The Prudent Investor Rule and Market Risk: An Empirical Analysis

Published date01 March 2017
Date01 March 2017
The Prudent Investor Rule and Market
Risk: An Empirical Analysis
Max M. Schanzenbach* and Robert H. Sitkoff*
The prudent investor rule, enacted in every state over the last 30 years, is the centerpiece of
trust investment law. Repudiating the prior law’s emphasis on avoiding risk, the rule
reorients trust investment toward risk management in accordance with modern portfolio
theory. The rule directs a trustee to implement an overall investment strategy having risk
and return objectives reasonably suited to the trust. Using data from reports of bank trust
holdings and fiduciary income tax returns, we examine asset allocation and management of
market risk before and after the reform. First, we find that the reform increased
stockholdings, but not among banks with average trust account sizes below the 25th
percentile. This result is consistent with sensitivity in asset allocation to trust risk tolerance.
Second, we present evidence consistent with increased portfolio rebalancing after the
reform. We conclude that the move toward additional stockholdings was correlated with
trust risk tolerance, and that the increased market risk exposure from additional
stockholdings was more actively managed.
I. Introduction
“October. This is one of the peculiarly dangerous months to speculate in stocks in. The
others are July, January, September, April, November, May, March, June, December,
August, and February” (Twain 1899:123). The long tradition of equating stock invest-
ment with speculation deeply influenced the law of trust investment, which until
recently discouraged investment in stock as “speculative” and favored investment in
government bonds. In emphasizing avoidance of default risk, traditional law did
not account for the relationship between risk and return, the difference between
Address correspondence to Max M. Schanzenbach; email: Schanzenbach
is Seigle Family Professor of Law, Northwestern University; Sitkoff is John L. Gray Professor of Law, Harvard
The authors thank David Abrams, John Campbell, David Coffaro, Allen Ferrell, Jesse Fried, John Goldberg,
Marcel Kahan, Yotam Kaplan, Louis Kaplow, Jonathan Klick, Howell Jackson, John Langbein, A. Mitchell Polin-
sky, Mark Ramseyer, Steven Shavell, Henry Smith, Kathy Spier, Stewart Sterk, Lawrence Waggoner, and workshop
participants at the annual meeting of the American Law and Economics Association, the Conference on Empiri-
cal Legal Studies, Columbia University, Harvard University, Northwestern University, and Stanford University for
helpful comments and suggestions. The authors also thank Terri Saint-Amour, Sandra Hough, and Jeannette
Leopold for excellent research assistance. Sitkoff thanks the Harvard Law School Summer Research Program for
financial support. In accordance with Harvard Law School policy on conflicts of interest, Sitkoff discloses certain
outside activities, one or more of which may relate to the subject matter of this article, at
Journal of Empirical Legal Studies
Volume 14, Issue 1, 129–168, March 2017
idiosyncratic risk and market risk, or heterogeneity in risk tolerance. Worse still, courts
considered the riskiness of each investment in isolation rather than in light of overall
portfolio risk, creating a perverse incentive not to diversify.
Twentieth-century advances in economics and finance, however, led to extensive
reform of the law of trust investment. The centerpiece of this reform is the prudent inves-
tor rule, which reorients trust investment from risk avoidance to risk management in
accordance with modern portfolio theory. Today, every state has enacted a statute that
applies the rule to trust investment (see the Appendix). In addition, almost every state
has applied the rule to charitable endowments,
and federal law applies the rule to
most private pension funds.
The rule has also been adopted across the British Com-
monwealth, and it is regularly invoked in other fiduciary investment contexts.
All told,
the rule governs the investment management of many trillions of dollars—and the rule
will soon apply to trillions more because a 2016 rulemaking by the Department of Labor
will extend trust fiduciary law to financial advice about retirement saving.
As canonically stated by the Restatement (Third) of Trusts (1992)
and the Uni-
form Prudent Investor Act (1994) (UPIA), 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”
(UPIA, § 2[b], 3; see also Restatement [Third], § 90[a]–[b]). The rule thus reorients
trust investment law from investment-level risk avoidance to portfolio-level risk manage-
ment. Upon assuming office, a trustee has a “reasonable time” to “make and
implement” an investment program that complies with the rule (UPIA, § 4; Restatement
[Third], § 92). Compliance with the rule is thereafter a “continuing responsibility”
(UPIA, § 2, comment). In sum, under the rule, a trustee must minimize idiosyncratic
risk, align market risk with trust risk tolerance, and manage risk on an ongoing basis.
Incorporating modern portfolio theory into the law of trust investment should
provoke little controversy. Whether trustees have applied the law properly in practice,
however, has yet to be studied. The importance of this question is highlighted by the
The Uniform Prudent Management of Institutional Funds Act (UPMIFA), promulgated in 2006 and since
adopted by almost every state, applies the prudent investor rule to charitable endowments (UPMIFA § 3).
A version of the rule is adopted by the Employee Retirement Income Security Act of 1974 (ERISA), which gov-
erns the fiduciaries of most pension funds (29 U.S.C. § 1104[a]; see also 29 C.F.R. § 2550.404a-1[b]). In Tibble v.
Edison Int’l, 135 S. Ct. 1823 (2015), for example, the Supreme Court applied the rule in a dispute under ERISA
over the investment options in an employer-sponsored pension fund.
The rule has been formally adopted in England and most of the British Commonwealth (Getzler 2009:238--39),
and it influences norms of fiduciary investment even in contexts in which it has not been adopted expressly (Sitk-
off 2014b:48).
The rulemaking expands the definition of who is a “fiduciary” under ERISA to include financial advisors to
retirement savers (Definition of the Term “Fiduciary”; Conflict of Interest Rule---Retirement Investment Advice,
81 Fed. Reg. 20946 [proposed Apr. 6, 2017, to be codified at 29 C.F.R. parts 2509--2510]).
The 1992 Restatement provision on the prudent investor rule was superseded without material changes by
Restatement (Third) of Trusts § 90 (2007) (hereafter, Restatement [Third]).
130 Schanzenbach and Sitkoff
fact that since adoption of the rule, stockholdings in personal trusts have increased sub-
stantially at the expense of government bonds, partly in response to the rule (Schanzen-
bach & Sitkoff 2007). Against this backdrop of movement outward on the risk/return
curve, we examine how the rule has affected management of market risk by trustees. It
bears emphasis that the rule “does not call for avoidance of risk by trustees,” but for
“prudent management of risk” (Restatement [Third], § 90, comment e[1]).
Our analysis, which relies primarily on data from bank trust holdings, proceeds in
two steps. First, we assess whether trustees have been sensitive to trust risk tolerance in
asset allocation. The heart of the prudent investor rule is the requirement that a trustee
implement “an overall investment strategy having risk and return objectives reasonably
suited to the trust” (UPIA, § 2[b]; see also Restatement [Third], § 90[a]). We use aver-
age trust account size as a proxy for trust risk tolerance. A larger trust can more readily
tolerate market volatility without imperiling its distribution obligations, such as support
payments to a surviving spouse. Moreover, given the strong correlation between overall
personal wealth and inheritances, the beneficiaries of a larger trust are more likely to
have other sources of support.
We find that adoption of the prudent investor rule primarily increased trust stock-
holdings by bank trustees with average trust account sizes in the 25th to 90th percentiles.
Banks with small average trust account sizes did not increase their trust stockholdings after
the reform, likely because those trusts were inframarginal—that is, they should have been
conservatively invested in all events and so were not constrained solely by prior law. In some
specifications, banks with the largest average trust account sizes also appear less responsive
to the reform, suggesting that the reform may have mattered less for the largest trusts.
Second, we assess ongoing management of market risk by examining the correla-
tion between changes in year-end observed trust assets and annual S&P 500 returns.
Despite increased stockholdings after the prudent investor rule, the correlation between
changes in year-end reported trust assets and annual market returns did not change. We
adduce evidence that this result reflects increased rebalancing over the course of the
year between our year-end observations of trust assets.
There is good reason to suppose that rebalancing would increase after the rule. The
normal practiceamong banks and other professionaltrustees is to have an “investment policy
statement” for each trust accountthat prescribes a target asset allocation range appropriate
to the risk tolerance of the trust. As a trust portfolio drifts out of its target asset allocation
range, the normal practice, emphasized by the federal regulator that examines banks with
fiduciary powersand required by the “ongoing duty” imposed by the rule“to monitor invest-
ments and to make portfolio adjustments if and as appropriate” (Restatement[Third], § 90,
comment e[1]), is to rebalance the portfolio back into the target asset allocation. However,
owing to the need forliquidity to make distributions to the beneficiaries,a constraint express-
ly recognizedby law, rebalancing may be more common in rising than in fallingmarkets.
In light of this institutional context, we test for rebalancing in two ways. First,
although the correlation between changes in year-end reported trust assets and full-year
S&P 500 returns did not change after the reform, we find that changes in year-end trust
assets did become more correlated with January-to-September S&P 500 returns, consis-
tent with increased rebalancing between our year-end observations of trust assets.
The Prudent Investor Rule and Market Risk

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