1 As one example of this disillusionment we quote the following passage from a New York Times article, “Investing in the Averages” (April 29, 1973, Bus. Sec., p. 1, cols. 1–5):Google Scholar

In February, the American Telephone and Telegraph Company reported that for almost the last six years the portion of its $10-billion pension fund managed by 31 banks had increased at about 8 per cent a year compared to about a 9 per cent increase in the Standard & Poor's average of 500 stocks.Google Scholar

Was A.T.&T. miffed at its bank advisers for their sub-par performance? Not at all.Google Scholar

“We are satisfied that we are doing as well as other large pools of capital,” said John F. Thompson, A.T.&T.'s director of pension-fund administration.Google Scholar

“Though it is defeatist not to try, because of A.T.&T.'s large pool of capital, I think it is unrealistic to expect to outperform the averages,” Mr. Thompson added.Google Scholar

Since the article appeared, some of A.T.&T.'s operating subsidiaries have, as mentioned in the text, begun placing some pension-fund assets in a market fund.Google Scholar

2 For previous discussions of this question see Richard A. Posner, Economic Analysis of Law 195–98 (Boston, 1973); Note, Trustee Investment Powers: Imprudent Application of the Prudent Man Rule, 50 Notre Dame Lawyer 519 (1975); Note, Fiduciary Standards and The Prudent Man Rule Under the Employment [sic] Retirement Income Security Act of 1974, 88 Harv. L. Rev. 960 (1975); cf. Note, The Regulation of Risky Investments, 83 Harv. L. Rev. 603 (1970).Google Scholar

3 Section 404(a)(1)(B) of the Employee Retirement Income Security Act of 1974, 1 U.S. Cong. & Adm. News ′74, 944 (ERISA), requires the pension fund to be administered “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” This is very similar to the “prudent man” rule of traditional trust law, see pp. 19–20, 24–28 infra. It has been argued, however, that the Act should not be interpreted as incorporating the “prudent man” rule of the traditional law in view of certain differences between pension and conventional trusts (see Note, Fiduciary Standards, supra note 2, at 965–69), which we discuss infra pp. 33–34.Google Scholar

4 See ERISA secs. 404(a)(1)(D), 410(a); cf. Note, Fiduciary Standards, supra note 2, at 968–69.Google Scholar

5 6 Geo. 1, c. 4, secs. 23 (1719).Google Scholar

6 Laurence C. B. Gower, The Principles of Modern Company Law 31 (3d ed. London, 1969).Google Scholar

7 George G. Bogert & George T. Bogert, The Law of Trusts and Trustees secs. 613–14 (2d ed. Kansas City, Mo., 1960) [hereinafter cited as Bogert, Trusts]; A. H. Oosterhoff, Trustees' Powers of Investment: A Study Prepared at the Direction of the Ontario Law Review Commission 6ff. (1970).Google Scholar

8 George W. Keeton, The Law of Trusts 248 (9th ed. London, 1968).Google Scholar

9 Pocock v. Reddington, 5 Ves. 794, 800, 31 Eng. Rep. 862, 864 (1801) (Arden, M. R.). Earlier chancellors had vacillated on the question; see Keeton, supra note 8.Google Scholar

10 Raby v. Ridehalgh, 7 De G.M. & G. 104, 44 Eng. Rep. 41 (Ch. Ap. 1855). See generally 3 Austin W. Scott, The Law of Trusts sec. 227.7, at 1818 (3d ed. Boston, 1967) [hereinafter cited as Scott, Trusts].Google Scholar

11 22 & 23 Vict., c. 35, sec. 32 (1859).Google Scholar

12 George W. Keeton, Modern Developments in the Law of Trusts 48–49 (Belfast, 1971).Google Scholar

13 See the compilation in Mayo A. Shattuck, The Development of the Prudent Man Rule for Fiduciary Investment in the United States in the Twentieth Century, 12 Ohio State L.J. 491, 502–4 (1951). See also Oosterhoff, supra note 7, at 232–44. Current state laws are compiled in the text and pocket part of Bogert, Trusts secs. 616–63.Google Scholar

14 See Bogert, Trusts secs. 616, 640.Google Scholar

15 In re Estate of Cook, 20 Del. Ch. 123, 125, 171 A. 730 (1934), cited in 3 Scott, Trusts sec. 227, at 1807.Google Scholar

16 Kimball v. Whitney, 233 Mass. 321, 331, 123 N.E. 665, 666 (1919).Google Scholar

17 At the outbreak of World War I the price level in Britain was at about the same level as in the year 1660. There had been some inflation during the Napoleonic Wars but it had been followed by deflation. Phyllis Deane & W. A. Cole, British Economic Growth 1688–1959: Trends and Structure 12–18 & chart following 350 (2d ed. Cambridge, England: The University Department of Applied Economics, 1969). Writing in 1960 and unaware of the enormous inflation that lay ahead, the authors said (at 17–18):Google Scholar

For those accustomed to the twentieth-century trends, however, the most striking implication of the earlier price data is the relative stability of the value of money …. Indeed, if we exclude the French wars and their immediate aftermath we can trace the index back to the Restoration without finding an annual reading which was more than a third above or below the 1913 level. The twentieth-century experience has been of an altogether different kind …. By 1959 retail prices were about four and a half times their level in 1913 and about seven times the low point of 1895.Google Scholar

18 Conflicts of interest have evidently played some role in the development and persistence of the antiquated court and statutory lists. The English chancellor was a high political officer of the government, perhaps not really so doubtful about “the soundness of other investment,” but concerned “to provide a broad market for government securities ….” 3 Scott, Trusts sec. 227.4, at 1813. American state legislatures are also, it would seem, influenced by political considerations: their statutory lists authorize state and local obligations and the issues of favored corporations. See, e.g., Va. Code sec. 26–40(9), authorizing “]s] tocks, bonds and other securities of the Richmond, Fredericksburg and Potomac Railroad Company ….”Google Scholar

19 The Trustee Investments Act of 1961, 9 & 10 Eliz. 2, c. 62, is conveniently reprinted for American readers in Bogert, Trusts sec. 615 (Supp. 1975). For discussion see Keeton, supra note 12, at 55ff.; Oosterhoff, supra note 7, at 49ff.Google Scholar

20 See the text of the Act in Shattuck, supra note 13, at 508–9; Oosterhoff, supra note 7, at 229–31; and as the enacted law of particular states, e.g., Maine Rev. Stat. ch. 160, secs. 18–21, in Bogert, Trusts sec. 633. ERISA-which preempts state law insofar as pension funds subject to ERISA are concerned (sec. 514)-appears to have adopted the basic standard of the Model Act (see note 3 supra).Google Scholar

21 See 3 Scott, Trusts secs. 227.14, 233.5, at 1848–54, 1933.Google Scholar

22 For an absurd example see In re Chamberlain's Estate, 9 N.J. Misc. 809, 810, 156 A. 42, 43 (1931), where the court, writing in 1931, declared: “It was common knowledge, not only amongst bankers and trust companies, but the general public as well, that the stock market condition at the time … [August 19291 was an unhealthy one, that values were very much inflated, and that a crash was almost sure to occur.”Google Scholar

23 To simplify analysis, assume that no dividends will be paid during the course of the year. The expected return of a stock includes, of course, both price appreciation and dividends.Google Scholar

24 The evidence is summarized in James H. Lorie & Mary T. Hamilton, The Stock Market: Theories and Evidence chs. 11–12 (Homewood, III., 1973). Incidentally, the Lorie and Hamilton book is an excellent introduction to the modern theory of finance on which our discussion is based. See also Modern Developments in Investment Management: A Book of Readings, James H. Lorie & Richard Brealey, eds. (New York, 1972).Google Scholar

25 If the stock rose when the market fell, and vice versa–if in other words its beta was negative–it would be highly prized by the risk-averse investor since its inclusion in the investor's portfolio would reduce the risk of the portfolio. This is stock C in the example on p. 8 supra. Such examples are rare.Google Scholar

26 See, e.g., Note, Fiduciary Standards, supra note 2, at 971 & n. 67.Google Scholar

27 James H. Lorie, Diversification: Old and New, J. Portfolio Management, Winter 1975, at 25, 28.CrossRefGoogle Scholar

28 Id. These numbers depend on precisely how the sample is constructed. It may be possible to get better results using smaller samples. This is a problem on which capital-market analysts are working at this time.Google Scholar

29 We shall have more to say about optimal diversification in Part IV, where we discuss specific investment vehicles for the prudent trustee.Google Scholar

30 There is, of course, more than one stock market. Since, however, roughly two-thirds by value of all stocks publicly traded in the United States are listed on the New York Stock Exchange, that exchange provides a pretty good proxy for the (United States) stock market as a whole, so we shall consider our hypothetical “market portfolio” to be limited to NYSE stocks. Whether a trustee's portfolio should contain additional stocks and other securities is discussed in Part IV of the article.Google Scholar

31 Historically, the expected return to common stocks has been on average about 3 percentage points above the long-term bond rate, which is about 9 percent today.Google Scholar

32 We set to one side the problems presented when the trust is created by the transfer of specific assets, other than cash or readily marketable securities, which may be costly to liquidate.Google Scholar

33 The relevant studies are summarized in Lorie & Hamilton, supra note 24, ch. 4. For a representative popular treatment see A. F. Ehrbar, Some Kinds of Mutual Funds Make Sense, Fortune, July 1975, pp. 57, 61–62.Google Scholar

34 Paul A. Samuelson, Challenge to Judgment, J. Portfolio Management, Fall 1974, at 17.CrossRefGoogle Scholar

35 Michael C. Jensen, Risk, The Pricing of Capital Assets, and the Evaluation of Investment Portfolios, 42 J. Bus. 167 (1969), summarized in Lorie & Hamilton, supra note 24, at 91–92.CrossRefGoogle Scholar

36 Information supplied by Batterymarch Financial Management Corporation.Google Scholar

37 Alexis L. Belash, Index-Matching: Applying the Efficient Markets Theory, 113 Trusts & Estates 292, 294 (1974).Google Scholar

38 Restatement of Trusts (Second) sec. 171 & Comment b (1957). The basis of the rule is not altogether clear. What is clear is that since a trustee may not resign his trust without court approval, he is under a duty not to delegate the trust in its entirety. See 2 Scott, Trusts secs. 106, 171.1, at 836, 1389.Google Scholar

39 E.g., In re Hartzell's Will, 43 Ill. App. 2d 118, 192 N.E. 2d 697, 709–10 (1963).Google Scholar

40 Restatement of Tjusts (Second) sec. 171 (1957).Google Scholar

41 William L. Cary & Craig B. Bright, The Delegation of Investment Responsibility for Endowment Funds, 74 Colum. L. Rev. 207, 224 (1974) (emphasis in original).CrossRefGoogle Scholar

42 Meck v. Behrens, 141 Wash. 676, 685, 252 P. 91, 95 (1927); see Annot., 50 A.L.R. 214 (1927). Speaking of the trustee who delegates the entire administration of the trust, Scott writes: “He is not only liable for losses resulting from the negligence or other improper conduct of the person to whom he committed the administration of the trust, but also for any losses resulting from the acts of that person.” 2 Scott, Trusts sec. 171.1, at 1390.Google Scholar

43 15 & 16 Geo. V, c. 19 sec. 23(1); see Gareth H. Jones, Delegation by Trustees: A Reappraisal, 22 Modern L. Rev. 381 (1959); Paling, The Trustee's Duty to Act Personally, 125 New L.J. 56 (1975).Google Scholar

44 See William F. Fratcher, Trustees' Powers Legislation, 37 N.Y.U.L. Rev. 627, 660 (1962); cf Cary & Bright, supra note 41; see also Note, Trustee's Power to Delegate: A Comparative View, 50 Notre Dame Lawyer 273 (1975).Google Scholar

45 Restatement of Trusts (Second) sec. 171 Comment b (1957).Google Scholar

46 Edward C. Lukens, Investment Trusts as Trust Investments, 79 U. Pa. L. Rev. 266, 268–69 (1931).Google Scholar

47 Bogert, Trusts sec. 679, at 2039 & n. 75 (1935 ed.).Google Scholar

48 Marshall v. Frazier, 159 Ore. 491, 517–18, 532–33, 544, 80 P. 2d 42, 52, 58, 81 P. 2d 132, 135 (1938).Google Scholar

49 Mayo A. Shattuck, The Legal Propriety of Investment by American Fiduciaries in the Shares of Boston-type Open-end Investment Trusts, 25 B.U.L. Rev. 1, 9 (1945).Google Scholar

50 Lukens, supra note 46, at 270.Google Scholar

51 E.g., King v. Talbot, 40 N.Y. 76, 88 (1869).Google Scholar

52 Alec B. Stevenson, Investment Company Shares: Their Use by Trustees, 85 Trusts & Estates 39, 47 (1947), citing Investment Company Act of 1940, 15 U.S.C. sec. 80a-13.Google Scholar

53 Casenote, 60 Harv. L. Rev. 1360 (1947); Stevenson, supra note 52, at 48.Google Scholar

54 Casenote, 34 Minn. L. Rev. 163, 165 (1950).Google Scholar

55 Casenote, supra note 53, at 1361; Alec B. Stevenson, Investment Company Shares: Their Place in Investment Management, 84 Trusts & Estates 611, 618–19 (1947).Google Scholar

56 In re Rees' Estate, 53 Ohio Abs. 513, 536, 87 N.E. 2d 397, 410 (Ohio Probate Ct., Cuyahoga C'ty, 1947).Google Scholar

57 53 Ohio Abs. 385, 85 N.E. 2d 563 (Ohio App. 1949).Google Scholar

58 Casenote, supra note 53; Casenote, supra note 54; Stevenson, supra note 52, at 141, 148–49.Google Scholar

59 But see In re Flynn's Estate, 205 Okla. 311, 237 P. 2d 903 (1951), assuming the prudence of trust investment in “well-managed investment trusts ….”Google Scholar

60 See the citations collected in 3 Scott, Trusts sec. 227.9A, at 1833 n. 2. Many of these are enactments of the Model Prudent Man Rule Statute, which was amended to authorize the purchase of shares in investment companies registered under the Investment Company Act of 1940. See Shattuck, supra note 13, at 508–9.Google Scholar

The new federal pension reform law invites pension trusts to invest in mutual funds. ERISA sec. 401(b)(1).Google Scholar

Aided by statute, corporate fiduciaries now operate so-called common trust funds pooling the investment assets of small trusts. These are in effect in-house mutual funds.Google Scholar

61 E.g., James P. Johnson, A Draftsman's Handbook for Wills and Trusts Agreements sec. 511, at 470 (1961) (trustees empowered to invest in “interests in trusts, investment trusts and common trust funds, without being limited by any statute or rule of law concerning investments by trustees …”).Google Scholar

62 A national survey of 800 attorneys and trust officers taken in 1949 (before enactment of most of the statutes cited supra note 60) discovered that “only one out of ten lawyers and trust officers, do buy investment company shares without specific language in the trust instrument; four times as many lawyers and three times as many trust officers (38% of all respondents) do so with specific language.” Alec B. Stevenson, Survey Reveals Trustees' and Attorneys' Interest in Investment Company Shares, 89 Trusts & Estates 228, 253 (1950) (emphasis in original).Google Scholar

63 E.g., Cary & Bright, supra note 41, at 224 (“an investment now considered to be proper almost everywhere”). See also authorities cited supra notes 49 through 60.Google Scholar

As early as 1950 a prominent Illinois practitioner in the field wrote:Google Scholar

If a trustee in Illinois has already invested in shares of an investment trust and if he faces litigation seeking to surcharge him for his action in that regard, and if I had the choice as to which of the two parties I would prefer to represent, I would put myself on the side of the trustee, feeling that thereby I would be more likely to be on the successful side of the case.Google Scholar

William H. Dillion, May Trustees Invest in Investment Trusts? 89 Trusts Sr Estates 396, 397 (1950).Google Scholar

The statutes cited supra note 60 are relevant to this point: when nearly half the states enact legislation explicitly authorizing trust investment in mutual funds and none explicitly forbids it, one may fairly infer that the statutes are declaratory of a common opinion of the prudence of the investment form.Google Scholar

The Restatement of Trusts (Second) sec. 227, Comment n (1957), however, remains non-committal: “Apart from statute it would seem to be not improper for a trustee to make such an investment, provided that it is a prudent one, and that such an investment does not involve any delegation by the trustee of his powers.” Scott, the Restatement reporter, states in his treatise: “The question whether a trustee can properly invest in … shares in an investment company is in most states an undecided question.” 3 Scott, Trusts sec. 227.9A, at 1833.Google Scholar

64 Some indication of the prevalence of trust investment in mutual fund shares is the extent of the litigation and the literature concerning the allocation of mutual fund capital gains dividends between successive trust beneficiaries. See 3 Scott, Trusts sec. 236.14, at 2016 & n. 9; cf. Annot., 98 A.L.R. 2d 511 (1964).Google Scholar

65 Shattuck, supra note 49, at 21.Google Scholar

66 Id. at 22.Google Scholar

67 Reported as In re Bank of New York [hereinafter cited as Spitzer], 723 N.E. 2d 700, 703 (N.Y. 1974) (citations omitted).Google Scholar

In Spitzer, a guardian ad litem appointed to represent the remaindermen interested in a bank common trust fund contested the bank's periodic accounting for a four-year interval between 1964 and 1968. Although the entire fund recorded a gross gain of $1,700,000, there were losses amounting to $238,000. The guardian challenged the prudence of four of the bank's securities investment decisions. On the bank's motion, the trial court granted summary judgment dismissing the objections to two of the four, and denied the motion for summary judgment as to the other two decisions (involving shares of Parke, Davis and Boeing on which the trust had lost over $45,000). Both sides appealed. A divided intermediate appellate court sustained the bank's motion for summary judgment on all four investments, 43 App. Div. 2d 105 (1974), and the court of appeals affirmed unanimously, supra. The dissenters in the intermediate court thought it was a telling argument that “[w]hatever accretion there was to the trust might just as well be credited to a generally rising market as to a claimed watchful and prudent management; one shudders to think what could have happened in a period of decline.” 43 App. Div. 2d, at 108. The case was in the appellate court before the bank had put in any evidence, and the opinion does not disclose on what basis the dissenters thought that the bank's management of the fund “might with equal efficiency have been carried out … by the doorman on duty.”Id.Google Scholar

68 Restatement of Trusts (Second) sec. 213 (1957).Google Scholar

69 For example, the language from Spitzer quoted in the text at note 67 supra is followed by a citation to Scott's account of the wrongful-investment rule.Google Scholar

70 Restatement of Trusts (Second) sec. 228 (1957); see also Annot., 24 A.L.R.3d 730 (1969).Google Scholar

71 323 N.E. 2d 700, 703.Google Scholar

72 Whether a trustee can ever employ leverage without running afoul of the rules of trust law is considered infra p. 33.Google Scholar

73 2 Scott, Trusts secs. 170, 170. 2, at 1297–99, 1304.Google Scholar

74 See 2 Scott, Trusts sec. 170.15, at 1340, citing inter alia Uniform Trusts Act sec. 7.Google Scholar

75 Restatement of Trusts (Second) sec. 228 (1957).Google Scholar

76 See p. 20, supra and p. 30, infra.Google Scholar

77 Restatement of Trusts (Second) sec. 228 (1957).Google Scholar

78 It is not necessary to hold all of the S&P 500 to have a portfolio that moves. in very close step with it. A carefully selected sample of 200 or even fewer firms may offer a close approximation at considerable cost savings. See note 28 supra and accompanying text.Google Scholar

79 William F. Sharpe, Bonds Versus Stocks: Some Lessons from Capital Market Theory, Financial Analysts J., Nov.-Dec. 1973, at 1.CrossRefGoogle Scholar

80 Among firms that specialize in making calculations of this sort, we know of Becker Securities Corporation and Dreher, Rogers & Associates, Inc., in New York City, and Frank Russell Co., Inc., in Tacoma, Washington.Google Scholar

81 3 Scott, Trusts secs. 191.3, 227.6, at 1587, 1816 & n. 1.Google Scholar

82 As in Sebree v. Rosen, 349 S.W. 2d 865, 889–90 (Mo. 1961).Google Scholar

83 Courts have long deemed it imprudent for a trustee to invest in the shares of new and untried enterprises. See 3 Scott, Trusts sec. 227.6, at 1816 & n. 4. That rule would not apply, however, to shares of newly organized mutual funds that invest in established enterprises. Market funds are conduits for investment in the securities of established, exchange-listed firms. For the same reason, when conventionally managed mutual funds were first being recognized as trust investments, it was never suggested that the rule forbidding investment in new and untried enterprises should be applied to them.Google Scholar