Excuses don't wash for fiduciaries who ignore the risks of a concentrated portfolio.
I have encountered over the years a number of situations where a large portfolio was concentrated in one stock or a very few stocks. These situations involved the portfolios of private family trusts, individuals, or non-profits. Some of the trustees responsible for investing and managing the portfolios were new to the job and others had been at it for a while. But all these trustees (and most of their beneficiaries) had one thing in common: an almost pathological aversion to paying taxes. That is, they didn't want to pay the taxes that would come due upon sale of a concentrated stock position in a portfolio. Let's explore why such avoidance may not always be such a good idea.
Back to the (Fiduciary) Basics
The "central consideration" of every investment fiduciary under the Uniform Prudent Investor Act (UPIA) is to determine the tradeoff between the risk and return of the portfolio for which it is responsible. It's problematic whether many fiduciaries are even aware of this paramount duty, much less carry it out. Instead, fiduciaries (indeed, many non-fiduciary investors) tend to get all hot and bothered about the return side of the risk-return tradeoff by either bringing up the past or peering into the future.
The Overwhelming Focus on the Return Side of the Tradeoff
Such fiduciaries bring up the past by looking at the track records of particular investments. "Track record investing" occurs when an investor identifies some investment such as a mutual fund with an outstanding track record and invests in it because the investor thinks that its historical performance--that is, its track record--will continue into the future. When fiduciaries become track record investors, they forget the sensible (and true) warning issued by the Securities and Exchange Commission: Past performance is no guarantee of future results. One good reason why this warning is all too true are the findings of virtually every reputable study of mutual fund performance over the last 40 years, which show that there's no reliable way to predict when--or which or even if--winners from the past will win again in the future.
Another problem with track record investing is that it doesn't do any good to rave about an investment with a marvelous track record unless one had been invested in the product that generated it. Those prattling on about a winning investment from the past who didn't hold it during that period are nothing more than, well, prattlers. Many others that decide to actually take the plunge and invest on the basis of track records then get to experience the often perverse tendency of superior track records to be followed by inferior track records. They zigged when they should have zagged; or maybe they zagged when they should have zigged, I forget which.
Other fiduciaries aren't content to bring up the past but instead want to peer into the future. They listen to the siren songs of stock-picking and market-timing investment advisors who are like a class of kindergarteners jumping up and down waving their hands, yelling "Pick me, pick me, I know the answer." A belief in stock-picking and market-timing is the belief that, to be successful in maximizing investment performance, an investor must be able to "see" into the future or find a "skillful" investment advisor that can. Fiduciaries--many of whom should (and do) know better--succumb to this fundamentally goofy idea that it's possible to predict which particular investment advisor will be able to predict which particular mutual fund, money manager, individual stock or bond, or asset class will turn out to be superior--or inferior.
Fiduciaries that engage in track record investing, stock-picking, or market-timing are guilty of a one-dimensional focus on return. To make matters worse, they have no control over the returns of investment track records because they're past, and they have no control over future investment returns because they're random variables subject to unpredictable uncertainty. Fiduciaries placing an undue emphasis on return, of course, also violate their "central consideration" under the UPIA: determine the tradeoff between return and risk in a portfolio. Perhaps more fundamentally, those focusing on return only--without taking risk into consideration--are nothing more than rank speculators not investors. No less an eminence than the father of modern portfolio theory, Nobel laureate Harry Markowitz, spotted this as a 23-year-old over a half-century ago. If you get nothing else out of this month's column, remember that investment fiduciaries--who are responsible for other people's money--cannot be speculators.
The Underwhelming Focus on the Risk Side of the Tradeoff
Returns, no doubt, are exciting to talk about when they're high. Even when they're low, they seem to attract attention in the way that a car wreck does. But risk, well risk, is a real snooze. Other than a general warning about risk, what else can you say about it? The endless numbers of talking heads on television and radio programs that love to discuss the unknowable future returns of an endless number of investment products have nothing to say about risk. Yet the UPIA, and particularly the Restatement 3rd of Trusts (Prudent Investor Rule) (Restatement), have plenty to say about the notion of risk and the critical role that broad diversification of portfolio risk plays in assessing fiduciary conduct.
The Duty to Diversify Risk
The duty to diversify risk is so central to modern concepts of prudence that the Restatement integrates the diversification requirement into the basic text and commentary of the prudent investor rule. The very first of five "principles of prudence" identified by the Restatement is that "sound diversification is fundamental to risk management and is therefore ordinarily required of trustees." Restatement commentary notes that the duty to diversify risk is based on principles of modern portfolio theory. John H. Langbein, the Reporter for the UPIA and the Chancellor Kent professor of law and legal history at Yale University law school, explains: "One of the central findings of Modern Portfolio Theory [is] that . huge and essentially costless gains [can be obtained by] diversifying [a] portfolio thoroughly."
Now wait a minute, why is Prof. Langbein citing the gains that can be achieved through broad diversification instead of the losses that can be reduced through broad diversification? After all, isn't the whole point of diversification to reduce portfolio risk and therefore portfolio losses? While the reduction of risk is important, it's not the whole story of why modern prudent investing requires ordinarily that fiduciaries diversify broadly. It's not even the sexiest part of the story which, yes, you guessed it, involves increased return, as you'll now see.
You Are Now Entering a Third Dimension: the "Diversification Effect"
In addition to thinking about investing in the two dimensions of risk and return, I suggest that fiduciaries should also think about investing in a third dimension: what Roger Gibson calls the "diversification effect." The diversification effect results from the conscious tradeoff between portfolio risk and return that reduces risk and simultaneously increases return, thereby creating a prudently diversified portfolio.
Indeed, broad diversification serves the only dependable "free lunch" in investing: reduced risk and increased return at the same time. Only through broad diversification do fiduciaries get the double-barreled benefit of reduced loss and enhanced gain. In fact, cutting down on the volatility of a portfolio's returns (i.e., risk) not only reduces losses but actually becomes the source of enhanced returns. This counterintuitive (and thus wholly confusing) notion was explored fully in my column last April.
That column made clear that investment Nirvana is not achieved by an unruly class of track record investing, stock-picking, and market-timing kindergartners. Instead, it is achieved by broad diversification of a passively managed portfolio that reduces risk and increases return at the same time--and by the simple "eat your spinach" rules of making sure to keep portfolio costs and taxes low.
But Uncle Ferdinand Always Said to Never Sell the Xerox Stock
The problem is that many fiduciaries responsible for large portfolios (whether for private family trusts, individuals, or non-profits) concentrated in one stock or just a few stocks don't know about all this; even if they do, it just doesn't register with them. They do know one thing, however: Selling their stock is to be avoided at all costs because otherwise they'd have to, gulp, pay taxes.
One reason often cited by fiduciaries of, for example, private family trusts for not selling a concentrated stock position is that family lore and trust documents conspire to tie their hands. After all, many testators of these trusts funded them with the stock of the company that loyally employed them for years and years. The beneficiaries of the testator naturally feel duty bound to honor Uncle Ferdinand's warning so often expressed during his lifetime (and from the grave): Don't you ever sell that stock.
While it may have been wonderful that Uncle Ferdinand was employed by Xerox for 45 years (full disclosure: I've never owned Xerox stock, although it might be held in one or more of the asset class mutual funds I own) and fortunate that his purchases of company stock through those years have now mushroomed into a $100 million one-stock portfolio, does anyone really believe in this day and age that it makes sense--economic or otherwise--to keep such large (or even small, for that matter) portfolios invested in just one stock or even a few stocks? The same question applies to, for example, the portfolios of large private foundations--with many public charitable beneficiaries dependent on them to carry out their religious, charitable, scientific, educational, and other purposes--that are invested, for example, north of 50% in one single stock. It is inconceivable that any reasonable person (including state attorneys general who are responsible for policing non-profits) would conclude, based on modern notions of fiduciary investing, that such a portfolio is anywhere close to being a prudently invested portfolio.
The risk inherent in a one-stock portfolio or one composed largely of just a few stocks is just about off the charts. Enron was a huge viable company one day and the next day (relatively speaking), it was in bankruptcy. That fate also awaited Pan Am, Arthur Anderson, MCI, as well as other giant companies. Polaroid and Xerox are not the companies they once were, nor is the value of their stock. That's just a reflection of the creative destruction that continually rolls through our capitalistic system. In my own state of California, Pacific Gas & Electric (a utility often referred to as a "widows and orphans" stock) went bankrupt in the first quarter of 2001. Most of my maternal grandmother's portfolio was concentrated in PG&E stock, and she lived a comfortable life as a result. I shudder to think what would have happened to her had she lived long enough to go through that bankruptcy.
The Taxes Will Kill Us
Another reason cited by fiduciaries for not selling concentrated positions of stock, of course, is that the portfolios would incur huge capital-gains taxes. Uh, let's step back a moment and think about that one. While the $15 million long-term capital-gains taxes incurred on the sale of an essentially zero-basis stock worth $100 million is assuredly "huge" on an absolute basis, it still is only 15% of the value of a portfolio. No one, of course, likes to pay taxes. Yet in a way, the beneficiaries of, say, private family trusts are actually quite lucky: A 15% long-term capital-gains rate is now at a historic low and really isn't too bad when you think about it. After all, that rate is less than the flat-tax rate on just income that Steve Forbes and others have proposed and most of the Eastern European countries have recently implemented. Good grief, the value of a stock can dip 15% or more within a single week or even within a day--and stay there for years.
And what if Congress lets the current 15% long-term capital-gains tax rate expire on Jan. 1, 2011? That rate is scheduled to rise to 20% then, but that's not to say that it can't be raised even more. Waiting to sell off concentrated stocks in portfolios in 2011 or thereafter and incurring an additional five percentage points of taxes (thereby reducing the value of the portfolio by the same amount) ordinarily isn't exactly the law's idea of prudent fiduciary conduct.
Just Sell Off the Portfolio and Be Done With It
So why shouldn't a fiduciary responsible for a portfolio not just sell off the concentrated positions in the portfolio, pay the 15% tax, prudently and efficiently mitigate risk through broad diversification, and then be done with it? That way, the fiduciary has eliminated all risk of a plunge in portfolio value. While trying to minimize taxes is a worthy objective, that objective should never be allowed to override a prudent risk management strategy.
Another point in favor of simply selling off a concentrated portfolio and paying taxes: assuming that, for example, the beneficiaries of a trust have already achieved a comfortable level of wealth, there's no need for them to assume the risk of concentrated stock positions. Biting the bullet and paying taxes makes even more sense if some (or all) of the beneficiaries of a trust have not yet achieved a comfortable level of wealth. Both groups can substantially reduce their risk by diversifying broadly, not only across the asset classes that compose a portfolio but also within each such asset class.
Restatement commentary warns investment fiduciaries: "Failure to diversify on a reasonable basis in order to reduce.risk is ordinarily a violation of both the duty of caution and the duties of care and skill." Both the Restatement and the UPIA define these three duties as no less than the very elements that comprise investment "prudence" itself.
Fiduciaries cannot sit by passively and ignore the existence of risk in their portfolios. All bodies of fiduciary law--the 1974 Employee Retirement Income Security Act, the 1994 Uniform Prudent Investor Act, the 1997 Uniform Management of Public Employee Retirement Systems Act and the 2006 Uniform Prudent Management of Institutional Funds Act--as well as modern investment theories require fiduciaries to take affirmative steps to diversify risk, preferably broadly, as part of a prudent process. It's a lot better to turn over 15% of a portfolio to the taxman and diversify broadly than risk the possibility of losing some other much larger amount.