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Practice 4.2: Monitor changes of investment advisors and managers

In Practice 4.1, we looked at the evaluation of an investment option by quantitative measures, namely, performance. While the impact of performance objectives are certainly the most easily understood, decisions can't be made on performance alone. Our next practice looks at qualitative factors that may have an impact on how well an investment option fits a portfolio.

Let's take a look at the actual Practice and Criteria. You can click on the image to view a larger version:

The Practice and Criteria call upon the fiduciary to first consider qualitative factors that may impact investment managers and advisors and, second, to act appropriately to the circumstances. We recommend that a qualitative review include at least the following six factors:

• Staff turnover: Has there been significant turnover and, if so, does the current staff instill the same confidence?
• Organizational structure: Has there been any changes to the organizational structure, such as through mergers and acquisitions, and what are the ramifications?
• Level of service provided: Is the level of service commensurate to the level of fees? What is the quality of online access to information?
• Quality of reports: Are reports timely, comprehensive and useful?
• Quality of responses to RFIs: Are requests for information responded to completely and in a timely manner?
• Investment education: Is there adequate explanation of the investment decisions made? Is there support for investor education?

If a look into any of these areas turns up an adverse response, the next steps are to evaluate the severity of the issue and whether or not it undermines that organization's ability to perform in the future. You would want to consider how the organization dealt with concerns as well as decide whether or not it looks like an isolated issue or a systemic problem.

Finally, a decision needs to be made as to whether or not to continue with a manager. Be sure to document actions taken or considered and the factors behind the decisions made. Precedent is important and this record can help assure that actions taken in one situation are consistent with actions taken in similar situations over time.

 For more information, consult the following resources:

•  Complete text of Practice 4.2 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation to Practice 4.2 from ERISA, UPIA, UPMIFA, MPERS, and relevant regulation and case law.
• The Prudent Practices for Investment Managers handbook. Familiarizing yourself with the fiduciary duties of investment managers will help a fiduciary better understand the qualitative and organizational issues that may impact their effectiveness.

Practice 4.1: Check investment performance

We have now reached the fourth step of the Fiduciary Quality Management System in our Spotlight on Practices series. The monitoring function of a fiduciary extends well beyond performance. All policy and procedural issues covered in the first three Steps are subject to ongoing review and analysis, which is equally as important as the process used to make those decisions the first time around.

The first Practice of Step Four is about monitoring the performance of money managers. This requires that performance be reported, evaluated, and acted upon through the application of watch list procedures and rebalancing protocol. So, monitoring is not just about what happened, but why and what to do about it.

Let's take a look at the actual Practices and Criteria. You can click on the image to view a larger version:

 
Composing performance reports requires the comparison of each money manager against appropriate criteria. This includes an appropriate "best fit" index, the performance of all managers in the peer group in which the manager competes, and any performance objectives that have been established in the investment policy statement.

Practice 3.4: Follow a due diligence process to select service providers

We covered in a previous post the need to engage service providers to manage those investment decisions that are beyond the responsible fiduciary's capabilities. The selection process is one of the most overlooked functions. Most fiduciaries simply abdicate the decisions to a vendor, adviser or money manager. Yet as with other prudent practices, there are a number of important decisions that need to be managed. Just as important as making a prudent selection of service providers is documenting how the decisions were made.

Let's take a look at the actual Practice and Criteria. You can click on the image to view a larger version:

 
The fiduciary must be able to demonstrate that process was followed in selecting service providers and written documentation is the most effective way to accomplish this. Upcoming 408(b)(2) regulation is going to have the effect of standardizing much of this process for ERISA plans when it becomes effective in April 2012 and shift a certain amount of the burden to the service providers themselves. Even with non-ERISA plans, requesting 408(b)(2)-like disclosures in a formal RFP process is a good way to manage the selection process. The key is to gather sufficient information from a number of potential providers that addresses capabilities, costs, fiduciary and non-fiduciary services to be provided, and security requirements.

Other considerations in custodian selection would be ensuring there is sufficient insurance to cover the portfolio, whether assets are commingled along with the assets of other clients, the expense ratio of the cash sweep vehicle that will be used with the separately managed accounts, and the custodians capabilities for corrected year-end statements, tax reporting and performance reporting.

For more information, consult the following resources:

• Complete text of Practice 3.4 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation to Practice 3.4 from ERISA, UPIA, UPMIFA, MPERS, and relevant regulation and case law.
• DOL's meeting your fiduciary responsibilities page
• An overview of the SEC adopted Custody Rule
• DrinkerBiddle: benchmarking as a part of a prudent process
• SEC staff responds to questions about the Custody Rule
• DOL offers tips for selecting and monitoring service providers for your employee benefit plan
• fi360 answers your questions on 408(b)(2) and fiduciary advice   

Practice 3.3: Investment vehicles are appropriate for the portfolio size

The primary focus of Practice 3.3 is the implementation of an investment strategy with appropriate investment vehicles, specifically the proper use of separately managed and commingled accounts, such as mutual or exchange-traded funds and unit trusts.

It is important for the fiduciary to be familiar with the universe of investment options (mutual funds, ETFs, and seperate account managers to illustrate the more common investment vehicles), as no one implementation structure is right for all occasions.

Let's take a look at the actual Practice and Criteria. You can click on the image to view a larger version:

 
There are four primary considerations related to this Practice, presented below along with our general commentary:

Due diligence processes are evolving

Anyone who is in an advisory role competing for assets under management or advisement knows that it is not easy to win prospective clients.  The most cynical argue that it's not what you know, but who you know that most often wins the day.  Although I would readily acknowledge that this happens, I am convinced that people are becoming more selective and more objective in choosing financial service professionals.

Practice 3.4 includes a Criteria that states: A documented due diligence process is applied to select the custodian and all other service providers.

This criteria requires a documented due diligence process, but what does this process look like?  Essentially, it has to be reasonable, which means an external party (think judge or arbitration panel) would conclude that it addressess criteria that are well aligned with industry norms, although not necessarily best practice.  A formal process where requests for proposals are requested, received and evaluated is certainly the best way to demonstrate due diligence in making a service provider selection.  However, less formal approaches are also permissible.  The key is to gather sufficient information from a number of service providers, such as their capabilities, costs, and ability to address security requirements.  That information can then be evaluated before making an initial selection, or when deciding whether or not the relationship with a service provider should continue.  At all times documentation, the evidence, is essential. Education, experience, and professional credentials are also certainly important when one contemplates engaging a service provider.  

In addition to these quantitative factors, qualitative factors such as who you know do continue to play a part in the due diligence process, but a recommendation should not be given lightly. We are often asked for such recommendations and are reluctant to provide one unless we have first-hand knowledge of the person or organization we are recommending.  Since it is impractical to personally know everyone that comes though our training, we typically recommend only those organizations (most often the request is for an advisor or record keeper) that have be awarded a CEFEX (Level III) certification.  In those cases, their process has been formally vetted and we know confidently that they are adhering to all the applicable fiduciary practices; in short, they have their fiduciary act together.  Level I (self-assessments) and Level II (consultant's or external assessments) are both less formal and although helpful, do not provide us sufficient information to make a recommendation; in most cases we don't have access to this data.  So if you want to put yourself in a better position to obtain personal recommendations, work towards an objective, external review of your process.  And if you have been asked for a recommendation, making them can be fine, but make sure you have done adequate due diligence before doing so.  "They are a good friend" really no longer cuts it.

Practice 3.2: Applicable "safe harbor" provisions are followed

Practice 3.2 requires that a fiduciary adhere to the provisions of any elected safe harbors. "Safe harbors" are defined by three basic traits. The first is that they are voluntary, though it would be almost foolish not to take advantage of available "safe harbor" provisions because of their second trait, which is that they may insulate a fiduciary from certain liability associated with the management of a portfolio's assets. Finally, they carry certain requirements on the fiduciary in order to qualify for protection, such as demonstrating prudent selection, prudent monitoring and acknowledgement of fiduciary status.

There are four established safe harbor provisions under ERISA for qualified retirement plans, which line up to the four criteria for this Practice:

 

The general, or 404(a), safe harbor protects the fiduciary from liability for actions of experts to whom they have delegated responsibility. The 404(c) safe harbor protects the fiduciary from liability for the actions of the participants.The fiduciary adviser safe harbor protects the fiduciary from liability for the advice of a Fiduciary Adviser. The QDIA safe harbor protects the plan sponsor from liability for having placed participants assets into an investment in the absence of direction from the participant.

In order to gain those protections, here are the basic requirements for each of the above safe harbors:

Practice 3.1: Implement with sound and consistent due diligence

Now having gone through all of the Practices in the Organize and Formalize Steps of the Fiduciary Quality Management System, we move on to the Implement Step. The Practices in this Step define procedures for a fiduciary to implement a client's current investment strategy. To a large degree, this equates to due diligence: What is the process for selecting your investments? Who are the service providers that will assist you? Is the process objective? And is it consistently applied?

The first Practice in the Step is to implement the investment strategy that was formalized in Step 2 with the required level of prudence. Let's take a look at the Practice and associated Criteria:

The law does not mandate the use of professional money managers, but to do otherwise would be foolish. A fiduciary is required to act prudently in implementing the investment strategy and will be held to a "prudent expert" standard. It is far more effective and efficient to manage the managers, rather than do it yourself.

Practice 2.7: Defining appropriately structured SRI strategies

Interest in incorporating ethical, environmental, moral, religious and/or corporate governance criteria into an investment strategy is on the rise. Investors and, by extension, fiduciaries want to make investment decisions that align with their own core values or the core values of who they represent. 

As long as the fiduciary exercises good judgment in keeping financial and social priorities in the proper perspective, there should be no problem in incorporating a socially responsible investment strategy. The key fiduciary concepts to keep in mind are 1) the duty of loyalty to serve the investors' best financial interests and 2) the exclusive purpose rule to orient investment decisions to the central purpose of the investment program (e.g, retirement plan sponsors must focus on meeting the retirement benefits of participants over serving the greater good of society). No matter how worthwhile or well-intended, fiduciary standards of care cannot be abrogated to accomodate the pursuit of an SRI strategy.

Let's take a look at the Practice itself and the associated criteria:

 

Generally speaking, any individual or organization may elect to apply an SRI strategy. Some specific situations where SRI is clearly permitted are when trust documents permit its use, a donor directs its use, or when a reasonable person would deduce from the mission of the organization that SRI should be adopted (e.g., one would expect that the American Cancer Society would not want to be invested in tobacco companies).

Once elected, an SRI strategy must be appropriately structured, implemented and monitored. The most widely used SRI strategy is to apply an SRI screen in selecting investments. As mentioned, the primary fiduciary concerns of SRI are the duty of loyalty and exclusive purpose rules. Fiduciaries should have evidence that any SRI screens used are unlikely to detract from performance. Having said that, it is important to note that all forms of due diligence represent "restrictions" that may impact returns. The key issue is whether that impact is likely to be adverse. SRI is just another screen that must be sufficiently researched for prudence, effectiveness and practicality and regularly monitored to ensure the intended results are being accomplished.

Practice 2.6: Maintaining the IPS

We refer to the preparation and maintenance of the investment policy statement as the most important function a fiduciary performs. It is the de facto business plan for the investment portfolio. It demonstrates to investors that an effective strategy is in place and helps ensure that the strategy is followed. In addition, in the event of an audit, litigation or dispute, it is one of the first documents an arbiter will want to see for evidence of prudence on the fiduciary's part.

Let's take a look at the Practice itself and the associated criteria:

A good IPS should have sufficient detail that a competent third party could implement the investment strategy, be flexible enough that it can be implemented in a complex and dynamic financial environment, yet not be so detailed as to require constant revisions and updates.  We suggest seven crucial components that comprise an effective IPS. We could go into great detail into each component, but for the purposes of this post, we'll just take a look at each one and why it is important:

• Executive summary--Defines the rules of the plan, such as the type of portfolio, which laws govern the plan, and the purposes and objectives of the plan.
• Roles and responsibilities of all parties involved--The roles and responsibilities of those who will execute the policy, such as the Investment Committee, Advisor, and Custodian. These roles should be defined by title, specific names can be detailed in the attachments.
• Diversification and rebalancing guidelines--The mix of asset classes that meet the risk/return profile of the portfolio or that would allow a participant to build a properly diversified portfolio. This would include any asset classes that have been omitted for specific reasons. This section encompasses the results of the five preceding Practices of Step 2 in our Spotlight on Practices series.
• Due diligence criteria for selecting investment options and service providers--Guidelines for the selection of investment managers and service providers. We will go over more details on the due diligence process when we get to Step 3 of our Spotlight on Practices series.
• Monitoring criteria for investment options and service providers--Guidelines for the review of investment options and service providers. We will go over more details of the monitoring process when we reach Step 4 in the series.
• Procedures to control and account for expenses--Guidelines for the review of fees and expenses, including comparison to appropriate benchmarks and use of request for proposals or requests for information. The additional disclosures required by the new 408(b)(2) rule for ERISA plans will facilitate this review. The key is that expenses paid are fair and reasonable for the service received. 
• Attachments--Used to identify specific information that changes on a more frequent basis, but does not affect the overall strategy, such as the names of the individuals filling the various roles, capital market assumptions, and the currently available investment options based on the guidelines of the strategy.

To learn more, consult the following resources:

• Complete text of Practice 2.6 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation to Practice 2.6 from ERISA, UPIA, UPMIFA, MPERS, and relevant regulation and case law.
• fi360's Investment Policy Statement Generator, including some free sample IPS documents for 401(k) plans, defined benefit plans, foundations/endowments, personal trusts and individual investors
• Morningstar Investing Classroom's guide to creating your IPS
• A Reish & Reicher article on the need for ERISA plans to have an IPS
• A Reish & Reicher article on common errors and omissions in IPSs
• An article written by our CEO, Blaine Aikin, for IMCA's Investments and Wealth Monitor magazine, titled The Investment Policy Statement: A Business Plan for Fiduciaries
• How to Write an Investment Policy Statement by Jack Gardner

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The Spotlight on Practices series highlights one of the Prudent Practices for Investment Fiduciaries in order each month. To learn more about the Practices, click "Spotlight on Practices" link in the categories list or visit the Practices page on fi360.com.  If you have any questions or comments, leave them in the comments section below each post, or email us at blog@fi360.com.

Practice 2.5: Only select asset classes that can be implemented and monitored effectively

The fifth Practice of the formalize step is to select asset classes that are consistent with the formalized investment policy and capable of being implemented and monitored. This means not only choosing the right asset classes for the portfolio, but tasking capable individuals, utilizing effective processes and tools, and considering the accessibiliy of the investment products to the portfolio. 

Let's take a look at the Practice itself and the associated criteria:

 
Fiduciaries must recognize the responsibilities of implementing and monitoring all investment selections. Some of the most monumental fiduciary breeches have occurred because the latest investment idea has been incorporated in a portfolio without a full understanding of the risks involved and adequate skills to evaluate the competence of the selected product providers. Lacking the understanding and skill to implement and monitor, the fiduciary must either avoid the investment altogether or engage prudent experts to perform the role. Even then, the fiduciary will have a learning curve to overcome in order to provide adequate oversight.

In addition, the individuals tasked with oversight and monitoring must be properly supported with, for example, appropriate software and data sources to perform due diligence. A more sophisticated investment generally requires more sophisticated analytical tools.

Finally, it must be considered whether an appropriate product can be found within a selected asset class. The idea of a certain asset class may sound attractive, but a lack of options might prohibit a fiduciary from finding one that is suitable.

There is no formula for determing the "best" number of asset classes to add to a portfolio, or which ones should be added. As with many of the decisions to be managed by the fiduciary, there is a hierarchy to the decision-making process. Top priorities in the process of selecting asset classes are:

1. The size of the portfolio
2. The investment expertise of the fiduciary, including the ability to assess the merits of complicated strategies and products
3. The ability of the fiduciary to properly monitor the number and variety of options considered
4. The sensitivity of the fiduciary to investment expenses

The table below is a suggested frame of reference for the order in which asset classes should be added. It starts with the big three that are the minimum required for a portfolio to be considered diversified: stocks, bonds and cash. International equities are added next primarily because of the diversification advantage they offer by virtue of relatively low correlation relative to U.S. investments and so on. The table is offered only as a general guide. Beyond the major asset classes, there is no prescription in law or regulations for the sequence, and the number a fiduciary decides to include depends on the factors addressed above.

# of options		Asset and sub-asset classes
3		Large blend, multisector fixed & cash
4	Add	International equity blend
5	Add	Small blend
6	Add	Intermediate fixed
7	Add	Mid-cap blend
8	Add	Large value, large growth
9	Add	Emerging markets
10	Add	Real estate
11	Add	High-yield fixed
12	Add	International bond

To learn more, consult the following resources:

• Complete text of Practice 2.5 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation to Practice 2.5 from ERISA, UPIA, UPMIFA, MPERS, and relevant regulation and case law.
• fi360's Asset Allocation Optimizer

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The Spotlight on Practices series highlights one of the Prudent Practices for Investment Fiduciaries in order each month. To learn more about the Practices, click "Spotlight on Practices" link in the categories list or visit the Practices page on fi360.com.  If you have any questions or comments, leave them in the comments section below each post, or email us at blog@fi360.com.