[This blog was originally published by Summitas at www.Summitas.com]
Over the course of several hundred years, proceeding in fits and starts, standards of fiduciary prudence have become ever more process-oriented and ever less outcome-oriented. This evolution occurred because, under prior trust doctrine, trustees were automatically liable for virtually any loss of principal: Liability for losses would “sit like a devil on the shoulder of every trustee.” (W. Brantley Phillips, Jr., “Standards of Prudent Investment under the Restatement (Third) of Trusts,” Washington & Lee Law Journal, Winter 1997.)
Today, even outside the trust context, pressed by advisors like me, family investors who aren’t fiduciaries in any legal sense have also become more and more process-oriented. Just as a thought experiment, let’s consider whether this is entirely wise.
It’s perfectly clear under modern principles of fiduciary conduct that a trustee who follows the prudent investor rule to the letter, but who dramatically underperforms, will be absolved of any responsibility. (Trust me, I know — I’ve testified against such trustees.) Let’s set aside the question whether this is an appropriate outcome, and instead look at it outside the fiduciary context.
What we observe is that families have gone to great lengths to draft mission statements and investment policy statements, have laboriously created investment committees, and have encouraged inclusiveness by bringing in the ideas and concerns of many different family units and generations. These families are, in effect, mimicking the behavior of legal fiduciaries, and they have been encouraged to do so by the wealth advisory community. Everybody involved obviously believes that sound, prudent processes will inevitably lead to sound investment outcomes.
But will they? Certainly it’s true that families with alarmingly dysfunctional procedures almost always experience bad outcomes. But it’s also true that many families who have developed extremely thoughtful, highly prudent, thoroughly inclusive procedures find that their investment returns are far below par.
What’s going on here? The simple answer is that these families are spending too much time on process and too little time on a little thing called opportunity costs. Technically, “opportunity costs” refers to market price movement that occurs between when somebody comes up with an investment idea and when they get around to executing it. Maybe you’ve heard of rapid-fire computer trading in which thousands of trades are executed on a split-second basis to try to take advantage of small and fleeting price disparities. The opportunity costs associated with the loss of even a second or two can mean the difference between a profit and a loss.
In a more typical situation, good advisors’ investment ideas tend to be good ones when they’re formulated, but those ideas will degrade in value over time, as other, less insightful investors belatedly pick up on the idea. What was a good idea on January 1 tends to be a less good idea on January 15 and tends to be a bad idea in March.
Sound, thoughtful family decision-making processes are crucial to holding a family together, especially during stressful periods of time, and they go a long way toward enabling families to keep their legacies intact. But if the procedures are ignoring opportunity costs, the game may not be worth the candle: Nothing breaks up a family more quickly than the loss of their capital.
Ask yourself if your family makes investment decisions like this: Investment ideas are communicated to your family by your advisor; your family takes these ideas under advisement; the ideas are forwarded to the family’s investment committee; Uncle Ralph, who hates hedge funds, weighs in from his safari in Africa; somebody checks the policy statement and notices that not enough notice has been given to younger generations to review the recommendations; Uncle Ralph will return from safari next month, so why rush into a decision he’s likely to oppose, etc., etc.
OK, I exaggerate. But like it or not, every day you spend being prudent is a day that your returns go down, because your investment ideas are going stale while you are waiting to implement them. Add these opportunity costs up over the days and months and years and you’ve got a seriously underperforming portfolio.
Ah, you are thinking, but by intensely reviewing my advisor’s recommendations, I’m weeding out the bad ones, and that will offset the opportunity costs. If that’s the case, my friends, you need to fire your advisor. Looking back over 30 years of working with families, I observe two things. First, families almost never disagree with a good advisor’s recommendations — they just implement them too late. Second, on the rare occasions when families overrule advisors, the families are usually wrong, thereby compounding opportunity costs with bad investment decisions.
Just as it’s true that a lawyer who represents himself has a fool for a client, a family that thinks it knows more about investing than its advisor either needs a new advisor or a new outlook. Family members often believe that they aren’t doing their job unless they review and discuss every action before the advisor implements it. But this ignores the realities of the marketplace and, especially, it ignores the relative skills and experience of families and investment professionals.
If I’m right that opportunity costs are crucially important but too often overlooked, and if I’m also right that prudent processes are a critical aspect of a family’s management of its capital, how can we reconcile the two? The critical issue, I suggest, is to identify what it is that families do best and what it is that investment professionals do best, then assign those tasks appropriately.
Many of the most critical activities associated with the management of private capital have no particular time pressure associated with them. For example, establishing an appropriate risk level for the capital is the single most important thing a family can do. That task requires a lot of discussion among family members and with the family’s advisor, and it ultimately results in a policy statement in which the key risk metrics are written down. But once this has been accomplished, all the family has to do it to review the policy regularly.
Similarly, the family needs to monitor investment performance, but short periods of performance are mainly irrelevant, so there is no time pressure associated with performance monitoring.
Finally, the family should always be striving to improve its understanding of the investment process and capital markets, but educational sessions, outside speakers at family meetings, and so on are not time sensitive.
Note that most of the issues I would assign to the family address not only broad and critical issues, but also principal/agent issues. No matter how good your advisor is, the interests of an advisory firm and the family whose principal is being invested can never be identical. By carefully considering the long-term strategic issues associated with wealth management, and writing them down in a policy statement, the family will have gone a long way toward aligning its own interests with those of its advisor.
By the same token, issues such as manager selection and replacement, tactical moves in the portfolio, and implementation of opportunistic ideas have serious opportunity costs associated with them and should be left in the hands of the professionals – subject, of course, to the family’s investment policy statement and to the family’s obligation to monitor the advisor’s decisions. If an advisor takes an action in violation of the policy statement, it must be undone at the advisor’s risk. Even if the action doesn’t violate the family’s policies, but simply makes the family uncomfortable, the advisor should reverse the trade at the family’s risk. (Both these events should be extremely rare.)
A good working example is offered by very large institutional investors, such as endowments, pension plans, and sovereign wealth funds. Best practices at such institutions allocate investment responsibilities between the institution’s board (or investment committee) and the institution’s in-house investment staff exactly as I’ve suggested above: The board or committee sets long-term risk targets, investment objectives, and policies, and establishes strategic asset allocation guidelines. The staff selects managers, negotiates mandates, shifts the portfolio tactically within the bounds set by the institution, and implements opportunistic investments (again, within the limits established by the policy statement).
In short, I suggest that families focus their activities on what they do best: broad, 80,000-foot issues associated with family cohesion and the critical issues that matter most to the long-term health of the family’s capital (especially risk and asset allocation strategy). Day-to-day, week-to-week, month-to-month investment decisions should be in the hands of a capable advisor.
Families who best balance the tension between prudence and returns will find that they have succeeded in having their cake and eating it, too: They will keep their families intact, preserve their legacies, and outperform other families.
Please note that this article is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.
