UPIA §2(b) re Duty to Balance Risk and Return

The preamble to the Uniform Prudent Investor Act notes, “The tradeoff in all investing between risk and return is identified as the fiduciary’s central consideration.” For most trustees determining the return that was produced by the assets held in trust is a fairly straightforward exercise. But measuring risk can be more problematic.

What’s the Risk?

The Bogert treatise states, “The trustee cannot assume that if investments are legal and proper for retention at the beginning of the trust, or when purchased, they will remain so indefinitely. Rather, the trustee must systematically consider all the investments of the trust at regular intervals to ensure that they are appropriate” (A. Hess, G. Bogert, & G. Bogert, Law of Trusts and Trustees §684, pp.145–146 (3d ed. 2009)). Where investment management duties have been delegated to an outside investment manager, key performance indicators and benchmarks are the tools used to meet the trustee’s duty to measure and balance the risk that is accepted in the pursuit of return.

Target Return

The manager’s actual performance will initially be compared to the trustee’s stated return objective. This begs the question whether the trustee has taken steps to define a targeted rate of return for the assets over which they are responsible. If they have not, they are encouraged to do so. The Target Return is stated as an absolute number (e.g., 7.0%) or as a real, inflation-adjusted number (e.g., Inflation+4.0%). Once identified, this is the long-term objective is communicated to the investment manager to whom investment duties have been delegated.

Benchmark

There are a variety of benchmark types that can be useful in gauging whether a manager’s activities have added to or detracted value from the trust, which shows up in the return and risk levels. No single benchmark can tell a whole story. Rather we suggest using multiple benchmarking methods, each with its own purpose and advantage. Following are a few benchmark constructions:

1. The trustee could blend a few simple stock and bond indexes in the same proportion as the current investments of the trust portfolio. The index components of this “vanilla” benchmark might consist of Russell 3000 for US stock, MSCI ACWI ex-US for int’l stock and Barclays Aggregate Bond or BofAML 1-10 Yr Muni for bonds.
2. The trustee could also create a benchmark using those same index components, but instead determining what specific blend historically produced a return equal to the trust’s Target Return.
3. Further, the trustee could use more detailed sub-asset class indexes (or better yet, index-based securities) in the same allocation as the investments when the manager first began. Any difference in performance between the actual portfolio and this benchmark could then be said to be attributable to the manager’s tactical decisions, whether in security selection, market timing, or departure from market cap weightings.

One important consideration is that most benchmarks assume no manager or product level fees, perpetual cost-free rebalancing and no cash holdings. Even still, much can be learned from a consistently applied set of benchmarks as to how the manager’s decisions are affecting the trust portfolio.

Risk

In addition to measuring the manager’s performance against the Target Return and fairly established benchmarks, there must be an evaluation of the risk that has been accepted by each manager. Some forms of risk are quantitative and can be discovered through statistical analysis. Other types of risk cannot be deduced from statistical inquiry and require a more subjective analysis.

Quantitative Risk Measures

• Standard Deviation / Downside Deviation
• Value-at-Risk
• Beta
• Max Drawdown
• High Month Return / Low Month Return
• Sharpe Ratio (risk-adjusted return)
• M-Squared (risk-adjusted return)
• Information Ratio (risk-adjusted return)

Qualitative Risks

• Lack of Liquidity: The % of the trust that cannot be liquidated within 5 business days
• Concentration: The % of the trust held in the single largest security
• Leverage: The % of leverage used by the trust as reflected in a debt-to-equity ratio
• Lack of Valuation: The % of the trust assets that do not have daily valuation

Collaborating with the Trustee’s Investment Manager

Most investment managers, if provided with this overview, can help the trustee create a record that these factors have been considered and documented. If the investment manager is unable to help the trustee develop such a record, a prudent trustee will take steps to independently evaluate these factors or find an investment manager that is willing and able to do so.