Fiduciary Corner

Blaine F. Aikin

In times of turmoil, investment policy statement is key

Showing in writing that you're following prudent processes will allay clients' fears

Sep 13, 2015 @ 12:01 am

By Blaine F. Aikin

Market volatility is back with a vengeance after a multiyear hiatus. Intraday swings of over 1,000 points in the Dow and headlines about a market meltdown have jolted investors from complacency to concern. And given that academics suggest loss aversion is a far more powerful motivator than greed, even those clients educated by their advisers about market risk will sometimes panic.

Veteran advisers who have navigated previous market drops successfully know that helping clients to stay focused on their goals and reliable methods of achieving them is the first order of business. But it takes more than hand-holding; keeping investors on track involves proactive client interaction to review the prudent processes that the adviser has in place.

When I speak of prudent processes, I am referring to the centuries-old prudent-man standard associated with the fiduciary duty of due care. Professionals must act with the skill, prudence and diligence of a reasonable person in a similar situation.

While managing expected risk and return is obviously central to all investment decision-making, due care is not about return maximization or risk minimization in absolute terms. Rather, it is about applying specialized skills to render investment advice about how to meet goals and objectives. Return and risk are input assumptions rather than outcome objectives. All too often, investors (and some advisers) lose sight of this fact and act precipitously, especially when confronted with frightening market conditions. Sound investment decisions are objectives-driven and process-focused. Investment mistakes are generally emotions-driven and transaction-focused.

The clash between an adviser's commitment to prudent processes and clients' propensity to act reflexively during periods of market upheaval poses two potential challenges for fiduciary advisers. The first and most pressing is effective client relationship management.

In this regard, an essential tool to foster productive client interaction is the investment policy statement. An IPS serves two primary purposes. First and foremost, it is the business and investment management plan for the portfolio. Defining roles and responsibilities, establishing liquidity requirements and a contingency plan for a “large loss” scenario, selecting asset classes that meet the client's risk and expected return parameters, and setting a rebalancing protocol are core parts of the prudent process that are captured in the IPS. The second purpose of the IPS — to codify good governance procedures — is really a byproduct of the first. The IPS serves as a useful reminder of the client's commitment in writing to a long-term investment plan and reminds them of the IPS' critical role. As a governing document, it also holds fiduciaries accountable for fulfillment of their responsibilities.


The client-adviser conversation in a time of turmoil can be expanded to include consideration of potential adjustments to the IPS based upon circumstances. For example, advisers and their clients may decide to update underlying assumptions about the investment philosophy or strategy for the portfolio, change the products or asset classes that will be considered for the portfolio, or adjust the amounts or schedule for planned additions to or withdrawals from the portfolio.

The second potential challenge is liability. Losses can lead to blame. When markets go down, investor complaints and arbitration cases usually go up. However, fiduciary advisers who have sound investment procedures in place and assiduously apply them are well-protected from a compliance standpoint and have the best chance of avoiding complaints in the first place.

The courts consistently have affirmed that fiduciary advisers are not expected to have crystal balls as one of their analytical tools. Last year, when the Supreme Court handed down a decision in an ERISA stock-drop case, it cited earlier precedent in this area, reminding us that “a fiduciary's fail[ure] to outsmart a presumptively efficient market … is ... not a sound basis for imposing liability.” In an often-cited 2005 case, the court emphasized that the “fiduciary duty of care requires prudence, not prescience.”

When markets head south, advisers should make sure that prudent processes for effective investment decision-making are ingrained in their business model. That is also true when markets head north, west or east.

Blaine F. Aikin is chief executive of fi360 Inc.


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