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Fiduciary Focus: Active vs. Passive Investing (Part 4)

Fiduciary must overcome two-part burden to justify active investing.

W. Scott Simon, 05/25/2005

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Many fiduciaries (as well as investors in general) are "active" investors. They believe that they (or someone they hire) can "beat the market" with an active investment strategy of stock-picking or market timing. The investment information system has a substantial interest in promoting and encouraging this belief. Such factors lead many fiduciaries to presume that active investment strategies are automatically the best way to implement portfolio asset allocations.

Reporter's General Note on Section 227 of the Restatement 3rd of Trusts (Prudent Investor Rule) appears to turn this presumption on its head: "The greater the trustee's departure from one of the valid passive strategies, the greater is likely to be the burden of justification [for selecting the proposed active strategy] and also of continuous monitoring [of it]."

This language is similar to Restatement commentary that establishes the standard by which the conduct of a fiduciary will be measured when it's contemplating an underdiversified investment strategy: "The greater the departure [from a suitable, diversified portfolio], the heavier the trustee's burden to justify the strategy in question."

The preceding language, as well as the overall tenor of the Restatement and the Uniform Prudent Investor Act, which emphasize the virtues of broad diversification and low costs and taxes, suggests strongly that passive investing is the "default standard" for investing and managing trust portfolios. Passive investing involves investing in index mutual funds and asset class mutual funds.

Although (in the words of the Reporter for the Restatement) " [Restatement] commentary … understandably tends to emphasize relatively passive investment …", principles of modern prudent investing do permit fiduciaries to use active investment strategies as well. Reporter's General Note on Restatement Section 227 explains: "Drawing a defined and potentially arbitrary line between active and passive programs…can and ought to be avoided in legal doctrine by simply relating any special burdens of justification to the existence and degree of extra expense and risk involved."

The Reporter for the Restatement elaborates on this in the fourth generalization concerning prudent investment: "To the extent an investment strategy involves extra management, tax, and transaction costs or a departure from an efficiently diversified portfolio, that strategy should be justifiable in terms of special circumstances or opportunities or in terms of a realistically evaluated prospect of enhanced return [from the strategy]."

Restatement commentary provides a helpful and practical two-part "burden of proof" test for a fiduciary to determine whether it can depart from a valid passive investment strategy and justify its active investment strategy: "Are the extra costs, taxes, and risks of the proposed active investment strategy 'substantial?'" Even if they are, can they be "justified by realistically evaluated return expectations?"

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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