Diversification, Prudent Investor Rules and International Accounts

Many financial advisors and investment professionals suggest that investors diversify their holdings by investing in international accounts.  This used to mean holding mutual funds that owned stock in internationally-based companies. But, after the globalization wave of the early 2000s, what exactly does an “international investment” look like?  And, how does the suggestion that market-risk be balanced by international investment apply to plan fiduciaries?

The reason why many investment professionals suggest diversification through international investing is to spread the investment risk among companies based outside of the United States. This isn’t the same as the diversification requirement in ERISA that defined contribution plans holding employer–based securities allow their employees to divest those employer-based securities; that is a discussion for another day. 

The Securities Exchange Commission defines international investing in five silos: U.S.–registered mutual funds; U.S.-registered ETFs; American Depository Receipts (ADRs); U.S. traded foreign stocks and trading on foreign markets. Slightly more complicated than international investing in the past, the U.S.-registered international focused mutual funds now include subcategories of funds including: global funds which may mix foreign-based companies in with U.S.-owned companies as well as international funds which invest in companies outside of the United States. These funds also include international index funds which track specific foreign markets. 

If the goal of international investing is to reduce risk, then focusing on U.S.-registered funds, according to the SEC may reduce some risk of investing internationally because those mutual funds are subject to U.S. securities regulations. Slightly farther along the risk scale, but still within the ambit of U.S. regulations are U.S.-registered exchange traded funds. In those ETFs, an investor can trade the ETF share like any other exchange-traded security allowing for ease of liquidation.  An ADR is slightly less liquid than the ETF. As the SEC notes, each ADR represents shares of stock in a foreign company that gives the investor a right to obtain that foreign stock. Conversely, some foreign companies trade their stocks directly on the U.S. markets, rather than as an ADR. Those companies may list their stock on more than one country’s market, as a way to decrease their own risk of market volatility. Finally, investors can trade on foreign markets by relying on a U.S. broker who can process orders for such shares.

How does balancing market risk through international investment apply beyond the individual investor to plan fiduciaries?

Its notable that fiduciaries of all stripes, whether ERISA related or not, have as a part of their duty of investing with prudence to diversify assets. As noted, usually, financial advisors to plans focus on the diversification of stock of employer-owned securities rules. But all fiduciaries have to invest prudently. And ERISA fiduciaries are required to follow the prudent investor rule just as other financial fiduciaries must [1].

The prudent investor rule as stated in the Uniform Prudent Investor Act (1994) requires that “[a] trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.”  And, a trustee must “diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”

In other words, the prudent investor rule requires proper diversification of assets. The definition of diversification is intentionally loose so that a fiduciary can best meet the needs of their beneficiary. That wiggle room for the fiduciary usually means the definition of prudent diversification is left to the discretion of the court.

More recently, the prudent investor rule has shifted from risk avoidance towards risk management. This tracks the shift of management of companies and organizations towards enterprise-based risk management, as noted in earlier blog posts. But the shift to risk management is not just on protecting the investor’s risk by appropriately encouraging diversification of accounts and including international investments, it also means that the FA should rely on its own compliance and risk management tools as well. Since the DOL expanded the fiduciary rule in 2015 to absorb the prudent investor standard, following a bank’s trust department compliance procedures could be helpful. Those compliance procedures often include noting adherence to the investor’s investment plan or in the case of ERISA funds, the plan documents. Additionally, the prudent investor rule requires that a fiduciary balance market risk.  Some financial advisors and analysts have suggested that the prudent investor rule requires that a fiduciary at the least consider international investments as a way of balancing market risk. Given that diversification depends on circumstances in which the beneficiary is operating, it may make sense to enhance compliance efforts by noting when and why plan has chosen a specific method of diversification, and more specifically, why international investments were chosen or passed over.

[1] Discussed in depth as applied to DOL fidicuary law expansion in 2015 by Max M. Schanzenbach, Ph.D., J.D., and Robert H. Sitkoff, J.D., see the Journal of Financial Planning article at https://www.onefpa.org/journal/Pages/AUG16-Financial-Advisers-Can%E2%80%99t-Overlook--the-Prudent-Investor-Rule.aspx