The Fiduciary’s Default Investment Choice
Index Funds Provide a Substantial Measure of Safe Harbor for Fiduciaries
For a number of reasons, passive strategies trump active management as the default
choice for any fiduciary. As a fiduciary anything you can do to reduce costs, lower risk
and improve performance of your endowment or foundation’s investments will enhance
your mission. Additionally, good governance of your funds will help attract new donors
and embellish your organization’s image. Finally, it reduces your personal financial and
All relevant fiduciary standards including the 1974 Employee Retirement Income
Security Act (ERISA), the 1994 Uniform Prudent Investor Act (UPIA), the 1997 Uniform
Management of Public Employee Retirement Systems Act (MPERS) and the 2006
Uniform Prudent Management of Institutional Funds Act, and Restatement 3rd of Trusts
(Prudent Investor Rule) have embedded language suggesting that Passive Investment
Strategies such as Index Funds, Asset Class Funds, and Exchange Traded Funds (ETF)
should be the appropriate implementation of a fund’s investment policy. Fiduciaries
ignore this at their peril.
The direction to consider passive strategies as the default implementation is so explicit
that it provides considerable “safe harbor” for fiduciaries. In our view, institutional class
index funds, asset allocation funds, and Exchange Traded Funds mean never having to
say you are sorry.
While active strategies are not specifically prohibited, the burden of proof required
to justify an active strategy is very high and probably impossible to meet in practical
terms. The Reporter for the Restatement elaborates on this in the fourth generalization
concerning prudent investment: “To the extent an investment strategy involves extra
management, tax, and transaction costs or a departure from an efficiently diversified
portfolio, that strategy should be justifiable in terms of special circumstances or
opportunities or in terms of a realistically evaluated prospect of enhanced return [from
the strategy]. The Reporter goes on to say: “The greater the trustee’s departure from one
of the valid passive strategies, the greater is likely to be the burden of justification [for
selecting the proposed active strategy] and also of continuous monitoring [of it].”
“Failure to diversify on a reasonable basis in order to reduce uncompensated risk is
ordinarily a violation of both the duty of caution and the duties of care and skill.”
That’s why Commentary to Section 227 of the Restatement 3rd of Trusts (Prudent
Investor Rule) cautions: “Because market pricing cannot be expected to recognize
and reward a particular investor’s failure to diversify, a trustee’s acceptance of
[uncompensated] risk cannot, without more, be justified on grounds of enhancing
It’s very difficult to read this Commentary and not get the point that fiduciaries must
prefer passive strategies from a risk management perspective. Our experience and
the overwhelming academic research indicate that active management strategies are a
highly effective method of increasing risk while reducing returns. Active investors can
reliably expect to reduce their returns by 1-2% per year while bearing a significant load
of uncompensated risk. Over the lifetime of a pension participant or trust account, this
is a significant sustained underperformance which places the fiduciaries squarely in the
crosshairs of the plaintiff’s bar.
Index funds offer “pure market exposure” with minimum uncompensated risk which
should be the objective of every fiduciary.
The overwhelming evidence shows that actively managed accounts cannot reliably add
value when compared to an unmanaged index. While 20 to 30 percent may beat the index
in any particular time frame, winners in one period are no more likely to outperform
during subsequent periods than mere random chance might indicate. Actively managed
funds tend to underperform by an amount of their additional expense. The relationship
between costs and underperformance is hard wired.
Stated another way, actively managed funds have a one in five to one in three chance of
beating an index, but the average underperformance is 1-2% per year. That’s a suckers
bet that reliably generates personal liability for the fiduciary.
The index fund is expected to track the index upon which it is based very closely, and
suffers from only a tiny cost drag relative to its actively managed competitors, virtually
eliminating the threat of underperformance. (A few index funds are able to exceed their
indexes due to a combination of trading advantages, income from securities lending, and
superior reconstitution strategy.)
Overall, benchmarking the performance of a passive strategy is straightforward,
tracking error should be trivial, and in any given market performance should mirror the
“Wasting beneficiaries’ money is imprudent” reads a blunt warning in Commentary to
section 7 of the Uniform Prudent Investor Act. From that perspective, institutional class
passive strategies offer the fiduciary excellent cost control.
“In investing and managing trust assets, a trustee may only incur costs that are
appropriate and reasonable in relation to the assets, overall investment strategy, purposes,
and other circumstances of the trust.” While the fiduciary is not obligated to provide the
lowest cost product available, he must be prepared to justify the additional cost.
It should be noted that salesmen often blow off the question of cost by explaining that
their recommendations fall well within industry standards. However, industry standards
are a license to steal, and are in no way the appropriate benchmark for fiduciaries. In the
pending Wal-Mart case, plaintiffs argued that the appropriate standard for cost was the
Vanguard Admiral Shares and that retail, actively managed fund costs were excessive
providing no additional value. It certainly would be hard to justify an additional 1% or
more per year of costs over and above that benchmark.
Appropriate fee disclosure is a high priority for any fiduciary. Most institutional class passive funds do not provide any fee sharing to custodians or pension administrators. In that case, custodians and administrators charge a fully disclosed fee to cover their services, and the issue of under the cover payments from the fund managers disappears.
Fiduciaries that utilize passive strategies can effectively, efficiently, and economically
implement their investment policy. The fiduciaries tasks of monitoring and oversight are
greatly simplified. Due diligence, cost control, risk control, underperformance and fee
disclosure almost disappear as potential issues for litigation. Any other choice exposes
them to unnecessary personal and corporate liability. All of these advantages combine to
make the passive approach the default choice for fiduciaries and the benchmark against
which alternative strategies will be judged.