The Prudent Investor Rule and Market Risk

Robert H. Sitkoff is the John L. Gray Professor of Law at Harvard Law School.

In a new working paper, entitled “The Prudent Investor Rule and Market Risk: An Empirical Analysis,” we examine fiduciary management of market risk. The backdrop for our study is a law reform that was meant to overcome a long tradition in fiduciary investment of equating stock with speculation. By focusing categorically on risk avoidance, traditional law did not account for the difference between idiosyncratic risk and market risk, the relationship between risk and return, or beneficiary risk tolerance. Worse still, courts considered the riskiness of each investment in isolation rather than in light of overall portfolio risk.

Twentieth century advances in economics and finance, however, led to extensive reform to the law of trust investment. The centerpiece of this reform is the prudent investor rule, which reorients fiduciary investment from risk avoidance to risk management in accordance with modern portfolio theory. Because the rule has been adopted in every state, because it applies to the entire field of fiduciary investing, including pension funds and charitable endowments, and because it has been adopted across the British Commonwealth, the rule governs the investment of many trillions of dollars in assets.

As canonically stated by the Restatement (Third) of Trusts (1992) and the Uniform Prudent Investor Act (1994), the prudent investor rule requires a trustee to manage a trust portfolio with “an overall investment strategy having risk and return objectives reasonably suited to the trust” and to “diversify the investments of the trust.” Upon assuming office, a trustee has a “reasonable time … to make and implement” an investment program that complies with the rule. Thereafter, compliance with the rule is a “continuing responsibility.” The trustee is under an “ongoing duty to monitor investments and to make portfolio adjustments if and as appropriate.” Accordingly, under the rule a trustee must minimize idiosyncratic risk, align market risk with beneficiary risk tolerance, and manage market risk exposure on an ongoing basis. The rule thus reoriented trust investment law from categorical risk avoidance to more nuanced risk management.

Incorporating modern portfolio theory into the law of fiduciary investment should provoke little controversy. Whether fiduciaries have applied the law properly in practice, however, has yet to be studied. The importance of this question is highlighted by the fact that, since adoption of the prudent investor rule, stockholdings in personal trusts have increased substantially at the expense of government bonds, in part in response to the rule (Schanzenbach and Sitkoff 2007). Against this backdrop of increased exposure to market risk since adoption of the rule, we examine how the rule has affected management of market risk by trustees. It bears repeating that the rule “does not call for avoidance of risk by trustees,” but rather for “prudent management of risk.”

Our analysis, which relies primarily on data from bank trust holdings, proceeds in two steps. First, we examine sensitivity to beneficiary risk tolerance in trust asset allocation. The heart of the prudent investor rule is the command to trustees to implement “an overall investment strategy having risk and return objectives reasonably suited to the trust.” We use average trust account size as a proxy for beneficiary risk tolerance, reasoning that beneficiaries of larger trusts will tend to have more tolerance for risk than beneficiaries of smaller trusts. The data show that stock holdings and average trust account size have been strongly correlated across the entire period under study, both before and after the reform. Moreover, we find that adoption of the prudent investor rule primarily increased stockholdings by banks with trust account sizes in the 25th to 90th percentiles. Banks with small average account sizes did not increase their stockholdings after the reform, likely because their trust accounts should have been conservatively invested in all events and so were not constrained solely by prior law.

Second, we assess ongoing management of market risk by examining the correlation between yearly changes in aggregate trust corpus and yearly changes in the S&P 500. In the words of the Restatement, “risk management by a trustee requires that careful attention be given to the particular trust’s … tolerance for volatility.” We find that, although stock holdings and so exposure to market risk increased after the prudent investor rule, trust corpus did not become more correlated with the S&P 500. To the contrary, a 1% change in the S&P 500 results in a 0.5% change in trust corpus for all years studied, before and after the rule. We explain this finding with evidence of more frequent portfolio rebalancing after the reform in accordance with the rule’s imposition of a duty to make ongoing portfolio adjustments. Because we observe trust corpus only at year end, but rebalancing occurs from time to time across the year, an increase in rebalancing could mute what might otherwise have been an increased correlation with the S&P 500. We also discuss the possibility that after the reform trustees might have invested in a broader range of stocks than those that comprise the S&P 500 (e.g., mid- and small-cap issues or foreign stocks), which would reduce the correlation between trust corpus and the S&P 500.

Our findings suggest that the centerpiece of the prudent investor rule, the direction to align market risk with beneficiary risk tolerance and to manage risk on an ongoing basis, has largely been followed. Our findings thus correct a misunderstanding in an ongoing policy debate about the law governing fiduciary investing. Some critics have suggested that in the years leading up to the financial crisis of 2008, the rule invited trustees imprudently to allow market risk to accumulate through excessive stockholdings. On this assumption of failed risk management, these critics have urged that the prudent investor rule be replaced with safe harbors or lists of approved investments. Our study challenges the empirical basis for those proposals.

The full paper is available for download here.

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