It is important to remember that the SEC views a broker as a commission salesperson and not a fiduciary advisor subject to the Prudent Person Rule.

The following is a review of a fiduciary's duties and how they benefit clients.

Duty To Diversify
Fiduciary rules require that modern portfolio theory should be used and all of a client's assets should be considered in an investment strategy.  This is particularly important when clients have concentrated stock positions or closely held businesses.

For example, if an executive has a large stake in the company that employs him, then the balance of his portfolio should be substantially more conservative than that of other investors since his income is dependant on market performance. In this case, fixed compensation is equivalent to a bond issued by the executive's employer and his annual bonus is comprised, often in large part, of restricted stock and options in the same company, whose fortunes are tied to the markets.  In cases such as these, it is impossible to reduce exposure to the company until after the client has stopped working at the firm.

In respect to diversification, fiduciaries are bound to show how they arrived at their decision on the following:
Asset class diversification - What was the process by which they decided on the asset classes to be held in the portfolio?

Diversification within an asset class - How many stocks will they hold and in what sectors relative to the index? 
What minimum diversification requirements will be mandated in the account guidelines for both stocks and bonds?
International diversification - What are the allocations and to which countries? What is the proportion of domestic and international holdings? What will the exposure be to foreign currency risk?

Alternative asset classes - What should be held in alternatives?  Are their liquidity issues if there's a need to reallocate large holdings in hedge funds and private equity?

Illiquidity - What is the budget for illiquid assets and how will this affect account rebalancing?

Concentrated positions - How are concentrated positions such as privately held business interests or employer stock and option holdings considered?

Return assumptions - Are return assumptions reasonable and based on future expectations as opposed to historical data?  Are illiquid asset return assumptions properly adjusted to reflect the fact that clients may not be able to access their investments in these funds for years?

Duty To Consider Taxes
Taxes are a critical consideration in the investment process and will be particularly important in the coming years.  Portfolio design should be based on the after-tax return of various asset classes.

Duty To Consider Fees
Fees matter, despite the fact that clients often invest in portfolios without carefully examining the fees they will be charged.  Since fees reduce returns, they should be part of the portfolio design process.  Advisors should explicitly explain to clients how fees are taken into account in designing their investment plans.  Also, advisors need to disclose their compensation for each of the portfolio alternatives they are proposing.

Duty To Be Loyal, Impartial And Objective
A fiduciary advisor is required to act in only the client's interests when making investment decisions, and to provide an objective opinion. The advisor will be required to show how his actions are designed only to benefit the person or persons for whom he is investing.  To ensure this obligation is met, fiduciary investment firms generally have committees that control and document the investment decision-making process.

Along with this responsibility is the duty to avoid self-dealing-when a trustee or other fiduicary takes advantage of his position and acts in his own interests rather than those of his clients.

Duty To Delegate To Experts
A prudent fiduciary is required to delegate certain decisions to experts if he does not possess the expertise to make a decision.  He can only delegate investment decisions to people with the requisite credentials, skills and experience. If there is a disagreement with a client, he will be required to show how they employed appropriate prudent experts. A fiduciary advisor has the duty to seek expert opinions in the same way a general medical practitioner relies on specialists for patient care.

The Duty To Monitor
A fiduciary should provide clear account management guidelines to each asset class manager and establish an appropriate benchmark for performance measurement. These guidelines will be used to control the risk that managers can take and to evaluate their performance.

The fiduciary should create an investment policy statement that lays out the risk and return parameters for the total client portfolio and provides information on the client's time horizon, tax situation, liquidity needs and any unique circumstances.  This document describes the advisor's strategy to the client and evaluates the performance of the strategy over time.  It should be viewed as a living document that changes as client needs and circumstances change. It should be updated at least annually.

Questions Raised By Recent Events
The current economic turmoil provides some insight into the value of fiduciary investing. Sound diversification, for example, is fundamental to risk management and is therefore ordinarily required of trustees. Yet diversification was notably absent in some of the key events that have led to the current market crisis.

Among the questions in the aftermath of the Bernie Madoff scandal is, to what degree were funds of hedge funds diversified? Tremont reportedly had 27% of its capital allocated to Madoff. Ezra Merkin's Ascot Partners LP reportedly had all of its capital under Madoff's management. Concentrated positions such as these were in contrast to the principles of diversification.

Why did some firms discourage investors from working with Madoff?  What due diligence process did fund of fund investors use to evaluate this fund?  Were the people doing the due diligence truly qualified to makes these judgments and what were their credentials? Did they understand the strategies being employed, the risks associated with them, and did they understand how to monitor the managers?

Prior to the recent decline in the market, did advisors have clients in large-, mid- and small-cap and international investments?  If alternatives were used, how was private equity accounted for and what was the asset class's correlation with the equity markets?  Did advisors understand clients well enough to get risk levels right?  How did they account for hedge fund gates and potential extensions of the time to repayment from private equity investments in their cash flow models and asset allocation models?

Conclusion
The recent turmoil in the financial markets has caused investors a great deal of concern and forced them to rethink where they will get advice in the future and how they will manage their advisors.  In fact, a recent survey by Prince & Associates showed that over 70% of high-net-worth clients want to fire their current financial advisors. This is not surprising given the losses investors have suffered and the low quality of the advice they have received.  Many were put into hedge funds and private equity investments at the peak of the cycle, when it was clear that the return opportunities were diminishing.  Is it surprising that the same "strategists" and "advisors" who encouraged investors to invest in tech stocks during the Internet bubble are the same people who were behind the recent push into alternatives and private equity?

Many investors took advice from commission sales people who were conflicted and in many cases unqualified to give advice to high-net-worth individuals. Also, many advisors lost sight of the fact that the primary goal of most wealthy investors is to protect and preserve their capital.

Today's wealthy investors are using sophisticated strategies that, just a few years ago, were only used by institutional investors. To carry out these strategies, investors need advisors who are not only educated and experienced, but who are without conflicts of interest and who adhere to a high fiduciary standard.

Advisors who follow the principles of prudent investing and work in the best interests of their clients will find they have better long-term results.    

William J. McBride, CFA, CIPM, is principal of Objective Investment Advisors LLC in Ridgewood, N.J. He can be reached at 201. 919.1191.