The Prudent Investor Rule

Philip Greely, the senior partner of a large old-line law firm, was pleased and not terribly surprised when a valued client asked him to serve as trustee of a substantial trust that was being established for the benefit of the client's children. After all, Greely was highly regarded for his judgment and experience, and this assignment offered him the opportunity to further cement the bonds he had established over time with the client.

Greely also felt confident that he was up to the task, having managed his own financial affairs for many years. His personal investment portfolio was conservative and high in quality, consisting exclusively of 'blue chip' U.S. stocks and government bonds. In addition, he sat on his firm's Investment Committee, which handled the management of the firm's sizeable pension plan. Although he was somewhat passive in his participation on the committee, he knew that the plan's assets, too, were safely invested in large U.S. companies and Treasury bonds.

Because this new assignment as trustee involved one of his biggest clients ' and someone else's money ' in an abundance of caution Greely decided to investigate whether the position involved any additional or unexpected responsibilities. He asked one of his firm's associates to research the issue and let him know what was expected of him under the requirements of the law. A short while later the associate returned and informed Greely that the entire answer was contained in a portion of the state's code that articulated what is known as 'The Prudent Investor Rule.'

The Prudent Investor Rule

The Prudent Investor Rule sets forth the basic rules governing the conduct of fiduciaries in the management of trust assets. While the legal standards for investment fiduciaries can be traced as far back as an 1830 Massachusetts court case creating the predecessor 'Prudent Man' standard, the Prudent Investor Rule is of much more recent origin. In 1992 the American Law Institute (ALI) released the Restatement of the Law Third, Trusts: Prudent Investor Rule. The ALI's diligent efforts represented a significant modernization of the fiduciary's investment responsibility, bringing it in line with the best practices of the institutional investment community, as well as with the academic underpinnings of those practices, popularly known as Modern Portfolio Theory. (In 1990 the pioneers of Modern Portfolio Theory were the recipients of the Nobel Prize in Economics for their profound contributions to contemporary portfolio management.)

Since 1992 nearly every state in the country has statutorily adopted the Prudent Investor Rule. While there are some variations in these legal promulgations, the Rule enunciates five basic principles:

1. Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees.
2. Risk and return are so directly related that trustees have a duty to analyze and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the trusts they administer.
3. Trustees have a duty to avoid fees, transaction costs and other expenses that are not justified by needs and realistic objectives of the trust's investment program.
4. The fiduciary duty of impartiality requires a balancing of the elements of return between production of income and the protection of purchasing power.
5. Trustees have the authority to delegate as a prudent investor would, and sometimes have a duty to do so.

The Prudent Investor Rule takes a comprehensive approach to portfolio management, and does not focus unduly on any single element of a portfolio. Rather than create a list of acceptable and prohibited investments, the Rule directs fiduciaries to be mindful of the impact of any portfolio constituent on the overall portfolio. Trustees' decisions are not to be evaluated in isolation, but in the context of the portfolio as a whole and as a part of an overall investment strategy.

The Rule directly acknowledges that risk taking is an integral and unavoidable part of the investment process. Indeed, the overly conservative concept of 'taking no risk' could result in the portfolio failing to even keep up with inflation, thereby losing its purchasing power over time. In evaluating the appropriateness of a strategy and set of investments, trustees are directed to consider many factors, including general economic conditions, the possible effects of inflation or deflation, tax consequences, and the expected total return from income and capital appreciation.

Beyond Plain Vanilla

Reviewing the express provisions of the Prudent Investor Rule, Greely began to rethink some of the fundamental premises of his investment decisions to date. With his own portfolio he had taken the view that blue chip stocks and government bonds were the only 'safe' investments worth making. Owning other types of stocks, such as those of smaller U.S. or foreign companies, seemed too risky and unduly volatile. Upon closer examination, though, Greely learned that over time these slightly more volatile markets frequently outperformed the stocks of larger U.S. companies, provided sufficient return to compensate for the higher volatility, and often moved out of tandem with the Dow and the S&P 500 indices. Indeed, he saw that by combining stocks from many markets in a single portfolio one could achieve superior overall tradeoffs between risk and reward.

Greely also discovered that institutional investors ' such as pension plans, endowments and foundations ' also made meaningful investments in a number of 'alternative assets' such as real estate, natural resources, high yield bonds, hedge funds and private equity. He learned that these types of investments, quite mainstream in institutional portfolio management, further improved portfolios in terms of enhancing returns, reducing risk, or some combination of the two. These asset classes and strategies make wonderful portfolio diversifiers partly because they move independently of the traditional stock and bond markets.

Greely's research made him seriously question the wisdom of his 'plain vanilla' approach to personal investing. It also made him wonder why his firm's pension plan wasn't invested in a strategically diversified portfolio, consistent with the practice of larger institutional investors.

Prudent Does Not Mean Stodgy

Greely also came to realize that the Prudent Investor Rule does not require fiduciaries to pursue an unreasonably conservative or otherwise second-rate approach simply because they're responsible for the funds of others. Quite to the contrary, the Rule directs a fiduciary to pursue the highest level of portfolio management: an optimal tradeoff between risk and return, in a manner consistent with the trust's needs and objectives. The Rule, moreover, explicitly recognizes that a portfolio can achieve its optimal level when asset allocation is effectively diversified and costs are well contained.

If a trustee lacks the experience, knowledge and objectivity to manage the portfolio appropriately, it is incumbent upon him or her to seek professional assistance. While the Rule authorizes such delegation, however, the trustee may not abdicate responsibility for wisely selecting and monitoring the professional.

With his newfound knowledge, Greely welcomed the opportunity to serve as trustee for his client's trust. In addition, he took steps to improve the composition of his personal investment portfolio, and that of his firm's pension plan.

Jim Berliner, a former practicing attorney, is President and Chief Investment Officer of Westmount Asset Management, Inc. (www.westmount.com), a registered investment advisory firm based in Los Angeles. Westmount manages over $800 million in client assets. For the last 3 years, he has been named by Worth magazine as one of the 100 leading wealth advisers in the U.S. He can be reached at 310-556-2502 or [email protected].

Philip Greely, the senior partner of a large old-line law firm, was pleased and not terribly surprised when a valued client asked him to serve as trustee of a substantial trust that was being established for the benefit of the client's children. After all, Greely was highly regarded for his judgment and experience, and this assignment offered him the opportunity to further cement the bonds he had established over time with the client.

Greely also felt confident that he was up to the task, having managed his own financial affairs for many years. His personal investment portfolio was conservative and high in quality, consisting exclusively of 'blue chip' U.S. stocks and government bonds. In addition, he sat on his firm's Investment Committee, which handled the management of the firm's sizeable pension plan. Although he was somewhat passive in his participation on the committee, he knew that the plan's assets, too, were safely invested in large U.S. companies and Treasury bonds.

Because this new assignment as trustee involved one of his biggest clients ' and someone else's money ' in an abundance of caution Greely decided to investigate whether the position involved any additional or unexpected responsibilities. He asked one of his firm's associates to research the issue and let him know what was expected of him under the requirements of the law. A short while later the associate returned and informed Greely that the entire answer was contained in a portion of the state's code that articulated what is known as 'The Prudent Investor Rule.'

The Prudent Investor Rule

The Prudent Investor Rule sets forth the basic rules governing the conduct of fiduciaries in the management of trust assets. While the legal standards for investment fiduciaries can be traced as far back as an 1830 Massachusetts court case creating the predecessor 'Prudent Man' standard, the Prudent Investor Rule is of much more recent origin. In 1992 the American Law Institute (ALI) released the Restatement of the Law Third, Trusts: Prudent Investor Rule. The ALI's diligent efforts represented a significant modernization of the fiduciary's investment responsibility, bringing it in line with the best practices of the institutional investment community, as well as with the academic underpinnings of those practices, popularly known as Modern Portfolio Theory. (In 1990 the pioneers of Modern Portfolio Theory were the recipients of the Nobel Prize in Economics for their profound contributions to contemporary portfolio management.)

Since 1992 nearly every state in the country has statutorily adopted the Prudent Investor Rule. While there are some variations in these legal promulgations, the Rule enunciates five basic principles:

1. Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees.
2. Risk and return are so directly related that trustees have a duty to analyze and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the trusts they administer.
3. Trustees have a duty to avoid fees, transaction costs and other expenses that are not justified by needs and realistic objectives of the trust's investment program.
4. The fiduciary duty of impartiality requires a balancing of the elements of return between production of income and the protection of purchasing power.
5. Trustees have the authority to delegate as a prudent investor would, and sometimes have a duty to do so.

The Prudent Investor Rule takes a comprehensive approach to portfolio management, and does not focus unduly on any single element of a portfolio. Rather than create a list of acceptable and prohibited investments, the Rule directs fiduciaries to be mindful of the impact of any portfolio constituent on the overall portfolio. Trustees' decisions are not to be evaluated in isolation, but in the context of the portfolio as a whole and as a part of an overall investment strategy.

The Rule directly acknowledges that risk taking is an integral and unavoidable part of the investment process. Indeed, the overly conservative concept of 'taking no risk' could result in the portfolio failing to even keep up with inflation, thereby losing its purchasing power over time. In evaluating the appropriateness of a strategy and set of investments, trustees are directed to consider many factors, including general economic conditions, the possible effects of inflation or deflation, tax consequences, and the expected total return from income and capital appreciation.

Beyond Plain Vanilla

Reviewing the express provisions of the Prudent Investor Rule, Greely began to rethink some of the fundamental premises of his investment decisions to date. With his own portfolio he had taken the view that blue chip stocks and government bonds were the only 'safe' investments worth making. Owning other types of stocks, such as those of smaller U.S. or foreign companies, seemed too risky and unduly volatile. Upon closer examination, though, Greely learned that over time these slightly more volatile markets frequently outperformed the stocks of larger U.S. companies, provided sufficient return to compensate for the higher volatility, and often moved out of tandem with the Dow and the S&P 500 indices. Indeed, he saw that by combining stocks from many markets in a single portfolio one could achieve superior overall tradeoffs between risk and reward.

Greely also discovered that institutional investors ' such as pension plans, endowments and foundations ' also made meaningful investments in a number of 'alternative assets' such as real estate, natural resources, high yield bonds, hedge funds and private equity. He learned that these types of investments, quite mainstream in institutional portfolio management, further improved portfolios in terms of enhancing returns, reducing risk, or some combination of the two. These asset classes and strategies make wonderful portfolio diversifiers partly because they move independently of the traditional stock and bond markets.

Greely's research made him seriously question the wisdom of his 'plain vanilla' approach to personal investing. It also made him wonder why his firm's pension plan wasn't invested in a strategically diversified portfolio, consistent with the practice of larger institutional investors.

Prudent Does Not Mean Stodgy

Greely also came to realize that the Prudent Investor Rule does not require fiduciaries to pursue an unreasonably conservative or otherwise second-rate approach simply because they're responsible for the funds of others. Quite to the contrary, the Rule directs a fiduciary to pursue the highest level of portfolio management: an optimal tradeoff between risk and return, in a manner consistent with the trust's needs and objectives. The Rule, moreover, explicitly recognizes that a portfolio can achieve its optimal level when asset allocation is effectively diversified and costs are well contained.

If a trustee lacks the experience, knowledge and objectivity to manage the portfolio appropriately, it is incumbent upon him or her to seek professional assistance. While the Rule authorizes such delegation, however, the trustee may not abdicate responsibility for wisely selecting and monitoring the professional.

With his newfound knowledge, Greely welcomed the opportunity to serve as trustee for his client's trust. In addition, he took steps to improve the composition of his personal investment portfolio, and that of his firm's pension plan.

Jim Berliner, a former practicing attorney, is President and Chief Investment Officer of Westmount Asset Management, Inc. (www.westmount.com), a registered investment advisory firm based in Los Angeles. Westmount manages over $800 million in client assets. For the last 3 years, he has been named by Worth magazine as one of the 100 leading wealth advisers in the U.S. He can be reached at 310-556-2502 or [email protected].