3

Prudent Investing and Alternative Assets

“A prudent man sees danger and takes refuge; but the simple pass on, and suffer for it.”

Proverbs 27:12. World English Bible

Long-term investors in illiquid assets seek to harvest special risk premia – notably an illiquidity risk premium – and achieve portfolio diversification gains. In pursuing these goals, however, many investment managers are not entirely free in their investment decisions. For example, pension funds and insurance companies as fiduciaries are generally subject to regulation that aims to limit the risk for their beneficiaries (and in systemically important cases, the broader economy). Thus, investment decisions take place within a legal framework that attempts to achieve a balance between two objectives – the maximization of returns and the protection of capital (Möllmann, 2007). In principle, there are two broad regulatory approaches to investing: first, the qualitative description of managerial behaviour according to the “prudent investor rule” and second, the explicit setting of quantitative restrictions (Franzen, 2010).

The general perception of what constitutes prudent investing has developed over time. Initially, “prudent investments” were largely defined by legal lists. In many jurisdictions, this rather static approach was eventually replaced by the prudent man rule. While the prudent man rule focuses on individual investments, over time this rule has increasingly been seen as still too narrow. With modern portfolio theory (MPT) showing that diversification may reduce risk at a given level of returns (and vice versa), the prudent man rule has been transformed into the prudent investor rule, which emphasizes investment risk at the portfolio level rather than at the level of single assets. Within a given portfolio, the treatment of alternative assets may vary considerably, for regulatory reasons and because of internal policies. According to one approach, quantitative investment rules are set that represent statutory restrictions on the extent to which trustees can seek exposure to unregulated markets and derivatives. While it is generally acknowledged that this is a “crude” system, it is often felt that restricting the share of invested capital per asset class works better than more sophisticated approaches from a risk management standpoint (Spiteri, 2011). This approach still exists in many countries, especially in emerging economies, and reflects a clear focus on protecting the capital for the beneficiaries. However, quantitative investment rules may lead to complacency and encourage concentrated investments in underperforming assets.1 As a result, investment restrictions on individual assets are increasingly criticized for producing sub-optimal investment results and even being imprudent from a portfolio perspective. It is expected that changes in regulation result in a larger share of capital being allocated to alternative asset classes.

In this chapter we address the question of “what is ‘prudent’?” in the context of alternative assets. This discussion is not limited to the regulatory perspective but raises wider issues, for example, regarding the role of the risk manager. Is this role limited to enforcing existing regulations or internal investment rules setting limits on the investor's exposure to individual asset classes? Or should the risk manager be the guardian of prudence in a broader sense, ensuring the protection of capital from a portfolio standpoint?

3.1 HISTORICAL BACKGROUND

During the Middle Ages, real estate was the primary form of wealth but feudalism imposed stringent restrictions on a landowner's ability to transfer land to their family upon death. As Hayden (2008) explains, the concept of a trust was created to bypass such feudal restrictions by allowing the transfer of the title to a third-party trustee. This trustee could then transfer the title to specified beneficiaries according to the grantor's instructions. Initially, the trustees did not actively manage property over longer periods but only served as transfer agents.

3.1.1 The importance of asset protection

Over time, the importance of asset protection became increasingly recognized and consequently the trustees also became more involved in management, buying and selling trust assets to achieve better returns for the beneficiaries. Trustees also began managing assets other than land. For example, in 1719 the British Parliament authorized trustees to invest in the shares of the South Sea Company. However, in reaction to the “South Sea Bubble”, the standards of prudence in trust investment were tightened.

The Court of Chancery developed a legal list of what were considered as proper investments. With the sole obligation of a trustee being the preservation of capital, the emphasis was on “safe” investments. However, the universe of “safe investments” was rather limited, at least in the view of the judges and legislators, consisting of long-term fixed-return obligations such as government bonds and first mortgages (Langbein and Posner, 1976). Assets that were not on the list were viewed as “improper”, and English and many American jurisdictions prohibited all trust investments in the securities of private enterprises until late in the nineteenth century.

3.1.2 The prudent man rule

The instruments that were open for investment generated poor returns thanks to high rates of inflation. At the same time, financial innovation led to new capital markets, raising increasing doubts about the concept of “safe investments”. Eventually, this concept was abandoned and replaced by the so-called “prudent man rule” as a new standard for governing investments by fiduciaries. As a legal doctrine it can be traced back to a case heard before the Supreme Judicial Court of Massachusetts in 1830.2 In this case, the judge suggested that trustees:

“observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”

The prudent man rule was originally formulated as a general statement of care, skill and caution. It aimed to give trustees sufficient flexibility to address particular circumstances. However, over time this flexibility was gradually limited by case law and influential treatises. This resulted again in certain investments and techniques being deemed “speculative” and therefore “imprudent”. Implicitly, this also rendered the application of modern portfolio management practices impossible.

The most important objective of the prudent man rule was the preservation of capital. The primary responsibility of the fiduciary was therefore not to lose any capital due to potentially speculative and risky investments. In performing their duties, fiduciaries were required to undertake appropriate due diligence for each individual investment, which had to be judged on the basis of its own risk/return characteristics – as opposed to its role in a diversified portfolio. The prudent man rule thus developed into a set of court-defined rules specifying what is generally imprudent, with several courts finding certain types of investment (such as second mortgages or new business ventures) intrinsically speculative and thus outside the universe of prudent investments. The various constraints and narrow judicial interpretations severely limited the types of investment that could be made and essentially again just left government securities and high-grade corporate bonds.

3.1.3 The impact of modern portfolio theory

Since the last revision of the prudent man rule in 1959 there has been a series of innovations in investment products that eventually became mainstream investments for a broad range of investors. Importantly, this includes the emergence of the venture capital and buyout industry and the proliferation of the limited partnership as the main vehicle to invest in private equity. Such investments were initially considered to be imprudent and inappropriate for pension funds. However, in 1979 the US Department of Labor clarified its prudent man rule under the Employee Retirement Income Security Act (ERISA) in a way that explicitly allowed pension funds to invest in assets that were perceived to be highly risky, including venture capital (Gompers and Lerner, 2001). This set the stage for a substantial increase in commitments to VC funds. Whereas new VC partnerships attracted only slightly more than USD 400 million in 1978, 8 years later more than USD 4 billion was invested, with pension funds accounting for more than half of all contributions.

The clarification of the prudent man rule in 1979 took place against the background of the increasing acceptance of MPT, whose whole purpose was to control risk by combining diversified assets rather than following an approach based on the appropriateness of holding a single asset. While an asset may fail the requirements of the prudent man rule in the sense that it may be too risky on a stand-alone basis, it may help mitigate portfolio risk thanks to its diversifying properties. Perhaps not surprisingly, therefore, the inherent conflict between MPT and the prudent man rule soon led to legal disputes.

The main problem was caused by the fact that fiduciaries could be held liable for a loss in one investment, irrespective of whether it was a prudent investment in the context of the portfolio taken as a whole and the performance of the other investments. For example, in First Alabama Bank of Montgomery v. Martin, 3 the Supreme Court of Alabama applied the prudent man rule analysis and evaluated each security transaction in isolation. Both the relevant market conditions and the fact that the assumption of risk for some stocks would likely result in higher returns on the entire portfolio were disregarded and the 17 disappointing stocks were found to be speculative. Hayden (2008) suggests that if MPT had been applied and notably the effects of individual transactions on an entire portfolio had been evaluated, the First Alabama court would likely have reached an opposing result.

3.2 PRUDENT INVESTOR RULE

As the clarification of the prudent man rule by the US Department of Labor already foreshadowed in 1979, the modern interpretation of “prudence” follows the lines of financial economics where investors seek to maximize the risk-adjusted total return on investment, with capital appreciation being placed on an equal footing with dividends and income. In evaluating expected returns, trustees are required to recognize the importance of protecting a portfolio against inflation. Consistent with this, the relevant level for measuring (risk-adjusted) performance is the entire portfolio rather than the returns of individual investments.

3.2.1 Main differences

As a consequence of these developments, the prudent man rule is no longer the standard in evaluating investing. Instead, it has been replaced by what has been labelled the “prudent investor rule”, which includes the concepts of due diligence and diversification. This is, for example, expressed in the US “Prudent Investor Act”, 4 which differs from the prudent man rule in four major ways (FDIC, 2005):

• Consistent with MPT, the entire investment portfolio is considered. This allows trustees to include riskier investments in their portfolio without fear of being held liable, after the fact, for the losses on any one investment. An investment needs to be consistent with the overall portfolio objectives determined by the beneficiaries' needs at the time of the acquisition, but hindsight is not a factor when judging prudence.
• Consequently, diversification of investments is a key factor for prudence. Trustees are still allowed to invest in a single asset class, but they must be prepared to justify that decision. Furthermore, the investment process should at least reflect the consideration of alternative asset classes.
• No particular asset class is mandatory, and there is no minimum number of asset classes that must be considered. While there is no category or type of investment deemed inherently imprudent, speculation and outright risk taking is not prohibited by the prudent investor rule. That said, the trustee is permitted – and even encouraged – to develop greater flexibility in overall portfolio management.
• Because of the increased complexity implied by these responsibilities, a trustee is not only permitted but literally obliged to delegate investment management and other associated functions to third parties.

Möllmann (2007) contrasts the prudent investor rule with what has often been described as a “draconian regime” of fund regulation, where outcome measures and quantitative rules apply. In a report commissioned by the European Commission – famously known as the “Pragma-Report”5 – quantitative investment rules for pension funds were criticised for being “in the way of optimisation of the asset allocation and securities selection processes and, therefore, may lead to sub-optimal return and risk taking” (Franzen, 2010). Meanwhile, such quantitative restrictions have mostly been abolished, and there is an increasing trend towards some form of prudent man rule in investment regulations and away from quantitative restrictions.

3.2.2 Importance of investment process

The “prudent investor rule” is a legal doctrine that focuses on the investment process, as opposed to labelling an investment or course of action as prudent or not. It is important to note that hindsight is no longer a component of the investment standard: if the process followed was prudent, i.e. based on what was known and not known at the time of the decision, then the decisions made are prudent, regardless of subsequent results.

With this reinterpretation the standard of prudence has shifted towards diversification, including alternative assets, with fiduciaries expected to engage actively in (corporate) governance. Trustees are now required to conduct an ongoing investment process that is, in substance and procedure, more complex and sophisticated than was previously required by law (Maloney, 1999). The broader universe of possible investment options and the application of MPT bring additional complexity: trustees not only have to evaluate the expected return and risk of holding an individual investment but also to assess its impact on the entire portfolio. This requires monitoring expected returns, standard deviations and correlations of all individual investments in the portfolio. Clearly, these responsibilities imply a different skill set compared with the traditional prudent man rule, and given the increased investment obligations for fiduciaries, delegation has become an integral part of the investment process. In fact, no individual professional or advisory firm can claim to be fully informed about the universe of possible investments and how they interact.

Consequently, under UK law, for example, trustees are not required to have professional investment knowledge; instead, they are legally obliged to obtain proper advice in relevant areas. As Hayden (2008) explains, trustees are “virtually compelled by considerations of efficiency” to delegate to qualified and supervised agents and may now be deemed imprudent for failing to do so in some situations. This has paved the way for the huge influence of investment consultants (Franzen, 2010). However, trustees still must act in a prudent manner in selecting and supervising them.

Given the emphasis that the prudent investor rule puts on the fiduciary's behaviour, it may not be surprising that what actually constitutes appropriate behaviour has remained subject to discussion. Many observers see the vagueness of the term as an important advantage, as it gives the investment manager the flexibility he needs in an ever-changing market environment. Others, however, have taken a more critical view, raising the questions of how and by whom reasonable behaviour should be defined (Möllmann, 2007). This question is particularly relevant, given that regulations – especially pertaining to the pension fund industry – often seem to set contradictory objectives. On the one hand, for example, a minimum return has to be guaranteed while, on the other hand, the trustee's investment capabilities are restricted. As Spiteri (2011) puts it:

“…it's like they are being asked to travel at 100 miles per hour and are then handed a bicycle as their mode of transport.”

3.3 THE OECD GUIDELINES ON PENSION FUND ASSET MANAGEMENT

While the interpretation of prudence in investment decisions continues to differ widely, even in sophisticated and mature markets, considerable effort has recently been made to develop a set of guidelines that can be applied universally by the pension fund industry. Published by the OECD (2006), these guidelines refer to a prudent person standard, under which a pension fund's governing body is “expected to undertake obligations related to the investment management function with the requisite level of skill to effectively carry out that function, and absent that level of skill or knowledge, to obtain the external assistance of an expert”. Importantly, the prudent person standard does not necessarily make portfolio limits redundant. As the guidelines make clear, such portfolio limits are generally intended to help implement the prudential principles of security, profitability and liquidity at the regulatory level rather than the pension fund level. However, to reiterate the guidelines emphasize that:

“portfolio limits that inhibit adequate diversification or impede the use of asset–liability matching or other widely accepted risk management techniques and methodologies should be avoided. The matching of the characteristics of assets and liabilities (like maturity, duration, currencies, etc.) is highly beneficial and should not be impeded.”

In Annex II of the OECD guidelines, it is recommended that policy makers and regulators “take account of and give proper consideration to modern and effective risk management methods, including the development of assets/liabilities management techniques”. Effectively, although the guidelines explicitly consider regulatory limits on individual asset classes, they urge that any such limits be set from the perspective of a portfolio approach rather than individual investments. Consistent with this approach, the guidelines highlight the need for implementing “a sound risk management process to appropriately measuring and controlling portfolio risk and the overall risk profile of the pension fund” (authors' emphasis).

3.4 PRUDENCE AND UNCERTAINTY

The prudent investor rule is usually associated with market-based portfolio management and supervision. Acting with prudence is deeply embedded in the principle of fiduciary duty, which forms a fundamental aspect of the Anglo-Saxon regulatory approach. Whereas investment risk has long been considered as the risk to the beneficiaries' capital, in the current context risk is generally perceived as falling short of a predetermined benchmark. Arguably, this shift in the definition of investment risk may have contributed to the observed herd behaviour in the investment community, with many large institutional investors just “hugging the benchmark”. Note, however, that the gravitational forces in investment approaches still differ across jurisdictions. In the United States, “expertise” and “prudence” are legally required in pension fund management. According to Franzen (2010), the governance structure of US pension funds clearly incentivizes risk taking on behalf of the pension fund fiduciaries:

“It seems doubtful if the heavily bond-geared portfolios of some continental European pension funds would pass the prudence test in the United States.”6

3.4.1 May prudence lead to herding?

The problem is, as Teresa Ghilarducci (labour economist and widely recognized expert on retirement security) observes, that these concepts “are whatever passes for standard practice by members of the pension fund industry” and that US law and supervisory authorities require “the industry to abide by the standards the industry itself defines” (Blackburn, 2002). However, from the viewpoint of individual investors, it “…is better to fail conventionally than to succeed unconventionally”, as Keynes famously observed, and requiring individual investors to follow industry standards in terms of asset allocation could, as The Economist has phrased it, boil down to “…requiring investors to buy tulips in 17th-century Holland because everyone else was doing so” (Buttonwood, 2008).

Against this background, we suggest four tests to determine whether an investment approach can be considered prudent:

• Assuming that a portfolio approach is taken, the portfolio should comprise assets that are fully understood. This requires that the investment in a particular asset is undertaken on the basis of thorough due diligence, a process that itself requires the necessary skills and experience. Unless an investment has been subjected to an appropriate due diligence process, it should be considered imprudent.
• There needs to be a researched and formalized investment strategy that is consistent with legal provisions and the objectives set by the beneficiaries (i.e., profile of liabilities, liquidity needs, risk tolerance, etc.).7
• Individual investments need to be consistent with the investment strategy. Whether an investment makes sense and whether it is prudent can only be assessed in the context of this strategy.
• The portfolio composition and its individual assets are monitored and deviations are reacted upon. In particular, over the long timeframes that are typical for alternative assets, investment strategies will typically need to be adjusted due to unforeseen market developments.

As far as alternative investing is concerned, investors face the important challenge that standard portfolio models have been developed for efficient markets where permanent rebalancing is possible. Many of the assumptions made in these models are violated in the context of alternative investing. Furthermore, data are usually of questionable quality or do not exist at all. All these factors result in a high degree of uncertainty that often appears to make many trustees feel uncomfortable when allocating a significant share to alternative investments.

3.4.2 May prudence lead to a bias against uncertainty?

Increasingly, the main responsibility of trustees lies in the overall asset allocation (Maloney, 1999). In most advanced markets, there are no a priori restrictions. However, while any investment can be chosen, there is no “safe” investment that protects a trustee from liability. In theory, the prudent investor rule incentivizes trustees to allocate more to alternative assets that have the potential to yield higher returns. But investors tend to prefer current and presumably more reliable information compared with valuations made on expectations in the future. While investors try to tackle this uncertainty through rigorous due diligence, in an environment characterized by uncertainty there are clear limits to identifying and quantifying risks. For trustees there may be another dilemma: is it acceptable to forgo financial returns because the asset in question cannot be integrated in the traditional MPT-based models and therefore only a very small fraction of capital, if any, is allocated to that asset? In principle, at least, this could imply a lower living standard for the beneficiaries than they could potentially enjoy.

3.4.3 Process as a benchmark for prudence?

Therefore, regulations like ERISA in the United States8 provide a safe harbour from liability if the trustee has given “appropriate consideration” to the facts and circumstances of the investment and its relationship to the needs of the pension plan (Maloney, 1999). In other words, such regulation is process- rather than rule-oriented, implying that actions are more important than outcomes which may be achieved through reckless behaviour. Trustees need to provide information on decision processes rather than just ensuring that the composition of the asset portfolio complies with quantitative restrictions. However, while the emphasis on processes aims at limiting downside risk, it is less clear to what extent the quality of processes actually drives investment performance. A challenge lies in assessing the quality of different practices themselves. What exactly do we mean by prudence, and how can different levels be distinguished?

Importantly, new approaches are developing in this area, for example, based on ISO/IEC 15504 (Software Process Improvement and Capability Determination, also known as SPICE). ISO/IEC 15504-4:2004 provides guidance on how to utilize a conformant assessment of processes to determine their capabilities and also guide their improvement.9 For each process, ISO/IEC 15504 defines a capability level on a defined scale.10 While originally this set of standards addressed the IT industry and related business management functions, it has become a universally recognized standard that is no longer limited to software development processes and in recent years it has also been applied by the investment industry.11

3.4.4 Size matters

What has been said so far applies to institutional investors whose investment decisions are not constrained by the size of the asset class. However, there are some large institutional investors where this assumption does not hold. The extreme example is Norway's government pension fund, the world's largest pension reserve fund, whose AuM has increased to more than USD 600 billion. Managed by Norges Bank Investment Management, the fund started out by investing in government bonds only. However, as the fund continued to grow in size, it was allowed to buy shares in 2007. With stocks representing 60% of the fund's portfolio, it holds around 1% of global equities. In an effort to diversify the portfolio further, the fund was allowed in 2008 to invest in emerging markets, and more recently property was added to the permissible universe of assets. However, no investments have been permitted in private equity. Based on an evaluation of the potential benefits of venturing into private equity by Phalippou (2011), the government decided not to invest in this asset class at this point in time. In a recent interview with the Financial Times (20 August 2012), Yngve Slyngstad, chief executive of the fund, explained that its abstinence was essentially explained by the fund's sheer size and the relatively small amounts of capital managed by private equity funds: “We are too large to make a significant allocation to alternative assets.” Relatively few players fall into this category. For most, it is the balance between prudence and uncertainty that represents the main challenge.

3.5 CONCLUSION

Modern standards of prudent investing aim to incentivize risk taking while discouraging recklessness. The danger lies in applying rules without understanding them and their limitations. In a similar context the quantitative analyst and author Emanuel Derman refers to the late Fisher Black, a leading academic in financial economics as well as a well-known practitioner: “He suggested traders at banks should be paid for the plausibility story they told behind the strategy they used, rather than for the results they obtained, thus rewarding intelligence and thinking rather than possible luck” (Dunbar, 2001). This puts emphasis on the process rather than the outcome – this is of particular relevance in the case of alternative investments where forecasting regularly fails and affects, as we will discuss in the following, the role of the risk manager. A clearly defined and sound risk framework is essential for a prudent operation and represents an important pillar of prudent management practice. The approaches and choices made can even affect the stability of the financial system as a whole. Franzen (2010) quotes a regulator: “You want efficiency in the system and that is what ‘prudence’ really is.”

1 Franzen (2010) points out that German “Pensionskassen” do not exploit their legal risk-taking limit.

2 Harvard College v. Armory, 9 Pick. (26 Mass.) 446, 461 (1830).

3 425 So. 2d 415, 427 (Al. 1982), cet. denie4 461 U.S. 938 (1983).

4 The PIA was adopted in 1990 by the American Law Institute's Third Restatement of the Law of Trusts and reflects a MPT and “total return” approach to the exercise of fiduciary investment discretion. The PIA was followed by the Uniform Prudent Investor Act (UPIA) in 1994. See 7B Unif. Law. Ann. 56 (1998 Supp.).

5 As it was authored by Pragma Consulting.

6 Hayden (2008) confirms that under the US Uniform Prudent Investor Act (UPIA), investing an entire portfolio in bonds would likely be a breach of duty.

7 According to Maloney (1999), under the UPIA a trustee must determine the appropriate risk profile for a trust and then develop and implement an investment strategy for the portfolio.

8 ERISA was enacted in 1974. The policy makers' central objective was to ensure adequate investment returns necessary for defined benefit plan participants.

9 See http://www.iso.org/iso/iso_catalogue/catalogue_tc/catalogue_detail.htm?csnumber=37462 [accessed 4 August 2011].

10 Scale with levels from 0 to 5: 0 – incomplete process, 1 – performed process, 2 – managed process, 3 – established process, 4 – predictable process, 5 – optimizing process. The capability of processes is measured against nine process attributes (process performance, performance management, work product management, process definition, process deployment, process measurement, process control, process innovation, process optimization) that get assessed on a four-point rating scale (not achieved (0–15%), partially achieved (>15–50%), largely achieved (>50–85%), fully achieved (>85–100%)).

11 The Luxembourg Centre de Recherche Public's Henri Tudor has been leading an initiative called “Banking SPICE”, with the objective of developing structured governance tools and providing a commonly accepted framework for process assessment and improvement in the finance and banking industry. See http://www.tudor.lu/ and http://www.bankingspice.com/web/Introduction.html [accessed 4 August 2011]. Together with one of the authors, Henri Tudor has been applying this framework to the European Investment Fund's valuation process to ensure that each of its private equity funds is valued appropriately, objectively and in a timely manner, reflecting current market conditions (as described in Mathonet and Meyer, 2007, ch. 7).