Are best practices enough?

In casual conversation about the troubled financial markets, the words “risk” and “uncertainty” often are treated as synonyms. But for the fiduciary, there must be no confusion about their very different meanings.

Risk may be defined as variability in outcomes. It can be estimated because the range and frequency of outcomes generally are understood.

Risk is intrinsic to investing and can be priced in the marketplace. Management of risk is a core responsibility of the fiduciary.

Uncertainty involves unknown outcomes and defies both effective measurement and management. The adage that financial markets hate uncertainty is true, as the still-unfolding subprime-credit crisis painfully illustrates.

Financial institutions bundled and rebundled simple loans, then created derivative products based on the loan packages, to the point where the potential outcomes for holders of the credit instruments became matters of conjecture rather than calculation.

Fiduciaries can’t passively accept uncertainty; they are obligated to seek active ways of minimizing uncertainty through rigorous, continuing due diligence.

Recommended reading on this subject is a new report, “Principles and Best Practices for Hedge Fund Investors,” prepared by the Investors’ Committee of the President’s Working Group on Financial Markets (available at amaicmte.org). The group comprises institutional investors serving as fiduciaries to public and private pension funds, foundations and endowments.

While targeted to those who invest in hedge funds, the concepts in the report apply to the selection and monitoring of virtually any investment. A fundamental premise of the report is that fiduciaries must assume the responsibility of gathering the facts about investments that they are considering, evaluate them thoroughly and act appropriately. That is all part of the job of reducing uncertainty in order to assess expected risks and returns prudently.

An important companion to the report is one by the group’s Asset Managers’ Committee.

It calls on hedge funds to implement proposed best practices voluntarily in five areas to promote investor protection and reduce systemic risk. These are disclosure, valuation, risk management, trading and business operations, and compliance, conflict and business practices.

The Asset Managers’ Committee hit upon the right areas and generally did a very good job of providing specific and comprehensive practices that would improve hedge fund governance. It also recognizes the responsibility of investment service providers, in this case hedge fund managers, to be ethical and forthcoming.

If they aren’t, investors and the fiduciaries who serve them will have an insurmountable barrier on the path to eliminating uncertainty.

Yet, in one important respect, the asset managers’ report is seriously flawed. It positions the proposed practices as a voluntary standard without placing them in the context of investment managers’ obligations as fiduciaries.

Widespread adoption of best practices is much more likely if they are viewed as an effective means of fulfilling fiduciary duties. Moreover, by definition, the extent to which managers will adhere to a purely voluntary standard is uncertain.

This undermines the reliability of outcomes and confounds assessments of risk.

In his comments during a June meeting of the Washington-based Managed Funds Association, Robert Steel, undersecretary for domestic finance of the Department of the Treasury, acknowledged the threats to the market and investors from unreliable information, as well as the importance of meaningful regulatory authority.

“As significant participants within our marketplace, you must set an example by maintaining the highest ethical standards,” he told the group.

“Attempting to ‘beat the market’ through fraud, manipulation or rumormongering is an unacceptable breach of market integrity. That’s not beating the market; that’s cheating the market,” Mr. Steel said.

“It is important that regulators have broad authority to investigate and prosecute those who seek to gain an unfair advantage,” he said. “These measures instill confidence in market participants that the market is operating in a fair and transparent fashion where rules matter.”

Ultimately, best-practices standards for asset managers, financial advisers and stewards (such as retirement plan sponsors and trustees) must converge with investors because, as fiduciaries, all are obligated to serve the investors’ best interests.

Blaine F. Aikin is president and chief executive of Fiduciary 360 LP in Sewickley, Pa.

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