Uncompensated risk: the orphan of modern portfolio theory.

• Author: Sarenski, Theodore J.

The Uniform Prudent Investor Act (UPIA) was promulgated by the Uniform Law Commissioners in 1994 and shortly thereafter enacted into law by nearly all states. The commentary to Section 3 of the UPIA explains how risk is to be managed:

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Modern portfolio theory divides risk into the categories of "compensated" and "uncompensated" risk. The risk of owning shares in a mature and well-managed company in a settled industry is less than the risk of owning shares in a start-up hightechnology venture. The investor requires a higher expected return to induce the investor to bear the greater risk of disappointment associated with the start-up firm. This is compensated risk--the firm pays the investor for bearing the risk. By contrast, nobody pays the investor for owning too few stocks... Risk that can be eliminated by adding different stocks (or bonds) is uncompensated risk. The object of diversification is to minimize this uncompensated risk... The Restatement (Third) of Trusts was promulgated by the American Law Institute in 1992 and remains the authoritative guidance for applying trust law. Chapter 7, Section 227, addresses the general standard of prudent investment and specifically discusses "risk and the requirement of diversification." Following are two clearly stated pronouncements about what is required of a fiduciary to prudently manage uncompensated risk:

The trustee's duties and objectives with respect to [nondiversifiable (compensated)] risk are not as distinct as those with respect to diversifiable [uncompensated] risk. [Restatement (Third) of Trusts [section]227, "Comment on Basic Duties of Prudent Investor," p. 19] Failure to diversify on a reasonable basis in order to reduce uncompensated risk is ordinarily a violation of both the duty of caution and the duties of care and skill. [Id. at 23] Uncompensated risk defined

Uncompensated risk is risk that can be eliminated with diversification and, unlike systematic or compensated risk, investors cannot expect added return for assuming more uncompensated risk. Uncompensated risk comes from the inherent risk of investments in industries and sectors and in individual companies, and from having too many of industries, sectors, or companies that are closely correlated or uncorrelated.

Uncompensated risk measurement

From the inception of modern portfolio theory until recently, only academics have taken the time and effort to measure how much uncompensated risk can be eliminated when constructing a portfolio. However, the academic standard for uncompensated risk measurement required the portfolio to be built entirely of equally weighted (to overcome weighting bias) and randomly selected (to overcome selection bias) constituents.

The academics' portfolios could not be used for real-world investment solutions because real-world portfolios had to be designed to deliver maximized risk-adjusted returns (i.e., compensated risk) and could not accommodate those rigid constraints. As a result, industry practice concentrated on managing compensated risk through asset allocation and all but ignored uncompensated risk.

The one concession industry professionals made to uncompensated risk management was adding a number of somewhat uncorrelated investments to their portfolios. This was a practice predicated on the assumption that uncompensated risk would be reduced to prudent levels if the portfolio contained somewhat more than "too few investments," an outcome suggested in commentary to Section 3 of the UPIA. That practice can cause some portfolio uncompensated risk to be reduced.

However, where the added investments were not asymmetrically compatible with the rest of the portfolio, that practice caused other new uncompensated risks to be created. The reasons for this apparent anomaly are that academics investigated uncompensated risks in the context of constructing an entire portfolio, whereas practitioners must...