Given the volatility of today’s stock market, the subject of fiduciary investing is a timely topic.  A fiduciary relationship creates the highest duty imposed by law, requiring that a fiduciary always put a client’s interests first and act solely on the client’s behalf.[1]

The financial services industry often relies on Modern Portfolio Theory (“MPT”) and the Prudent Investor Rule (“Rule”)[2] in providing investment advice.  When advisers are questioned about the quality of their investment advice, they often invoke the “total portfolio” position adopted by MPT and the Rule as justification for their advice.  Many financial advisers use MPT-based asset allocation software programs to develop their asset allocation recommendations.

While most financial advisers are aware of the “total portfolio” approach of MPT and the Rule, they are often unfamiliar with other key tenets of MPT and the Rule.  Consequently, many financial advisers are unaware that their practices may be totally inconsistent with MPT and the Rule, leaving them exposed to liability for financial losses sustained by their clients.

MPT
MPT was introduced in 1952 by Dr. Harry Markowitz, who was awarded a Nobel Prize for his work with MPT.[3]  Prior to MPT, portfolios were constructed based upon the risk and return of investments.  With MPT, Markowitz suggested that covariance, or the correlation of returns between investments, should be considered in the construction of investment portfolios.

While MPT has been legitimately criticized for various reasons[4], consideration of the correlation of investment returns still remains a valuable factor in investment management.  By combining investments that have a low, or even negative, correlation of returns, a financial adviser can effectively provide downside protection for an investment portfolio.

The Prudent Investor Rule
The Rule is a part of the Restatement (Third) of Trusts.  The Rule establishes standards for the prudent investment of trust assets.  While the Rule itself is not law, forty-four states and the District of Columbia have adopted the Uniform Prudent Investor Act, the codification of the Rule.[5]  Even though the Rule speaks in terms of a trustee’s fiduciary duties, the Rule has basically been applied as the standard of conduct for all financial fiduciaries.

§ 90 [1992 § 227]. General Standard of Prudent Investment

The trustee has a duty to the beneficiaries to invest and manage the funds of the trust as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances of the trust.

(a) This standard requires the exercise of reasonable care, skill and caution, and is to be applied to investments not in isolation but in the context of the trust portfolio and as a part of an overall investment strategy, which should incorporate risk and return objectives reasonably suited to the trust.

(b) In making and implementing investment decisions, the trustee has a duty to diversify the investments of the trust unless under the circumstances,  it is prudent not to do so.

 (c) In addition, the trustee must:

 (1)  conform to fundamental fiduciary duties of loyalty and impartiality;

(2)  act with prudence in deciding whether and how to delegate authority and in the selection and supervision of agents; and

(3)  incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship.[6]

Three points emphasized by the Rule are the importance of acting prudently, the  importance of diversification, and the need to consider the contribution of each investment to the portfolio as a whole.  A fiduciary’s duties apply not only to the initial investment process, but also to the fiduciary’s ongoing duty to monitor the portfolio and make portfolio adjustments if and as appropriate.[7]  The duty to monitor also applies to situations where a fiduciary outsources actual management of a portfolio to a third party.[8] 

The Rule stresses that it is not intended to endorse or exclude any specific financial theory.[9]  Nevertheless, there are obvious similarities between the Rule and MPT, most notably the emphasis on diversification and the importance of the correlation of investment returns as a factor in portfolio management.

MPT and Fiduciary Status
The mere reliance on MPT in the diversification process raises potential liability issues for financial advisers.  Very few financial advisers know much more about MPT beyond how to use software programs.  Consequently, advisers generally cannot and do not attempt to explain to clients the methodology they used in preparing their asset allocation recommendations or the potential risks involved.

It is well established that investment advisers,[10] financial planners,[11] and stockbrokers handling discretionary accounts[12] are fiduciaries.  Some states impose fiduciary status on all stockbrokers, regardless of whether the customer’s account is discretionary or non-discretionary.  Other states base the determination of a stockbroker’s fiduciary status on non-discretionary accounts by considering the facts of each case.

A common theory for fiduciary liability on non-discretionary brokerage accounts is to assert that the stockbroker had de facto control of the account.  There is precedence holding that a broker has control over a non-discretionary account when a customer lacks the experience or knowledge to evaluate the broker’s recommendations and independently assess the suitability of same.[13]  Since very few investors are familiar with or understand the concept of MPT, it should be argued that a stockbroker who used MPT in connection with a non-discretionary account had control over the account.[14]

MPT and Risk Tolerance
Evaluating a client’s risk tolerance level is a critical step in the diversification process.  Errors in risk tolerance evaluation and unsuitability issues are common allegations in arbitration cases.

Financial advisers often base their risk tolerance analysis on questionnaires.  While these questionnaires may provide some useful information, reliance on such questionnaires can be dangerous due to the questionable quality of the questions on such questionnaires and the ease of manipulating and misinterpreting such questionnaires.[15]  Furthermore, such questionnaires typically only address a client’s willingness to assume investment risk.  Both MPT and current legal standards agree that a proper risk tolerance analysis requires an analysis of both a client’s willingness and ability to bear investment risk.[16]

MPT presents another risk tolerance issue.  MPT views a client’s risk tolerance level as a relative measurement, based on the assumption that investors are willing to assume greater risk as long as the potential reward compensates them for such additional risk.  Not only does this seem to be inconsistent with the “willingness and ability” tests, it is also contrary to current legal standards that view a client’s risk tolerance level as an absolute measurement.  For the courts to hold otherwise would deny an investor any meaningful way to ensure that their true risk tolerance desires and financial condition are respected.

The Duty to Diversify
For financial fiduciaries, diversification requires more than the common concept of diversification in terms of number of investments alone.  As Markowitz pointed out, effective diversification requires the “right kind” of diversification for the “right reason,” that “it is not enough to invest in many securities.  It is necessary to avoid investing in securities with high covariances among themselves.”[17]

The Rule agrees with this position, stating that

” [R]easonably sound diversification is fundamental to the management of risk,…”[18]

 ” Thus effective diversification depends not only on the number of assets in [an investment} portfolio but also on the ways and degrees in which their responses to economic events tend to cancel or neutralize one another….”[19]

” Failure to diversify on a reasonable basis in order to reduce uncompensated risk is ordinarily a violation of both the duty of caution and the duties of care and skill.” [20]

Both MPT and the Rule stress the importance of the correlation of returns of investments in the diversification process.  Factoring in the correlation of returns, however, presents challenges for financial advisers, as well as potential liability exposure.

Computerized Asset Allocation Liability
The use of asset allocation software programs (“software programs’) is pervasive in the financial services industry.  Most of these software programs are based on MPT or the Capital Asset Pricing Model (“CAPM”), a variation of MPT.  CAPM was developed by Dr. William F. Sharpe, who was awarded a Nobel Prize for his work with CAPM.[21]

Most commercial software programs only allow MPT-based calculations based on generic asset categories.  If a customer decides to implement the financial adviser’s asset allocation recommendations, most commercial software programs do not allow the adviser to go back and rerun the asset allocation calculations based on the client’s actual investments.  Consequently, neither the adviser nor the client knows whether the actual portfolio’s risk/return projections are consistent with the original asset allocation projections that convinced them to purchase the investment products.

As part of our forensic financial planning process, we go back and perform an asset allocation analysis based on the actual investment products sold to an investor.  Not surprisingly, we often find significant differences between the risk/return projections of the original asset allocation recommendations and the investment portfolio actually implemented.  This may further explain why financial advisers do not go back and perform a post-implementation portfolio analysis.

The fact remains that given MPT’s emphasis on the importance of diversification and the correlation of returns, the failure to perform a post-implementation analysis based on the investor’s actual investments leaves a financial adviser exposed to potential liability, especially when they relied on MPT in other phases of the advisory process. Depending on the level of inconsistency between the original projections and the post-implementation projections, it can be argued that the financial adviser’s acts are equivalent to fraud, a sophisticated form of bait-and-switch.[22]

Another issue with computerized asset allocation is the “black box” mentality of some financial advisers, with the financial adviser blindly accepting the recommendations of a software program.  While MPT proposes the concept of an “optimized” portfolio, Markowitz also warned that the “optimized” portfolio is not always suitable for a client in light of their financial needs and/or financial situation. [23]

Financial advisers and compliance personnel often try to defend computerized asset allocation recommendations by pointing to NASD Notice to Members 04-86, which approved the use of investment analysis tools by member firms.  While the Notice did allow use of such tools, the Notice is actually directed more to the disclosure requirements that are required when using such tools rather than the viability or value of such tools.  The Notice clearly states that any member using investment analysis tools remains responsible for ensuring compliance with all applicable securities law and regulatory rules, especially the suitability[24] and fair dealing/good faith rules[25].

As mentioned previously, MPT has been the target of legitimate criticism.  Most of the criticism of MPT has centered on issues such as the validity of the input data, the inherent bias of the calculation process toward certain types of investments, the tendency for counterintuitive recommendations and the overall inherent instability of the MPT process.  These issues have lead one asset allocation expert to refer to MPT-based software programs as “error-estimation maximizers.”[26]  The financial services industry is well aware of these issues.  They simply hope that the plaintiffs’ securities bar does not recognize and capitalize on them.

Static Asset Allocation Liability
Correlation of returns, like returns and risk measurements, are constantly changing.  Furthermore, recent studies have shown that in many cases the correlation of returns between asset classes has increased as volatility in the stock markets has increased, effectively negating the benefit of low or negative correlations.[27]

The relative instability of the correlation of returns suggests that asset allocation recommendations should be dynamic to protect investors by adjusting to changes in the economy and/or the stock market.  Markowitz never stated that asset allocations should be static.  Sharpe has stated that the asset allocation process must be dynamic to respond to changes in the market and the economy.[28]

The value of dynamic asset allocation is further supported by studies showing that avoiding the “worst” days of the market has a much greater impact on overall portfolio return than missing the “best” days of the market.  According to one recent study, missing the “best” 10, 20 and 100 days on the market, defined as the Dow Jones Industrial Average (“DJIA”), during the period 1990-2006 would have reduced an investor’s terminal wealth by 38%, 56.8% and 93.8% respectively.  Conversely, avoiding the worst 10, 20 and 100 days on the DJIA over the same period would have improved an investor’s terminal wealth by 70.1%, 140.6% and 1,619.1% respectively.  The study found similar results for the period 1900-2006.[29]

The concept of static asset allocation also contradicts the Rule’s standards for prudent fiduciary investing, which state that

“Asset allocation decisions are a fundamental aspect of an investment strategy….These decisions are subject to adjustment from time to time as changes occur in the portfolio, in economic conditions or expectations, or in the needs or investment objectives of the trust.  This is consistent with the trustee’s duty to monitor investments and to make portfolio adjustments if and as appropriate.”[30]

Nevertheless, the financial services industry has denounced dynamic asset allocation as “market timing” and has promoted the “buy-and-hold” approach to investing.  This “buy-and-hold” mentality is apparently based on an erroneous interpretation of the famous BHB study.[31]

The BHB study studied 91 pension plans and analyzed the impact of the plans’ allocation among three asset classes – stocks, bond and cash.   The BHB study concluded that, on average, asset allocation accounted for approximately 93.6% of the variability of the plans’ returns.[32]  Considering that historically stocks have been more volatile than bonds and bonds more volatile than cash, these findings are not surprising.

The BHB study focused on the variability of returns, not the returns themselves.  The financial services industry has repeatedly misrepresented the findings of the BHB study to insinuate that the BHB study proves that asset allocation accounts for 93.6% of an investor’s returns.  Financial advisers then use these misrepresentations to promote a “buy-and-hold approach,” since active asset allocation would theoretically add only a minor benefit.  Ironically, these same advisers often then turn around and recommend actively managed investments.

The findings of the BHB study have been the subject of numerous studies, with various results significantly reducing the purported impact of asset allocation.  A recent study suggests that market movement actually has the greatest impact on the variability of portfolio returns, with asset allocation and active management playing an equal, but much lesser, role.[33]

Conclusion
Current practices in the financial services industry, particularly in the financial planning and investment advisory industries, are prime areas for litigation by the plaintiffs’ securities bar.  The situation is so bad that Nobel Laureate Dr, William Sharpe has described the situation as “financial planning in fantasyland.”[34]

This paper has discussed various issues with current diversification practices within the financial services industry.  In many cases financial advisers are improperly using MPT and/or the Rule in the creation of asset allocation recommendations, resulting in questionable financial advice and unnecessary financial losses for investors.  While financial advisers and their counsel often attempt to use portions of MPT and the Rule in defending securities cases, the plaintiffs’ securities bar can actually use the core tenets of MPT and the Rule to prove clients’ claims.

Note: This a copy of a law review article that was originally published in the PIABA Bar Journal in 2010.  The article is copyrighted material of the Journal, with all rights reserved. This article is published with the permission of the both PIABA and the Journal.

Notes

1. In re Sallee, 286 F.3d 878, 891 (6th Cir. 2002)
2.  Restatement Third, Trusts § 90 (The Prudent Investor Rule). Restatement Third, Trusts, copyright 2007 by The American Law Institute. All excerpts from the Restatement herein are reprinted with permission. All rights reserved.
3. Harry M. Markowitz, “Portfolio Selection,” Journal of Finance, Vol. 7, No. 1 (1952); Harry M. Markowitz, Portfolio Selection, 2nd Ed. (Cambridge, MA: Basil Blackwood & Sons, Inc., 1991).
4. Richard O. Michaud, Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation (Boston, MA: Harvard Business School Press, 1998) 36.
5.  Available online at http://www.nccusl.org/update/uniformact_factsheet/uniformacts-fs-upria.asp.
6. Restatement, § 90.
7. Restatement, §§ 80 comment d(2), 90 comment e(1).
8. Ibid.; Liss v. Smith, 991 F. Supp. 278, 312 (S.D.N.Y. 1998)
9.  Restatement, § 90 comment e(1).
10.  S.E.C. v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194, 84 S.Ct. 275, 11 L.Ed.2d. 237 (1963).
11.  Investment Advisers Act Rel. No. IA-1092 (October 8, 1987).
12. McAdam v. Dean Witter Reynolds, Inc., 896 F.2d 750, 766-67 (3d Cir. 1990); Leib v. Merrill Lynch, Pierce, Fenner & Smith, 461 F. Supp. 951 (E.D. Mich. 1978).
13.  Follansbee v. Davis, 681 F.2d 673, 677 (1982).
14. Roger W. Reinsch, J. Bradley Reich and Nauzer Balsara, “Trust Your Broker?: Suitability, Modern Portfolio Theory, and Expert Witnesses,” St. Thomas Law Review, Vol. 17, No. 2 (2004): 173-199, 187.
15. Michael E. Kitces, “Rethinking Risk Tolerance,” Financial Planning, March 2006, 54-59.
16.  Markowitz, Portfolio Selection, 6; In re James B. Chase, NASD Disciplinary Proceeding No. C8A990081 (September 25, 2000).
17. Markowitz, Portfolio Selection, 89.
18. Restatement, § 90 comment e(1).
19. Restatement, § 90 comment g.
20.  Restatement, § 90 comment e(1).
21. William F. Sharpe, Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice, (Princeton, NJ: Princeton University Press, 2006) 206-209.
22. Johnston v. CIGNA Corp., 916 F.2d 643 (Colo. App. 1996).
23. Markowitz, Portfolio Selection, 6.
24. NASD Conduct Rule 2310, Recommendations to Customers (Suitability); IM-2310-2, Fair Dealing with Customers
25. NASD Conduct Rule 2110, Standards of Commercial Honor and Principles of Trade; NASD Conduct Rule 2120, Use of Manipulative, Deceptive or other Fraudulent Devices.
26. Michaud, 36
27. William J. Coaker, II, “The Volatility of Correlation,” Journal of Financial Planning, Vol. 19, No. 2 (2006): 57-69; Rachel Campbell, Kees Koedijk and Paul Kofman, “Increased Correlation in Bear Markets,” Financial Analysts Journal, Vol. 58, No. 1 (2002): 87-93; Eric Jacquier and Alan J. Marcus, “Asset Allocation Models and Market Volatility,” Financial Analysts Journal, Vol. 57, No. 2 (2001): 16-30.
28. William F. Sharpe, “Adaptive Asset Allocation, “Financial Analysts Journal, Vol. 66, No. 3 (2010): 45-59; Sharpe, Investors and Markets, 206-209.
29. Javier Estrada, “Black Swans, Market Timing and the Dow,” available online at papers.ssrn.com/sol3/papers. cfm?abstract_id=1086300, 3-7.
30. Restatement, § 80 comment d(2).
31. Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, Vol. 42, No. 4 (1986): 39-48.
32. Brinson, 39.
33. James X. Xiong, Roger G. Ibbotson, Thomas M. Idzorek, Peng Chen, “The Equal Importance of Asset Allocation and Active Management,” Financial Analysts Journal, Vol. 66, No.2 (2010): 22-28.
34. W. Sharpe, “Financial Planning in Fantasyland,” available on the Internet at http://www.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm.

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