Fiduciary Corner

Blaine F. Aikin

Prepare clients now for an extended period of abnormally low portfolio returns

The expectations many investors have baked into their financial plans for the future are based upon recent or historic gains

Jul 31, 2015 @ 2:35 pm

By Blaine F. Aikin

There are times when expectations don't square well with reality. Today, the expectations many investors have baked into their financial plans for the future are based upon recent or historic returns. But the reality is that we are likely to be entering a protracted period of abnormally low portfolio returns, and relatively few investors are prepared for it.

Interest rates are low, inflation is low, equity valuations are high, debt levels are high and the monetary and fiscal tools governments use to stimulate growth are fully deployed. We are operating in a global investment environment that many money managers and market analysts are calling the most challenging they have observed in their careers.

Jack Welch famously called upon business leaders to “face reality as it is, not as it was or as you wish it to be.”

Advisers who are ready to face reality should address the ramifications of a protracted period of low returns in terms of:

1. Client characteristics and goals.

2. Investment policy.

3. Due diligence processes.

4. Monitoring protocols.

This process serves to fulfill fiduciary obligations to serve clients' best interests under prevailing circumstances, raise client awareness of factors contributing to their financial well-being and demonstrate the depth and breadth of support the adviser contributes to the relationship.

Both institutional and individual investors use the same means of creating financial preparedness for future goals: deposits, withdrawals, portfolio risk and return trade-offs, and prioritization of objectives. Though the complexity and extent of control over these factors varies widely between institutional and individual investors, they are fundamentally the same and need to be examined.

Increasing deposits often means fund raising for institutions versus finding new sources of income for individuals. Reducing withdrawals involves separating mandatory from discretionary spending and cutting costs, including investment expenses. Consideration of portfolio risk and return trade-offs should involve exploring the capacity and willingness to take on more risk in pursuit of higher returns. Finally, the prioritization of objectives is crucial to making sound decisions about how scarce resources will be allocated and to seize opportunities to lock in future funding for nondiscretionary goals (e.g. using insurance for estate planning needs, prepaid college tuition plans, etc.).

Generally, a reexamination of client characteristics and goals in the context of a changing investment climate leads to investment policy adjustments. In particular, a low-return environment may warrant broader portfolio diversification, such as through the introduction of alternative or “absolute-return” investments. Many analysts expect correlations between asset classes to decline and market volatility to increase, which would benefit more broadly diversified portfolios. Such conditions may also prompt greater flexibility in investment policy relating to tactical asset allocation or active management.

Due diligence is always important but it is never more critical than in a low-return environment. While a rising tide may lift all boats, Warren Buffett observed that “only when the tide goes out do you discover who's been swimming naked.” Earning a few basis points more through superior investment performance makes a proportionately greater impact when overall market returns are low. Similarly, costs claim a larger portion of the returns achieved; therefore, careful due diligence on all service providers is critical to make sure that the portfolio is being managed as efficiently as possible.

Finally, as the recent Supreme Court decision in the Tibble v. Edison International case reinforced, monitoring is a fundamental, ongoing fiduciary duty. Circumstances can and will change. Reasonable people can also disagree regarding the outlook for the economy and markets and the appropriate course of action to take.

The important thing is to have a sound process in place to regularly and thoroughly evaluate current and expected conditions that would materially influence the decision making of a prudent fiduciary. This “prudent man standard” requires fiduciaries to consider the facts and circumstances they know or should know are relevant to investment decision making and to act accordingly. The way to demonstrate conformity to this standard is to follow and document a process.

Habitual monitoring is the hallmark of comprehensive fiduciary oversight. It provides the opportunity to proactively anticipate, assess and address inevitable changes in client circumstances and the investment environment. It is a programmed reality check that promotes the benefits of foresight and helps avoid the potential regrets of hindsight.

Blaine F. Aikin is president and chief executive of fi360 Inc.

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