How the Prudent Man Rule Governs Your Investment Portfolio

Prudent-Man-RuleInvestment managers are held accountable to a variety of guidelines that restrict their ability to invest funds to reasonable venues. These restrictions include investment fund policy statements, suitability requirements, and legal restrictions based on the type of security that they are managing. However, as the investment environment modernizes, so does the manager’s ability to create returns and mitigate risks in their portfolios.

While traditionally, investment managers were restricted from using ‘modern’ strategies in their client-offered portfolios, the evolution of the definition of care has recently allowed advisers to improve the level of sophistication in their client portfolios for the better. Specifically, this adjustment is the result of a change in what is known as the Prudent Man rule, which defines how it is that investment managers must manage their portfolios similarly to how it is that a hypothetically ‘prudent’ individual would.

Originally, the Prudent Man rule was surrounded by controversy because of the way in which it restricted an investment manager from taking on risk in a way that would allow them to earn returns. Specifically, the rule required that managers avoid all forms of risk possible (rather than mitigate risk through diversification), restricted the kinds of investment securities that could be included (ruling out options, and therefore risk-reducing buy-write strategies), used awkward return metrics that isolated the returns of individual securities, and lastly, stopped managers from seeking expertise in areas that were beyond their understanding.

This last point meant that an investment manager was the sole point of contact allowed to work on a given portfolio, rather than having a multi-disciplinary team with a variety of expertise to collaborate on the portfolio as a project. The end result is that the rule focused on avoiding risks, and therefore avoiding returns. Worse yet, the rule ignored the benefits of taking on a portfolio-level approach to investment, and therefore prevented advisers from doing their jobs.

The adjustments to the Prudent Man rule, albeit somewhat hard to see from a consumer standpoint, were a huge adjustment to the legal restrictions that govern investment managers. Specifically, they allowed managers to begin look at their securities as an entire diversified portfolio, and to use a total return index to accommodate such. From there, they were allowed to collaborate internally to ensure that the maximum level of expertise was allocated to a portfolio, and they could therefore access any kind of security that would meet the client’s needs.

The end result is that the interests of client-suitability, and the contexts surrounding the portfolio became an important part of what an investment manager is allowed to do, rather than the fear of market risk restricting them to being paid to hold funds in a savings account on behalf of their client.

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