(30)_The_Safe_Harbor_for_Prudent_Fiduciary_Investing

CHAPTER 30
THE “SAFE HARBOR” FOR
PRUDENT FIDUCIARY INVESTING
— HOW YOU CAN PROTECT THE
TRUSTEES YOU ADVISE FROM
UNNECESSARY RISKS, COSTS
AND TAXES WHILE EARNING
CAPITAL MARKET RETURNS
Charles Stanley
Overview
After a careful reading of the pertinent legal documents and their com-
mentaries, one concludes that a strategy of investing in pure passive low1
cost asset class funds, including Index Funds and diversified passively
managed Exchange Traded Funds (ETFs), is the safe harbor or default
standard for fiduciary trust investing. Active investment strategies in-
crease costs, risks and taxes over the comparable passive asset class
strategies. While active strategies are permitted, a trustee who decides to
incorporate active strategies should be able to objectively justify why he
or she is accepting greater risk, greater costs and greater taxes for the
trust by employing these active investment strategies.
Learning Objectives
By the end of this chapter, you should be able to:
• know the similarities and differences in the legal framework for
prudent investing strategies for trustees in the United States (specif-
ically California);
• know that there is a “safe harbor” investment strategy for trustees
that incorporates two key provisions:
The pertinent documents in California include the California Uniform Prudent In1 -
vestor Act (UPIA) and the American Law Institute’s Restatement [Third] of Trusts.

! THE TRUSTED ADVISOR’S SURVIVAL KIT360
a. required diversification and its purposes:
i. to eliminate non-systematic risk,
ii. to create efﬁcient portfolios, and
b. pay only costs that are reasonable and appropriate to the trust
and the strategies implemented; andinform the trustees you
advise about these key concepts to help them avoid liability in
their oversight of their investment portfolios.
PURPOSE
Fiduciary liability is a growing concern. Our purpose is to demonstrate
that low cost passive asset class or “index” investing is the safe harbor or
default standard for fiduciary trust investing, and any departure to active
investment strategies that increase risk and costs, while allowable, should
be demonstrably justified. We will compare and contrast the legal
framework for fiduciary trust investing between California and Ontario,
since these are the two communities most affected by cross-border con-
cerns between Canada and the United States. (Most Canadians immigrat-
ing to the United States move to California, Arizona or Florida. Both
California and Arizona are community property states, and trusts are
drafted under state law. None of these distinctions between community
property and common law change the principles of prudent investing
addressed in this chapter. All three states have their form of the Uniform
Prudent Investor Act.)
SIGNIFICANCE
Every California trustee and co-trustee is accountable to the Uniform
Prudent Investor Act (UPIA). Every Ontario trustee is accountable to the
Ontario Trustee Act. The importance of the UPIA is emphasized by the
fact that it is placed under “Duties of Trustee” in the California Probate
Code, and failure to follow the UPIA constitutes a breach of trust for
which a trustee is liable to be removed and liable for damages. This is
especially significant for attorneys, accountants, trust officers and private
fiduciaries who act as trustees, since they are held to the standard of pro-
fessional trustees rather than non-professional trustees. Since the trustee
is liable for failure to follow the Act, it is assumed to be malpractice for
an attorney or CA to fail to advise the trustee of his or her responsibility
under the Act. The principles of prudent investing incorporated in the
UPIA are applicable to all fiduciary investing, whether under the typical
family trust arrangement, charitable funds or any other trust format.

THE “SAFE HARBOR” FOR PRUDENT FIDUCIARY INVESTING !361
DEFAULT LAW
Default law means that the provisions of the law will apply if the provi-
sions of the trust don’t spell out a different provision. It appears that the
Ontario Trustee Act puts more emphasis on the sufficiency of the trust
language than is the case in California or the United States in general.2
While both jurisdictions have similar language in law, the courts in the
United States have tended to give more weight to the requirements of the
UPIA in the absence of very strong language in the trust overriding the
language of the statute. In particular, this has applied to the requirement
to diversify assets. There are a few cases in which trustors authorized the
trustees to retain either Kodak or IBM stock and not diversify the posi-
tion. Without going into the detail of these cases, the end result is that if a
trustor truly wants to have a future trustee retain an asset, then that
trustee would be well advised to use very specific and demanding lan-
guage that essentially forbids the trustee to diversify from that position.
Otherwise, if it would be deemed prudent to diversify from that single
position, the courts will most likely side with diversification. It would
appear to me that this would be more likely in the United States than in
Canada, but any Canadian would do well to take this under advisement.
ACTIVE VERSUS PASSIVE INVESTING — DEFINING
ACTIVE AND PASSIVE INVESTMENT MANAGEMENT
Active management is the traditional way of building a stock portfolio,
and always incorporates some form of stock picking and/or market tim-
ing. Regardless of their individual approach, all active managers share a
common thread: they buy and sell securities selectively, based on some
forecast of future events. This is the form of investment strategy you hear
or read about almost exclusively in the financial press/media and is prac-
tised by the vast majority of professional investors (stock brokers and
investment advisors whether retail or institutional).
Passive or index managers or equilibrium-based investors (similar
but distinct approaches to passive investing) make no forecasts of the
stock market or the economy, and no effort to distinguish “attractive”
from “unattractive” securities. Their goal is to hold virtually all of an
asset class or dimension of the market. For example, they will often con-
struct their portfolios to closely approximate the performance of well-
recognized market benchmarks such as the Standard & Poor’s 500 index
(large U.S. companies) — Canada’s version would be the TSX — Rus-
sell 2000 index (small U.S. companies) or Morgan Stanley EAFE index
(large international companies).
Ontario Trustee Act, R.S.O. 1990, c. T.23, s. 68; California UPIA §16046(b).2

There is an ongoing debate that argues whether it is “better” (mean-
ing who will outperform) to invest with passive or active investment
strategies. This chapter is not one of those. While we will comment on
that question, the premise is not whether one is “better” than the other,
but, rather, how a trustee establishes an investment policy which most
nearly fits with the criteria of prudence delineated by the UPIA and the
Restatement [Third] of Trusts, including the commentary in California
and the Trustee Act in Ontario.
THE TRUSTEE’S DUTY TO DIVERSIFY
California UPIA § 16048: Duty to Diversify Investments
16048. In making and implementing investment decisions, the trustee has a
duty to diversify the investments of the trust unless, under the circum-
stances, it is prudent not to do so.3
The Prefatory Note to the (Uniform Prudent Investor) Act (as pro-
mulgated by the National Conference of Commissioners on Uniform
State laws) states that the Act “draws upon” the Restatement [(Third) of
Trusts] (“Restatement”), while the Reporter for the Act notes that the Act
“codif[ies]” the Restatement. A commentator observes: “[The Act’s] tie
to the Restatement is significant, because it is the Restatement that pro-
vides numerous examples of prudent and imprudent investing, as well as
providing the underlying rationale of the rules that are now part of the
[Act].”4
In California, a great deal of investing by trustees of personal trusts,
even when done in conjunction with professional investment advisors
and stock brokers, is done without being informed by the law and the
commentary around it.
The purpose of diversification is twofold: first, it is to eliminate, or
at least substantially reduce, uncompensated or non-systematic risk. This
is a basic tenet of Modern Portfolio Theory. The commentary to the Re-
statement says:
In understanding a trustee’s duties with respect to the management of risk, it
is useful to distinguish between diversifiable (or “uncompensated”) risk and
market (or non-diversifiable) risk that is, in effect, compensated through
California Probate Code, Part 4, Article 2.5. Section 27(6) of the Ontario Trustee Act3
provides:
(6) A trustee must diversify the investment of trust property to an extent
that is appropriate to,
(a) the requirements of the trust; and
(b) general economic and investment market conditions.
W. Scott Simon, The Uniform Prudent Investor Act: A Guide to Understanding (Ca4 -
marillo, CA: Namborn Publishing 2002) at 3.

pricing in the marketplace. The distinction is useful in considering fiduciary
responsibilities both in setting risk-level objectives and in diversification of
the trust portfolio.
In the absence of contrary statute or trust provision, the requirement of cau-
tion ordinarily imposes a duty to use reasonable care and skill in an effort to
minimize or at least reduce diversifiable risks. … these are risks that can be
reduced through proper diversification of a portfolio. Because market pric-
ing cannot be expected to recognize and reward a particular investor’s fail-
ure to diversify, a trustee’s acceptance of this type of risk cannot, without
more [i.e., a rational examination of the portfolio’s risk], be justified on
grounds of enhancing expected return. What has come to be called “modern
portfolio theory” offers an instructive conceptual framework for understand-
ing and attempting to cope with non-market risk. The trustee’s normal duty
to diversify in a reasonable manner, however, is not derived from or legally
defined by the principles of any particular theory. See Reporter’s General
Note on Comments e through h for discussions of asset pricing, types of
risk, and the advantages of diversification.
Another aspect of risk management deals with market risk, often called
“systemic” or “systematic” risk, or more descriptively for present purpos-
es, simply non-diversifiable or compensated risk. The trustee’s duties and
objectives with respect to this second category of risk are not as distinct as
those with respect to diversifiable risk. They involve quite subjective
judgments that are essentially unavoidable in the process of asset man-
agement, addressing the appropriate degree of risk to be undertaken in
pursuit of a higher or lower level of expected return from the trust portfo-
lio. In this respect the trustee must take account of the element of conser-
vatism that is ordinarily implicit in the prudent investor rule’s duty of
caution. Opportunities for gain, however, normally bear a direct relation-
ship to the degree of compensated risk. Thus, although an inferred, general
duty to invest conservatively is a traditional and accepted feature of trust
law, that duty is necessarily imprecise in its requirements and is applied
with considerable flexibility. [author’s emphasis]5
The first purpose of diversification then is to eliminate uncompen-
sated or non-systematic risk to the extent possible. Compensated or sys-
tematic risk is the risk of the market, a risk that one cannot reduce or
eliminate by diversification. It is clear in modern investing that there is
no investment that is free of risk. The UPIA and the Trustee Act call for
an investment portfolio that is risk-efficient, that is, the portfolio only
takes risk for which it will be compensated and where the risk is appro-
priate for the trust.
PASSIVE INVESTING AND COMPENSATED RISK
Passive investment strategies involve purchasing virtually all the securi-
ties in the relevant segment or dimension of the market. For example, if
the relevant segment of the market is the S&P 500 Index, a passive in-
Section 227 of Restatement of Law [Third] Trust, Comment e.5

vestor will hold all 500 stocks in the same approximate weight as the
market and will only change them when the index is changed. In the case
of international stocks in the mature markets, one would buy virtually all
of the stocks in the MSCI EAFE Index (Europe, Australasia and the Far
East). These relevant indices represent “the market” we are investing in.
If I hold the entire universe of securities in “the market”, by definition I
am taking only the market risk — no more and no less. As soon as I de-
cide that I will employ an active strategy and only pick what I believe to
be securities with the greatest short-term promise (short term meaning
until I decide that they no longer hold superior promise), I reduce diver-
sification and take on a greater risk that I will not perform as the market
performs, both in terms of volatility and returns. I now have what is
termed in the Restatement Comments in Section 227 “uncompensated”
risk. My choice of securities that is less than “the market” will either
outperform or underperform and will have either more or less volatility
as defined by standard deviation. All Active strategies, by definition, take
on uncompensated risk. Failure to diversify on a reasonable basis in or-
der to reduce uncompensated risk is ordinarily a violation of both the
duty of caution and the duties of care and skill.6
The second purpose of diversification is to create “efficient” portfo-
lios. Modern Portfolio Theory was developed from the Nobel Prize win-
ning work of Harry Markowitz. Among other things, it has taught us
about the significance of asset allocation. Proper asset allocation allows7
us to create investment portfolios that are deemed “efficient”, that is,
they are designed to provide the greatest return for a given amount of
risk. The creation of portfolio models under this theory assumes asset
classes (as represented by indices like the S&P 500, the MSCI EAFE,
etc.) made up of compensated risk only. The introduction of uncompen-
sated risk dilutes the reliability of an asset allocation model. The degree
to which risk is being controlled is called into question.
Ibid.6
Gary P. Brinson, L. Randolf Hood, and Gilbert L. Beebower, “Determinants of Portfo7 -
lio Performance” (1986) 42 Financial Analysts Journal 39 and again Gary P. Brinson,
Brian D. Singer and Gilbert L. Beebower, “Determinants of Portfolio Performance II:
An Update” (1991) 47 Financial Analyst Journal 44 and again William E. O’Rielly
and James L Chandler, Jr., “Asset Allocation Revisited” (2003) 13 Journal of Finan-
cial Planning 94 all indicate that in excess of 90% of an investment portfolio’s vari-
ability of returns is determined by the Asset Allocation.

PASSIVE STRATEGIES AND INVESTMENT COSTS
California UPIA § 16050: Costs and Expenses
16050. In investing and managing trust assets, a trustee may only incur costs
that are appropriate and reasonable in relation to the assets, overall invest-
ment strategy, purposes and other circumstances of the trust.8
With all investment strategies there are costs. These costs include
commissions, advisor fees, transaction fees, mutual fund internal expense
ratios, research costs, bid/ask spreads and market impact costs. Passive
investment strategies cost less than active strategies.
Internal Expense Ratios (IER) in the United States and Management
Expense Ratio (MER) in Canada
All mutual funds have an internal expense ratio that represents the cost of
the fund doing business and making a profit. Most actively managed
funds in the United States include in the IER a fee known as a 12b1 fee
that was authorized by the SEC to fund marketing efforts of no load mu-
tual funds. The typical IER fee is around .25%; it can be more, and with
“C” shares it is typically 1.00%. Most passively managed funds in the
United States do not include a 12b1 fee, especially those that are de-
signed for use in institutional settings. The IER of the average stock mu-
tual fund according to leading investment research firm Morningstar is
1.51% compared to the MER of 2.51% in Canada. The passively man9 -
aged index funds at Vanguard, a client-owned investment management
company, for example, average .22%. This gives the passively managed
Vanguard portfolio a 1.29% advantage against U.S. funds and a 2.29%
advantage against Canadian funds.
The more rigorous academic studies [of internal expenses] find that expense
ratios generally detract from fund performance. On average, fund managers
are unable to recoup the expenses that funds pay via better performance.
California Probate Code Article 2.5. Section 27 of the Ontario Trustee Act provides:8
23.1 (1) A trustee who is of the opinion that an expense would be properly
incurred in carrying out the trust may,
(a) pay the expense directly from the trust property; or
(b) pay the expense personally and recover a corresponding amount from
the trust property.
(2) The Superior Court of Justice may afterwards disallow the payment or
recovery if it is of the opinion that the expense was not properly incurred in
carrying out the trust.
Larry MacDonald, “Keeping up with the Deep Thinkers”, Canadian Business Online9
(May 29, 2003), online: <www.canadianbusiness.com>. See also Janet McFarland and
Rob Carrick (with files from Keith Damsell), “The fee crunch: Not all investors get
value for money”, GlobeAdvisor.com (June 24, 2004), online: <www.globeadvisor. 
com>.

These findings suggest that basing fund investment decisions at least partial-
ly on fees is wise. Lower cost funds have a smaller drag on performance that
active managers must overcome. Taken to their logical conclusion, these
results may suggest that index funds, accompanied by the lowest expense
ratios in the mutual fund industry, are a more logical long-run investment
choice than more expensive actively-managed funds.10
This issue of cost is a greater problem for Canadian investors than
for U.S. investors. The average Canadian MER is about 1% greater than
the average U.S. IER. A small part of that cannot be avoided by more
efficient management because it is attributable to the Goods and Services
Tax (GST) at a 5% rate. Beyond that, there is a difference in the distribu-
tion systems between Canada and the United States. It seems to me that
the use of low cost asset class funds is even more important in Canada
than the United States due to the significant delta between the cost of
actively and passively managed funds.
The following chart illustrates the long-term impact of fees on in-
vestment returns. For many trust-owned investments, this kind of long-
term perspective is required.
!
Chart provided by Dimensional Fund Advisors (2000).
Turnover Ratio and Brokerage Costs
By definition, passively managed funds have a low turnover rate. It is the
policy of passive funds to buy their universe of stocks and hold them un-
til they no longer fit the specific universe the fund is to emulate. Actively
managed funds, however, generally have significant turnover. Turnover
creates brokerage commissions that are not reported in fund prospectus-
Jason Karceski, Miles Livingston and Edward S. O’Neal, Mutual Fund Brokerage10
Commissions, a report commissioned by Zero Alpha Group (January 2004) at 2.

es. To find these costs, one must order a copy of the Statement of Addi-
tional Information (SAI) and then decipher it from what is often pooled
reporting for the entire family of funds — a task that takes some amount
of speculation.
!
Source: Jason Karceski, Miles Livingston and Edward S. O’Neal, Mutual
Fund Brokerage Commissions (Zero Alpha Group, 2004).
For 2001, Morningstar data shows that turnover for the average
U.S. domestic equity fund was 106%. The average turnover for these
largest 30 funds (in Exhibit 1) is 57% — half that of the average fund.
There are 3 index funds in this sample of 30. If we separate these out, the
average commission rate for the actively managed funds is 11.3 basis
points [.113%]. This contrasts to an average of .45 basis points [.0045%]
for the index funds (the three dots in the bottom left of the chart).
Bid/Ask Spread Cost
In addition to brokerage commissions, there is another implicit cost to
investors created by the spread between the bid (sell price) and ask (buy
price) for a stock. After explaining their methodology for deriving the
“average” cost of the bid/ask spread, Karceski, Livingston and O’Neal
concluded, “A fund with a turnover ratio of 100% would thus incur 36

basis points [.36%] per year in implicit trading costs.” Carrying the log11 -
ic a step further, we can estimate that a comparable large passive portfo-
lio such as the Vanguard Index 500 fund with a turnover ratio of 5%12
would incur implicit trading costs of 1.8 basis points [.018%] per year, a
reduction of 2000%.
Market Impact Cost
An additional implicit cost is incurred when a mutual fund, as a large
investor, actually moves the prices of the stocks in which it transacts. If a
fund wishes to sell a very large amount of a stock, this significant selling
pressure may actually reduce the price at which the fund is able to sell
the stock (which is obviously bad for the fund). This change in the stock
price driven by large trades is called market impact.13
Academic researchers have suggested that commissions represent
less than half of the total cost of trading for institutional investors. There-
fore, while commissions represent a quarter of a point per year for the
average fund, total trading costs likely surpass a half of a percentage
point for the average fund. These are costs that are not disclosed in the14
prospectus or in any commercially available investment database.
Karceski, Livingston and O’Neal have called for the disclosure of at least
the brokerage costs of mutual funds to be disclosed in their prospectuses.
Exhibit 2, below, portrays the more complete picture of costs in
four of the largest mutual funds in the Morningstar U.S. database. Exhib-
it 3, below, portrays four high turnover funds and the undisclosed costs
which significantly outstrip the disclosed IER. As you can see, the dis-
closed PBHG large-cap IER understates the true costs by approximately
740%.
Ibid. at 7.11
Morningstar Premier online service (March 19, 2007) <http://quicktake.morningstar. 12
com/fundnet/Snapshot.aspx?Country=USA&Symbol=VFINX>.
Jason Karceski, Miles Livingston and Edward S. O’Neil, Mutual Fund Brokerage13
Commissions, a report commissioned by Zero Alpha Group (January 2004) at 3.
Ibid. at 6-7.14

!
!

If we apply the same methodology to the Vanguard 500 Index Fund
as was applied in the above actively managed scenarios, we find that the
IER is .18%, brokerage commissions are .0045% and the implicit trading
costs from the bid/ask spread are .018%, for a total of .2025% compared
to 8.59% for the PBHG large-cap fund.
In all fairness and in the interest of full disclosure, Karceski, Liv-
ingston and O’Neal state:
We have some reservations about the use of this data to draw over-arching
conclusions. First, it appears as though the data is subject to errors. Although
we delete outliers, there may still be errors in this data. It is also possible that
some of the observations we delete are, in fact, valid. Second, we are forced to
allocate commissions across the funds in a registrant [Fund Family]. The ad
hoc measures we construct are the best we can do with the data we have.15
This study is one of the few attempts by academics to determine the
impact of these investing costs and was handled with the best of efforts
to arrive at reliable analysis, so, while acknowledging the possibility of
error, at the same time I believe the conclusions are reasonable and valu-
able in the measurement of the relative cost impacts between active and
passive investing strategies. When a trustee makes good fiduciary deci-
sions regarding investment strategy, this allows the trustee to observe the
relative value in the use of low cost passively managed asset class funds
as compared to the various actively managed alternatives.
PASSIVE MANAGEMENT OUTPERFORMS ACTIVE
MANAGEMENT OVER TIME
If “active” and “passive” management styles are defined in sensible ways, it
must be the case that:
(1) before costs, the return on the average actively managed dollar will
equal the return on the average passively managed dollar and
(2) after costs, the return on the average actively managed dollar will
be less than the return on the average passively managed dollar.
These assertions will hold for any time period. Moreover, they depend only
on the laws of addition, subtraction, multiplication and division. Nothing
else is required.
. . .
To repeat: Properly measured, the average actively managed dollar must
underperform the average passively managed dollar, net of costs. Empirical
analyses that appear to refute this principle are guilty of improper measure-
ment.16
Ibid. at 7.15
William F. Sharpe, “The Arithmetic of Active Management” (1991) 47 The Financial16
Analyst’s Journal 7.

Many people would think this is an outrageous statement except for
the fact that it comes from one of the leading financial academics in the
United States, William F. Sharpe, winner of the Nobel Prize in Eco-
nomics in 1990 and the Stanco 25 Professor of Finance, Emeritus at
Stanford University.
Of course, averages are made up of all data points. In this case, it
includes some actively managed funds that potentially outperformed the
passive fund along with those that underperformed. Random statistical
expectations tell us that some fund managers will outperform the market
in any given year. They also tell us that it will probably not be the same
active manager consistently outperforming year after year. Studies of
manager performance have supported this position.17
JUSTIFYING ACTIVE STRATEGIES VERSUS PASSIVE
STRATEGIES
The Restatement Commentary, below, warns trustees about the perils
often associated with active investing. These include the greater risks,
and higher costs and taxes of stock picking and market timing.
Active strategies, however, entail investigation and analysis expenses and tend
to increase general transaction costs, including capital gains taxation. Addi-
tional risks also may result from the difficult judgments that may be involved
and from the possible acceptance of a relatively high degree of diversifiable
risk. These considerations are relevant to the trustee initially in deciding
whether, to what extent, and in what manner to undertake an active investment
strategy and then in the process of implementing any such decisions.
If the extra costs and risks of an investment program are substantial,
these added costs and risks must be justified by realistically evaluated return
expectations. Accordingly, a decision to proceed with such a program in-
volves judgments by the trustee that:
a) gains from the course of action in question can reasonably be
expected to compensate for its additional costs and risks;
b) the course of action to be undertaken is reasonable in terms of its
economic rationale and its role within the trust portfolio; and
c) there is a credible basis for concluding that the trustee — or the
manager of a particular activity — possesses or has access to the
competence necessary to carry out the program and, when delega-
tion is involved, that its terms and supervision are appropriate.18
This Commentary suggests that the trustee meet a two-part test to
determine the prudence of implementing an active investment strategy.
This two-part test asks:
Mark Carhart, “On Persistence in Mutual Fund Performance” (1997) 52 Journal of17
Finance 57.
Restatement §227, Paragraph h.18

(1) Are the extra costs, taxes and risks of the proposed strategy “sub-
stantial”?
(2) If they are, can they be “justified by realistically evaluated return
expectations?”
Consequently, the trustee who conducts this test should consider
whether:
1. the proposed investment strategy’s gains can reasonably be expect-
ed to overcome its additional costs and risks;
2. the strategy is suitable to the risk/return profile of the trust portfolio
and the facts and circumstances of the trust or its beneficiaries; and
3. the trustee (or its agent) has the requisite competence to carry out
and monitor the strategy.
The Commentator suggests that it is very difficult to “beat the mar-
ket” through any means of active investment management. The objective
of using an active rather than a passive investment strategy is to beat the
returns a passive (market) investment strategy would provide.
Economic evidence shows that, from a typical investment perspective, the
major capital markets of this country are highly efficient, in the sense that
available information is rapidly digested and reflected in the market prices of
securities. As a result, fiduciaries and other investors are confronted with po-
tent evidence that the application of expertise, investigation, and diligence in
efforts to “beat the market” in these publicly traded securities ordinarily
promises little or no payoff, or even a negative payoff after taking account of  
research and transaction costs. Empirical research supporting the theory of
efficient markets reveals that in such markets skilled professionals have rarely
been able to identify under-priced securities (that is, to outguess the market
with respect to future return) with any regularity. In fact, evidence shows that
there is little correlation between fund managers’ earlier successes and their
ability to produce above-market returns in subsequent periods.19
The test for deciding whether to use an active strategy initially re-
quires an estimate of expected returns. How does one reasonably deter-
mine that the active strategy will exceed the future return of the market
benchmark and therefore outperform the passive strategy?
Track Record Selection
The most common method, although warned against constantly, is what I
will call the “track record” method. What has the track record of this
manager/strategy been in the past? The first and glaring problem with
this approach is the warning found on every mutual fund prospectus in
Restatement §227, General Note on Comments e through h: Introduction to Portfolio19
Theory and Other Investment Concepts.

the country: “Past performance is no guarantee of future results.” Sec-
ond, evaluating past performance is always a matter of “how you slice
the pie”, or how you determine the time frame for the sample of past per-
formance. A track record can be tremendously different if the time frame
is changed by as little as one quarter.
Outstanding track records always represent greater risk than the
market because, by definition, the stock picking that selected less than all
the market stocks in question is under-diversified relative to that market.
Lastly, track records don’t account for taxes or commission loads.
For example, Fidelity Magellan generated an average annual pre-tax return
of 18.3% over the ten year period from mid-1985 to mid-1995. But once the
reality of taxes (and commission loads) is taken into account, the after-tax
return drops to 12.7%. This turns a track record that seemingly widely out-
performed the market into one that came close to underperforming it.20
Skillful Manager Selection
The other method of manager selection is to attempt to find “skillful”
money managers separate from their track record. There are now many
independent consultants and institutions dedicated to identifying these
most skillful or “Best of Class” money managers. These include compa-
nies like Frank Russell Company, Callan Associates, Wilshire Associates
and SEI Investments. The criteria will include things like:
1. the money manager’s investment philosophy and style;
2. their discipline in making buy/sell decisions;
3. the consistency of the application of their process and the stability
of their personnel; and
4. while it is not specifically listed as a component, the manager’s per-
formance track record, as it is inevitably a significant part of this
analysis.
While this is all admirable and undoubtedly an honest effort,
A [Frank] Russell [Company] analyst notes, “If I have to base future expec-
tations, I want to base it on skill as opposed to identification of good per-
formance.” But this reasoning, like that used to justify track record invest-
ing, may have some flaws. Russell’s own studies indicate that it takes a long
time to identify skill statistically. In fact, a money manager must have a
track record of at least 15 years — and sometimes as much as 80 years or
even longer — before it’s even possible to eliminate sheer luck as the source
of the manager’s superior performance. Even when a manager is found to be
W. Scott Simon, The Uniform Prudent Investor Act: A Guide to Understanding (Ca20 -
marillo, CA: Namborn Publishing, 2002) at 113.

skillful statistically (based on the track record of past performance), that’s
no indication that it will be skillful in the future.21
It is, therefore, difficult to establish reasonably that an active strate-
gy is a superior choice to a low cost passive strategy. W. Scott Simon
identified five specific reasons to consider low cost passive investing as
the safe harbor or default standard for prudent fiduciary investing:
1. First, the zero sum nature of financial markets means that all pas-
sively managed money invested in a particular market will earn the
market return.
2. Second, the costs and taxes associated with passive investing are
relatively lower.
3. Third, passive funds are broadly diversified so they are relatively
lower risk.
4. Fourth, passive funds don’t experience style drift.
5. Fifth, passive funds aren’t subject to “manager risk” like active in-
vestment products.22
THE ROLE OF THE FINANCIALADVISOR
One might conclude from the foregoing that the cost of an Investment
Advisor is an unnecessary burden on the trust. That is a naïve and costly
conclusion. So, what is the role of the Investment Advisor under this
regime and why are the advisor’s fees appropriate?
First, The California UPIA and the Ontario Trustee Act are predi-
cated on the dominance of the Noble prize winning Modern Portfolio
Theory. These Acts and others like them around the world have codified
Modern Portfolio Theory as appropriate for fiduciary investing. To meet
the requirements of the applicable statutes, one must be able to imple-
ment Modern Portfolio Theory. Most non-professional investors do not
have the capacity to do so. As one who advises trustees, you should be
recommending that they hire a professional capable of implementing
Modern Portfolio Theory and the other criteria of the applicable statutes.
Second, there are several choices for implementing passive asset
class investments. Some of those are not available in some jurisdictions.
Some are structured differently and have unique advantages over others
— a subject that goes beyond the scope of this chapter. For example,
while the popular American Vanguard Index Funds would certainly meet
the criteria in this chapter, there are some drawbacks to Index investing
Ibid. at 114.21
Ibid. at 122-23.22

that can be overcome by the use of passively managed asset class funds
like those offered by Dimensional Fund Advisors and available only
through approved Investment Advisors. Properly structured ETFs are
also a viable option.
The professional advisor will be able to assist the trustee: (1) in the
creation of a proper asset allocation that is science based, not emotionally
driven; (2) in the selection of appropriate investment strategies for filling
in the various asset class selections; (3) in monitoring their performance;
(4) in facilitating appropriate rebalancing of the portfolio over time; and
(5) in documenting all of this in a professionally drafted Investment Poli-
cy Statement.
All of the above is done in the context of the particular trust and its
requirements. The discipline brought to the process by a truly qualified
professional Investment Advisor is well worth the annual fees charged by
professional advisors. However, this is one of those fees that must be
reviewed by the trustee to be sure it is reasonable and appropriate to the
trust and the investment strategies used by the trust. Unexamined fees
can become excessive and may not be justified.
CONCLUSION
Both the California UPIA and the Ontario Trustee Act contain two sec-
tions that significantly speak to investment strategy: the duty to diversify
in order to reduce or eliminate uncompensated risk and develop efficient
portfolios; and the duty to only incur costs that are appropriate and rea-
sonable in relation to the assets, overall investment strategy, purposes
and other circumstances of the trust. Included in costs to be considered
are tax costs.
(1) By definition, a low cost passive asset class mutual fund or ETF
reduces uncompensated risk as much as possible. Any active strate-
gy, because it holds something less than the full market dimension
it is chosen to represent, by definition, contains uncompensated
risk.
(2) Due to its essential buy and hold strategy, a low cost passive asset
class fund, ETF or Index Fund is lower in all costs: lower IER or
MER, lower brokerage costs, lower bid/ask spread costs and a low-
er potential for market impact negatively affecting investment per-
formance than a comparable active strategy.
(3) A low cost passive asset class fund will generally not underperform
the market dimension it is chosen to represent by more than the
costs of investing. Most actively managed funds underperform the
“market” most of the time — few outperform, and those that do

generally do not persist in that outperformance over the investment
time period required by most trusts.
(4) Since it is apparent from the Trustee Act, the UPIA, the Restatement
and the Commentary and Notes on the Restatement that a trustee
should take only compensated risk unless he or she can justify active
uncompensated risk, and since the UPIA requires trustees to pay only
reasonable costs, it is apparent that the use of low cost passive asset
class funds is the default strategy or safe harbor for prudent fiduciary
investing for trustees.
It is then my conclusion that those professionals who advise
trustees must look carefully at the basic investment strategies that are
being implemented. There should be a rational justification of any active
strategies being proposed or implemented against a comparable passive
strategy in regard to risks, costs and taxes. Can the fiduciary justify the
active strategy as being more prudent for the trust than the passive strate-
gy? If not, then a passive strategy should be used to implement the in-
vestment portfolio.

(30)_The_Safe_Harbor_for_Prudent_Fiduciary_Investing

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