Answers to Your Questions about Managing Uncompensated Risk
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1. There’s no mention of UCR in my IPS, what should I do?
In order to be in compliance and avoid breach of fiduciary duties, your Investment Policy Statement (IPS) must describe how UCR will be managed.
Uncompensated risk is defined as:
Uncompensated Risk (UCR), also known as diversifiable risk is defined in Section 3, Comments of the Uniform Prudent Investor Act as: “risk that can be eliminated … [by diversification]”
Because stakeholders can never be compensated for assuming UCR, fiduciary duty requires UCR to be eliminated by diversification, but without providing specific guidance. The only guidance provided is that UCR reduction must be “reasonable”. In larger (over $10 million) portfolios “reasonable” requires UCR be reduced to zero or nearly zero. The “reasonable” test for smaller portfolios depends upon the size of the equity allocation, trading costs, and the costs of monitoring the added constituents. UCR removal is achieved by overlaying securities that are poorly correlated and optimally weighted to the existing asset allocated portfolio.
Uncompensated risk removal must occur at a portfolio’s every level.
Each manager of separately managed accounts, mutual funds, exchange traded funds, etc. owned in an overall portfolio is responsible for UCR elimination in his/her investment fund; while overall portfolio’s fiduciary has the responsibility to oversee that each fund manager is managing UCR in accordance with fiduciary standards.
The overall portfolio’s fiduciaries are also responsible for UCR elimination at the overall portfolio level and must demonstrate that prudent UCR elimination has occurred and is an integral part of managing the overall portfolio.
Here are the steps to develop and incorporate an UCR strategy into your IPS:
- Quantifiable standards for prudent UCR levels for the portfolio must be established.
- Risk levels are measured to determination any excess UCR.
- If the level of UCR exceeds the standards established, steps must be taken to reduce the excessive UCR
- The standards for UCR and the method of monitoring it must be memorialized in the IPS.
- Once everything is in place, and the UCR is being continuously monitored, contemporaneous reports must be created that identify the amount of UCR in the portfolio. These reports will serve to verify that the portfolio has achieved the benchmark standards established for the portfolio.
Note: As with all investment strategies, it is imperative that UCR strategy be managed with the utmost care, accuracy, and prudence. It is the essence of maintaining compliance with fiduciary laws.
How can PFA be of assistance?
If you need assistance with any of the steps outlined above or the entire process, or if you have any questions, PFA can assist you, give us a call at 248-644-7400 or email us. Absolute confidentiality is assured because we are a CPA firm bound by our profession’s high ethical standards. Furthermore, information that could disclose the portfolio’s owner is not needed for testing purposes and is therefore never requested.
Based on an assessment of your portfolio, we can:
- Help establish “reasonable” UCR levels for your portfolio(s).
- Separately fine-tune your portfolio’s UCR using asymmetric correlations and rebalance to achieve maximum diversification in accordance with revised IPS addendum.
- Separately issue a written certificate addressed to the fiduciary, documenting that the diversification strategy implemented in the rebalanced portfolio is prudent and reasonable.
Request our Checklist for including Uncompensated Risk in your Investment Policy Statement.
2. How do I determine how much excessive UCR is in my portfolio?
“Excessive uncompensated risk” is defined as: Levels of UCR beyond which is deemed “Reasonable”.
The first step to complying with fiduciary law and best practices is to properly measure the portfolio’s diversification. Unfortunately, this presents a significant challenge that many trustees or fiduciaries fail to recognize. For the untrained professional, it is nearly impossible without the right, analytical tools, such as Weighted Average Intra-Portfolio Correlation (IPC), Concentration Coefficient (CC), and Eigenfactor Dimensionality (KLD).
PFA can help you determine the amount of excessive UR in your portfolio
We have developed a proprietary testing protocol that calculates and measures the absolute equivalent number of equally weighted diversification resources, also known as diversification dimensions (DDs) present in a portfolio. Each DD has the ability to move independently within a portfolio’s structure. More DDs equal more diversification and the presence of less Uncompensated Risk. Your portfolio is then compared to a “Reasonably” developed portfolio of like size with similar allocation between equities and fixed income.
For assistance with measuring the amount of excessive UR in the portfolio, or if you have questions, please call 248-644-7400 or email us.
More on the metrics we use to measure the UR in the portfolio
[Weighted Average] Intra-Portfolio Correlation (IPC): IPC is a stand-alone holistic measure that identifies the degree to which all of the assets in a portfolio move together. Relative portfolio metrics such as alpha, beta and r-squared measure an asset’s movement against that of the market or an index. IPC measures a portfolio’s overall diversity, and identifies how well or poorly the portfolio will react to systematic or market risk.
Concentration Coefficient (CC): CC is a metric that measures the level of a portfolio’s concentration as the number of investments held, if they were all equally weighted. CC is an important non-systematic diversification metric because of the significant role constituent weightings play in a portfolio’s overall diversification. The higher the CC number, the better protected against company or strategy specific risks.
Eigenfactor Dimensionality (KLD): KLD is a metric that quantifies the number of diversification elements that have the ability to move independently within a portfolio’s structure. The larger the number of independently moving elements, the broader the portfolio’s diversification.
3. How do I eliminate excessive uncompensated risk from my portfolio?
The first step to eliminating excessive uncompensated risk (UR) is to determine how much UR is in the portfolio and how much is excessive. This is discussed in the previous Question/Answer.
Once the amount of excessive UCR is determined, there are procedures for eliminating or reducing it – see our methodology below.
You may be asking, when is some level of UCR acceptable, and at what level would the UCR be considered excessive?
The level of acceptable UCR depends on the size of the portfolio. Eliminating substantially all UCR in larger ($10 million plus) portfolios is achievable and cost effective. Larger portfolios have sufficient asset bases to add holdings to adequately diversify and thereby eliminate UCR. Almost all UCR in large portfolios can and should be eliminated.
However, in smaller portfolios, it becomes uneconomical to eliminate all UCR given the costs of transactions and monitoring. UCR can be eliminated by investing in pooled investments (mutual funds). The rule of thumb is to continue to add holding up to the point that th1e savings are less than the additional costs.
This brings us back to the fact that whatever level of UR you want to eliminate it must be done as part of the Investment Policy Statement, with benchmarks and continual monitoring and reporting.
PFA’s methodology to eliminate excessive uncompensated risk
PFA will conduct an assessment of the uncompensated risk in your portfolio, as well as an in-depth diagnostic investigation to identify changes that must be made to bring the portfolio into compliance with diversification standards of 3rd Restatement of Trusts and UPIA. This step will pinpoint causes of inadequate diversification and recommend solutions that bring diversification into fiduciary compliance.
We will help you to reduce uncompensated risk in the portfolio using our proprietary testing protocol. This methodology calculates and measures the absolute equivalent number of equally weighted diversification resources, also known as diversification dimensions (DDs) present in a portfolio. Each DD has the ability to move independently within a portfolio’s structure. More DDs equal more diversification and the presence of less Uncompensated Risk. Your portfolio’s is then compared to a “Reasonably” developed portfolio of like size with similar allocation between equities and fixed income.
For assistance with measuring the amount of excessive UR in the portfolio and reducing it, or if you have questions, feel free to call us 248-644-7400 or email us.
Contact us for an UR assessment or a Case Study on how we help clients manage UR.