Modern portfolio theory, risk and fiduciary duty

It was only a few decades ago that trustees in many jurisdictions were restricted from investing in certain assets. Fiduciary duty has evolved as the thinking about investments has changed. This is true, then, of how trustees should be applying fiduciary duty to current day investment challenges, including systemic risk and climate change risk.

Ed Waitzer, professor and director of the Hennick Centre for Business and Law at the Osgoode Hall Law School in Toronto, has written extensively on trustee fiduciary duty and how the trustee duties in the pension context have evolved.

He will feature at the PRI-CBERN Academic Network Conference in Toronto this October, presenting a draft of the paper, The fiduciary duty – emerging themes in Canadian fiduciary law for pension trustees, which is the third in a series of research projects on the subject.

In it he says fiduciary duty is a dynamic concept – and while it is firmly rooted in clear and enduring legal principles, it has responded to changing contexts and worldviews.

“Events of the last decade have challenged the efficient market hypothesis, and the use of modern portfolio theory, as the basis for prudent investment and risk management practices (and, accordingly, the consequential legal framework governing pension fiduciaries),” he says.

He also says that pension fiduciaries are increasingly expected to consider questions of future value, rather than simply market price.

“Aside from the hazards of market volatility, they are expected to assess the impact of their investment decisions on others, including generations to come, with all the uncertainties so entailed. Accordingly, there is a growing recognition that risk management for pension funds extends well beyond that which is captured by market benchmarks, extending to market integrity, systemic risks, governance risks, advisor risks and the like.”

People out, returns in

Similarly an article by Jay Youngdahl, a partner at the Texas-based Youngdahl & Citti in the US and a visiting fellow at the Initiative for Responsible Investment in the Hasuer Center for Nonprofit Organisations at Harvard University, says many view modern portfolio theory (MPT) as the only way to comply with fiduciary duty in investment even though it is arguably incompatible with productive investment in the conditions that exist today.

In the article The time has come for a sustainable theory of fiduciary duty in investment, he says the foundation of the duties of fund trustees in the US began years ago in an environment of very different societal and investment expectations.

“Blind adherence to MPT no longer appears to be sufficient in fulfilling a trustee’s true investment duties to beneficiaries in the real… Current conceptions of fiduciary duty need to reflect this reality,” he says.

In the same article Youngdahl says the rigorous mandate to conform to the legal fiduciary duties has been a longstanding standard of trust law, while the definitional content of the investment function of this duty has been in constant evolution.

“…Adherence to fiduciary duty is ironclad, but the substance of the investment duty has always been malleable,” he says. “If you look at the history of fiduciary duty the basis has never changed, but what you do to fulfil that has to be dynamic.”

By way of example, he looks at the Restatement of Law in the US, an influential convention whereby experts in law convene, assess the law and make pronouncements about it.

He says the Restatement of the Law Second, Trusts, in place until 1992, said trustees could not purchase shares on margin or buy bonds selling at a great discount. They also could not buy shares in new companies, so no venture capital investments or investments in capitalisations, and it was considered improper to buy land.

“So, for example, distressed debt would be a per se violation,” he says.

Youngdahl observes that people are no longer at the crux of the fiduciary duty.

“One thing that has happened to fiduciary duty is that people have fallen out of it. Now it is equated with a quarterly return. This is a distortion of what it’s about historically and what it should be about,” he says.

“Trustees have been looking at that wrong. The trustee fiduciary duty is all about protecting promises and pension promises are long term.”

In this context he says trustees have a duty to think long term, and to think about the factors that affect the long term.

“In the context of the fiduciary duty you have to think about long-term things. It is a violation to only think of quarterly returns.”

 Collective thinking to incentivise the long term

In the first of Waitzer’s series of articles, he argued pension funds take the lead on long-term thinking. The second article said if you weren’t convinced by the logic, then the law will get you, and he did sessions with trustees on what the lawsuit would look like. This third article looks at how, generically, the courts are likely to respond.

Waitzer argues that trustees have a duty to consult, a duty of obedience, a duty to collaborate, and a duty to comply with social norms.

“It is no longer legislatures defining law, but some social norms. All will be articulated in the law in short order,” he says. “But the article I haven’t written is OK, we hear you: what do we do?”

A key obstacle to thinking long term is that all of the incentives are short term, which he argues could be diffused by acting collectively.

“I’m the first to confess I don’t hold myself out as an expert in long-term thinking or how to balance competing interests. We need the ability to think long term when incentives are virtually all short term. But the duty to act collectively will change those incentive structures and we need to equip people to do it.”

He points to the PGGM PEP portfolio as an example. Click here

Waitzer says considering ESG factors when making investment decisions is compatible with trustees’ duty of care, as it allows them to evaluate sources of risk that would otherwise be overlooked.

“Climate change and impacting a systemic change is absolutely a fiduciary duty,” he says.

It’s sustainability, stupid

At the January United Nations Investor Summit on Climate Risk and Energy Solutions, the chief executives of California’s two largest pension funds, Ann Stausboll of CalPERS and Jack Ehnes of CalSTRS, were both vocal about the relationship between fiduciary duty and climate risk. The question of what fiduciary duty encompasses is a dynamic question that pension funds globally are pondering.

Stausboll, chief executive of the $235-billion CalPERS, says fiduciary duty of pension funds should extend to issues outside the parameters typically understood as being directly related to beneficiaries’ financial interests.

“As fiduciaries, it is our job to make sure investors, businesses and policymakers are responding aggressively and creatively to the risks and opportunities associated with climate change and other sustainability issues,” she says.

Other papers by Ed Waitzer in his recent series

Reclaiming fiduciary duty balance

Defeating Short-termism – why pension fnds must lead