Equis Partners Prudent Investor Rule

  • View

  • Download

Embed Size (px)

Text of Equis Partners Prudent Investor Rule

  • 8/12/2019 Equis Partners Prudent Investor Rule


    Investment PolicyGuidelines & StrategiesWithin the Context of

    The American Law Institute ! s

    Restatement of the Law Third: Trusts

    Prudent Investor Rule

    Equius Partners, Inc.

    4 Hamilton Landing, Suite 205 ! Novato, California 94949 ! 415-382-2500 ! www.equiuspartners.com

  • 8/12/2019 Equis Partners Prudent Investor Rule



    The purpose of this paper is to summarize the Equius Partners investment policy guidelinesand strategies for the management of client assets within the context of the 1992 restatementof the Prudent Investor Rule. Our goals are to provide our clients and trust duciaries witha basic foundation on which to build the most appropriate investment strategy and to assistthem in developing the condence to stay with the strategy through all market conditions.

    We pay particular attention to portfolio risk and adherence to the principles outlined in theAmerican Law Institutes Restatement of the Law Third, Trusts: Prudent Investor Rule(1992). Our investment strategy is also heavily inuenced by the highly regarded efcientmarket research of academics such as Eugene Fama, Sr. (University of Chicago), KenFrench (Dartmouth College), and William Sharpe (Stanford University).

    Specically, we will focus on our policies regarding:

    Portfolio diversication

    Long-term risk and return objectives

    Investment related costs

    Ination protection & growth of assets

    Our investment advisor responsibilities

    Equius Partners considers each of these principles when developing investment strategies forall of our clients. We believe from experience and through our research of academic and -nancial industry studies that these principles are fundamental to long-term investment suc-cess. The following sections provide additional text from The Prudent Investor Rule andEquiuss specic strategies to address these principles.

    The Prudent Investor Rule (Foreword, page IX):

    This work restates the basic rule governing investment of assets of a trust, known as the pru-dent investor rule.

    This formulation of the prudent investor rule affords more latitude for exercise of judgmentby the trustee than had been thought permitted by the Restatement Second of Trusts. Moreover,the revised rule focuses on the trusts portfolio as a whole and the investment strategy on whichit is based, rather than viewing specic investment in isolation.

    Reecting modern investment concepts and practices, the prudent investor rule recognizesthat return on investment is related to risk, that risk includes deterioration of real return owingto ination, and that the relationship between risk and return may be taken into account inmanaging trust assets. Correlatively, the formulation requires the trustees to take account ofthe relationship between return and risk in light of the purposes and circumstances of the trust.

    This Restatement is a guide for practitioners of law, trustees, and investment advisers as wellas a source of legal authority.


    Equius Partners, Inc.

    4 Hamilton Landing, Suite 205 ! Novato, California 94949 ! 415-382-2500 ! www.equiuspartners.com

  • 8/12/2019 Equis Partners Prudent Investor Rule


    The Prudent Investor Rule (Introduction, page 5, paragraph 4)

    Principles of Prudence:

    1. Sound diversication is fundamental to risk management and is therefore ordinarily required oftrustees;

    2. Risk and return are so directly related that trustees have a duty to analyze and make consciousdecisions concerning the levels of risk appropriate to the purposes, distribution requirements, andother circumstances of the trusts they administer;

    3. Trustees have a duty to avoid fees, transaction costs and other expenses that are not justied bythe needs and realistic objectives of the trusts investment program;

    4. The duciary duty of impartiality requires a balancing of the elements of return between produc-tion of current income and the protection of purchasing power; and

    5. Trustees may have a duty as well as having the authority to delegate as prudent investors would.

    Diversication and Risk & Return

    The Prudent Investor Rule (Page 6, paragraph 3)

    1. The rst two of these principles are fundamental to risk management. This pervasive duty [todiversify] and its vital role in minimizing uncompensated risk are emphasized in the commen-tary, not only as a matter of caution but also as a basic aspect of due care and skill. (Page 6,

    paragraph 1)

    2. Although carrying uncompensated risk is ordinarily undesirable, the same cannot so simply besaid of risks that are compensated by expectations of increased return. This so-called market riskis unavoidable in investing, and duciary decisions are therefore concerned with the appropriate

    degree of that risk. (Page 6, paragraph 2)3. The prudent investor rule recognizes that investments and course of action are properly judged

    not in isolation but on the basis of the roles they are to play in specic trust portfolios and strate-gies.

    Equius Partners Policy Guidelines & Strategy:

    In developing investment policies for clients, Equius begins with the consideration of theportfolios stock/bond diversication. We believe this decision has the greatest impact onportfolio risk (measured in return volatility and potential loss of principal). Investors gener-ally accept the fact that stocks are riskier than xed-income securities, but most are unawarethat both asset classes subject investors to what is called uncompensated riskrisk expo-sure that does not result in commensurately higher returns.

    Since risk and return are directly related, its important that we understand our clients objec-tives and increase or decrease long-term exposure to asset class risk appropriately. This re-quires that we also understand the sources of portfolio risk and expose our clients to onlythose which have the greatest chance of compensating them with higher returns over time.


    Equius Partners, Inc.

    4 Hamilton Landing, Suite 205 ! Novato, California 94949 ! 415-382-2500 ! www.equiuspartners.com

  • 8/12/2019 Equis Partners Prudent Investor Rule


    Fixed-Income Securities

    The primary risks facing investors in xed-income securities are interest rate risk, term risk,purchasing power risk (ination), and default risk. Interest rate risk refers to the uctuationsin interest rates and their effect on bond prices. Simply stated, as interest rates rise, bondprices fall. Term risk refers to the fact that interest rate uctuations have greater effect on

    longer-term bonds.

    Equius Partners believes that from a risk/return perspective, investors are better off in highquality short-term bonds. Table 1 shows the annual risk and volatility for various maturitiesand indicates that maturities of ve years or less provide better diversication benets thanlong-term bonds.


    After the overall stock/bond mix determined, the next decision involves the allocation amongthe various stock asset classes. In order to arrive at a prudent strategy for managing stockrisk, its critical to understand the sources of risk. Uncompensated risk (non-market risk) isrisk that can be diversied away. This risk is pervasive in the active strategies employed bymost independent money managers and mutual fund managers. It is considered uncompen-sated because, on average, taking this risk does not result in higher returns. In other words, allof the economic forecasts, market trend analyses, and research into individual companies per-formed by active managers does not, on average, result in higher-than-market returns afterfactoring in the costs of those efforts.

    Market risk, on the other hand, cannot be diversied away and investors are compensated fortaking it. In other words, the more market risk an investor takes (e.g., the greater their alloca-tion to stocks), the higher their expected return. The only practical way for trustees to elimi-nate uncompensated risk and isolate market risk is through the use of index funds orpassively-managed asset class funds.

    In recent years, the concept of market risk has been expanded to include two additional riskfactors. Eugene Fama, Sr. and Kenneth French, academics at the University of Chicago andDartmouth College respectively, have been at the forefront of this research and have shownthat a companys size (market capitalization) and price-to-book ratio are additional risk fac-tors that also cannot be diversied away and investors are compensated for taking these risks.

    The price-to-book ratio denes the difference in risk and return characteristics betweengrowth stocks (high prices to book value) and value stocks (low prices to book value).

    Indices are not available for direct investment. Their performance does not reectthe expenses associated with the management of an actual portfolio. Past per- formance is not a guarantee of future results. Not to be construed as investmentadvice. Annual Risk = standard deviation of annual returns.


    Equius Partners, Inc.

    4 Hamilton Landing, Suite 205 ! Novato, California 94949 ! 415-382-2500 ! www.equiuspartners.com

  • 8/12/2019 Equis Partners Prudent Investor Rule


    Differences in risk and return characteristics are what dene asset classes. Chart 1 illustratesthese risk dimensions. As investors move away from the market, which is dominated by largegrowth companies due to mark

Search related