How does the suggestion that market-risk be balanced by international investment apply to plan fiduciaries?
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
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 .
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
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.
 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
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