Mark Twain, in Pudd’nhead Wilson, 1894, wrote:
October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.
Now, more than 125 years later, many again share this sentiment in the wake of extensive market volatility occasioned by the COVID-19 pandemic. Trust investment law, however, has long been attentive to market risk. Indeed, prudent risk management is at the heart of the prudent investor rule (PIR). Under the PIR, a trustee must align a trust’s market risk exposure with the trust’s risk tolerance given the purpose of the trust and the beneficiaries’ circumstances. A trustee ordinarily must also diversify to avoid idiosyncratic risk, that is, risk that can be avoided by diversification.
After the financial crisis of 2007-2009, during which the S&P 500 fell roughly 50% from previous highs, some scholars and practitioners called for a reassessment of the PIR, worrying that it had encouraged trustees to take on too much risk. Especially given recent market volatility during the pandemic, the question of whether trustees have appropriately managed market risk is again salient. Against that backdrop, we’ll summarize the key findings of our previously published rigorous empirical study of market risk management by bank trustees using data that spanned multiple prior financial crises.1
Specifically, using data from reports to federal banking regulators of trust holdings by banks that are in the federal reserve system, we undertook an econometric examination of both asset allocation and portfolio rebalancing before and after each state enacted the modern PIR.2 We had two main findings:
1. Enactment of the PIR was associated with increased stockholdings by bank trustees, but not among banks with average trust account sizes below the 25th percentile, a result that’s consistent with sensitivity in asset allocation to trust risk tolerance.
2. Enactment of the PIR was associated with increased portfolio rebalancing by bank trustees, a result that’s consistent with increased management of market risk.
Given these findings, we concluded that the observed reallocation toward additional stockholdings after each state enacted the PIR was correlated with trust risk tolerance and that the increased market risk exposure from those additional stockholdings was more actively managed.
Prudent Man to Prudent Investor
The long tradition of equating stock investment with speculation, such as by Twain in Pudd’nhead Wilson, deeply influenced the law of trust investment, which, until the PIR, discouraged investment in stock as “speculative” and favored investment in government bonds. In emphasizing avoidance of default risks, the earlier prudent man rule and legal listsdidn’t account for the relationship between risk and return, the difference between idiosyncratic risk and market risk or variability 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 led to extensive reform to align trust investment law with modern portfolio theory (MPT). Generally speaking, to obtain a greater expected return, an investor must assume greater market risk. Market risk is thus compensated in that more exposure to market risk yields more expected return. Idiosyncratic risk, by contrast, is different because it’s generally uncompensated. Such risk can be reduced or even eliminated by diversifying. It follows, therefore, that the prudence of a given investment must be considered in light of its contribution to the overall portfolio’s expected risk and return.
These insights led to a movement in the mid-to-late 1980s to revise the prudent man rule, refashioning it as the PIR, reorienting the law of trust investment from investment-level risk avoidance to portfolio-level risk management consistent with MPT. To this end, the rule implements two key reforms:
1. “A trustee’s investment and management decisions respecting individual assets 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.”3
2. A trustee must “diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”4
Accordingly, the PIR requires a trustee not to avoid risk altogether but to evaluate the purpose and circumstances of the trust, to choose a commensurate level of overall market risk and expected return and to avoid wasteful idiosyncratic risk by diversifying.5
Need for Empirical Study
Whether trustees have properly applied the risk management principles prescribed by the PIR hadn’t been subject to rigorous empirical investigation before our prior study. The importance of this question is highlighted by the fact that stockholdings in personal trusts have increased substantially since the early 1990s at the expense of government bonds, insured deposits and money market funds.6 “Trust Asset Allocation,” this page, traces the percentage of trust assets in our sample data held in stock versus in “safe” assets, which in accordance with the legal lists and the prudent man rule we define as government bonds, insured deposits and money market funds (the graph ends in 2008 because federal regulators stopped collecting personal trust asset allocation data thereafter).7 There are clear, mirror-image trends, with stockholdings increasing and “safe” holdings decreasing in the years after promulgation of the PIR in the Restatement (Third) of Trusts in 1992 and the Uniform Prudent Investor Act in 1994.
Against this backdrop of movement outward on the risk/return curve, we examined how the PIR has affected management of market risk by bank trustees. It bears emphasis that the PIR “does not call for avoidance of risk by trustees,” but for “prudent management of risk.”8 Our analysis proceeded in two steps:
1. We assessed whether the bank trustees in our sample data had been sensitive to trust risk tolerance in asset allocation.
2. We assessed whether the bank trustees in our sample data had managed market risk on an ongoing basis by periodic rebalancing.
In both steps, we used the differing dates of each state’s enactment of the PIR as a natural experiment that allowed for graphical as well as rigorous econometric before-and-after and across-states comparisons.
Trust Account Size
The heart of the PIR is the requirement that a trustee implement “an overall investment strategy having risk and return objectives reasonably suited to the trust.”9 We used average 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.10 If trustees have been sensitive to trust risk tolerance in trust asset allocation, we should observe larger trust stockholdings in banks with larger average trust account sizes than in those with smaller average trust account sizes.
The data show that differences in average trust account size are indeed associated with large differences in the percentage of assets held as stock. “Account Size Comparisons,” this page, depicts the percentage of trust assets held in stock for each quartile of average account size in the data. We also include the 90th to 100th percentiles as a separate category because the average account size in this group is much larger than the rest. Percent stockholdings line up as expected. The lowest quartile of banks by average account size held only 10% to 20% of trust assets in stock, whereas the top quartile held roughly between 40% and 60% of trust assets in stock, and the top 10% held roughly between 40% to 65% of trust assets in stock. “Account Size Comparisons” thus implies that as average account size increases, the bank trustees in our sample took on increased exposure to market risk.
In our formal study, we confirmed this interpretation of “Account Size Comparisons” with a rigorous econometric analysis.11 That analysis confirms that the increase in market risk exposure following enactment of the PIR traces entirely to banks with average trust account sizes in and above the 25th percentile. Stockholdings by banks with average trust account sizes below the 25th percentile were unaffected by the reform. Accordingly, we concluded that adoption of the PIR primarily increased trust stockholdings by bank trustees with average trust account sizes at or above the 25th percentile. Banks with small average trust account sizes didn’t 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 weren’t constrained solely by the prudent man rule.12
Another proxy for trust risk tolerance is situs. We posit that on average, trusts in Delaware have a higher risk tolerance than trusts in Florida. Delaware is a preferred situs for larger and more sophisticated trusts. Florida, by contrast, is a preferred retirement destination whose population is more dependent on a steady stream of income. New York should be somewhere between Delaware and Florida, because New York is a populous and wealthy state but not a preferred situs for out-of-state trusts. Finally, we posit that on average, trusts in South Dakota have over time come to resemble trusts in Delaware, because in the timeframe of our data, South Dakota emerged as a competitor to Delaware in the jurisdictional competition for trust funds.13
“State Comparisons,” this page, depicts the percentage of trust assets held in stock between 1986 and 2008 by banks in those four states. The states line up precisely as expected, with Delaware trusts having the most market risk exposure, Florida trusts having the least, New York somewhere in between and South Dakota evolving over time to resemble Delaware.14 As with “Account Size Comparisons,” “State Comparisons” implies sensitivity by bank trustees to risk tolerance in asset allocation.
Periodic Rebalancing
The PIR also governs a trustee’s “continuing responsibility for oversight of the suitability of investments already made.”15 A trustee is thus under an “ongoing duty to monitor investments and to make portfolio adjustments if and as appropriate,” for example, by rebalancing the portfolio in light of actual investment performance and changes in circumstances.16 In the words of the U.S. Supreme Court:
. . . a trustee has a continuing duty to monitor trust investments and remove imprudent ones. This continuing duty exists separate and apart from the trustee’s duty to exercise prudence in selecting investments at the outset.17
There’s good reason to suppose that rebalancing would increase after the PIR. The typical practice among bank trustees, emphasized by bank regulators, is to have an investment policy statement for each trust account that prescribes a target asset allocation range appropriate to the risk tolerance of the trust.18 As a trust portfolio drifts out of its target asset allocation range, the typical practice is to rebalance the portfolio back into the target asset allocation. “Re-balancing guidelines, which define when an asset category should be adjusted, are necessary to maintain a policy’s consistency and a portfolio manager’s discipline.”19 However, owing to the need for liquidity to make distributions to the beneficiaries, rebalancing may be more common in rising than in falling markets.20
We couldn’t observe directly whether banks maintained target levels for asset classes by rebalancing on a regular basis. However, we could observe how bank stockholdings correlated with stock market returns. Thus, we tested for rebalancing in our formal study by examining with rigorous econometric analysis the changing correlations across time of reported year-end trust assets with S&P 500 returns.21 More frequent rebalancing should reduce the long-run correlation between reported trust assets and the stock market. For example, if trustees sell into a rising market to stay within their stock allocation target, then reported trust assets will become less correlated with the market.
Prior to the PIR, bank stockholdings were strongly correlated with overall stock market performance. After the PIR, this relationship changed. Bank stockholdings remained correlated with short-run market performance. However, in the long run (a year or more), this relationship broke down, and market performance became less correlated with the value of overall trust assets and stockholdings in particular. This finding is consistent with bank trustees rebalancing by selling over time in up markets and buying over time in down markets. We concluded, therefore, that the increased market risk exposure resulting from the observed increase in stockholdings, and so movement outward on the risk/return curve, was actively managed by periodic rebalancing (in addition to the initial alignment with trust risk tolerance).
Two Core Conclusions
Our formal econometric analysis yielded two core conclusions. First, the observed increase in stockholdings by bank trustees after the PIR was attributable to banks with average trust account sizes above the 25th percentile. Second, bank trustees managed the additional exposure to market risk associated with increased stockholdings by more frequently rebalancing portfolios.
Although our findings don’t prove that investment practice was optimal under the PIR, they paint a clear picture of how bank trustees responded to the reform. After enactment of the PIR, trustees increased stockholdings in only the relatively more risk tolerant trusts and rebalanced more often to manage the resulting increase in exposure to market risk. For those who believe that MPT is an appropriate benchmark for trust investment management, these findings should be comforting as we experience increased market volatility during the COVID-19 pandemic.
Endnotes
1. See Max M. Schanzenbach and Robert H. Sitkoff, “The Prudent Investor Rule and Market Risk: An Empirical Analysis,” 14 J. Emp. Legal Stud. 129 (2017). We draw freely on this prior work without further attribution.
2. For further detail on the data, see ibid., at pp. 140-42.
3. Uniform Prudent Investor Act (UPIA) Section 2(b) (1994); see also Restatement (Third) of Trusts (Restatement Third) Section 90(a) (2007).
4. UPIA Section 3; see also Restatement Third Section 90(b).
5. For examples of “special circumstances” that could justify not diversifying and so bearing idiosyncratic risk, see Robert H. Sitkoff and Jesse Dukeminier, Wills, Trusts, and Estates, at pp. 641-42 (10th ed. 2017).
6. See Max M. Schanzenbach and Robert H. Sitkoff, “Did Reform of Prudent Trust Investment Laws Change Trust Portfolio Allocation?,” 50 J. L. & Econ. 681 (2007) (attributing some of the reallocation to enactment of the prudent investor rule (PIR)).
7. See Schanzenbach and Sitkoff, supra note 1, at pp. 133-34. In truth, such investments in fact carry inflation and reinvestment risk, especially for investors with a longer time horizon.
8. Restatement Third Section 90 cmt. e(1).
9. See supra note 3.
10. See, e.g., Edward N. Wolf and Maury Gittleman, “Inheritances and the Distribution of Wealth or Whatever Happened to the Great Inheritance Boom?” 12 J. Econ. Ineq. 439 (2014).
11. See Schanzenbach and Sitkoff, supra note 1, at pp. 147-53.
12. While banks with the smallest average trust account sizes increased their equity holdings from a little over 10% to just under 20%, our formal analysis didn’t link this change to a state’s adoption of the PIR by statute. Rather, the increase in equity holdings for these banks appears to be part of a secular trend across all banks unrelated to legislative enactments of the PIR (though possibly related to the 1992 publication of the PIR in the Restatement Third). Further, there’s evidence that stockholdings in the range of 20% may be short- or medium-run risk minimizing, suggesting that the observed increase in equity in banks with small average trust account size may well have reduced risk.
13. See Robert H. Sitkoff and Max M. Schanzenbach, “Jurisdictional Competition for Trust Funds: An Empirical Analysis of Perpetuities and Taxes,” 115 Yale L.J. 356 (2005).
14. For “Account Size Comparisons,” we count “miscellaneous” assets, which include ownership interests in limited liability companies and derivatives, as stock because they also reflect market risk exposure. Such assets became a large fraction of reported Delaware trust assets during the 2000s, comprising 28% of reported Delaware trust assets by 2008, reflecting a tendency toward trust investment through a limited liability company, which in turn holds stocks and other investments.
15. UPIA Section 2 cmt.
16. Restatement Third Section 90 cmt. (e)(1).
17. Tibble v. Edison Int’l, 135 S. Ct. 1823, 1828 (2015).
18. An investment policy statement should specify “the account’s risk tolerance,” its “investment goals and return requirements” and “asset allocation guidelines.” Comptroller of the Currency, Investment Management Services: Comptroller’s Handbook, at pp. 106–107 (2001).
19. Ibid., at p. 141.
20. Restatement Third Section 90 cmt. e(1), for example, instructs that in assessing risk tolerance a trustee should consider “regular distribution requirements ... and any irregular distributions that may in fact become necessary.”
21. See Schanzenbach and Sitkoff, supra note 1, at pp. 154-63.