Investment Advisor Evaluation

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  • This paper outline has been updated through Article IX, providing some procedural steps for a prudent investment adviser evaluation. Article X will address the implications of both: a) the expertise of a plan's own named fiduciary committee/trustee board' and b) the plan's funding policy and objectives for whether a plan that needs an overall professional investment adviser should use, or move toward giving this investment professional the investment discretion contemplated by ERISA's default fiduciary investment structure.
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  • Article III -- On asset allocation expertise --has been added to the work on progress on Investment Advisor Evaluation
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Investment Advisor Evaluation

  1. 1. The Selection, Monitoring, and Evaluation ofDiscretionary Trustees and Investment Advisors 0
  2. 2. Article I. Practice standards for overall pensioninvestment fiduciaries require not only a comprehensiveand comparative evaluation of discretionary trusteesand investment advisors; but evaluations undertaken ata high level of care, skill, prudence and diligence.Section 1.01 The evaluation criteria, the process used toconduct the evaluation, and the documentation of the evaluationprocess are, to a significant extent, governed by the evaluationsconducted by the set of other prudent fiduciaries in similarlysituated plans who are familiar with conducting suchevaluations. (a) Comment: As the practice standards for evaluating investment advisors and trustees evolve, in part because of the availability of improved and/or more efficient evaluation support services, the threshold standard that is represented by the practices of other fiduciaries will continue to be raised.Section 1.02 Fiduciary obligations are not merelybenchmarked to relative standards; rather, the substance of anyadvisor selection / evaluation must rationally correspond to thecost, benefits, and risks associated with the services to beprovided for a particular plan. (a) Comment: Regardless of relative practice pattern benchmarks, each fiduciary is obligated to step back and look objectively at the cost and benefits involved in supplementing internal evaluation efforts with available outside support.Section 1.03 It follows from Sections 1.01 and 1.02 above,that a fiduciary must not only look at what it is attempting toaccomplish and the process that other fiduciaries use inreaching similar goals; but the fiduciary must also self-evaluate;namely, assess its own expertise in this area, the efficiencies intime and resources that can be gained from outside support,and the degree to which its unique evaluation needs can beimproved by such outside evaluation support services. (a) Comment: It is virtually impossible for anyone inexperienced in comprehensive and comparative evaluations of investment 1
  3. 3. advisors to undertake, without outside assistance, an adequateevaluation at a reasonable expenditure of time and financialresources. Moreover, given the extent of the comparative data,expertise, and the economies of scale available from advisorevaluation support services, these services appear to be able toadd value and/or reduce the costs of even other outside expertswho support fiduciaries in this area. 2
  4. 4. Article II. The overall investment fiduciary for a pensionplan will usually need support from an investmentadvisor with the people, experience, tools, and anoverall practice discipline organized around supportingthe plan’s funding policy.Section 2.01 ERISA codified perhaps the most fundamentalrequirement for the proper management of any pension plan –one often neglected in the public sector, perhaps especially inthose less sophisticated police and fire plans with governancestructures that are divorced from the financial needs of theultimate plan sponsor -- that the investment approach for everypension plan must be explicitly ordered toward meeting theplan’s funding policy. (a) Comment: The use of investment consultants whose contractual scope of services is not focused on supporting a plan’s funding policy can only be appropriate in two situations; namely, 1) limited scope engagements such as advising on a particular asset class or other investment specialty; or 2) when a plan fiduciary has the internal expertise, and/or uses the additional advisors needed, to establish an investment policy designed around the funding ratio volatility targets and constraints of the plan’s funding policy. 3
  5. 5. Article III. Ever since Labor Day 1974, and at least adecade earlier for large pension plans, expertise atportfolio diversification (i.e., correlation management)and portfolio optimization (asset allocation modeling toachieve the lowest portfolio volatility at any given levelof expected geometric return) has been central tofiduciary portfolio management; and therefore, to thecore of any evaluation and selection of investmentadvisors with a role in portfolio asset allocation.Section 3.01 Today, a prudent fiduciary can neither pickmanagers / funds without an explicit asset allocationmethodology for evaluating those managers and funds in thecontext of an overall asset allocation policy evaluation, nor canit prudently use an asset allocation model for such an evaluationif the efficacy of the model is below the standards of care, skill,prudence and diligence used by similarly situated, and prudent,fiduciaries familiar with asset allocation modeling. (a) Comment: Plan participants can enforce fiduciary practice standards [Note: Even government plan fiduciaries are often explicitly subject to ERISA fiduciary standards by State law.] governing the application of portfolio construction expertise for achieving a pension plan’s funding policy objectives. A fiduciary who selects and/or continues to use of an overall portfolio investment advisor whose advice and core practice discipline is not grounded in the explicit optimization and ordering of the pension portfolio to a plan’s funding policy objectives is a clear candidate for such enforcement – and for personal liability. 4
  6. 6. Article IV. A key criteria for the evaluation ofinvestment advisors is the sophistication of the advisorwith respect to forward looking capital market research.Section 4.01 The fundamental reorientation to fiduciaryportfolio management brought about by modern portfolio theoryarose because MPT introduced the science of portfoliooptimization. For example, MPT demonstrated that the expectedreturn of a portfolio could be constructed to approach, and evenexceed, the expected return of the highest returning componentof the portfolio, but with less volatility. At a point in history morethan six decades after Harry Markowitz introduced us to thebeginnings of modern portfolio theory, no prudent fiduciary cannow make asset allocation decisions without framing thesedecisions through portfolio optimization models. However, suchdecision framing models can not prudently use only historicaldata inputs, even when the models are advanced and providesophisticated looks at third, fourth, and mixed momentdistributions. (a) Comment: Asset allocation policies need to be periodically reexamined every 12 to 24 months; but no more frequently than annually. Perhaps the clearest marker for whether an advisor adequately deals with the interplay of historical data and forward looking capital market assumptions is a weaker discipline for both: i) regular periodic policy reviews, and ii) the rigor of each such review with respect to forward looking capital market assumptions. While the less expensive advisors to smaller plans may more appropriately use, subject to scenario and stress testing, the capital market research and assumptions of others, more sophisticated advisors will necessarily have a heavier evaluation weighting assigned to their ability to provide specific advice on the forward looking capital market assumptions themselves. 5
  7. 7. Article V. A sophisticated investment advisor will haveexpertise in combining investment strategies, and notmerely asset classes, in order to achieve a plan’sfunding policy objectives.Section 5.01 In the extreme, an advisor can put together aportfolio intended to hedge away nearly all market relatedperformance. In such a portfolio, active management willcompletely dominate asset allocation as the driver of investmentperformance. Similarly, advisors that have their investmentpolicy advice on the false premise that some natural or financiallaw requires that asset allocation must dominate portfolioperformance can not be judged to be skilled or knowledgeableadvisors. Rather, highly rated advisors will demonstrate apractice discipline that is able to combine various combinationsof actively managed investment strategies in order to increaseexpected portfolio returns without increasing overall portfoliovolatility.Comment: The hiring of an investment advisor in order tosecure, for any one or more long only asset classes, activemanagers who will outperform the average managers in thoseasset classes is, even for those skilled, experienced, andknowledgeable advisors who conduct a diligent evaluationprocess, on average, a zero-sum game. Therefore, investmentadvisors whose value proposition is primarily based on longonly manager / fund selection will at best, rank highly only as tothe most dubious of all advisor evaluation criteria. A skilled andknowledgeable investment advisor supported by a competentmanager due diligence and research team is, however, likely toreduce the chances for selecting active managers with grosslyinferior controls as well as those managers taking grosslyunwarranted investment risks to achieve returns. 6

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