Managing Uncompensated Risk, Manage 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 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 a number of securities that are poorly correlated and optimally weighted to the existing asset allocated portfolio.

Uncompensated risk removal must also occur in every level in a portfolio. 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 memorialize An Uncompensated Risk strategy in 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.

You can access a NO-COST private/online platform that passes your portfolio through a trailing one-year period of screening tests to identify hidden diversification problems. You sign on, enter symbols & % of total, print results, sign-off, and your information is erased. (NO-COST –GO TO THIS LINK)

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 re-balanced portfolio is prudent and reasonable.

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2. How do I determine how much excessive UCR is in my portfolio?

Fiduciary law requires that uncompensated risk (UCR) is actively measured and monitored, and that excessive UCR is eliminated.

“Excessive uncompensated risk” is defined as: Levels of UCR beyond which is deemed “UnReasonable”.

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. PFA can help you determine the amount of excessive UR in your portfolio

We have developed a proprietary testing protocol that calculates and measures a Portfolio’s Intrinsic Dimensionality aka diversification elements (DEs) present in a portfolio. Each DE has the ability to move independently within a portfolio’s structure. More DEs 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.

You can access a NO-COST private/online platform that passes your portfolio through a trailing one-year period of screening tests to identify hidden diversification problems. You sign on, enter symbols & % of total, print results, sign-off, and your information is erased. (NO-COST –GO TO THIS LINK TO CONNECT)

More on the metrics we use to measure the UNCOMPENSATED RISK in a portfolio:

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 count, the better the portfolio is protected against company or strategy specific risks.

Diversification Elements (DE): DE is a metric that quantifies the number of diversification elements that have the ability to move independently within a portfolio’s structure. A larger the number of independently moving elements, signifies a broader portfolio diversification and the presence of less uncompensated risk.

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3. How do I eliminate excessive uncompensated risk from my portfolio?

The first step to eliminating excessive uncompensated risk (UCR) is to determine how much UCR is in the portfolio and how much is excessive.

You can access a NO-COST private/online platform that passes your portfolio through a trailing one-year period of screening tests to identify hidden diversification problems. You sign on, enter symbols & % of total, print results, sign-off, and your information is erased. (NO-COST –GO TO THIS LINK TO CONNECT)

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.

We will help you to reduce uncompensated risk in the portfolio using our proprietary testing protocol. Our web-based testing protocol leverages expertise, software and process allowing a novice, using the internet, to easily calculate Concentration Coefficients, Intrinsic Dimensionalities and Variance Gaps, the essentials of DIVERSIFICATION ELEMENT quantification. Your portfolio’s DIVERSIFICATION ELEMENT is then compared to the DIVERSIFICATION ELEMENT of a portfolio similar in size having an asset allocation similar to yours but prudently diversified to achieve (maximum-reasonable) reduction of UNCOMPENSATED RISK.