Recent scandals call into question the integrity of the securities and mutual fund markets: cooked corporate books, misconduct by investment banking firms and brokerage houses in touting securities, claims of after-hours trading in mutual funds and allegations against market makers for self-dealing in executing trades.
Must we add to that list of infamy bank trustees who who fail to reduce their fees even though they're using a mutual fund for all or a portion of a trust investment portfolio? The answer is a resounding “Yes,” according to several pending class actions against Bank of America and LaSalle Bank.
What do the Restatement (Third) of Trusts and Uniform Prudent Investor Act say? One of the major innovations of the UPIA — now law in 41 states and the District of Columbia — is that it empowers trustees to delegate such fiduciary functions as investing. But delegation creates new conundrums. And, while the restatements and uniform law are valuable guides, a rapidly evolving and increasingly dangerous financial marketplace constantly sparks questions that they alone cannot answer. For example: If we accept the widely held belief that predicting stock price increases is a futile game and 90 percent of portfolio performance is the result of asset allocation, is there even a place for actively selecting and managing investments? When exactly is it appropriate to delegate investing to an outside manager or to use mutual funds? And if outsiders and mutual funds are used, what impact should this outsourcing have on the trustee's compensation?
Some answers are found in recent financial studies. We also sought instruction from John H. Langbein, the Sterling Professor of Law at Yale University, who acted as the reporter for the UPIA and an official advisor on the third restatement of trusts.
POWER TO DELEGATE
First, the basics: Section 171 of the third restatement of trusts, issued in 1992, says: “A trustee has a duty personally to perform the responsibilities of trusteeship except as a prudent person might delegate those responsibilities to others. In deciding whether, to whom, and in what manner to delegate fiduciary authority in the administration of a trust, and thereafter in supervising agents, the trustee is under a duty to the beneficiaries to exercise fiduciary discretion and to act as a prudent person would act in similar circumstances.”
UPIA's Section 9(a) provides: “A trustee may delegate investment and management functions that a prudent trustee of comparable skills could properly delegate under the circumstances. The trustee shall exercise reasonable care, skill and caution in: (1) selecting an agent; (2) establishing the scope and terms of the delegation, consistent with the purposes and terms of the trust; and (3) periodically reviewing the agent's actions in order to monitor the agent's performance and compliance with the terms of the delegation.”
Given the range of circumstances affecting different trusts, there is no one-size-fits-all answer to the questions of whether and in what manner a trustee should exercise the power to delegate. Whereas the lay fiduciary may be required by prudence to delegate all investment duties to a skilled professional advisor or institution, the corporate fiduciary or professional financial advisor may not need to delegate any. In a larger estate, with the need and resources for extensive diversification in niche assets, even the sophisticated trustee may have to seek specialty sub-advisors to fulfill the portfolio needs. And a corporate trustee that might reasonably use a common trust fund or proprietary mutual fund to meet diversification and asset allocation needs may be compelled by poor performance of its fund over time to move the assets to another fund or even to an outside mutual fund or advisor.
THE PRUDENT INVESTOR
The question of how much and what to delegate is further complicated by the dictates of the Prudent Investor Rule and modern portfolio theory, as embodied in the UPIA and third restatement of trusts. These require that investments “must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.”1
A trustee's duty to invest has two major components: the need to create an asset allocation model — the percentage of equities vs. bonds in the most simplistic example — and to construct a portfolio for each of the segments chosen. Recent financial studies have implications for both. First, the studies suggest that active investment selection and management may indeed be worthwhile; therefore it may be essential to leave investing to the professionals (mutual funds and specialty managers) who can exploit inefficiencies in various markets, and spread the cost of obtaining and analyzing information. Second, while the studies confirm that asset allocation is important and complicated enough to delegate to professionals, they make clear that, contrary to popular belief, it is not so important as to overshadow asset selection and management.
The term “risk and return objectives,” mentioned in the UPIA, comes from modern portfolio theory, which posits that an investor must be willing to undertake heightened risk or volatility to gain greater returns. The premise is that markets (such as the large capitalization segment of the U.S. stock exchanges) are efficient to some degree, in that information about a stock is quickly translated into prices that reflect the present value of future revenue streams.2 The movement of stocks is frequently described as a “random walk,” implying that it is futile to predict an asset's future price. And UPIA Section 8 directs fiduciaries to minimize expenses.
So what's a fiduciary to do? If no one is any good at selecting investments, it is unnecessary to delegate that function and imprudent to pay extra for it. Should trustees therefore resort to passive investing in an S&P 500 index or exchange-traded fund (which serve surrogates for the whole market)? Should they use passive strategies for all asset classes, rather than manage them actively through mutual funds or advisors?
The answer is that fiduciaires should use active management. The reasons:
Index funds are not efficient in many markets.3
Asset allocation studies show that choosing multiple asset classes provides superior returns and less volatility than relying on the S&P 500 index.
Recent studies suggest investors can profit even in an efficient market, in part because there is always another person who must sell or buy something for external reasons, such as a need for liquidity. As University of California Los Angeles professor Didier Sornette notes: “Those investors are willing to ‘pay up’ for the privilege of executing their trades immediately,” allowing the efficient trader to find a counterpart for a profitable trade.4 And, Sornette says, people sometimes “trade on what they think is information but is in fact merely noise.”5 Such people may be misled by their brokers or friends, or simply have a delusional confidence in their investment abilities.
Other, recent analyses show that markets are, at best, only somewhat efficient.6 Because it takes time for information to filter out to traders, and because careful traders attempt to mask their trades so that their insights are not poached by others, there is a time lag before even public information is disseminated and translated into price. Moreover, notes Larry Harris, chief economist at the Securities and Exchange Commission, how efficiently stocks are priced “depends on the costs of acquiring information, and how much liquidity is available to informed traders.”7
This observation suggests a need for specialists with the funding and incentives to seek information and the execution skills to act on such information. Whether it is a specialty trader in an illiquid and opaque emerging market or a hedge fund operator with the megacomputer necessary to uncover and exploit pricing anomalies, a trustee can utilize an expert's skills if the trust he manages has the assets and risk and return characteristics to take advantage of them. Such experts can spread the cost of information-gathering, so that they can provide it to fiduciaries at a fraction of the cost that a non-specialist otherwise would pay.
Various psychological and empirical studies in the developing field of behavioral finance also recently have provided compelling explanations for the volatility of stock and financial prices. Behavioral finance argues that in many instances, strutting investors would be better off delegating their duties to emotionless professionals.
The Nobel Prize for Economics awarded to behavioral finance theorist Daniel Kahneman in 2002 validates the influence of such alternative explanations for market activity. As Robert J. Shiller — author of the famous Irrational Exuberance (Princeton University Press, 2000) — noted in his 2002 treatise “From Efficient Market Theory to Behavior Finance”: “After all the efforts to defend the efficient markets theory there is still every reason to think that, while markets are not totally crazy, they contain quite substantial noise, so substantial that it dominates the movements in the aggregate market. The efficient markets model, for the aggregate stock market, has still never been supported by any study effectively linking stock market fluctuations to subsequent fundamentals.”8
Behavioral finance provides explanations for the variations in pricing and the psychological underpinnings of the seemingly irrational behavior that econometricians dismiss as noise in a world that they claim must be rational. The behavioral finance analysis posits that investors, both individual and corporate, cripple their performance by overconfidence, overreaction to price movements, and regret or fear that they will miss the next big thing or fail to bail when the other lemmings are running. Cognitive dissonance allows investors to ignore losses (chalking them up to bad markets or bad luck) and attribute gains to illusory skills, thus overestimating their capabilities.
Asset allocation studies point to empirical evidence that investment in diverse asset classes can provide superior returns and reduce the volatility of a given portfolio. One classic study by Roger Gibson,9 co-director for the Center for Fiduciary Studies at the University of Pittsburgh's Katz Graduate School of Business, compared the returns from 1972 through 1997 of portfolios composed of single investments in either the S&P 500, the EAFE Index (a sampling of common stocks in 20 European and Pacific Basin countries), the National Association of Real Estate Investment Trusts Equity Index and the Goldman Sachs Commodity Index. The study compared single index portfolios with all possible combinations of the four market sectors. The investments in single markets had lower returns and higher volatility, including much worse performance in certain bad markets when compared to portfolios containing equal weights of all four sectors.
The results of asset allocation can be a major component of the total return of a trust's investments. A comprehensive study by the famous economist Roger Ibbotson and his associate Paul Kaplan of the returns of 91 balanced mutual funds over the 10 years ending in March of 1998 and 58 pension plans for a five-year period ending in 1997, found that 40 percent of the difference in returns among the various funds reflected asset allocations against benchmark indices. Sixty percent, the study reported, reflected the “manager's ability to actively over- or under-weight asset classes and securities relative to the [asset allocation] policy and on the magnitude and timing of those bids.”10 The study clarifies earlier studies of leading economist Gary Brinson and his colleagues reporting that 90 percent of the variability of certain pension plan performance over time was the result of asset allocation policy.
Thousands of professionals have misinterpreted and incorrectly cited these studies' findings, leading them to erroneously conclude that active management accounted for only a tiny fraction of portfolio performance at best.11 In fact, the Brinson studies dealt with the returns over time of individual pension plans and did not measure the performance differences among the various funds. Those studies showed that if a manager started out with one allocation, variance in the weightings over time explained 90 percent of the variance in plan performance.
A problem with constructing a portfolio is that different investment classes can perform well and poorly within a year or two. A review of the Callan Periodic Table of Investment Returns from 1983 through 2002 shows that the best performers constantly change.12 For instance, an international index returned the best performing of eight stock and bond classes in 1993 and 1994, but was the worst performer in 1995, and second-to-last in 1996. The S&P Barra Growth Index ruled the market from 1995 through 1998, then plunged to the second-worst performance from 2000 through 2002.
To be prudent, a trustee must evaluate whether to invest in various asset classes, based on the size of the trust, its terms, liquidity needs, and beneficiaries' risk tolerance and time horizons. This task is difficult and significant — so that to be truly prudent, trustees need to evaluate their own abilities, then delegate to other managers some or all investment functions they cannot adequately perform.
Having set out the economic and financial background, we now need to explore how the terms of the Uniform Prudent Investor Act should be applied. Professor John Langbein answered some of our questions.
Q: Given all the scandals in the mutual fund world, should trustees continue to use pooling vehicles?
Langbein: The trustee should still be able to delegate to a mutual fund manager and rely on the growing sophistication of fund companies and the SEC to prevent abuses. Despite the barnacles on some boats, nothing changes the fundamental position of the prudence of using pooled vehicles for investment diversification.
The duty of prudence and the duty to monitor are part of any delegation to a mutual fund or investment manager. Trustees have to take appropriate steps to ensure that the agent is acting appropriately.
Q: Harley v. Minnesota Mining and Mfg. Co.13, suggests trustees may have a duty to consult outside experts if the trustees lack expertise to monitor a sub-manager.
Langbein: The responsibility of trust management is to ask, “Do I have somebody who understands the attributes of the investments?” and “Who supervises the people who make the trade?”
However, you can contrast the duty of the supervisor of Nick Leeson [the investment manager at Barings Bank accused of losing $1.3 billion in risky investments] who engaged in sophisticated hedge strategies, with a trustee who held stock in WorldCom. The Barings Bank did not have a supervisor who understood what Leeson was doing, and hence did not stop his initial losses or the increasingly leveraged trades that he made to attempt to recover the losses. That is a failure of supervision. In the WorldCom case it would be outrageous to assume that a trust officer or lay trustee should have been suspicious of the audited financial statements of a publicly traded company.
There is no dishonor in relying on audited financials. If such monitoring of audited financials of a public company were required, analysis would be impossible. The trustee is not an insurer of an investment, but does have a monitoring responsibility commensurate with the objective risk level. Diversification is the primary protection against a WorldCom problem.
Q: In what manner must trustees tailor portfolios to the needs of beneficiaries?
Langbein: A trustee needs to evaluate the risk tolerance and investment needs of the beneficiaries. It should be emphasized that the Restatement (Third) of Trusts, Sections 27 and 28, adopted in 2003, make express the requirement that the trust be managed for the benefit of the beneficiaries. If the settlor has directed an investment policy that is inappropriate, it is the trustee's duty to go to court to get instructions. The grounds could be changed circumstances under the Restatement (Second) of Trusts, Section 16714 or the duty to the beneficiary under third restatement, Sections 27 and 28.15
Similarly, draftsmen often do a poor job detailing the preference that trustees should give to surviving spouses. Most trustors tend to favor their spouses, even at the expense of their children, the remaindermen.
Over time we have seen industry standards develop, although they are not carved in stone, for dealing with impartiality issues when no preference is expressed for the income beneficiary. There has been an increasing tolerance for equities across the generations. I think the presumptive norm for a life and remainder trust has moved from a 40/60 equities-to-bond ratio to a 60/40 allocation, as the superiority of equities over the long run has been demonstrated. However, there is a vast range of alternatives that would call for the trustee to depart from such an allocation. The main factor is income needs. The smaller a trust is and the more dependent it is on income, the less likely that it can tolerate the swings of equity weightings. Also there is the tax situation. One of the consequences of the UPIA has been for banks to move more into equities.
Q: But what if the beneficiary can't sleep at night if the portfolio is not all in bonds or not 100 percent in the family company or stock of the settlor's former employer?
Langbein: Trustees have a duty to educate beneficiaries about risks. They have a similar duty to educate co-trustees when those co-trustees have misconceptions about the risks of undiversified investments. This is an objective standard. If the widow is the only beneficiary, and the instrument directs the suboptimal investment, the trustee can honor that requirement and treat it as a form of consumption by the sole beneficiary. But if there are remaindermen, and the income beneficiary says she can't sleep at night if diversification is undertaken, the trustee needs to go to court for instructions under the second restatement of trusts. There is a world of difference between retention authorization and retention direction language. I may have the power to go over Niagara Falls in a barrel, but it is not prudent to do so. The restatement makes these issues easier to resolve, with its express requirement that trusts are to be administered solely for beneficiaries.16
The same issues are present in retention of family businesses in a trust. Such retention language ignores management guru Peter Drucker's17 insight that 70 percent of inherited family businesses are failing businesses. Many were dependent on the skill of the settlor and it is imprudent to keep them after he is gone. A trustee should at the drop of a hat go to court to seek instructions to sell such businesses under the changed circumstances provisions of Section 167 of the second restatement.
There are four problems in such cases: First, it is hard to know what such closely held businesses or real estate investments are worth. Valuations often are deeply deficient, reflected by the steep discounts that the IRS allows in estate tax valuations. Second, these investments are illiquid, and therefore may not meet the needs of the trust beneficiaries. Third, unlike securities or mutual funds, there are far fewer analysts who can provide an expert opinion about the value and risks of such investments. Fourth, such investments require much more active management and many trustees simply lack the skills or should not incur the expense of providing skilled management.
Q: Section 9(a)(3) of the UPIA states that the trustee “shall exercise reasonable care, skill and caution in: … periodically reviewing the agent's actions in order to monitor the agent's performance and compliance with the terms of the delegation.” Does the trustee have to evaluate all 8,800 mutual funds or all money market funds on a continual basis?
Langbein: No. The trustee has to take into account the cost factor. The prudent trustee selects a smaller subset of the universe, simply on grounds of efficiency. There is a benefit to the beneficiary in having the trustee concentrate on a small universe of alternatives, so long as there is continual monitoring of transaction costs and performance. One barrier to changing funds is the tax cost.
Q: What about proprietary mutual funds? In states that authorize such funds, why not simply require the trustee to look at every comparable fund?
Langbein: One of the things a settlor may have wanted in selecting a particular trustee was that trustee's expertise in money management, including access to its proprietary funds. Choosing a bank trustee may suggest some deference to the bank's decision to use its own investment vehicles — so long as those vehicles are competitive in performance and price in the long run. There is some history of banks shooting stragglers among their funds. With a proprietary fund, a trustee can jawbone management to get better performance; the trustee has a voice as well as an exit strategy to deal with performance or expense problems. With a third-party fund the only real option may be to fire the fund.
Q: One of the comments to Section 9 deals with the need to pay attention to costs in delegating. It states: “The trustee must be alert to protect the beneficiary from ‘double dipping.’ If, for example, the trustee's regular compensation schedule presupposes that the trustee will conduct the investment management function, it should ordinarily follow that the trustee will lower its fee when delegating the investment function to an outside manager.” How does that rule apply to the professional trustee who retains liability for determining the investment needs, selecting the agents, and monitoring them? I see cases such as Estate of Arnold “O” or Harley v. MMM18 in which a court is prepared to hold a trustee liable for failing one of those elements in the case of submanagers.
Langbein: The comment deals with a large number of different situations on a spectrum. If the lay trustee brings in the bank or mutual fund to make all decisions, then charging a full trustee fee is questionable. The trustee would be charging twice for the same services. But in circumstances in which the trustee uses in-house and outside expertise to obtain a superior result, there may not be a need to reduce trustee fees — despite the aggregate cost increase.
There is the modern movement to distinguish asset allocation responsibilities from portfolio construction. There are two sets of decision-makers that are oriented to different aspects of the beneficiary's welfare: determination of the investment needs and asset allocation, then implementing those allocations by using a manager for portfolio construction within each allocation. The benefit may be greater to the beneficiary from being able to implement the use of allocations to segments that the trustee would not be cost-effective in managing. This does not mean that the combined use of skills can't wind up costing more, if prudent judgment is that the beneficiary is made better.
The general rule covers a range of circumstances. A small trust may not be able to take advantage of some types of diversification, because of the costs and scale needed. Using individual assets may be too expensive even for a trust with several million dollars; they may have to use pooled investment vehicles. A larger trust may have the assets and risk tolerance to use such submanagers. The costs of supervising some specialty managers may be justified by the returns; hence you might prudently justify a higher compensation for the trustee, in light of the returns.
The big distinction is whether you are retaining asset allocation or delegating it along with portfolio construction. The trustee who retains responsibility for asset allocation can prudently use submanagers and may not need to reduce its fees. The difference is that the widow in the trailer park is well-advised to delegate asset allocation as well as portfolio construction; she needs to reduce her trustee fees as a result. At the other end of the spectrum, if a New York bank trustee retains its analysis of the investment policy and asset allocation, and retains the large cap portfolio because of its skills, but ships out foreign stock portfolios to a submanager, there should be no diminution of fees. Then there are all the variations in between these extremes. You have to look at cost factors, but it is an aggregate cost sensitivity depending on the circumstances of the trust and the portfolios delegated to submanagers and the results.
- UPIA Section 2(b).
- Larry Harris, Trading & Exchanges: Market Microstructures for Practitioners, Oxford University Press (2003), p. 240.
- Dominic J. Campisi and Patrick Collins, “Index Returns as a Measure of Damages in Fiduciary Surcharge Cases,” Trusts & Estates (June 2001), p. 140.
- Didier Sornette, Why Stock Markets Crash, Princeton University Press (2003) at p. 48.
- Harris, p. 240.
- Ibid, p. 243.
- October 2002, p. 12 (Cowles Foundation for Research in Economics, found at http://Cowles.econ.yale.edu/P/cd/d13b/d1385.pdf). A review of Shiller's writing is worthwhile for any investor, from Irrational Exuberance (Princeton University Press, 2000), published as the bubble burst to “Human Behavior and the Efficiency of the Financial System,” which also can be accessed at the Cowles website and discusses such useful topics in explaining financial markets as regret and cognitive dissonance, overconfidence, magical thinking and that important subset of financial players afflicted with “quasi-magical thinking.” It is a quick primer to understanding the insights of behavioral finance, but should be reviewed when alert and anxious to learn why markets behave as they do.
- Asset Allocation: Balancing Financial Risk, (McGraw Hill, 2000), p. 163.
- Roger Ibbotson and Paul Kaplan, “Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?” (2000) p. 27. This can be found at Ibbotson.com. A shorter version can be found at pages 116-121 of Ibbotson Associates, Stocks, Bonds, Bills, and Inflation, 2003 Yearbook.
- John Nuttall, “The Importance of Asset Allocation,” which can be found at http://publish.uwo.ca/~jnuttall/.
- The table can be viewed at www.callan.com.
- 42 F.Supp.2d 898 (D.Minn. 1999), rev'd. on other grounds 284 F.3d 901 (8th Cir. 2002).
- Langbein has a forthcomingarticle in Northwestern Law Journal on “Mandatory Rules in the Law of Trusts” that explains these developments.
- Called the “father of modern management,” by the Harvard Business Review; author of 30 books on management.
- Matter of Arnold “O”, an Incapacitated Person, 719 N.Y.S.2d 174, 177 (App. Div. 2001) and Harley, 42 F.Supp.2d 898 (D.Minn. 1999), rev'd. on other grounds 284 F.3d 901 (8th Cir. 2002).