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Use of AI: The BGI-BOT was used extensively to draft this article. This tool is a proprietary AI Generative closed chatbot that only utilizes curated digital content that has been prepared by the author and other industry thought leaders including Dr Sean Hannah, Eric Dyson, Hugh O’Toole, and Jamie Greenleaf.
Get ready for a blizzard of new investment options (Shiny New Objects) and accompanying ad campaigns that will infer higher returns and less risk with each.
Now that cautionary regulatory fences have been removed around private equity, bitcoins, and certain alternative investments investors are going to be tempted to play in the SNO.
Well…that’s okay if it is an investor’s own money. But it is not okay when an investment portfolio is subject to a fiduciary standard of care.
Note: With regards to alternative investments, there are certain ‘alts’ that have been used by prudent fiduciaries for decades – real estate being one of the prime examples.
Fiduciary responsibility is inclusive of the principle that no investment strategy or product will be deemed imprudent solely by the nature of the investment itself, but rather by the process through which investment decisions were made.
Prudence is measured by the integrity of the fiduciary’s process…not by investment results.
5 Ts
To begin, fiduciaries should consider the "5 Ts" - important attributes and behaviors that key decision-makers should possess before attempting to invest in a portfolio of SNO.
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Time: An investment in SNO will likely consume more of a fiduciary’s time than the total time spent on all other asset classes in a portfolio.
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Talent: SNO requires considerably greater skill and expertise in order to make informed decisions and to accurately interpret complex information. Here fiduciaries are cautioned to prudently select and delegate to an expert when lacking such talent.
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Trust: There often is a lack of transparency with SNO which requires fiduciaries to place even greater trust in the capabilities and intentions of those involved in executing the SNO strategy.
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Temperament: Key decision-makers need to remain calm and rational, especially when faced with volatile returns and uncertain or conflicting information. It also means being open to changing one's mind as new facts become known.
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Tools: An investment in SNO will likely require access to additional tools, models, software, and data analytics in order to effectively implement and monitor the strategy. This often will result in increased fees and expenses which will need to be justified and accounted for by fiduciaries.
The 5 Ts collectively ensure that the investment strategy is executed efficiently and aligns with stated goals and objectives.
5 Es
SNO presents a number of unique challenges, yet a fiduciary can still demonstrate their procedural prudence if a sound governance process is followed.
Engage
Determine who is going to lead…who best demonstrates the behaviors associated with the 5 Ts.
Explore
An investment in SNO should be based on an analysis of, at least, four elements…Risks, Assets, Time Horizons, and Expected Outcomes. We would suggest the acronym RATE as a heuristic:
Risks: Demonstrate an understanding of the level and sources of risks. Not just investment risk, but also the risk of drawing in opponents who may be critical of the investment strategy.
Assets: Identify the level and sources of assets that will be invested. An allocation of less than 5% in SNO will not likely provide a meaningful impact on the risk/return profile of the overall portfolio; more than 10% as an initial investment may be deemed imprudent by opponents.
Time Horizon: Determine the timeframe over which the strategy will be executed and evaluated. SNO typically involves longer holding periods and may have less liquidity than traditional asset classes.
Expected Outcomes: Define the anticipated results or goals that the strategy aims to achieve. Keep in mind, SNO will likely be the asset class that carries the highest fees and expenses and will consume more of a fiduciaries time and energy.
Envision
Once the RATE inputs have been identified, the next step is to define the portfolio’s asset allocation – the percentage that will be allocated to each asset class. One significant challenge with SNO is developing the inputs for an optimizer since most SNO will not have sufficient history to model return premiums, risk levels, and correlation coefficients.
If detailed SNO information is lacking, one simplified approach would be to create a generic asset class – a sleeve – to represent all of the investments in SNO. Then for modeling purposes assign the sleeve the attributes of microcap stocks – the highest modeled return; the highest risk level (return variability); and a correlation coefficient of 50 or (.50).
Once the asset allocation is determined, define the most appropriate investment strategy and then prepare or revise the IPS (investment policy statement).
Execute
An investment strategy that is inclusive of SNO should be executed through one or more experts who have been prudently selected. If key decision-makers are serving in a fiduciary capacity, it would not be wise to make a direct investment in SNO, particularly if there are defined safe harbor procedures that may insulate decision-makers from fiduciary liability.
This also is the step where fiduciaries will need to demonstrate that they have accounted for the total fees and expenses associated with the investment in SNO; have identified every party compensated by the fees and expenses; and have determined that the fees and expenses are appropriate given the level of services performed by each party.
Examine
SNO often presents unique challenges because of the lack of sufficient data to adequately analyze performance and compare results to benchmarks and peer groups.
At least quarterly, fiduciaries should determine whether the overall investment strategy has a high probability of meeting stated goals and objectives and whether the portfolio needs to be rebalanced.
A periodic examination also needs to be conducted for possible conflicts of interest or self-dealing. SNO normally involves considerably higher fees and expenses that can easily be diverted to fund pay-to-play or other inappropriate sales and marketing schemes.
In summary, investing in SNO can be an exciting form of entertainment for individual investors, but it comes with significant risks and challenges for fiduciaries. The key to success – for both individuals and fiduciaries – rests in adhering to a disciplined process that prioritizes procedural prudence over speculative outcomes.