The Uniform Prudent Investor Act (UPIA) codified the key process requirements of trustees for the management of trust assets. Unlike the previous prudent man requirements, UPIA looks to modern portfolio theory (MPT) to provide a theoretical framework for making investment decisions. However, MPT is an abstract mathematical model that doesn’t incorporate the practical and operational issues faced by fiduciaries. Understanding this framework is the core concept from which future implementation of the provisions of UPIA will evolve.
MPT: The UPIA Challenge
MPT is a mathematical model of risk, return and diversification. Its key insight is that a collection of risky assets can have an overall level of risk lower than that of each individual asset. This insight contradicted the old common law tradition of the prudent man, which required that investments be judged individually as to their risk and ability to generate income. MPT illustrated that the inclusion of assets previously deemed “imprudent” didn’t actually increase the risk of a portfolio, but could, in fact, reduce the risk of a portfolio as a whole. The drafting committee of the UPIA codified these concepts in their work.
MPT assumes that reasonable, unbiased estimates of future returns and risk are available for investors, along with the correlation of returns among individual assets. The theory also assumes risk can be adequately measured by the standard deviation of the returns. The mix of investments that provides the highest return for a given level of risk constitutes the efficient frontier, as investors will prefer the less volatile portfolio for a given level of expected return. In practice, this analysis is typically performed using aggregate asset classes (for example, stocks, bonds, real estate and cash), rather than each individual security in a portfolio. Importantly, MPT doesn’t state what constitutes an asset class nor provide a comprehensive list of them.
When the UPIA was drafted in the early 1990s, the universe of asset classes was limited and generally agreed on to include traditional categories, such as U.S. large cap stocks, foreign stocks, bonds and real estate. The UPIA didn’t consider the potential for the investment industry to manufacture new asset classes, taking advantage of the language of MPT. Today, fiduciaries face an often bewildering array of nontraditional investment options, most of which claim to be unique enough to deserve the status of “separate asset class.” Must fiduciaries accept and make an allocation to every category that a substantial portion of the investment industry deems an asset class? If not, what’s a reasonable decision framework for discerning among these options?
To illustrate what a fiduciary might have reviewed in the 2000s, an efficient frontier was created for three asset class categories: 90-day Treasury bills, intermediate-term bonds and domestic large capitalization common stocks for the period from 1990 to 2007.
The period in “Historical Performance Review,” p. 50, included the rise and fall of tech stocks, but ends just before the 2008-2009 financial crisis. “Historical Performance Review” also includes the asset category of hedge funds, using the HFRI Fund of Funds Composite Index. The HFRI index isn’t included in the efficient frontier, but sits above the index, illustrating a superior risk/return profile than any possible combination of cash, bonds and stocks. Indexes of hedge funds of funds (HFOFs) provide a good insight into aggregate performance of hedge funds, as they reflect actual manager selection decisions by fiduciaries and mitigate survivorship bias and other problems with hedge fund data. In accordance with MPT, some of the underlying strategies included in hedge fund portfolios may, individually, possess a higher volatility and return factor than the long-only broad equity index as represented by the S&P 500 group of stocks.
The investment industry, seeking a way to market seemingly risky hedge funds to fiduciaries, seized on the fact that historical returns on diversified hedge fund portfolios had exhibited similar volatility characteristics to intermediate-term fixed income portfolios, but had achieved higher returns. Accordingly, consultants and promoters of these funds began referring to HFOFs as “fixed income substitutes.” Trustees, concerned about their responsibility to maximize portfolio results as stipulated under UPIA, engaged fund sponsors based on the historical or projected elements of risk and return in comparison with the more traditional asset classes. “Adding Hedge Funds to the Mix,” p. 51, compares an efficient frontier using the HFRI Fund of Funds Composite Index to the efficient frontier in “Historical Performance Review” from 1990 to 2007.
As the HFRI Fund of Funds Index demonstrated a superior risk/return profile to bonds during this period, it dominates the efficient frontier comparison. Assuming there were no other operational issues and this historical data is representative of future results (both very big assumptions), no rational investor would invest in bonds knowing this information. A cautious fiduciary might take the approach of the 60 percent stocks/20 percent hedge funds/20 percent bond portfolio in “Adding Hedge Funds to the Mix,” still reaping some of the hypothetical benefits of the “asset class.”
Hedge funds, of course, didn’t perform like bonds during the 2008-2009 financial crisis. The combination of illiquidity, leverage and net long exposure to stocks led the HFRI Fund of Funds Composite Index to return –21.4 percent in 2008, compared to 5.24 percent for the Barclays Aggregate Index. Perhaps more frustrating is the fact that returns continued to lag after the market bottomed in 2009, as illustrated in “Hedge Funds Were a Poor Bond Substitute,” p. 52.
While any asset class (assuming hedge funds can be considered one) may have a disappointing 5-year performance, a stark disconnect exists between the performance of hedge funds over this period and the expectations set by the investment industry. Record flows into hedge funds prior to the financial crisis compressed returns and drove managers to employ more leverage and add illiquid assets. While there’s nothing wrong with including hedge funds in a trust portfolio, the reasoning employed by too many fiduciaries during the past decade to justify these investments was sorely lacking. A higher line on a pro-forma efficient frontier graph was too often deemed a sufficient reason for investment. Important questions, such as liquidity, taxes, leverage, operational risk or transparency weren’t adequately addressed.
MPT: Management Issues
The traditional investment model consists of fiduciaries crafting an asset allocation based on an assessment of investor risk preferences and return needs. Management within each asset class category is delegated to one or more outside investment managers. The hedge fund issue presents a problem, as it bears on several ill-defined issues relating to MPT and its practical implementation within the UPIA statutes. Few fiduciaries in the 1990s thought of hedge funds as an asset class on par with stocks and bonds. To what degree was the widespread acceptance of this view by the mid-2000s due to clever marketing from the investment industry, rather than thoughtful and objective analysis? It appears that too many fiduciaries let vendors of investment products define asset classes and, therefore, entire portfolio allocations, rather than assume the responsibility of performing their own analysis.
MPT assumes market efficiency and, therefore, precludes market timing. Investor asset allocations can differ from that of the aggregate market due to differences in utility or practical operational reasons, but excess returns from market timing shouldn’t exist. Managers in an efficient market also shouldn’t deliver sustained alpha (excess returns beyond fair compensation for the assumption of risk). The value proposition of hedge funds centers on the claim that they provide alpha, but according to MPT, sustained alpha can’t exist. How then, can an investment category dependent on generating alpha be deemed an asset class under MPT? If hedge funds are an asset class, then is a fiduciary that decides to not invest engaging in market timing? How can MPT require investment into an asset class that it says can’t exist?
UPIA Support of Hedge Funds
What would have provided a better and more reasonable framework for making these decisions? The UPIA itself is rather ambiguous. The provisions of the UPIA that would have guided and supported these investments include:
1. Trustees must balance the tradeoff between risk and return as their central consideration;
2. Trustees need to diversify assets under their care;
3. Trustees may consider all categories of investment when structuring the holdings of the trust portfolio; and
4. Trustees may delegate to third parties the responsibility for the day-to-day management of some or all of the trust assets.
However, paying close attention to each of the following additional UPIA provisions would have improved the decision process to include hedge funds:
1. Current economic conditions;
2. The possible impact of inflation and deflation;
3. The expected tax consequences of investment activity;
4. The role of each asset class;
5. The expected total return of the portfolio from both an income and appreciation standpoint;
6. Costs of management and administration;
7. The need for liquidity; and
8. Any unique issues regarding included assets and the beneficiary or trust as a whole.
“Eight-Point Guide,” this page, shows how to implement both the spirit and the letter of the law when constructing a trust portfolio under the UPIA.
Due Diligence Inquiries
Stepping outside of the basic requirements of the UPIA is in the spirit of the law and requires trustees to examine products heavily promoted by the investment industry with an enhanced level of skepticism. In the case of hedge funds, trustees would have been well-served if they had included the following in their due diligence inquiries:
1. When formulating expected returns, how realistic is the proposition of widely available alpha net of management fees averaging 1.5 percent on invested assets plus 20 percent of performance? No economic basis exists for the belief that hedge funds, in the aggregate, should have a positive expected return gross of fees beyond fair compensation for the risk assumed. Fiduciaries should question the sustainability of past high levels of return, particularly when the strategy is in the process of experiencing considerable growth in invested assets. Alpha is a zero-sum game, as investors, on average, must get market returns less fees. Fiduciaries should ask how much risk managers are taking to play this game.
2. Does the standard deviation of historical returns adequately reflect the risk of strategies using derivatives, short sales and illiquid assets? With derivatives, it’s easy to create investment strategies that have a payoff profile of small consistent returns under most circumstances, but with a low probability of catastrophic losses during a turbulent market environment. Thinly traded securities, likewise, often have an artificially low volatility, with the risk only apparent when liquidity is demanded at short notice.
3. If hedge funds are an asset class, are fiduciaries required to invest in the large managers that comprise the majority of assets in the fund universe?
4. Are aggregate leverage and liquidity constraints, including gates and lockups, factored into the analysis?
When viewed in the aggregate, these questions all point to the conclusion that hedge funds should be viewed as investment managers, rather than a separate asset class, and monitored as such. Changes in the hedge fund industry should be viewed differently from structural changes in the stock or bond markets, and fiduciaries should remain aware of potential risks stemming from growth in the industry, as well as regulatory and operational issues. Making investment decisions on these issues doesn’t constitute market timing. Again, there’s nothing inherently wrong with allocating to hedge funds, but this framework would delegate the investment to a manager-hiring decision, rather than a strategic asset allocation.
Client’s Circumstances Important
When a fiduciary structures an investment portfolio, it’s critical that a client’s specific circumstances, rather than academic theories, prevail. While paying attention to what has occurred in the past is important, relying purely on historical results has the potential to produce disappointing future results. As portfolios are constructed, fiduciaries should pay close attention to the provisions of the UPIA. They provide not only what must be done, but also direct fiduciaries in what should be done.