The Challenge of Investing

401K Plan Advisors’ investment philosophy discusses the challenge of investing and its solution.

The basic responsibility given to plan sponsors is included in the Uniform Prudent Investors Act (UPIA). UPIA is a legal document that was published by the American Law Institute in 1992. UPIA is based on a concept called Modern Portfolio Theory.

Modern Portfolio Theory actually won a Nobel Prize in 1990 for Harry Markowitz PhD. Modern Portfolio Theory is a scientific way to build a portfolio that can identify and measure the amount of volatility (risk) for any given level of expected return.

Modern Portfolio Theory is the idea that you should diversify, measure risk, and know all costs. Not only are these the plan sponsors primary responsibilities as a fiduciary, but the great news is that there is an academic and scientific method, if applied appropriately, that can give you very good solutions and prudent reasons for making an investment decision. Ultimately it helps you reduce your liability.

There are some caveats that you need to be aware of in regards to responsibilities that fall on the shoulders of plan sponsors. First, plan sponsors must have a prudent process for selecting funds and investments inside of the portfolios for the participants. It is not enough to say, “Well, my broker showed me a list of fifteen mutual funds, and we all agreed they had great performance, and so that’s why I picked them.” That is not a process.

A process must clearly state how these individual funds were chosen, what asset categories were picked, and how they worked together to diversify or reduce risk in a portfolio. This process has to be written down and it has to be monitored to make sure that the underlying investments are actually doing what they’re supposed to do. If they are found not to be fulfilling their roles they must be replaced. This is a very difficult task for anyone who is not an investment expert.

Cost Must Be Carefully Considered.

Every investment in the portfolio must be carefully monitored for trading cost, internal commissions, turnover, and bid/ask spread cost. It falls on the shoulders of the plan sponsor to prove that these fees are justified and prudent to pay inside of the portfolio. All these costs are not available in the prospectus, an independent analysis must be performed to determine what these actual costs are. The total costs can be daunting.

It actually states in UPIA that any time you deviate from mutual funds or asset class portfolios that are derived to get market returns (with very low turnover) the burden of proof falls on the person who does not use Modern Portfolio Theory.

Hyperactive Management

Hyperactive management is a process where three things happen (sometimes all three at the same time).

The first is Stock Picking. Stock Picking is when you hire a manager, mutual fund company, or a large financial institution, and what they do inside of the mutual fund is try to buy and sell individual stocks in an attempt to provide superior returns and beat the market.

The second is Market timing. Market Timing is when you hire a fund manager or money manager and get in and out of stocks when they think the market is going to change directions. In effect, what they are doing is trying to predict the markets ups and downs.

The third is Track Record Investing. Track Record Investing is looking at a fund manager or money managers past performance over the past ten, fifteen or even twenty years, and using that as a tool with the hope of superior performance in the future.

These three types of hyperactive management are extremely suspect and they leave the plan sponsor open for many potential litigious problems, because all the studies show that those forms of investing are much more in the line of speculation, and not true prudent investing.
There is zero correlation between a money manager’s ability to pick stocks, time the market or to repeat their lucky past performance, with their ability to do so in the future.

Even though these hyperactive funds and managers have sophisticated product names, there is no way they can tell you what the future performance of their investments will be. Many plan sponsors and participants have felt the sting and pain of this type of management when they’ve trusted many of the large mutual fund companies and large financial institutions who led them to believe that these forms of investing were prudent, and could actually help them maximize their wealth on a consistent and predictable basis.

Research has proven time and again that managers (no matter how great their track record was in the past) consistently and predictably underperform the market going forward into the future. Why? It is often the result of high internal costs.

Apart from the fact that fiduciaries (who are responsible for managing other people’s money) should not engage in speculative investing, one of the many issues with speculative investing is that it requires fiduciaries to constantly be right.

Yet fiduciaries cannot always be right when it comes to portfolio performance. They must, however, be prudent when it comes to their fiduciary conduct. Fiduciaries as well as attorneys, accountants and other professional advisors who are concerned with issues of legal liability and fiduciary obligations should understand this crucial difference.