The (Im)Prudent Man Rule

From Gabriel Hament

BY GABRIEL HAMENT SRQ DAILY SATURDAY PERSPECTIVES EDITION SATURDAY DEC 30, 2017

The question of what investments are suitable for funds held in trust, for a finite period or in perpetuity, for the benefit of private persons or corporations, has engaged the legal and financial communities for centuries.

The oft-cited “prudent man rule” originated in a seminal court case involving Harvard College and Jonathan and Francis Amory, both trustees of a fund of $50,000 established by their brother and cousin, John McLean. The fund was to distribute current income to the late McLean’s wife, Ann, and upon her death the residuum, or corpus, of the trust was to be given to Harvard College and Massachusetts General Hospital. The trustees selected what many fiduciary advisors would view as an inappropriate weighting towards equity securities (100 percent) and no allocation to fixed-income instruments. After the passing of Mrs. McLean, just over $29,000 remained in the trust. Harvard sued the remaining living trustee, Francis Amory, and argued placing the entirety of the trust’s assets in common stock, which offered no security of principal and jeopardized the interests of the ultimate beneficiaries of the trust, Harvard College and Massachusetts General Hospital. The court, siding with defendants, decided trustees acted as any prudent person would, given their skill level in the context of the economic backdrop at that time.

This legal precedent established a wide scope of discretion in which trustees could operate when constructing and managing portfolios. Thirty years later, the New York Court of Appeals greatly narrowed the list of acceptable investments permitted under the prudent man rule.In essence, government bonds and notes backed by a pledge of real estate (mortgage securities) were designated as the only acceptable investment for funds held in trust. This thinking stands in stark contrast to today’s modern portfolio management techniques.  

Nearly a century after King v. Talbot, Harry Markowitz in 1952 introduced to the world Modern Portfolio Theory. MPT postulates that when a portfolio blends securities that lack strong correlations, security-specific, nonsystemic risk can be neutralized and “diversified away.” Thus volatility originating from any one security or sector or asset class is dampened, and returns attributed to the overall market can be captured. William Sharpe, in 1966, built on the MPT foundation by focusing not just on the directional price relationship of combinations of securities in a portfolio (co-variance) but also on the aggregate risk-return characteristics across a portfolio. Managers desire to construct portfolios that optimize the risk-adjusted return, garnering the largest possible return over the risk-free rate, per unit of “risk” as measured by standard deviation. Visually, this concept is depicted by graphing the efficient market frontier.

The work of Markowitz, Sharpe and others, paired with two studies published by authors working under the Ford Foundation, elevated the importance of capital appreciation to the same level as principal preservation and current income. The resulting approach, dubbed “total return investing,” is intended to preserve the real purchasing power of endowments for the benefit of current and future generations. The codification of these related concepts is represented by the 2006 Uniform Prudent Management of Institutional Funds Act and signed into law in 2011 by Gov. Rick Scott.

So, with the floodgates now open, large institutional pools with infinite lifespans, such as university endowments, have allocated a sizeable percentage of assets to hedge funds, private equity and venture capital. An As reported by Pensions & Investments’ James Comtois, for fiscal year 2017 ending June 30, “The average 12-month return for the large US endowments in P&I’s universe … was 13.2 percent vs. 1 percent for the prior year.” The range of returns among the 31 universities was wide, with Grinnell College clocking in at 18.8 percent ($1.9 billion endowment) and Harvard’s $37.1 billion pool returning 8.1 percent. For FY 2016, Harvard lost 2 percent. Note Harvard’s fund has been undergoing a significant restructuring involving the shuttering of internally managed funds, with a shift toward external managers. Harvard excluded, the other 30 higher-education endowments on P&I’s radar saw returns averaging in the low-to-mid teens for FY 2017.

At Cumberland Advisors, we are not exuberant supporters of “2-and-20” hedge funds and other alternative investments. Multi-year lock-out periods, the relinquishing of custody of donor funds to general partners, onerous fee structures, and lack of real-time reporting and transparency inherent in these partnerships all provoke a healthy dose of skepticism. We express reservation particularly in regard to lack of public oversight in the management of 501(c)(3) monies. In contrast to the near total transparency involved in the selection and monitoring of managers for state and local government pools, the public has little access to the inner workings of investment committees of community foundations, colleges and other not-for-profits.

The Pensions and Investments article referenced above with 1, 5 and 10-year average returns of endowments of over $500 million, as reported by the Wilshire Trust Universe Comparison Service. The Vanguard Balanced Index Fund’s Semiannual Report, which includes average annual total 1,5 and 10-year returns.  

The jury is still out on whether the inclusion of exotic instruments is necessary or appropriate for perpetual pools of funds supporting charitable activities.

Gabriel Hament is an investment adviser representative at Cumberland Advisors. 

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