You demonstrate prudence by the process through which your client’s investment decisions are managed. No investments are imprudent on their face. It is the way in which they are used, and how decisions as to their use are made, that will be examined to determine whether the prudence test has been met. Even the most aggressive and unconventional investment can meet the standard if arrived at through a sound process; while the most conservative and traditional one may not measure up if a sound process is lacking.

You need to have a defined due diligence process for selecting prudent experts to implement the investment strategy. Keep in mind when you’re developing your due diligence criteria that “simple” is preferable to “complex” when operating in a complex and dynamic environment.

In developing due diligence criteria it is strongly suggested that you:

  • Develop a process that can be consistently applied in any manager search
  • Can be easily communicated to other decision-makers, including the client
  • Can be used in both the search and monitoring phases of the decision-making process

Go to the Checklists and Templates tab to download:

Due Diligence Checklist for Evaluating a Money Manager

Active versus Passive:

These are what we believe to be the salient arguments:

  • It’s not an either or decision – prudent investors will use both in a portfolio.
  • If the client is indifferent to the use of active or passive, go passive in implementing the large cap, core portions of the investment strategy.
  • If you decide to go active, document the fact that you believe the added costs are justified (See Dimension 4.2).
  • How much do you believe in the science behind asset allocation? The stronger your belief system, the more faith you can put into passive investing.

As the adviser, you must be able to: (1) identify every party that has been compensated from the client’s portfolio, and (2) demonstrate that the compensation was fair and reasonable for the level of services being provided. You should benchmark fees and expenses and remain current and knowledgeable of prevailing costs and services in the marketplace.

A good practice is to periodically review contracts and service agreements to ensure that:

  • The client still requires the services being contracted;
  • The vendor’s pricing is still competitive; or,
  • To discover new services the vendor may be able to provide the client.

A common misnomer associated with this duty is the requirement that the fiduciary must select the lowest priced service provider, or lowest priced basket of goods and services. Not so. Instead, what is required is that the fiduciary be able to demonstrate the process that was followed to determine four things  – What, How, Who and Why:

  1. What are the fees and expenses associated with a client’s portfolio?
  2. How do the fees and expenses compare to other service providers, or investment options?
  3. Who is being compensated by the client’s portfolio?
  4. Why is the compensation warranted?

Another common, related, misnomer deals with proprietary, or commission-based products. With the exception of ERISA, existing fiduciary Acts (UPIA, UPMIFA, and MPERS) do not contain blanket prohibitions against the use of such products. However, these commission-based products are still subject to the same procedural prudence requirements as any other product or service suggested by the fiduciary, and will certainly raise a red flag with auditors, compliance officers, regulators and litigators. For this reason, financial institutions may unilaterally decide to prohibit such products as a way to mitigate risk.

Go to the Checklists and Templates tab to download:

Procedural Checklist for Fees and Expenses