Other Voices

To be a fiduciary, invest like one

The industry fails investors by clutching to a long-gone past, rather than moving forward by offering proven, updated investment approaches offered to large institutions

Sep 11, 2016 @ 12:01 am

By Lee Kranefuss

Investor education has frequently been the headline story regarding the new Department of Labor fiduciary rule, and pundits on both sides of the issue have argued passionately over fees. But investment selection and process have been shockingly absent from much of the discussion. With the rule a reality, discussion should shift to how to invest like a fiduciary. After all, if one is to be scrutinized as a fiduciary — normally the practice of large pension plans judging their managers — it seems prudent to educate yourself and your clients about the methods that have proved effective for the largest investors.

It is law dating back centuries. Fiduciaries must put clients' interests before their own and must use the best available insights in making decisions. That's not to say advisers are likely to be subjected to lawsuits over a year of bad performance because of investment selection. However, it is reasonable to suggest savvy investors already hold their advisers to a rigorous fiduciary standard — or at least reward advisers who behave in this manner. And it starts with fees. A fiduciary cannot use a higher-cost product that does not have proven, long-term results to justify the choice.

(More: A comprehensive, searchable database of advisers' fiduciary FAQs)


The fiduciary duty has driven profound shifts. Over the last five years, passive U.S. equity funds had inflows of $471 billion, while active U.S. equity funds had outflows of $573 billion, according to Morningstar Inc. Much can be attributed to costs. (The average annual expense ratio of U.S. equity passive funds is 12 basis points, versus 79 bps for active funds.)

But that is the tip of the iceberg. The fundamental fiduciary obligation is about portfolio construction. The rhetoric from all sides calls for more education. If that leads to an expansion of advisers' and investors' understanding of well-established institutional investing techniques, it may well be the greatest achievement of the rule. This is true, especially in light of today's markets, where past approaches are inapplicable and the results may be the source of fiduciary breach claims in the future.


Consider that we are now in the 10th year of what may one day be called “The Great Financial Crisis of the 21st Century.” It's shocking how little is discussed about the real crisis hindering investors' ability to build retirement savings. Traditional stock picking and buy-and-hold investing, as well as other time-honored investing maxims, are no longer suited to today's markets. Global markets have sluggishly plodded along without an upward trend for over 18 months, and volatility can spike at any time, as seen following the Brexit vote.

Meanwhile, investors have real current and future income needs and — according to a recent Natixis survey — are expecting (unrealistically) 9.5% annual returns above inflation.

But the industry continues to do business as usual, rolling out pundits on TV to tout their favorite stock picks and launching new products based on the latest hot funds.

In a further lack of recognition of the new market reality, the industry continues to propose building portfolios with 60% stocks (a mix of domestic stocks with a smattering of overseas and emerging-market stocks for spice) and 40% bonds (presumed to be stable and income-generating). Investors are told this approach provides long-term appreciation and income, and mutes market downturns. Most 401(k) target-date funds implement something like this.

Buried inside this model is a subtle belief — which is no longer true — that the bond and stock markets are somewhat independent. But correlations have increased over time between U.S. stocks and bonds, and dividend yields on the S&P 500, which are over 2%, are comparable to the yield on a 20+ year U.S. Treasury bond. With pretax dividend yields about equal to long-term bond rates, a portfolio as described gains little to no additional income from its bond allocation.


Seldom discussed is what will happen when — not if — yields rise. If 30-year rates rise from 2% to 3%, investors will be shocked to find their “safe” bonds lose 15% of their value. Suppose this event also causes stocks to fall 10%? A 60/40 portfolio, which was supposed to mute a downturn, would suffer a 12% capital loss on a 10% stock market correction.

Stocks provide little solace. The significant rise in developed-market equity values since 2009 in recent years has come more from multiples expansion than earnings growth. Appreciation in developed markets has slowed and volatility is up, which translates to more risk, less reward.

A static, buy-and-hold portfolio approach is of little use today. The industry fails investors by clutching to a long-gone past, rather than moving forward by offering proven, updated approaches that have long been offered to large institutions. These more-effective techniques pioneered by academics and large institutional investors have yet to be shared broadly, but are the new gold standard for portfolio construction.

What are the keys to this approach?

Real diversification: Investors can't get positive returns from a part of the market they are not in. We all know something will go up, but no one knows what. Having many chips on the table — both across and within asset classes (including alternatives) — will yield a better investment outcome than trying to identify the winners in advance.

Dynamic risk management: If volatility goes up where one of the investment chips lies, one must trim that position. Reducing drawdown is as valuable as prognosticating about upside. If you take risk management a step further, like an institution, then you will also examine the co-movement of positions under various scenarios. Which positions might move together or apart if rates rise or inflation strikes? Understanding this allows you to adjust to build not just a good portfolio but a robust one.

These ideas are not new; large institutions have been using them for years. It's time the industry applies them to all investors.

Lee Kranefuss is co-chairman of 55 Capital, an investment firm that specializes in managing portfolios with ETFs. He is also executive chairman of Source, a U.K.-based ETF sponsor, and the creator of iShares.


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