Investment discretion

  • Author : Sarah Genequand
  • Date : June 2010
ABOUT THE AUTHOR: Sarah Genequand TEP is Chief Operating Officer at Passive Management SA

In the current environment, trustees face increasing challenges and risks. One of these is the risk of being engaged in lengthy litigation initiated by a disgruntled beneficiary for the breach of fiduciary duty. Currently several trustees (mainly in the USA) are being sued for breach of trust over investment decisions they have made. The arguments that have been put forward by the plaintiffs include the failure of the trustees to take into account the financial impact on the trust fund when exercising their discretion over investments, mainly due to the high costs associated with such investments and the risk of exposing the fact that these investments are failing to outperform the relevant benchmark. This underperformance, combined with the compounded effect of the high fees, has cost millions to beneficiaries by delivering lower returns.1 This ultimately resulted in the trust fund dropping to a significantly low level and hence disgruntled beneficiaries.

Minimum standard of care

When it comes to investment decisions, at common law the minimum standard of care expected from professional trustees is to invest the trust assets as a prudent man of business. This duty has been codified by modern trust legislation2, imposing a statutory duty of care upon the trustee so that when exercising its investment powers, the trustee must carry out the following:

  • select risk and return objectives that are reasonably suited to the particulars of the trust;
  • diversify;
  • evaluate investments in the context of the trust fund as a whole;
  • avoid unreasonable or inappropriate costs; and
  • consider the tax consequences.

On the other hand the reality of investments encompases the following features:

  • all studies have demonstrated that each year very few managers beat the market and that it is impossible to identify those managers in advance (as each year, it is a different group);3
  • selecting an investment manager or investments is similar to making a forecast on the future, which entails making a decision based on uncertainty;
  • fees and taxes have a dramatic impact on performance (2 per cent a year can reduce the trust fund by over 50 per cent!4); and
  • past performance is no indication of future results.5
Doing your duty

So how do we accommodate reality within the scope of the fiduciary duty imposed upon the trustee? The answer may be found in the requirements of the Uniform Prudent Investor Act (UPIA), which leads trustees to favour the use of index funds over active mutual funds for the management of trust assets. The reporter’s general note to the restatement of UPIA states that ‘the greater the trustee’s departure from one of the valid passive strategies, the greater is likely to be the burden of justification for choosing an active investment strategy.’ As a trustee, if you plan to use active mutual funds, you must show that you have appropriately considered the additional costs.

Index funds

Using index funds is a step in the right direction, but trustees should go a step further by choosing to passively invest trust funds. Like index funds, passive funds seek to capture the market returns but they are not bound to follow an index by keeping a low tracking error. Using passive funds is a risk-efficient, cost-efficient and tax-efficient way of being broadly exposed to the financial markets.


When exercising their investment powers, trustees, having resolved to passively invest the trust fund, will have carried out the following:

  • controlled the risk and ensured that any potential loss is rigorously calculated;
  • completely removed forecasting in the investment making process. Any decision is made knowingly and no surprises will arise when it comes to reviewing performance;
  • implemeneted a straightforward investment review process;
  • implemented a significant reduction in fees and costs associated with the management of the trust fund;
  • improved the overall performance of the trust fund for each additional level of risk taken.

Today, ETFs, trackers, index funds and passive funds flourish on the markets. Having to select which ones to use is time consuming and complex. The proliferation of these instruments should not prevent the trustee from switching their investment process to a simple and straightforward passive management strategy. According to W. Scott Simon6, the trustee should bear in mind that ‘passive investing appears to be the standard for investing and managing trust portfolios. (…) fiduciaries that use passive investment products can demonstrate prudent investment conduct.’7

Risk Reduction

  active management index management

 passive management

Forecast  include forecast include forecast no forecast
Asset allocation asset allocation may vary over time depending on the markets and the decisions made by the managers asset allocation may vary depending on the markets (due to market timing) asset allocation always in line with risk profile as defined by the trustee – regular rebalancing
Diversification low diversification medium diversification maximum diversification(penetrating the markets entirely)
Investment review lack of clarity in the nature of investments easy to monitor as portfolio is a life benchmark easy to monitor as portfolio is a life benchmark
 Costs high costs

hidden commissions

high transactions fees (high turnover)
low costs

no commissions

medium transactions fees (medium turnover)

low costs

no commissions

low transactions fees (low turnover)
Tax consequences not always taken into account not taken into account passive funds are built in order to increase tax efficiency
Bruno, Mark, ‘Wal-Mart suit hits 401(k) fees’, in The Financial Week, April 28, 2008.
Uniform Prudent Investor Act (UPIA) adopted in 1992 by the American Law Institute’s Third Restatement of the Law of Trust and approved by the American Bar Association in 1995.
Jensen, Michael, ‘The Performance of Mutual Funds in the period 1945-1964’ in Journal of Finance, Vol 23, No 2 (1967) pp 389-416.Davis, James L., ‘Mutual Fund Performance and Manager Style’ in Financial Analyst Journal 57, no 1 January 2001 : pp 19-27.Dalbar, Study shows market timers lose their money, April 2004.Prof. Barras, L. , Scaillet, O., Wermers, R., Swiss Finance Institute,‘False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas’ in Research Paper Series N°08-18, 2008.Cogan, Philip, ‘Money for old hope’ in The Economist, Special Report, 28.02.2008’ Fama, E. & French, K., ‘Luck versus Skill in the Cross Section of Mutual Fund Returns’ in Journal of Finance, December 2009. Regnier, Pat, ‘Can you outsmart the market?’ in The Fortune Magazine, 21.12.2009. Zweig, Jason, ‘Why so many investors keep fooling themselves?’ in The Wall Street Journal, 16 January 2010.
Tribeca Advisors LLC, The 7 Deadly Sins of Retirement Plans…and How to Avoid Them!, 2008,
General Note on Restatement of UPIA §227, comments E-H ‘evidence shows that there is little correlation between fund managers’ earlier success and their ability to produce above-market returns in subsequent periods.’
W. Scott Simon 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. He is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts.
Simon, Scott W., The Prudent Investor Act: A guide to understanding, Namborn Publishing Company, 2002


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