We believe it is important that judges, estate planning attorneys, fiduciaries, and trustees understand what it means to prudently invest under state law. Our white paper, Prudent Investing Under the California Probate Code seeks to inform the reader of the law and provides suggestions for proper compliance within California. The Executive Summary below serves to highlight the more salient points. To access a full version of the white paper, please click here.
Prudent Investing Under the California Probate Code
Investing is an area fraught with the potential for personal liability for trustees and fiduciaries. This is especially true for those who are unversed in the California fiduciary investment laws, found in Probate Code §2101, §2574, and, §§16045 – 16054.
• §2101 indicates that guardians and conservators are governed by the law of trusts, which places them under the obligation to comply with the Uniform Prudent Investor Act, §§16045 – 16054, as well as with §2574.
• §2574 lists the specific types of investments that guardians and conservators may acquire without court approval, primarily exchange-traded stocks and bonds, certain short-term bonds, and money market funds. The authors identify several weaknesses of this section of the Probate Code, including no mention of the need to diversify a portfolio and the fact that mutual funds are not included in the list of pre-approved investments. Though mutual funds and other investments may be used, they require prior court approval, which can be a costly and time-consuming process.
• §§16045 – 16054, the “Uniform Prudent Investor Act,” (UPIA) or “Prudent Investor Rule” is the most recent investment law enacted by California and embraces the most current concepts of “prudent investing.” It grew out of ERISA (the Employee Retirement Income Security Act), which lays out appropriate investment management practices for trustees of corporate retirement plans. ERISA and UPIA admonish fiduciaries to embrace the principles of Modern Portfolio Theory, an investment methodology that has garnered three Nobel Prizes in economics. Modern Portfolio Theory is founded on research demonstrating that investment risk is best managed at the portfolio level (as opposed to the individual asset level) through careful diversification, not through market timing or stock picking.
Under Modern Portfolio Theory, diversification is a mathematical term derived from correlation analysis. The concept of correlation is based on the fact that the various sectors of the market and economy are subject to differing business cycles. Chosen carefully, if one invests in companies in multiple sectors of the markets, and if those sectors have differing cycles, one achieves diversification and a reduction in the potential risk of loss at the portfolio level. Conversely, even though one might attempt to diversify by investing in differing sectors, if those sectors tend to share the same market cycle, one will have achieved little actual diversification, resulting in a portfolio that rises and falls with the same volatility as the shared market cycle. For example, from a macro-economic perspective, the cycles of most equity types (large, mid, and small cap) overlap closely.
Negative correlation occurs when the values of two investments typically move in opposite directions. For example, equities and bonds are often negatively correlated. Inflation tends to drive the value of real assets up, so equities (representing ownership of corporate assets) will, over the longer term, rise in dollar value in response to inflation. Conversely, inflation causes interest rates to rise, so the market value of existing bonds not only falls in response to inflation, but the inflation erodes the buying-power of the bonds, which have fixed-dollar values.
Although stocks and bonds are often negatively correlated, that is not always the case. Generally, the best an investor can hope to achieve is to assemble a portfolio of “non-correlated” assets…assets driven by differing, unrelated market or economic forces. Their price movements relative to one another tend to be arbitrary. If the correlation between assets is measured and then used to create a portfolio with, say, a dozen or more non-correlating assets, it will be a rarity when all the assets move up or down simultaneously. Such a portfolio would be well diversified – its risk of loss potentially lower than a more highly correlated portfolio. It is therefore critical that a fiduciary’s investment advisor possess the analytical tools necessary to measure the correlations between individual assets in his portfolio in order to create truly diversified portfolios.
In the investment industry, the two most common methods of measuring what is referred to as “investment risk” are beta and standard deviation. Both are measures of the volatility of an asset’s market price – the idea being that the more volatile the price movements, the higher the risk. But both standard deviation and beta give equal weight to upside and downside volatility. An asset showing upside volatility with little downside volatility could feasibly give rise to more attractive investment returns with less risk of loss – an obviously desirable asset. Unfortunately, since both beta and standard deviation give equal weight to upside and downside volatility, the asset just described would be treated as being very risky by those two most common forms of “risk” measurement. Neither represents an actual measure of the risk of loss, which is the fiduciary’s prime concern.
One of the most basic principles of Modern Portfolio Theory is that, “given two investments with equal returns, a rational investor would choose the investment with lower risk.” Thus, a fiduciary needs to measure “risk” as the potential for loss, not as mere price volatility.
The most effective tool the authors have found for measuring risk of loss is semi-standard deviation. The similarity of name to standard deviation is unfortunate, but is a consequence of the fact that semi-standard deviation is computed in a manner similar to the standard deviation. Semi-standard deviation ignores upside volatility and focuses only on the probability of downside volatility – hence it is a true measure of the risk of loss, not merely of volatility. Thus, the greater the semi-standard deviation of an investment, the greater have been the actual losses suffered by that investment historically, whereas a high standard deviation may result from large gains as well as from losses.
The use of scatter charts employing semi-standard deviation as the measure of risk can greatly facilitate management of fiduciary accounts in compliance with the prudence mandates of UPIA. At a mere glance, the advisor, fiduciary, attorney and judge can see the historical risk of loss and, simultaneously, the return of portfolios relative to an appropriate benchmark, thereby enabling them to easily determine the prudence with which the portfolios are being managed.
By requiring that an advisor’s investment research and reporting include the use of correlation tables, scatter charts and semi-standard deviation (or a valid equivalent measure of actual risk of loss if the advisor has a preferred alternative), fiduciaries and trustees are more likely to achieve the following benefits with the potential for:
- Fewer and/or smaller losses in fiduciary accounts.
- Higher long-term investment returns with improved ability to provide for the client’s long-term needs.
- Reduced potential liability for a fiduciary arising from mismanagement of the assets.
- A substantial improvement in a judge’s ability to expeditiously, yet accurately oversee the prudence with which fiduciary accounts are being monitored and managed.
Click Here to access the full version of the white paper Prudent Investing Under the California Probate Code.