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Transcript of Aicpa pfp presentation january 2016w jbv
Why Inadequate Diversification Causes Most Fiduciaries to
Breach their Fiduciary Duties
AICPA PFP CONFERENCE January 16, 2016
PRESENTED BY:STEWART FRANK, CPA/PFS, AIFA
BINGHAM FARMS, MI 48025800-572-7574
Copyright 2015 Precision Fiduciary Analytics. All Rights Reserved
I. Introduction
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TATUM v. RJ REYNOLDS INVESTMENT COMMITTEE
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A panel of the 4th Circuit Court ruled 2 to 1 that the defendant had breached its fiduciary duty when it made the right decision for the wrong reason by failing to follow procedural prudence.
TAKEAWAY: Procedural prudence is mandatory in all matters fiduciary, including diversification.
TIBBLE v. EDISON INTERNATIONAL Opinion
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“under trust law, a fiduciary … has a continuing duty … to monitor [trust] investments.”
“… in the case of an omission”, the statute of limitation commences on “the latest date on which the fiduciary could have cured the breach or violation.”
Writing for a (9-0) SCOTUS, Judge Breyer cited Restatement 3rd of Trusts and The Uniform Prudent Investor Act (UPIA), as the legal foundations for the Court's unanimous opinion:
In situations where a fiduciary never monitors,
the statute of limitations is essentially voided,
exposing that fiduciary to breach of
fiduciary duty claims from the inception of
stewardship through the current date.
TIBBLE v. EDISON INTERNATIONAL Legal Takeaway
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TIBBLE v. EDISON INTERNATIONAL Fiduciary Takeaway
As a result of its unanimous decision
in the Tibble v. Edison case, SCOTUS
has classified all fiduciaries
into two distinct types:
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TIBBLE v. EDISON INTERNATIONAL Diversification Takeaway
1. Those who have been sued, and
2. Those who are going to be sued
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II. Fiduciary Concerns
PREFATORY NOTE (2): “[managing] the tradeoff between risk and return in all invest[ment] activities [including diversification] is identified as being the fiduciary’s central consideration” [Emphasis added]
Uniform Prudent Investor Act (UPIA)Diversification
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Systematic Risk (a/k/a Market Risk) is unavoidable & undiversifiable, and because it is common to all securities within a particular “market”:
a) It cannot be reduced by diversification.b) It changes only when market conditions do.
Source: Uniform Prudent Investor Act, Section 3, Comments
Uniform Prudent Investor Act (UPIA) Systematic Risk
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Asset Allocation is NOT Diversification It is the process used to balance the risk /return tradeoff
Unsystematic Risk (a/k/a Diversifiable Risk) is avoidable and is defined as:
Risk that diversification can eliminate.
“As long as stock prices do not move exactly together, the risk of a diversified portfolio will be less than the average risk of [its] … separate holdings”.
Source: Uniform Prudent Investor Act, Section 3, Comments
Uniform Prudent Investor Act (UPIA) Unsystematic Risk
Copyright 2015 Precision Fiduciary Analytics. All Rights Reserved
“Failure to diversify on a reasonable basis … to reduce uncompensated risk is ... a violation of both the [fiduciary] duty of caution and the [fiduciary] duties of care and skill.” [Emphasis added]
Source: Commentary to Sec. 227, Restatement 3rd of Trusts
Restatement 3rd of TrustsUnsystematic Risk
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Asset Allocation = Systematic (Market) Risk Management
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DEFINITION of ‘Asset Allocation‘An investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.
Source: http://www.investopedia.com/terms/a/assetallocation.asp
DEFINITION of 'Diversification'A risk management technique that … strives to smooth out unsystematic risk … in a portfolio … [The] benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
Diversification = Unsystematic Risk Management
Source: http://www.investopedia.com/terms/d/diversification.asp
Copyright 2015 Precision Fiduciary Analytics. All Rights Reserved
Investment Monitoring Fiduciary IssuesThe Lawsuits are Coming
A big and easy payday awaits beneficiary/plaintiffs and their litigating attorneys for suing fiduciaries.
1. Inadequate diversification is ubiquitous, fact based and is easily proven with mathematics. 2. Contingent beneficiaries are often antagonistic to and/or lack a personal relationship with the fiduciaries they sue. 3. Most IPSs inadvertently provide written documentation of a fiduciary’s own breaches. 4. Huge low risk financial incentives exist for plaintiffs and their attorneys, and huge high risk disincentives exist for defendants and their attorneys.
Copyright 2015 Precision Fiduciary Analytics. All Rights Reserved
Through Investment Policy Statements (IPS) and implementation and monitoring of their resulting asset allocation, management of compensated risk is usually compliant.
However, by failing to mention uncompensated risk, over 90% of IPSs TELL us multiple breaches of fiduciary duty have been committed.
IPS OmissionThe “TELL” of Diversification Breaches
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“Diversification. Diversification across and within asset classes is the primary means by which undue risk of large losses over long time periods will be avoided.”
“Volatility & Risk … return objectives can be achieved while assuming acceptable risk levels commensurate with ‘market’ volatility.”
“Risk Tolerance Investment theory and historical capital market return data suggest that … in order to attain higher returns one must accept higher risk (e.g. volatility of return).”
Sampling of Diversification & RiskProvisions from Real IPS s
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Copyright 2015 Precision Fiduciary Analytics. All Rights Reserved
Sample 10-Year Damage CalculationFor A $1 Million Imprudently Diversified
60%/40% Portfolio
III. Prudent Portfolio Construction
“Eggs & Basket” Portfolio ConstructionMean Variance Optimization of Risk Assets
Source: Wikipedia
1. Expected return and risk tolerance are established.2. Establish which risk asset classes (baskets) you wish to include.3. Input projected values for return, standard deviation, and
correlation for each asset class.4. Construct Tangency Portfolio (optimized for volatility-adjusted
returns) plot Efficient Frontier (EF). Copyright 2015 Precision Fiduciary Analytics. All Rights Reserved
Asset Allocation Used ToReduce E & B Portfolio’s Market Risk
Source: Wikipedia
5. Add the right percent of risk reduction assets into the mix.6. Bring the overall portfolio down the CAL to conform to
stakeholder’s time horizon and (systematic) risk/return profile.7. But what about diversification to reduce Uncompensated Risk?
Copyright 2014 Precision Fiduciary Analytics. All Rights Reserved
Security Weighting StyleAsset Class Industry Sector Region Country+ All Other
69%Non-Systematic
Risk
31%Systematic (Market)
Risk
31%Systematic (Market)
Risk
31%Systematic (Market)
Risk
49%Non-Systemic
Risk ,
Sans Security
Risk
Non-Systematic Risk
7%
A
Compensated & Uncompensated Risk Systematic & Unsystematic Risk
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Security Weighting StyleAsset Class Industry Sector Region Country+ All Other
69%Non-Systematic
Risk
31%Systematic (Market)
Risk
31%Systematic (Market)
Risk
31%Systematic (Market)
Risk
49%Non-Systemic
Risk ,
Sans Security
Risk
Non-Systematic Risk
7%
Undiversifiable & Diversifiable Risk Systematic & Unsystematic Risk
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A
Poorly Diversified
Security Weighting StyleAsset Class Industry Sector Region Country+ All Other
69%Non-Systematic
Risk
31%Systematic (Market)
Risk
31%Systematic (Market)
Risk
31%Systematic (Market)
Risk
49%Non-Systemic
Risk ,
Sans Security
Risk
Non-Systematic Risk
7%
Compensated & Uncompensated Risk Systematic & Unsystematic Risk
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Poorly Diversified All ETF
Portfolio
x
Well Diversified Perfect World
Portfolio
1. Equally Weighted – to overcome concentration bias.
2. Representative Collection of Assets - to overcome selection bias.
All Unsystematic Risk Measurement ResearchHas 2 Qualifiers
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How many different investments does it take to “reasonably” reduce unsystematic risk?
How unique must the investments be to accurately measure a portfolio’s unsystematic risk reduction?
Same Qualifiers – Old Method
Results obtained using equal (naïve) weighting to overcome weighting bias.
Never required an answer because only randomly chosen assets were included to overcome selection bias.
Questions Answers
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How many different investments does it take to “reasonably” reduce unsystematic risk?
How unique must the investments be to accurately measure a portfolio’s unsystematic risk reduction?
Current Method of Unsystematic Risk AnalysisIs Scientifically Based
? depending on result obtained from scientific formula used to calculate equivalent equal weighting. [Correlation Coefficient (CC)].
Degree of uniqueness calculated by scientific formula. [KLD Algorithm].
Questions Answers
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Same Qualifiers – New Method
Evolution of Uncompensated Risk Reduction By Diversification (1968 – 1993)
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Evans & Archer (1968) – determine uncompensated risk reduction is measured by the variance of a single asset to the variance of a portfolio with increasingly more securities.
Elton & Gruber (1977) – a 15-security portfolio has 32% more risk and a 60-security portfolio has 20% more risk than a 100-security portfolio.
Statman (1987) – investors should hold 40 securities (sans leverage).
Markowitz (1991) - "To reduce risk, it is necessary to avoid a portfolio whose securities are all highly correlated with each other.“
Fama and Booth (1992) – coin the term “diversification returns,” representing additional return realized (i.e. diversification Alpha) in a portfolio because of diversification.
Cleary & Copp (1993) – quantified the number of equally weighted securities required to reduce various percentages of uncompensated risk. a 65% reduction requires 30; a 90% reduction requires 50; a 95% reduction requires 100; and a 99% reduction requires 200.
Newbould & Poon (1993, 1996) – conclude a portfolio must exceed 100-securities in order to be within 5% of the average market return and 20% of the average market risk.
Domian, Louton and Racine (2003) - over 60 stocks needed to avoid a significant shortfall risk.
Statman (2004) – 300 securities are required before the marginal benefit is equal to the marginal cost of diversification.
Brandes Institute (2004) – develops Concentration Coefficient (“CC”) that expresses portfolio concentration as the equivalent number of equally-weighted stocks.
Domian, Louton, & Racine (2005) - 164 stocks are needed to have a 99% chance of exceeding the long-term performance of Treasury bonds.
Evolution of Uncompensated Risk Reduction By Diversification (1993 – 2005)
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Considine (2008) – “… a [well diversified] 60/40 portfolio of stocks and bonds generates 2% to 2.5% per annum in return beyond what is achievable with a [portfolio having a similar asset mix but]…is under-diversified”.
Damschroder & Ladd (2009) – invent and patent an algorithm that accurately measures uncompensated risk of real world portfolios.
Damschroder, et. al. (2014) – diversification weighted S&P 500 outperforms cap-weighted S&P 500 by 4.27% per annum over 18 years.
Evolution of Uncompensated Risk Reduction By Diversification (2008 – 2014)
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IV. Managing Diversification Strategy vs.Managing Asset Allocation Strategy
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Risk /Reward Scatter Plot3rd Quarter 2015
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Comparative Portfolios Data Table3rd Quarter 2015
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Comparative Portfolios Data Table3rd Quarter 2015
1. MVO asset allocated portfolios can lead to portfolios with prudent systematic risk levels but never to prudent unsystematic risk reduction.
2. Low correlation drives prudent diversification; low volatility has nothing to do with diversification.
3. MVO is designed to optimize asset allocation for volatility-adjusted returns; it cannot achieve or measure uncompensated risk reduction through diversification.
4. MVO relies on variance minimization to achieve lower portfolio volatility; Diversification works best when volatile assets are combined with other poorly correlated volatile assets.
5. By targeting expected return, MVO tends to select assets with low standard deviations.
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Why E&B Portfolios Have Zero Impact On Uncompensated Risk
2 Metrics Required To Prudently Measure Unsystematic Risk
1. Concentration Coefficient (CC) is the mathematical formula we use to quantify the number of equivalent equally- weighted holdings present in a portfolio.
2. We use the KLD Algorithm to measure the number of diversification elements or sources are present in a portfolio.
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Concentration Coefficient (CC) Measures Weighting Element Only of Unsystematic Risk
1. CC measures a portfolio’s concentration in terms of the number of assets held and their respective weightings, but not their uniqueness. It restates a portfolio’s holdings as an equivalent number of equally weighted assets.
2. CC accounts for significance of asset weighting to a portfolio’s diversification.
3. CC allows academic discoveries based on equal weighting to be applied to real world portfolios.
4. The higher the CC, the less concentrated the portfolio. It becomes proportionally less as concentration increases.
Example - 2 asset portfolio weighted 50% - 50% = CC of 2 weighted 75% - 25% = CC of 1.6
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1. KLD is the name of an algorithm used to calculate the number of intrinsic dimensions with unique diversification characteristics.
2. Each dimension represents an element having the ability to act or move independently inside a portfolio's structure.
3. The larger the number; the greater the ability of each portfolio dimension to perform independently; and the more broadly diversified the portfolio.
4. Because independent performance is the hallmark of diversification, when used in combination with CC, scientific measurement of uncompensated risk eliminated from a portfolio is achieved.
KLD Algorithm Calculates & Measures Uniqueness Element of Uncompensated Risk
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Comparative Portfolios Data Table3rd Quarter 2015
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Comparative Portfolios Data Table3rd Quarter 2015
1. MVO tends to create portfolios heavily invested in too few assets to be diversified.
2. Purported diversification measurements consisting of standard deviation, correlation, beta, and R-Squared are systematic risk metrics but provide absolutely no unsystematic risk information.
3. The number of portfolio constituents is not a definitive measurement of unsystematic risk.
4. Most E&B portfolios do not have enough sources of diversification to reasonably reduce uncompensated risk.
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Why E&B Portfolios Have
Small Impact on Uncompensated Risk
Unsystematic (Diversifiable) Risk Analysis
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Uncompensated (Diversifiable) Risk Analysis
xxx
Uncompensated Risk Eliminated by Diversification
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V. Conclusion
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1. Develop a prudent diversification strategy for measuring and managing uncompensated risk.
2. Incorporate the strategy in the Investment Policy Statement (IPS).
3. Implement the strategy in managing the portfolio.4. Quantitatively monitor the portfolio for uncompensated
risk outcomes and compare results to appropriate benchmarks and compliance with IPS.
Important - Be sure to maintain a documented record of the procedurally prudent process followed for all diversification decisions made.
Steps Required To Have Statute of Limitations Begin Tolling
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If you have questions or would like help with diversification issues please contact either:
Stewart Frank CPA/PFS AFIA800-572-7574
J. Ben Vernazza CPA/PFS TEP emeritus831-688-6000
Thank You For Your Interest
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