Understanding the context of prudent investing requires understanding two fundamentally different approaches to investing: Active and Passive management.
The long-term objective of prudent investors is to achieve the maximum net total return on investment with the lowest exposure to risk. This makes sense. Risk aversion is understandable when dealing with investments in general, and especially in the context of retirement accounts.
The intuitive concept of a prudent investor, especially in the context of managing trust assets, is one who employs diligence in research, understanding of market cycles and the ability to pick which stock is a winner. To actively beat the market requires teams of expert analysts and managers who have proven track records and highly rated funds. It costs a lot of money.
Fundamentally it’s easy for the intuitive fiduciary to adhere to such a concept. Indeed this is what much of the industry - the stock brokerage firms, mutual fund families, many investment advisors and the media - are telling us is the correct path. And, as fiduciaries, we have a duty to manage the trust assets to a Prudent Investor standard.
The problem with these fundamental concepts and the intuition which drives them is that they don’t hold up under long-term scrutiny when considering returns, costs and risk exposure.
From a fiduciary perspective then, where decisions on investment style are critical to the long term care of the plan participants, what is the correct decision to make?
Quite simply, passive management. Passive management has the goal of matching the market return. Studies have shown overwhelmingly that the most prudent method to obtain the highest return for the lowest risk is through passive investing or indexing. While no investment strategy eliminates risk altogether, passive indexing can eliminate uncompensated risks that are inherent in active methods. And, by investing in the entire market or alternatively in a specific asset class in the market, there are lower transaction costs, expenses and management fees compared to actively managed funds which have substantially higher hurdle rates.
For more information on passive management and enhanced indexing:
DFA
Barclays Global Investing
Through SummitPlan, which offers a backbone of passive indexing investment options, retirement plan fiduciaries can have confidence that each of the core elements of plan management - sound governance, prudent investments and compliance - are achievable.
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