Fiduciary Duty Under Law & the Accepted Science of Portfolio Diversification

— By Stewart Frank CPA/PFS, AIFA and J. Ben Vernazza CPA/PFS, TEP

Fiduciary Diversification Duties Required by Law

Trustees are prohibited from delegating the management of a trust’s diversification strategy to anyone else, including advisors. That means that, if you are a trustee you are totally responsible and 100% liable for breaches of fiduciary duty from mismanagement of a portfolio’s diversification strategy, regardless of who made or implemented the imprudent diversification decision. That’s right—you can be sued and held accountable for damageseven if it was your investment advisor who failed to adequately diversify your trust’s portfolio. That means the full responsibility for developing and managing a compliant diversification strategy rests entirely on your shoulders.

Diversification is so fundamental to prudent investing that the mere existence of a poorly diversified portfolio is the only proof needed to determine that the trustee committed multiple breaches of fiduciary duty. Here’s why:

“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 & skill.” (Source: Commentary to Section 227, Restatement 3rd of Trusts)

To avoid breach of fiduciary duty liability, all trustees and fiduciaries must be able to prove that uncompensated risk in their portfolios was reduced on a “reasonable” basis through diversification during their stewardship.

Steps Required to Avoid Breach of Fiduciary Duty Problems

  • Develop and maintain a separate, prudent diversification strategy that functions as an overlay to the existing return strategy, and
  • Create and maintain contemporaneous reports that become evidentiary records verifying the existence of the prudently managed diversification strategy.

It is imperative that the diversification strategy be managed and implemented with the utmost care, accuracy, and prudence. It is the essence of maintaining compliance with fiduciary laws.

Popular Diversification Methods Don’t Measure Uncompensated Risk

The first step to complying with the law and best practices for managing a portfolio’s diversification strategy is to properly measure its diversification. Unfortunately, it presents a significant challenge, one that many fiduciaries fail to recognize.

Popular portfolio metrics of beta, alpha, Sharpe, correlation, standard deviation, R2, and percentage of portfolio value allocated to various asset classes used by most trustees, other fiduciaries, and advisors to measure diversification, only measure systematic or market risk; they cannot and do not measure uncompensated risk removed from a portfolio by diversification.

That’s right, the portfolio metrics and asset allocation methodologies used to measure systematic risk and diversification are totally ineffective for uncompensated risk and diversification measurement, a fact recognized throughout academia and accepted by the courts.

Methodology We Use

Our proprietary testing protocol leverages expertise, software and process to calculate and measure the absolute equivalent number of equally weighted diversification resources, also known as diversification dimensions (DDs) present in a portfolio. Each DD has the ability to move independently within a portfolio’s structure. More DDs equal more diversification and the presence of less Uncompensated Risk. Your portfolio’s is then compared to a “Reasonably” developed portfolio of like size with similar allocation between equities and fixed income.

For more information go to Stewart’s website (http://www.precisionfiduciary.com/), and see the steps involved by going to Ben’s website (http://www.benvcpa.com/one-step-abc/).

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GET A FIDUCIARY PRUDENCY CERTIFICATE: Stewart Frank and Ben Vernazza work together with fiduciaries to ensure compliance. We can issue a written certificate addressed to a fiduciary, documenting that the diversification strategy implemented is prudent and reasonable. This establishes for the time period covered that the portfolio’s “uncompensated risk” was reduced to a “reasonable” basis through diversification during the fiduciary’s stewardship.