A Prudent Investment Policy Statement (IPS) Will Chart Prevailing Conditions

The investment policy is the guiding principle that is generally accepted by investment products, managers and advisors. The IPS is an essential part of deciding investment selection and monitoring. The IPS translates client needs and goals into guidance for investment decisions. Since clients cannot reasonably be expected to have the expertise for this translation, the investment manager or advisor (“Expert”) is expected to take on this responsibility.

It stands to reason that prudent investing requires a prudently prepared investment policy. Such prudence requires that the Expert act on available information in developing or recommending an IPS. The IPS must be reflective of changing conditions in the investment universe and with the client.

Unfortunately, the usual practice today has been to establish a rigid investment policy and then to treat failures of such policies as aberrations. When applied to investment product policies, this rigid structure remains viable for as long as investment conditions remain static and has the advantage of facilitating comparisons among products. On the other hand, clients holding such products suffer when foreseeable conditions change.

Applying a rigid investment policy to individual portfolios and to retirement plan lineups is convenient and defensible since the “story” does not change and a simplistic argument can be used to justify failures. The effect is investors are made to suffer otherwise avoidable conditions.

One approach that has been taken to address the rigid policy approach has been to broaden the policy guidance to accommodate foreseeable conditions. This solution; however undermines the usefulness of the investment policy, ultimately making it of no value.

Superior Standard of Care

The investment losses that result from a rigid investment policy make such an approach inferior. A superior standard of care requires that avoidable losses be avoided.

The adaptation to changing investment conditions is embodied in the foundational principle of a superior standard of care, the Prudent Expert Rule, which requires “acting in the interests of clients with the care, skill, prudence and diligence under the prevailing circumstances that a prudent expert acting in a like capacity and familiar with such matters would act.” The “prevailing circumstances” language is an explicit requirement for adapting to changing conditions.

One Great Weakness

Changing clients’ circumstances is frequently recognized by the client or by a diligent expert. Unfortunately, evidence of changes in investment conditions is frequently ignored to the peril of clients.

Investment policies that are based on the study of decades of investment activity tend to be accepted as “absolute truth” and strong evidence to the contrary is treated as a temporary aberration. There are a number of examples in the recent past where historical trends have blinded investment managers and advisors to the changing conditions that were evident.

The last 20 years has provided two vivid examples of cases where the changes in investment conditions were evident but largely ignored. In the 1990’s, the dot-com bubble was recognized as unsustainable but changes to the IPS that reflect this danger were very rare. The result was that there were widespread losses.

Example: An investment policy of limiting exposure to excessively high P/E ratios would be a prudent step at the time the bubble was recognized.

The second recent predictable change in investment conditions were the real estate investments based on inadequate borrower creditworthiness. This was so obvious; the new investment vehicles were created to exploit the anticipated crash! Still, little was done to investment policies to avoid the catastrophe that was expected.

Example: Adherence to a policy of buying only AAA rated issues would have offered no protection and could have been changed to apply only to investment structures where past experience warranted.

In both of these cases, it was argued that the investment losses were unavoidable since generally accepted investment theories were used. While this line of reasoning may have won lawsuits, it does nothing to deliver a superior standard of care to clients.

Today’s Weakness

There is an equally certain and even more damaging set of conditions that exist today that are largely being ignored with respect to investment policies.

It is no secret that short term interest rates are at unprecedented levels. Experts agree almost universally, that the only reasonable direction is for short term rates to increase and with them rates in the entire fixed income market. Furthermore, the repayment of US treasury securities obligations is being questioned in the face of growing unfunded liabilities and weakened worldwide competitiveness.

The unanswered questions are when and how will losses be felt.

The timing is affected by both Federal Reserve policy and investor sentiment. A flight out of fixed income can be more devastating than aggressive increases in short term rates!

The “how” can be a sudden loss in value, a gradual loss over time or a period of high volatility.

Investment policies today should be re-examined, considering these possibilities. Solutions include reducing reliance on fixed income securities as a capital preservation vehicle. Consideration should be given to a policy of replacing fixed income investments with an appropriate blend of cash and equities.

Hedging strategies have been developed to avoid fixed income losses. Investment policies can also be amended to incorporate such strategies.

Will Conforming to Investment Theory Be Enough?

In the past, foreseeable losses have been successfully explained by the use of generally accepted investment theories. This reasoning, however, has a limited life. At some point, the judicial system will hold that “experts should know that the theory would not have worked.” This is particularly true in today’s fixed income environment.

It is evident that current theories did not contemplate today’s prevailing circumstances. Never has there been such a sustained period of such low rates held by so many investors in such great amounts. No theory that is based on past history can reasonably be expected to work.

It is also evident today that conditions in the Treasury market are not sustainable. The relatively flat US and European economies and the rising Chinese economy suggests that borrowing power will be limited in the future, leading to unpleasant choices. Again, such circumstances were never conceived in the development of investment theories in use today.

The combination of previous failures and the predictability of the prevailing circumstances make it unlikely that Experts will continue to get a free pass. Experts will be expected to prove conformance with stated policies and that the policies had a reasonable chance of success under the then prevailing circumstances.

Experts seeking to deliver a superior standard of care to clients have little choice but to revise investment policies that assume stability and low volatility in the fixed income markets.

Conclusion

While it is a clear that a superior standard of care requires monitoring of prevailing circumstances and updating investment policies as appropriate, the actual response may vary. There is likely to be no established precedent for what to do, thus requiring expert judgment in many cases. The way a policy is adapted to changing circumstances should be based on reasonable courses of action.

Experts seeking to deliver a superior standard of care must have and use the ability to make timely amendments to investment policies when foreseeable conditions are recognized.