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Tuesday 14 August 2012

Minding the Chastity Belts: Fiduciary Duties and 900 Pound Lemmings

"Today investors herd around short-term investment strategies adopted by other prudent experts who manage similar funds. This has unleashed a flock of 900-pound lemmings into the economy."
Crusading Fiduciaries

If you were a medieval knight embarking on the twelfth century equivalent of a Mediterranean cruise, aka going off on the Crusades, you would have needed someone at home to take care of the castle, the gold and the chastity belt keys.  That person was known as a fiduciary.

The fiduciary’s duties were those of loyalty and prudence; perfect qualities for today’s equivalent, the financial advisor.  Sadly most financial advisors don’t see themselves in this light.  Even sadder, those that do are usually to be found in that herd of 900-hundred pound lemmings that constitute the mass of behaviorally compromised investors. Time for a re-think, all round.

Duties, Not Contracts

Historically the concept of a fiduciary was to place certain duties on individuals or organizations entrusted with responsibilities to act on behalf of others; primarily where those others were less able to manage those responsibilities themselves.  It’s a relationship of trust, commonly between someone who understands the issues at hand – the fiduciary – and someone who doesn’t – their client.  Managing money on behalf of most private investors would generally fit that description.

However, many managers in such positions don’t regard themselves as fiduciaries, placing upon themselves the far less onerous responsibility of managing to the contract in place between them and their clients.  A recent report from the UK suggests that this is wrong; and even if it isn’t most investors should run a mile or more from advisors who don’t accept fiduciary responsibilities. 

Unfortunately this investment relationship has been dogged by two long and familiar shadows.

Loyalty and Prudence

Firstly, many investment advisors don’t accept the role of a fiduciary, preferring instead to rely on contracts – which usually favour the advisor, who may be able to understand them, over the client, who usually can’t.  Many advisors will avoid fiduciary responsibilities because a fiduciary relationship overrides any contract – in common law, if the fiduciary breaks the terms of the trust the contract is irrelevant.  This is generally covered by the first duty of the fiduciary, that of loyalty: to act in good faith, and to avoid conflicts of interests, such as taking commissions on products sold to clients, even where disclosed.  

Secondly, the actual role of a fiduciary in respect of investment is governed largely by the second duty – that of prudence.  In theory this means that they shouldn’t take on excessive risks.  Unfortunately this has generally translated into fiduciaries believing that they have a responsibility to maximise profitability while following the mantra of efficient markets.  Unsurprisingly this has led them into herd following behavior creating an attitude of "reckless caution”.

Common Law Investing

This has left investors seeking an advisor with two problems.  The first one is actually finding an advisor that accepts fiduciary responsibility rather than seeking to maximise their own commissions.  The second one is making sure that your fiduciary, when you can actually find them, isn’t a dumb cluck rule following junkie.  Unfortunately the laws governing fiduciary responsibilities have tended to foster reliance on herding around the dubious mantra of efficient market theories such that fiduciary responsibility has tended to reduce to following Modern Portfolio Theory (MPT) and seeking to maximise short-term profits. 

Naturally enough this has meant that most fiduciaries have produced the same financial returns as most of the rest of the market; lousy.  Trust, it seems, isn’t enough to generate decent returns, especially when the common laws’ understanding of behavioral finance is several points under zero.

Psychopathic Markets

We’ve previously looked at the way that the legal system regards efficient markets theory as the touchstone against how investments should be managed, and why this is wrong (See: Behavioral Law and Disorder).  Inevitably, however, this bias creeps into all kinds of different areas where investment advice is provided, and it’s understandable that fiduciaries measure themselves against this guidance: you can’t get sued for managing against the law, even if this guarantees your clients a whopping loss when efficient markets inevitably turn into psychopathic ones.

Of course, you’d think this behavior would cut across the duty of prudence, but the legal definition is more complex than this.  Most US and UK fiduciaries are covered by something called the Prudent Investor Rule, which is governed by Modern Portfolio Theory, requiring diversification based on the requirements of efficient markets: and the introduction of this rule caused a noticeable change in the investment policies of fiduciaries as Robert Sitkoff and Max Schanzenbach noted in The Prudent Investor Rule and Trust Asset Allocation:
“Using federal banking data spanning 1986 through 1997, the authors find that, after adoption of the new prudent investor rule, institutional trustees held about 1.5 to 4.5 percentage points more stock at the expense of "safe" investments. This shift to stock amounts to a 3 to 10 percent increase in stock holdings and accounts for roughly 10 to 30 percent of the over-all increase in stock holdings in the period under study.”
The Kay Report

The recent Kay Report to the UK government on the management of UK equity markets has placed the idea of efficient markets squarely in the cross-hairs:
“We question the exaggerated faith which market commentators place in the efficient market hypothesis, arguing that the theory represents a poor basis for either regulation or investment. Regulatory philosophy influenced by the efficient market hypothesis has placed undue reliance on information disclosure as a response to divergences in knowledge and incentives across the equity investment chain. This approach has led to the provision of large quantities of data, much of which is of little value to users. Such copious data provision may drive damaging short-term decisions by investors, aggravated by well-documented cognitive biases such as excessive optimism, loss aversion and anchoring. “
The report suggests that all intermediaries should be required to manage to fiduciary standards, not just those that choose to, and that the adherence to MPT and efficient markets needs to be removed:
“Asset holders should recognise that diversification is most likely to be achieved by a diversity of asset management styles, rather than by calculations derived from an asset allocation model, the employment of a large number of managers, or the selection of a large number of stocks. “
Sea Changes

If this report was ever acted upon it would represent a sea-change in the way advisors and their clients interact.  Advisors would be legally obliged to avoid – not manage – conflicts of interests and would be expected to “take such care as an ordinary prudent man would take if he were minded to make an investment for the benefit of other people for whom he felt morally bound to provide” (Learoyd v Whiteley (1887) 12 AC 727).  Simply implementing asset allocation against the MPT would no longer meet this requirement. 
“The Review does not believe that there could be any sound basis for placing trust in an intermediary who does not recognise these duties of loyalty and prudence, and considers that a relationship that falls short of these standards fails to show appropriate respect for an investing client … Caveat emptor is not a concept compatible with an equity investment chain based on trust and stewardship. “
Of course, the chances of these recommendations ever seeing the light of day are limited; but that doesn’t mean that we shouldn’t judge our advisors by these standards.  An advisor that isn’t a fiduciary isn’t safe and a fiduciary that doesn’t understand the limits of efficient markets theory and can’t provide evidence for how they’re guarding against behavioral biases should be avoided (see Clueless: Meet The Overprecise Pundits).

This is our money, not theirs.  We’re owed a duty of loyalty and prudence.  Otherwise when we get back to our castle we’ll find they’ve unlocked the chastity belt and run off with the gold and the rest of the lemmings


  1. Hi Timarr,
    You continue to talk good sense. Good spot on the Kay review also.
    Reliance on EMH and assumed normal distributions of returns are at the centre of the challenge.
    Trouble is until the establishment can agree on another way to meausre risk there will be no change in the Investment training given to advisers.
    So what does the poor punter do? - apart from read your blog and (hopefully) buy my book when it comes out?

  2. Thanks for your great info. I agree with it. My experiences as a stockbroker showed me some of the tricks of the investment trade, and I have shared some that I can on my youtube channel. I hope there is something of interest to you and your readers there. Keep writing:

  3. Great article. I am an RIA and agree with what you are saying. I manage portfolios differently than many of my colleagues do. I can honestly say that I understand the limits of MPT but I also feel I take a risk by being different. Today, a fiduciary can just as easily face a lawsuit by not being invested "conventionally".

    I would love to read your thoughts on better ways to measure prudence.