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"The Prudent Investor Act And The Great Recession" by Ravin J. Shah


The Prudent Investor Act And The Great Recession
by Ravin J. Shah
Introduction

Much of the commonly accepted wisdom surrounding investing and the markets derives from two theories: the Modern Portfolio Theory (MPT) and the Efficient Markets Hypothesis (EMH). The scope of their influence can be seen in everything from investment valuation to securities regulations. See John Authers, Wanted: New Model for Markets, FINANCIAL TIMES, Sept. 29, 2009. In addition, these models serve as the framework for New York's adaptation of the Uniform Prudent Investor's Act in EPTL §11-2.3 (PIA).

When it was passed, the PIA was perceived as the long-awaited vehicle for change by bringing the antiquated methods of trust management into the modern era. With rules like 'no investment is inherently imprudent,' the PIA was seen by trustees as reflective of the 'realities' of the markets. However, given the events of the past ten years, the conventional wisdom of the MPT and EMH have come under question. The "lost decade," as it is sometimes referred to, has caused considerable anxiety and pain to countless beneficiaries and as a result many scholars and professionals have come to question the wisdom of these models. See Daniel Gross, The Lost Decade, SLATE, Nov. 11, 2009 (explaining how in a period from April 2001 to April 2011 the S&P 500 has given back all its gains and the implications of that reality).

Critics point to the nascent field of behavioral finance when attacking the MPT and EMH, which has provided new insights into investing and the motivations of investors. Critics also attack the PIA by pointing out that the "vague standards . . . [of the PIA] provide[] trust beneficiaries with little protection against agency costs that . . . [have] lead trustees to invest too heavily in equities." Stewart Sterk, Rethinking Trust Law: How Prudent is Modern Prudent Investor Doctrine?, 95 CORNELL L. REV. 851, 851 (2010). See generally Dimitri Vayanos & Paul Woolley, Capital Market Theory after the Efficient Market Hypothesis, VOX, Oct. 5, 2009.

In this article, I will explain both the MPT and EMH models (Part I), outline their flaws (Part II), and offer solutions (Part III). My goal here is to stimulate debate among readers to consider the appropriate course of action in light of newly introduced realities.

Part 1

A. Historical Background: "Legal list" Approach & "Prudent Man" Approach

Historically, there are two approaches taken to managing trust assets. First, the New York State Court of Appeals in King v. Talbot laid the foundation. 40 N.Y. 76 (1869). In this case, the court said, ". . . the trustee is bound to employ such diligence and such prudence in the care and management, as in general, prudent men of discretion . . . employ in their own like affairs." Id. at 86. Furthermore, it was not prudent "to place the principal of the fund in a condition, in which, it is necessarily exposed to the hazard of loss or gain . . . and in which, by the very terms of the investment, the principal is not to be returned at all." Id. at 88 (original emphasis). Thus, investments in equities were per se imprudent. Under this line of reasoning, "states developed, either by statute or case law, a "legal list" of permissible trust investments . . . ." Sterk, supra, at 856.

The "legal list" approach was predominantly used until the 1930s and 40s until a second method known as the "prudent man" rule was adopted by an increasing number of states, which was largely set by the decision in Harvard College v. Amory. 26 Mass. 446 (1830). Under this standard, a trustee must, "conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence . . . manage their own affairs . . . in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of the capital to be invested." Id. at 461. This approach became popular when studies in the 30s and 40s "showed that returns on trust investments in "prudent man" states were almost double the returns in legal list states." Martin Begleiter, Does the Prudent Investor Need the Uniform Prudent Investor Act - An Empirical Study of Trust Investment Practices, 51 ME. L. REV. 27, 32 (1999).

B. Times Change & Dissatisfaction Rises

The conservative and capital preservation driven strategies of the legal list and prudent man were in accord with the sentiment of the times, the Great Depression era. See Sterk, supra, at 857 (2010). However, starting in the 1940s, the U.S. economy went through an unprecedented period of growth that spanned 60+ years. Taking the S&P 500 Index as a general marker of the economy, the adjusted close on January 3, 1950 was 16.66 and on January 3, 2000 the adjusted close was 1,455.22, an 8,600% gain. See http://finance.yahoo.com/q/hp?s=%5EGSPC+Historical+Prices (closing prices were obtained through Yahoo Finance Historical Prices tool. It is also important to note that the adjusted closing price on Jan. 2 1970 was 93.00, a 458% gain). During the post WWII era, equities typically generated higher returns than more traditional trust investments, like bonds. Additionally, during the "malaise" of the 70s, inflation was rampant and it became apparent that the "safe" investments like bonds bore a risk of their own -- inflation eroding the trust principal. See Sterk, supra, at 857.

C. Markowitz, Fama and the Prudent Investor

a. Modern Portfolio Theory (MPT)

Despite the market conditions, trust investing rules did not change until 1990s. These changes got their start in 1952, when Harry Markowitz wrote his article Portfolio Selection and linked the concepts of risk and reward. See generally Harry Markowitz, Portfolio Selection, 7 J. FIN. 77, 77 (1952) (advocating MPT as an alternative investment theory). The basis for his theory is that investors want high returns, are "risk averse" and thus want dependable returns. See Sterk, supra, at 858; Begleiter, supra, at 33. In this way, for an investor to choose a high risk investment it must provide the requisite amount of return to 'compensate' the investor for taking the given amount of risk. To think about it another way, for a given level of return, an investor will look for an investment with the lowest level of risk. Begleiter, supra, at 33.

Markowitz's true insight came within the realm of diversification as it relates to risk. He stated that there are two basic types of risk: systematic and unsystematic risk. Systematic or market risk, is the risk that is inherent in the market; the risk that "the return of the market . . . will be less than predicted." Id. (emphasis added) Unsystematic or firm specific risk deals with the risk that is specific to a given security and/or its industry. This refers to the "possibility that the return of a particular asset will be less than expected." Id. (emphasis added) As such firm-specific risk could be diversified away, and systematic risk or market risk could not. See Sterk, supra, at 859. Thus, while never eliminating all risk, Markowitz argued that a diversified portfolio will have less overall risk than an undiversified portfolio.

b. Efficient Market Hypothesis (EMH)

In 1960, Eugene Fama introduced his Ph.D. thesis that later became the Efficient Markets Hypothesis. His theory filled the gap left by Markowitz's MPT, namely "how to determine the expected return of a particular investment." Sterk, supra, at 859. The base premise was that in an efficient market "prices provide accurate signals for resource allocation." Eugene Fama, Efficient Captial Markets: A Review of Theory and Empirical Work, 25 J. FIN. 383,383 (1970). If capital markets were efficient then the "prices of securities would reflect accurately the expected risk and return of those securities" and thus incorporate the best available information about those securities. See Sterk, supra, at 860. On the other hand, if the markets weren't efficient and didn't incorporate all available information, then there would be a misallocation of capital. Fama engaged in empirical studies and concluded that "securities prices quickly and fully reflected available information about those securities." Id. at 859. See Fama, supra, at 414-16 (1970) (noting that there was evidence to support the EMH and sparse contrary evidence).

The implications of this conclusion were important because it meant that no investment was inherently a "bad" investment because the price already incorporated the firm-specific risk. See John H. Langbein, The Uniform Prudent Investor Act and the Future of Trust Investing, 81 IOWA L.REV. 641, 649 ("[MPT] teaches that the risk intrinsic to any marketable security is presumptively already discounted into the current price of the security"). As such, in its purest or strongest form, it was not possible to 'beat the markets' with a proprietary investment strategy. This meant that when investing, one could put his or her money into risky or higher risk stocks and diversify away the firm specific risk by holding a diversified portfolio.

c. The Solution: Prudent Investor Act

As time went on, both the MPT and EMH became increasingly accepted and there was increasing pressure to change the seemingly antiquated legal list and prudent man standards. See generally John H. Langbein & Richard A. Posner, Market Funds and Trust-Investment Law, 1 AM. BAR FOUNDATION RESEARCH J. 1 (1976) (advocating the MPT and EMH and recommending index funds as appropriate investments). Seen as too restrictive, the legal list method banned all equities and the prudent man approach required the trustee to evaluate the 'prudence' of an investment in a vacuum. See Sterk, supra, at 861. Additionally, the income beneficiaries and remaindermen were at odds with the investment strategies that should be employed. The income beneficiaries often wanted investments that provided the greatest amount of immediate income, while the remaindermen wanted investments that grew the money in a safe and reliable way.

This changed in the 1990s with the Uniform Prudent Investor Act and the Restatement (Third) which adopted much of what MPT and EMH held. Multiple states enacted their own version, including New York with EPTL §11-2.3. The tension between the income beneficiary and remaindermen would be alleviated by allowing trustees to invest for other objectives besides capital preservation, like total return. No longer would the trustees bear the liability for investing in securities that were too risky or speculative. The required diversification of investments would reduce risk without compromising return. The only worry that remained was market risk or systematic risk, which could be managed by adjusting the percentage of the portfolio that was invested in the high-risk high-return securities.

Part II


A. MPT-EMH and Behavioral Finance


The MPT and EMH provide great insights into risk, but recently flaws have been revealed when these principles are applied to the real world. As mentioned above, investors have been described as risk-averse. However, sometimes investors do not act according to this methodology. Robert J. Shiller of Yale has "show[n] that mass psychology, herd behavior and the like have an . . . effect on stock prices . . . ." Joe Nocera, Poking Holes in a Theory on Markets, N.Y. TIMES, June 6, 2009. Other "studies have established that when investors make significant investment profits, they . . . [do not sell and] . . . subject themselves to greater risk with . . . [their] "found money" than they would if they ha[d] not enjoyed recent successes." Sterk, supra, at 870. Furthermore, researchers have found that investors are often 'loss averse' and refuse to liquidate the investment hoping it will rise again and thus, "expos[e] themselves to greater risks than the expected future return of those stocks." Sterk, supra, at 870 & n. 101 (2010); see also Terrance Odean, Are Investors Reluctant to Realize Their Losses?, 53 J. FIN. 1775, 1775 (1998).

Additionally, according to the MPT and EMH, firm-specific risk can be diversified away, leaving only market or systematic risk. The foundation of the conclusion lies in Maslow's risk-return mechanism which was based on his observation of the correlation that exists between investments. However, the weakness here is the assumption that correlations remain static. Professor Siegel of University of Pennsylvania noted, "The most serious attack on efficient markets is the change in correlation of asset classes under extreme conditions." See Authers, supra.

B. Implications for Trust Investing and Management

Given the recent lessons learned from behavior finance the PIA does not have provisions to protect against things like the herd mentality and an over weighted portfolio. Instead, the focus of the PIA was put on the trustee's requirement to diversify and ability to make distributions to the beneficiaries "in accordance with risk and return objectives . . . [of the] entire portfolio." N.Y. EST. POWERS & TRUSTS LAW §11-2.3(b)(3)(A) (Mckinneys 2010). Additionally, the PIA stated that "no investment was inherently prudent or imprudent." However, even Markowitz's article recognized that not "every investment would be sensible if appropriately diversified . . . it acknowledged that more work was needed to develop a strategy for . . . [calculating risk and return figures for individual securities]." Sterk, supra, at 874.

Furthermore, there is no guidance as to the proper amount or percent of a portfolio that an asset class should constitute. In their study, Schanzenback Sitkoff, "demonstrated persuasively that . . . when states adopted the UPIA, trustees invested a higher percentage of trust portfolio in equities than before the adoption of the statute." Id. at 893 (2010). See Max M. Schanzenbach & Robert J. Sitkoff, Did Reform of Prudent Trust Investment Laws Change Trust Portfolio Allocation?, 50 J.L. & ECON. 681, 687 (2007).

With regard to why or how these investments became such a big part of the portfolio is a multifaceted question that may have many explanations. One answer may be related to the agency problem that is created when there is a delegation of investing authority. Agency relationships increase the chance of the herd mentality. Considering trustees, like mutual fund managers, often sell themselves on performance, the likelihood of the money being put into a specific "hot" area is increased. "Once momentum becomes embedded in markets, agents [(in this case a trustee)] logically respond[s] by adopting strategies that are likely to reinforce the trends." Vayanos & Woolley, supra.

The most significant implication of the PIA is that it does nothing to grapple with market risk. The overall goal should be to fashion a statutory scheme that is manageable and doesn't sit on the extremes of the spectrum. An overly stringent regime exposes beneficiaries to inflation risk and does not allow the trustee to meet the obligations that the testator intended. Alternatively, a very open policy does not give guidance and can lead to foolhardy investment strategies that harm the testator's intent and beneficiaries. The Prudent Investor Act got it right in some areas, but not all.

Part III

The Model Portfolio Theory and Efficient Markets Hypothesis are not the panacea that they were once thought to be. There are issues with how diversification, risk and reward are calculated and implemented into the overall model. Thus, the question becomes, where do we go from here? What model should we follow?

The list of possibilities is wide and varying. Andrew Lo of MIT, for example, has incorporated "evolutionary biology in proposing that markets adapt and evolve over time." See Authers, supra. Another theory called "Maslowian Portfolio Theory" is premised on Maslow's Hierarchy of Needs. See Phillipe J.S. DeBrouwer, Maslowian Portfolio Theory: An Alternative Formulation of the Behavioral Portfolio Theory, 9 J. OF ASSET MGMT. 359, 359 (2008) (In this theory the financial needs of the client, are categorized and then put in order of importance so that the objective of investing is always clear). Still others advocate that the MPT and EMH should be expanded to incorporate other models "based on irrational behavior." Vayanos & Woolley, supra. Even though these theories may touch on some truths, they are still in the early stages of research and the "reliable applications . . . [to the real world are, by some accounts,] distant." Authers, supra.

While researchers continue to figure out the best practical use of these theories, there may be a push for change in the statute to include provisions that limit the amount of the portfolio that may be invested in a particular asset class. If inflation is a big concern, the portfolio could be required to invest in treasury inflation protected securities (TIPS) as well as other asset classes (like commodities) that often provide a hedge against rising inflation. This way the portfolio would recognize that investors are often loss averse by investing in bonds and at the same time providing for meaningful appreciation with the equities portion.

Conclusion

Much has been learned in the past few years. The reality is that there is an element of risk in every investment. Correlations between investments can change and seemingly "safe" investments can lose all their value overnight. It is an amorphous and frustrating concept that is often dependent on changes in circumstances.

Regardless of the testator's investment literacy, it is vital for every drafter, trustee and portfolio manager to thoroughly and effectively interview the testator regarding his or her intent. The beneficiaries should also be interviewed to understand their needs. Whether a portfolio incurs gains or losses, the statutory design should provide a trust manager with the solace that he or she carried out the testator's objectives with his or her risk level in mind. In the end, there is no substitute for getting to know the client and what his or her objectives are.

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This page contains a single entry from the blog posted on August 4, 2012 9:01 AM.

The previous post in this blog was "Reflections On The Use Of Anti-Suit Injunctions In International Arbitration" by Vikram Sharma.

The next post in this blog is "Consumer And Employee Disputes: Statute v. Agreement To Arbitrate" by Anna Mitchell.

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