Hinckley Investments (“Hinckley”) is a registered investment advisory firm. Hinc

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Hinckley Investments (“Hinckley”) is a registered investment advisory firm. Hinckley provides investment management, financial planning and investment advisory services to individuals and institutions. The firm has grown rapidly through strong investment performance, exceptional client servicing and a personalized approach to portfolio management and financial planning. Hinckley is regulated by the Securities and Exchange Commission (“SEC”) and must adhere to the Investment Advisers Act of 1940. Hinckley and its employees must act as fiduciaries for their clients. Per the SEC, a fiduciary must act for the benefit of the person to whom he/she owes fiduciary duties, to the exclusion of any contrary interest (1). Hinckley requires that all employees sign a code of ethics and read the firm’s ethics manual. All employees are required to put clients’ interests first, to provide full and fair disclosure of all material facts and to expose all conflicts of interest to clients. Joe Phillips and Samantha Williams head Hinckley’s socially responsible investment practice. Socially responsible investing (“SRI”) is also known as socially conscious or impact investing. SRI is an investment strategy which seeks both financial return and social good. Investments are reviewed for social, governance and environmental factors in addition to investment and financial considerations. Hinckley is a leader in SRI investing. Over the past five years, nearly 75% of its new clients joined Hinckley because of the SRI investment opportunity. Hinckley charges clients a 1% annual fee for its investment management services. The management fee is charged as a percentage of the client’s portfolio value. A $100,000 portfolio would be charged $1,000. Several years ago, Joe and Samantha created an investment SRI screening filter to identify potential stocks for investment. The filter includes traditional financial factors and metrics such as a company’s expected earnings growth rate, historical returns, dividend yield, beta and balance sheet strength. The filter excludes industries with poor environmental records such as oil companies. Companies that pass the initial filter are further researched. Joe and Samantha review the financial outlook for each company and estimate future earnings and dividend growth to estimate the stock’s intrinsic value

."Many forms of conduct permissible in a workaday world for those acting at arm's length are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior." Meinhard v. Salmon, 249 N.Y. 458, 464 (1928) (Cardozo, B)

Joe and Samantha also research each company’s filings for evidence of poor social, governance or environmental behavior. Companies that are found to have no major social, governance or environmental issues and trade at an intrinsic value estimate that is 20% or more above the current stock price are added to the firm’s SRI portfolio.
Before Hinckley launched the SRI portfolio strategy, Joe and Samantha back-tested the SRI filter and found that a portfolio of stocks based on their SRI filter and investment process outperformed the S&P 500 stock index (“S&P 500”), a widely used index for U.S. stocks, over the past 10 years. The S&P 500 is a passive index of stocks which does require not active investment research or analysis. A mutual fund based on the S&P 500 index may be purchased by investors for an expense ratio of approx. .05%. The expense ratio is recurring on an annual basis.   A $100,000 portfolio would be charged $50.
Bob Smith is a Hinckley client and was attracted to the firm’s SRI investment approach. He has been a Hinckley client for five years. His grandson is a business student at USM and just completed the Financial Management 320 course. He was interested in reviewing his grandfather’s investment returns for the SRI stock portfolio managed by Hinckley. Over the past five years, the Hinckley managed SRI portfolio generated an annualized return of 8.2% after fees. This compares to an annualized return for the S&P 500 of 10.3% over the same period. Mr. Smith was surprised to learn that the Hinckley portfolio had lagged the S&P 500 by such a wide margin. If Mr. Smith’s portfolio had been invested in the S&P 500 instead of the SRI portfolio, the account would be $250,000 larger. Mr. Smith’s grandson also noticed that the Hinckley managed SRI portfolio had been more volatile and could be considered riskier than the S&P 500 over the past five years.  
Mr. Smith scheduled a meeting with Joe and Samantha to review his portfolio. When asked about his portfolio’s underperformance versus the S&P 500, Joe and Samantha commented that an SRI portfolio is not constructed to match the performance of the S&P 500. Mr. Smith responded “I did not know that my portfolio could end up doing so much worse than the S&P 500. I know that we discussed SRI investing in general but why did you choose a portfolio that is doing so poorly? I thought companies that had strong social, environmental and governance practices would be less risky not more risky.” Joe and Samantha responded, “we discussed and disclosed that investing involves risk and your portfolio could decline in value. You also agreed that we would be allowed to select the investments for your portfolio.”
Have Joe and Samantha fulfilled their fiduciary duty to Mr. Smith?
Should they have done anything different?

identify issues, problem solve, propose solutions, justify proposals, communicate clearly, convey points and observations and craft a well-reasoned response to the questions?.

Explanation / Answer

Following actions were taken by Joe and Samantha to construct portfolios :

"Joe and Samantha created an investment SRI screening filter to identify potential stocks for investment. The filter includes traditional financial factors and metrics such as a company’s expected earnings growth rate, historical returns, dividend yield, beta and balance sheet strength. The filter excludes industries with poor environmental records such as oil companies. Companies that pass the initial filter are further researched. Joe and Samantha review the financial outlook for each company and estimate future earnings and dividend growth to estimate the stock’s intrinsic value

Joe and Samantha also research each company’s filings for evidence of poor social, governance or environmental behavior. Companies that are found to have no major social, governance or environmental issues and trade at an intrinsic value estimate that is 20% or more above the current stock price are added to the firm’s SRI portfolio.

Before Hinckley launched the SRI portfolio strategy, Joe and Samantha back-tested the SRI filter and found that a portfolio of stocks based on their SRI filter and investment process outperformed the S&P 500 stock index (“S&P 500”), a widely used index for U.S. stocks, over the past 10 years."

Hence, it appears that they have done the needful and have given their best to research the best investments. Also as it is mentioned that Mr. Smith was informed that his portfolio could fall in value, that he had given his consent in choosing stocks to invest, it doesn't appear that Joe and Samantha have failed to fulfill their fiduciary duties towards Smith. It was not promised in the contract that SRI will keep outperforming and give better return than S&P. Neither it was a luring strategy to attract investors. Smith can't blame Joe and Samantha for poor portfolio performance just because S&P has given better return.

Smith's view that socially responsible and environment conscious companies are less riskier also is not correct at all. Rather it is just the opposite. These companies put the environment's interest first and hence are bound to sacrifice higher profit aspects than their not so socially responsible counterparts. Smith should have researched well and known what he was getting into. Surely, these companies will rise but they need more time.

However Joe and Samantha should compensate their clients for the lower returns by reducing their annual expense ratio which appears too high for a portfolio which is already giving lower returns. The present expense ratio of 1% will drive away future investors. It should be at least reduced to and kept in the margin of 0.1 to 0.5% until the portfolio return rises.

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