Fiduciary Investment Research Articles

Comment Letter of Professors Max M. Schanzenbach and Robert H. Sitkoff on the Department of Labor’s Proposed Rulemaking on Financial Factors in Selecting Plan Investments

In June of 2020, the Department of Labor proposed a rule-making on financial factors in selecting ERISA plan investments (“Proposal”), in particular environmental, social, and governance factors (“ESG”). In general, we are supportive of the Proposal’s central purpose of subjecting ESG investing to the same fiduciary principles of loyalty and prudence that are applicable to any type or kind of investment. We do, however, have some criticisms. Our basic point is that the law neither favors nor disfavors ESG investing. Any investment decision by an ERISA trustee or other fiduciary — whether in the context of a direct investment, shareholder engagement (including proxy voting), or menu construction, and whether reliant on ESG factors or otherwise — is subject to the same fiduciary principles embodied in the duties of loyalty and prudence. Our chief criticisms, therefore, reflect instances in which the Proposal differentiates or could be construed as differentiating ESG investing from other types or kinds of investment strategies. First, the Proposal and accompanying commentary could be read to suggest that all manner of ESG investing is inherently suspect, presumably on fiduciary loyalty grounds, and therefore that ESG investing by an ERISA trustee or other fiduciary is always subject to enhanced scrutiny that requires extra process relative to other types of kinds of investment strategies. Such a position is inconsistent with law and sound policy. To be sure, an ERISA trustee or other fiduciary violates the duty of loyalty if she uses ESG factors to provide benefits for third parties (what we call “collateral benefits ESG”). However, use of ESG factors in pursuit of enhanced risk-adjusted returns (what we call “risk-return ESG”) is not suspect under the duty of loyalty. Instead, risk-return ESG is analyzed under the duty of prudence, which applies in the same manner to risk-return ESG as to any other type or kind of investment strategy. Departure from neutral application of fiduciary principles also requires drawing distinctions between ESG investing and other investing, a definitional morass that would create uncertainty and invite litigation. Second, portions of the commentary are unclear or phrased in a manner that could be construed as taking positions, such as with respect to active versus passive investing, that are not consistent with neutral application of the principles of fiduciary investment law. The commentary is also notable for not addressing certain other relevant matters, such as the use of ESG factors in shareholder engagement (sometimes called “stewardship” or “active shareholding”). We identify material instances of such language or omissions and urge appropriate clarification, particularly regarding the “tiebreaker” rule for purportedly economically equivalent investments. This comment letter is largely but not entirely based on “Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee,” 72 Stanford Law Review 381 (2020), https://ssrn.com/abstract=3244665.

Comment Letter of Professors Max M. Schanzenbach and Robert H. Sitkoff on the Securities and Exchange Commission’s Request for Comment on the Names Rule for Mutual Finds in Light of ESG Investing and Other Market Developments

In March 2020, the Securities and Exchange Commission asked for public comment on the names rule (rule 35d-1) for mutual funds in light of developments since the rule's adoption in 2001. Among such developments, the request for comment identifies burgeoning investor interest in environmental, social, and governance (“ESG”) investing and the corresponding proliferation of funds that purport to make use of ESG factors. This response to the SEC’s request for comment has two purposes: First, we provide clarifying context for the ESG investing phenomenon and a summary of the current state of theoretical and empirical literature in financial economics on it. Second, we discuss how this context informs the critical relationship between ESG disclosure by a mutual fund, both in the fund’s name and in its prospectus, and the rules (e.g., state trust law or ERISA) that govern the extent to which a trustee or other fiduciary may use ESG factors in fiduciary investment. We organize this response in four parts: (1) we provide a clarifying taxonomy on the meaning of ESG investing and the methods for implementing it; (2) we discuss the inherent subjectivity in identifying and applying ESG factors; (3) we assess the current theory and evidence on whether ESG investing can improve risk-adjusted returns; and (4) we identify four interrelated questions of regulatory policy stemming from growing investor interest in ESG investing, situating the request for comment toward potential revision of the names rule within that four-part framework. This response is largely but not entirely based on “Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee,” 72 Stanford Law Review 381 (2020), https://ssrn.com/abstract=3244665.

Fiduciary Investments in Cannabis Securities

This paper analyzes whether an investment in cannabis securities would be a breach of fiduciary duty under fiduciary investment standards. This paper considers legality issues arising from marijuana-related securities under criminal statutes and securities laws and the prudence of investing in such securities under fiduciary investment principles, including the prudent investor rule.

Fiduciary Financial Advisers and the Incoherence of a 'High-Quality Low-Fee' Safe Harbor

Americans now hold trillions of dollars in individual retirement savings accounts. Concerned about conflicts of interest among financial advisers who provide advice to retirement savers, the Department of Labor has proposed imposing fiduciary status and a "best interest" standard on such advisers. To ameliorate the resulting compliance costs, the DOL has also raised the possibility of a safe harbor for certain "high-quality low-fee investments." However, the notion of a "high-quality" investment is in irreconcilable tension with the highly individualized assessment of risk and return that is required by modern portfolio theory, the well-accepted concept from financial economics that has been codified in the "prudent investor rule" as the standard of care for fiduciary investment. This policy incoherence is worrisome because of the potential for the safe harbor to swallow the best interest standard.

Fiduciary Duty: Underperforming Assets

This paper discusses the duties of a fiduciary with respect to underperforming assets held in a client’s account. A trustee, investment adviser, and investment manager each is a fiduciary. Because trust law most clearly articulates fiduciary rules, this paper focuses on trust law as the principal foundation of fiduciary law. Although investment advisers are not strictly subject to trust law, the fiduciary investment principles applicable to advisers are very similar to those governing trustees. Accordingly, this paper discusses the legal framework and principles applicable under trust law generally with respect to the investment and management of trust assets, focusing specifically on the treatment of assets that underperform based on relevant measures of investment performance. These general principles may apply differently to investment advisers depending on the facts and circumstances.

Long-Term Financing in Europe

Although policymakers in Europe are increasingly focused on fueling economic growth and job creation with infrastructure projects that require long-term investment, there are potential obstacles to channeling investment capital appropriately. To help shape the policy debate, CFA Institute recently brought together key thought leaders and policymakers at the forefront of the long-term financing debate to explore the implications for investors of less dependence on bank financing and more interest in investment capital. Speakers included John Kay, chair of “The Kay Review of UK Equity Markets and LongTerm Decision-Making” (prepared at the request of the UK government) and currently chair of the CFA Institute Future of Finance Advisory Council, and Fons Lute, managing director of the fiduciary mandates investment team at BlackRock. Discussion centered on three major topics: regulation, the transition from relationship banking to transaction banking, and better due diligence. In Europe, regulation has focused more on market conduct than on market structure, but most of the roundtable participants agreed that structure is a longer-term issue. Further complicating matters in Europe is the diversity of needs within European countries; some countries have a large need in the mortgage market while others are targeting infrastructure or public works. The transition from relationship banking to transaction banking has increased the intermediary chain, eroding knowledge of both investors and borrowers. In addition, longer-term financing needs a diversity of financing to match cash flow needs. Investors may not currently have the same level of expertise where long-dated maturities are concerned. Longer-term financing needs better due diligence and the possibility of nonbank loans. In the aftermath of the financial crisis, financing has lacked diversification, with the drying up of the securitization market and the difficulty of finding seed capital in private equity. CFA Institute is closely monitoring the debate around long-term financing. In a June 2013 comment letter to the European Commission, CFA Institute reflected the opinions developed in an EU members’ poll. The comment letter highlighted five priorities: (1) regulatory framework, (2) short-termism, (3) investment vehicles, (4) securitization, and (5) fair value accounting. First, a regulatory structure at the EU and national level that incentivizes long-term investing is essential. Second, in regard to short-termism, asset owners should hold asset managers accountable for performance over longer-term evaluation horizons rather than the current tendency to focus on quarterly returns. Third, concerning investment vehicles, innovation in developing new pooled fund vehicles targeted toward infrastructure and other long-term investments (“long-term investment funds”) is welcome and can afford investors important diversification opportunities. Any such new investment vehicles should offer enhanced disclosure to investors regarding risks and redemption restrictions. Fourth, a revival of the securitization market is welcome but must not be characterized by the complexity and opacity of deals in the past. CFA Institute proposes a special designation that would distinguish those long-term investments that satisfy a suitably high standard of disclosure quality. Finally, CFA Institute refutes the notion that fair value accounting policies contribute to short-termism and argues that fair value can in fact reduce the information asymmetry that exists between issuers and investors as to the value of corporate assets and liabilities. Because Europe is trying to stimulate its sluggish and diverse economy, especially through small and mediumsized enterprises (SMEs), long-term financing will be the focus of many talks within the European regulatory environment. Both the European Commission and the European Parliament will be taking stock in the coming months, preparing for elections in the European Parliament and for a new Commission. With investors playing a growing part in SME financing, it is essential that policymakers consider these issues from an investor perspective.

Empirical Test of the Liquidity-Based Theory of the Closed-End Funds

Theory argues that the rationale for the existence of closed-end funds (CEFs) is that they provide investors indirect exposure to their underlying illiquid assets without the high cost associated with trading them directly. Consistent with this reasoning, we show that risk-averse investors invest in CEFs to diversify their portfolios into the illiquid markets in which CEFs specialize. Moreover, investor demand for CEFs is a positive function of the CEF portfolio’s illiquidity level. A direct comparison of CEF holdings with those of CEF investors reveals that the latter underweight stocks invested by CEFs, which are typically small and illiquid. Such impacts of liquidity on investment behavior also vary across investor identities, depending on the level of fiduciary responsibility, investment horizon, and investment style. Beyond the CEF industry, our findings shed new insights on the benefits of the closed-end structure observed in other market segments.

Fiduciary Accountability for Managing Funding Ratios in Florida's Local Government Pension Plans or 'You've Got to be Very Careful if You Don't Know Where You're Going, Because You Might Not Get There' - Yogi Berra

Fundamental fiduciary investment practice standards require the development of an investment policy in order to further a plan’s funding policy objectives. Until now, local government pension plans used almost the opposite approach. Under this old paradigm, local government plans used “long-term” investment policies regardless of the plan’s financial and cash flow needs; and then used the “expected return” from that policy as the dominant element of a faux funding policy; namely, the actuarial valuation. On October 1, 2000, the City of Fort Myers had fully funded the accrued liabilities of its general employee pension plan. By October of 2010, plan assets were insufficient to cover any liabilities for either the accrued benefits of its covered active employees, or for the contributions that employees themselves had made to the plan. Moreover, only 83.2% of obligations for existing retirees were covered by assets, even at the high 7.75% discount rate used to value liabilities.This decline to 0% coverage also occurred in the large general employee pension plans of nine other Florida cities. The thesis here is that, at least in Florida, where a local government is required to make its ARC (actuarially required contribution) that this kind of decline is a result of funding policy discipline failures. The paper reviews the performance of a range of standard asset allocation portfolios to confirm that the market over this period was generally consistent with 7% expected returns, if not the above average actuarial expected return assumptions returns used by each of these 10 general employee pension plans. A changing public pension paradigm, best illustrated by the Robert Novy-Marx burning money hypothetical, is at the core of this discipline failure. This hypothetical showed how a public pension plan could improve its apparent funded status by actually burning bonds in order to get rid of stable, but relatively low expected return investments. The objective of the burning was so that the remaining assets would be invested – for the long-term – in high volatility / high expected return equity assets. Under the old “long-term” only paradigm, the actuary would then discount liabilities by this higher equity expected return rate rather than a blended portfolio rate, showing an actuarially better funded plan.GASB (Government Accounting Standards Board) principles for liability accounting and disclosure have changed such that a “long-term” liability discount rate can, for future disclosures, only be used to the extent that an investment policy with that expected return will be used on real assets. This paper helps to show how many of the conclusions of recent LeRoy Collins Institute research on Florida’s underfunded municipal pension plans relate to a plan’s funding ratio objective. One of the most significant of these conclusions is that the cash flow out of many local government plans are now very significant; and can be much larger than the monies being contributed for the plan’s unfunded accrued liability.The GASB change is very significant, not just because of its new standards, but also because these standards reinforce fundamental fiduciary practice standards. These practice standards require that investment policies further a plan’s funding policy objectives rather than the other way around. The GASB change will also help to remove the moral hazard in public sector pension governance that had restricted both investment consultants and actuaries from helping plans achieve a plan’s funding ratio objectives.Local government pension trustees should be setting and managing to plan funding ratio objectives; and they now should have additional valuable resources for helping them in this role; namely, the actuary and the investment consultant.

Fiduciary Investment Under Uncertainty: Examining Pension Plan Investment Behavior When Trustees Have Reputational Utility

Pension funds investment behavior have found to be persistent over time. Empirical findings of such persistence support conjectures that belief biases such as overoptimism and reputational concerns affect fiduciary investment behavior. Standard mean-variance analyses do not consider the implications of prudent-man laws on pension fund investment. We suggest an alternative way to derive pension portfolio choice by explicitly allowing pension trustee to make a joint belief-allocation choice in a utility function which takes an entropic form and considers investment objectives in a fiduciary environment. Our results demonstrate that pension trustees are inherently optimistic in forming projections but such optimism increases with the degree of risk-aversion. Further, the higher the level of risk-aversion, the more likely trustees will conform to peer group consensus and the less likely the consensus will change over time. This pattern of investment behavior seems consistent with empirical observations.

The Economics of Fiduciary Investment Advice

An inability to accurately detect quality prior to or even after purchase distinguishes professional advice from other consumer goods or services. A consumer that is unable to assess the difference between an advisor's recommendation and the ideal recommendation is vulnerable to the self-serving behavior of the agent. Regulation that decreases the agency costs to consumers (or increases costs to planners not acting prudently) can increase consumer welfare. A client who trusts their advisor believes that the advisor is less likely to take advantage of the information asymmetry inherent in an expert-advice relationship. This trust also reduces client oversight and provides opportunities for advisors to make recommendations that maximize their own welfare within the boundaries of the regulatory rulebook. Applying a fiduciary standard to all financial professionals who provide personalized advice will eliminate many of these conflicts of loyalty between advisors and clients and will increase bonding costs to more closely align incentives.

Investment Considerations under the Prudent Investor Act

In Part Two in a series on fiduciary investment matters, the author focuses on how portfolio choice interacts with trust distribution policies to produce wealth flows to current and future trust beneficiaries. The author first frames the discussion through an examination of portfolio effects on beneficiary wealth during an extended period of historical returns. Next, the author examines whether different distribution choices, from simple income-only choices to more complex unitrust methods, can significantly impact wealth flows to beneficiaries. The author finds that in terms of wealth effects to all parties, portfolio choice dominates distribution policy choice over the period examined, although distribution policy can mitigate year-to-year variations in wealth flows. This conclusion leads to a recommendation that fiduciaries should move beyond the traditional balanced portfolio to incorporate asset classes that have a higher risk-return profile to ensure long-term portfolio performance.

The Morningstar Fiduciary Grades: A Critical Analysis

This paper examines the “Fiduciary Grade for Mutual Funds” developed and released by Morningstar, Inc. In particular, it examines the utility of the Fiduciary Grades as a tool for bank trust departments and other corporate fiduciaries that invest fiduciary assets in mutual funds. This paper concludes that the Fiduciary Grades are a flawed investment tool because they do not encompass all of the relevant factors an investor should consider when investing in mutual funds, apply questionable standards, and are not a substitute for the exercise of fiduciary discretion with respect to an individual fiduciary account. The Fiduciary Grades have a limited focus and are not a reliable indicator of a mutual fund’s compliance record, quality of fund management, or suitability as a fiduciary investment. Unquestioning reliance on the Fiduciary Grades could result in misguided investment decisions.