This content is from: Corner Office

The "Prudent Person" Is a Bad Investor

Institutional investors need to explore more innovative and creative solutions, such as peer-to-peer collaboration, to break away from the herd.

I spend my life trying to convince large beneficiary investment organizations – such as pensions, sovereign funds and endowments – to act in innovative ways, to adopt new models of investing, and to cultivate more aligned access points to assets and risk factors needed to achieve long-term objectives. I do this because of two deeply held beliefs:

1) Innovation Pays: The best investors are those that accept financial markets as constantly changing ecosystems and, as a result, are themselves constantly exploring innovation. Good investment ideas don’t last forever, which means there are significant rewards for spotting new opportunities early and acting in an entrepreneurial manner quickly. Naturally, because most institutional investors herd, there are returns to be delivered investing unconventionally. Indeed, some of the best opportunities do not fit neatly in asset class silos.

2) Innovation Saves: The financial services industry is taking too much of its share of "the pie." This is an industry that placed 100 individuals on the Forbes 400 and accounts for one third of corporate profits in the US of A. Pretty good for an industry that doesn't actually make anything (Zing). In my view, too many institutional investors have lost their marbles at the altar of alpha. As I see it, saving money on fees and costs is the only risk free return in the investment business. But in order to grab it, innovation is necessary.

In short, I’m passionate about bringing innovation and unconventional thinking to these beneficiary organizations. However, my passion often runs into structural problems that limit funds’ ability to act creatively. And one of the single biggest culprits in this regard is the Prudent Person Rule.

Around the world’s financial markets, the Prudent Person Rule is seen time and time again as a guiding light for trustees, directors and fiduciaries of beneficiary investment organizations. In the U.S., for example, the Prudent Person Rule says that fiduciaries must act solely in the interest of beneficiaries “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character with like aims.”

This sounds sensible, sure, but it has some foul consequences. Specifically, the big problem with prudent-person rules are the perverse incentives they create for pensions to avoid innovation and hold onto convention.

Research actually shows that these rules push investment organizations to hug benchmarks and avoid doing anything that would make them stand out from the crowd. According to Russell Galer of the OECD:

“To find out what ordinary prudent persons are doing, one might, quite naturally, look at a peer average or relevant index as a benchmark. Indeed, trustees are likely to find themselves in breach of their fiduciary obligations – and potentially legally liable – if their plan’s investment performance (or the performance of any investment manager that they have engaged on behalf of the plan or fund) is consistently below average and they have taken no steps to address the situation.”

Also, as Gordon Clark of Oxford University has noted:

“Instead of looking forward and being part of a process whereby community norms and conventions adapt to a changing environment, trustees may seek refuge in the past where certainty prevails, albeit at the cost of reinforcing convention.”

Consider the example that the Prudent Person Rule makes an explicit case for diversification “so as to minimize the risk of large losses.” What about the possibility of big gains? Investors are nothing more than risk managers, so shouldn’t they be allowed — and sometimes encouraged — to manage risk in concentrated pools or in new ways? Let’s not get into the fact that a broadly diversified portfolio of assets you barely understand is more risky than a concentrated portfolio of assets you know well and have a high conviction in... let's just focus on doing things differently from the crowd.

Anyway, as I see it, one of the key governing principles of our beneficiary institutions — the very principle meant to protect them — is partly to blame for their inability to innovate and professionalize, which renders them vulnerable to the powerful interest of the finance industry — and facilitates these intermediaries in extracting rents that far exceed value created by the finance ecosystem.

But, it’s not all bad news, there is actually a work-around that allows the truly innovative investors to move beyond antiquated notions of prudence and fiduciary duty (looks left, then right): It’s peer-to-peer collaboration.

I’m sure readers of this column have noticed that I do a lot of work on how beneficiary institutions can come together in new and creative ways to foster innovation. My personal view is that peer collaboration can add significantly to the resource base of the organization. It can also provide a unique "action space" for innovation and entrepreneurialism, as peers can share costs, pool capital and diversify exposures. In addition to those factors, if a pension can convince its peers —which are also fiduciaries — to work with them on something innovative, they have almost by definition fulfilled their obligations under the Prudent Person Rule (almost).

In sum, the community of investors needs to recognize that a "prudent person" isn’t going to be a very successful investor in the long run. Over-diversification and benchmark hugging is not a recipe for success in this business. Sorry. My advice to these funds is to try to co-opt the notion of a peer benchmark and bring your peers along the path of innovation with you. That, in my humble opinion, would be prudent.

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