The Art of Fiduciary Investing: Controlling the Controllable

“[I]nvesting intelligently is about controlling the controllable.”
Ben Graham, “The Intelligent Investor”

The world of fiduciary investing is going through a significant stage, as more attention is being focused on various issues such as advisory fees, annual fees charged by investments, disclosure of material information, and effective risk management. While many consider the rules of fiduciary investing complex and confusing, fiduciary investing can be relatively simple if one follows Ben Graham’s advice.

I am often asked to name the best books on investing. In my opinion, Graham’s “The Intelligent Investor,” and Charles Ellis’, “Winning the Loser’s Game,” should be required reading for all fiduciaries. Ellis’ discussions on risk management as the proper focus of wealth management and the use of incremental costs and returns as the proper basis for evaluating investments are invaluable in assessing compliance with the fiduciary duty of prudence.

Graham’s concept of controlling the controllable is equally sound. No fiduciary can control the performance of the markets. The law does not impose liability on fiduciaries based solely on an investment’s performance. The law does impose liability on fiduciaries for failing to meet their fiduciary duties of prudence and loyalty, particularly with regard to unnecessary/excessive costs and the failure to provide proper portfolio risk management through effective diversification, two of the controllable elements referenced by Graham

Graham actually references four controllable elements: costs (specifically funds with excessive annual fees); risk management (through effective diversification); taxes (through focusing on capital gain treatment), and the investor’s own behavior. With regard to costs, fiduciaries often mistakenly focus on fees on a relative basis. Even the judicial system makes this mistake.

Fiduciary law, ERISA included, requires a fiduciary to always act in the best interest of the client. Consequently, investment costs should be evaluated in terms of the incremental costs and incremental benefits to the client, the idea advanced by Ellis. I have written about my own metric, the Active Management Value Ratio™, which is a simple calculation requiring only subtraction and division. Another useful metric for evaluating investment costs is Ross Miller’s Active Expense Ratio, which is available online.

While excessive costs have been the focus of recent ERISA actions, I believe that the next wave of ERISA litigation will focus on the failure of plan sponsors to provide the “broad range” of investment options required under ERISA Section 404(c) in order to allow plan participants to effectively diversify their pension accounts so as to minimize the risk of significant investment losses. Based on my experience, the investment options offered by most defined contribution plans consist of mainly of unnecessarily expensive and highly correlated equity-based mutual funds.

Many defined contribution plans are electing 404(c) status, as it potentially allows them to shift investment risk to the plan participants. However, it is has been suggested by at least one prominent ERISA attorney that very few plan sponsors are actually in compliance with all of Section 404(c)’s requirements. Consequently, many plan sponsors and plan fiduciaries face unlimited personal liability for the performance of the plan participants’ investment accounts.

Graham’s inclusion of the need to control one’s behavior has special relevance to fiduciary investing. The issue of conflicts of interest is a key issue in today’s investment industry. Fiduciaries who fail to “control the controllable” can expect to see litigation alleging breach of their fiduciary duties due to conflicts of interest, particularly financial conflicts of interest. Fiduciaries in the ERISA arena should note the post-LaRue trend of courts to recognize and protect the rights and interests of plan participants, as evidenced by the decisions in the recent Braden-Tibble-Tussey trilogy.

Leonardo da Vinci once said that “simplicity is the ultimate sophistication.” Steve Jobs, Apple’s legendary leader also adopted this belief. Whether conducting a fiduciary audit or trying a breach of fiduciary action, I simplify the process by focusing on whether the fiduciary has controlled the controllable – costs, risk and their own behavior. Investment fiduciaries who adopt a similar focus and properly control these elements-while at the same time putting the client’s best interests first-greatly reduce the chance of being successfully being sued for a breach of fiduciary duty. claim.


About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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