The Overlooked Obligation to Evaluate Return on Investment Fees
FIGURE 1 : Asset Allocation of Private and Public Pension Funds ( 1980 – 1999 )
“ A trustee may only incur costs that are appropriate and reasonable in relation to the assets , the purposes of the trust , and the skills of the trustee … Wasting beneficiaries ’ money is imprudent .”
Uniform Prudent Investor Act ( UPIA )
The Restatement of Law Trusts ( 3d ) incorporated what was known as the Uniform Prudent Investor Act ( UPIA ). In 1994 , the National Conference of Commissioners on Uniform State Laws approved the UPIA and recommended its enactment in all states . As of December 31 , 2023 , nearly all 50 states have codified the UPIA into law .
Most trustees appreciate the diversification principles required under the UPIA , but few appreciate the obligation to manage costs . Yet this responsibility is clearly articulated in Section 7 of the UPIA . The quote above provides the specific language . As trustees continued to add investments that increased asset management fees and corresponding costs of portfolio oversite over the last 30 years , few asked themselves the critical question of whether the incremental benefits exceeded the incremental costs . With each passing year , therefore , the costs of diversification began to increasingly outweigh the benefits .
abundance of caution . For the remainder of the 1970s , VC firms were unable to raise sufficient capital from institutional plans , which caused pain for the nascent technology industry . Desperate to reestablish relationships with institutional plan trustees , the National Venture Capital Association lobbied the Department of Labor ( DoL ) to permit a more lenient interpretation of the Prudent Man Rule .
Source : Statistical Abstract of the United States : 2000 , U . S . Census Bureau , 530 .
In June 1979 , the DoL issued new guidance to allow for a more flexible interpretation of the Prudent Man Rule . On June 21 , 1979 , Ian Lanoff , the administrator of pension and welfare programs stated , “ Although securities issued by a small or new company may be a riskier investment than securities of a blue chip company , such an investment may be entirely proper under ERISA ’ s prudence rule .” The DoL ’ s shift on the issue of prudence restored VC funding . In addition , trustees had the flexibility they needed to allocate more heavily to common stocks . This contributed to a multi-decade shift of institutional investment plans toward publicly traded equities . In 1980 , equity allocations constituted 23 % of pension plan allocations . By 1999 , equity allocations constituted 73 % of their portfolios ( See Figure 1 ).
Modern Portfolio Theory and the Restatement of Law Trusts 3d ( 1992 )
In 1990 , Harry Markowitz was one of three co-recipients of the Nobel Prize in Economic Sciences . The award recognized the impact of a paper he had written nearly four decades earlier . Published in March 1952 , Markowitz ’ s article , entitled “ Portfolio Selection ,” provided a mathematical construct that reframed the discipline of portfolio management . Mathematical models based on MPT enabled investors to visualize the return and risk attributes of a portfolio by inputting estimates of the expected return , volatility and correlations of various asset classes in the portfolio . By measuring return and risk at the portfolio level , the risk of any single investment became less impactful . This gave trustees greater leeway to invest in riskier assets , provided that total portfolio risk was tolerable .
MPT also provided the American Law Institute with a powerful tool to provide trustees with the flexibility that they long desired . In 1992 , they published a third revision of the Restatement of Law of Trusts . By embracing MPT and refocusing prudence on the “ totality ” of portfolio risk , trustees finally felt empowered to venture beyond the most conservative stocks and bonds . The restatement also instructed trustees to create a diversified portfolio unless specifically instructed otherwise . Finally , the restatement modernized the language of the Prudent Man Rule by renaming it the Prudent Investor Rule .
Among the most significant impacts of the Prudent Investor Rule was that it gave trustees license to invest in a wide variety of new asset classes and sub-asset classes . This was critical to the rise of alternative asset classes in institutional portfolios .
The Rise of Alternative Investments and Corresponding Plan Costs
In 2000 , David Swensen , CIO of the Yale Investments Office , published his best-selling book , Pioneering Portfolio
18 FINANCIAL HISTORY | Winter 2024 | www . MoAF . org