Balancing client growth and income objectives with capital preservation.

Investment advisors occupy a unique niche in the financial-services industry. They are designated as fiduciaries by the Investment Advisors Act of 1940, which is still today the definitive legislation governing investment advisors.

The fiduciary standard goes considerably beyond the “suitability” requirement of securities brokers, requiring an advisor to

• act in the best interests of clients and also provide investment advice in the clients’ best interests;
• owe one’s clients a duty of undivided loyalty and utmost good faith;
• not engage in any activity in conflict with the interest of any client and take steps reasonably necessary to fulfill one’s obligations;
• employ reasonable care to avoid misleading clients and provide full and fair disclosure of all material facts to one’s clients and prospective clients;
• eliminate, or at least disclose, all conflicts of interest that might incline the advisor—consciously or unconsciously—to render advice that is not disinterested.

“Those with responsibility to invest money for others should act with prudence, discretion, intelligence, and regard for the safety of capital as well as income.”

In establishing whether investment advice is in the client’s best interests, the courts have often turned to the “prudent man” standard, articulated by Judge Samuel Putnam in 1830: “Those with responsibility to invest money for others should act with prudence, discretion, intelligence, and regard for the safety of capital as well as income.” Therein lies the challenge for today’s investment advisor.

The traditional passive, or buy-and-hold, bear market defense has been to allocate a portion of the portfolio to bonds with the expectation that a decline in stock values will be at least partially offset by an increase in bond values. With bond yields at historically low levels, there is little chance that will happen if a significant market decline occurs in the near future. In fact, the 10-year expected return for a portfolio with the majority of its assets in bonds is at its lowest level in almost a century of data.

The desirability of investing in equities comes from the long-term upward trend of the stock market. But even long term, the market has been an inefficient source of growth. Over the last 75 years, the major stock market indexes spent nearly two-thirds of the time working through declines and the return to prior highs. Only one-third of the time were the indexes actually increasing in value.

In the most recent bear market declines, the S&P 500 fell 49% and the NASDAQ 100 declined 80% from 2000 to 2002.

In the 2007 through 2009 decline, the S&P 500 Index lost 57% of its value, while the NASDAQ lost 55%. At the end of 2013, the NASDAQ had yet to regain its 2000 high, while the S&P 500 had an annualized yearly gain of just less than 2% over that 13-year period.

The challenge

The challenge for investment advisors has been to rebuild client portfolios, given more than a decade of lackluster equity returns combined with five years of interest rates at historic-low yields. To meet their clients’ income requirements, for example, many advisors have allocated that portion of the portfolio which traditionally would have been in bonds to dividend-paying stocks. However, this actually increases portfolio risk as, unlike bonds, dividend-paying stocks have no guarantee of return or maturity value (although bonds carry their own risks of default) and are vulnerable to declining stock markets as well as to company risk.

Given that an advisor has a duty to manage client portfolios consistent with fiduciary principles—and that preserving capital is also helpful in preventing investor lawsuits—there need to be defensive tools in place to manage the increased portfolio risk to fill the void created by the prospects for bond investors. One way of doing that is to make sure that portfolios are flexible and opportunistic with actively managed use of all the defensive tools available to today’s asset managers. That is the core of active management.

Today’s investment advisor is operating in extraordinary market circumstances. Natural market forces of supply and demand, of efficient pricing in response to information, and even reversion to mean have been distorted by government intervention. The long-term effect on the market cycle will be known only in hindsight, but as fiduciaries, investment advisors must take the uncertainty of the market into consideration in their investment approaches.

Active management, in contrast with traditional buy-and-hold investment strategies, gives the investment advisor the ability to respond to market conditions, whether in pursuit of new opportunities for profit or in defensive reaction to preserve capital in the event of a significant market decline. Through the use of active management strategies, investment advisors can employ investment approaches that seek to moderate the volatility of the market, help investors stay the course, and provide benefit to the portfolio from the long-term gains of the market. Active management not only makes sound investing sense, it also makes sound fiduciary sense.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.