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Monday, January 7, 2013

Article on Alternative Investments

Philip J. RucePhilip J. Ruce (J.D., William Mitchell College of Law) recently published his article entitled The Trustee and the Prudent Investor: The Emerging Acceptance of Alternative Investments as the New Fiduciary Standard, 53 S. Tex. L. Rev. 653 (2012).  The introduction from the article is below: 

In the years after the Restoration during the early eighteenth century, the English economy was in a state of transition. The banking system was relatively new--the traditional role of goldsmiths had gradually changed into that of bankers, and the new stock market was becoming “more active and liquid” as the number of investment opportunities increased.  More importantly, the English monarchy came to be at the mercy of Parliament for two of the fundamental powers of government: first, taxes could only be increased with Parliament's consent; and second, for the first time the borrowing of funds by the government became guaranteed by Parliament, ushering in the “birth of national debt.”
As the national debt quickly grew (due in no small part to increasingly expensive wars), the Bank of England was created with the purpose of lending money to the government and transforming “‘the chaotic assortment of obligations”’ issued by the English leadership. As the debt grew, so did the costs of borrowing funds, and in 1711 the South Sea Company was created to compete with the Bank of England in supporting the national debt.
As a reward for consolidating and homogenizing the various types of national debt, the government agreed to pay the South Sea Company a higher short-term interest rate (to be financed through duties) in order to replace the long-term interest rates that had been paid previously. The biggest incentive for the company, however, was a veritable trade monopoly in the South Seas, which was a region widely known for its nearly limitless opportunity for financial gain.  This monopoly was granted by Parliament in 1711.
As national debts increased, however, concerns were raised regarding the debt-reduction measures taken by France; England felt that there would be harsh repercussions for their country if they did not catch up swiftly.  In 1719, national debt annuities created nine years earlier were converted outright to South Sea shares; this had the effect of the debt being easier to redeem, but also easier to discharge.
The markets reacted positively to these and other related developments. Lewis Melville wrote, “As soon as Parliament gave the preference over the Bank to the South Sea Company, the price of its stock went up in leaps and bounds.” Unfortunately for investors, in 1720 the wheels came off. Massive trading put the settlement process under pressure, and South Sea closed its books in order to catch up with its backlog. When the books were reopened, selling was quick--stock that was once worth £1,000 was now worth £100. Ultimately the South Sea company created a plan to be taken over by its former rival, the Bank of England, and the year ended in scandal and governmental investigations.
Though reasons and explanations for this bubble (indeed, often cited as the earliest modern-day asset bubble) were sought, it was frequently thought that this type of speculation was the work of “rapacious[] . . . individuals” exhibiting irrational behavior. From a fiduciary perspective, the development of the bubble and the subsequent decline was particularly disturbing because it was thought that no prudent man would invest in something so speculative. In response to the burst bubble, the English Court of Chancery created a list of investments that were presumptively proper for trustees.  These “legal lists” were later adopted by the United States and were generally made up of government bonds and first mortgages and “proscribed investments in equity.”
These restrictive rules led to the creation of the “prudent man rule,” which evolved into the present-day “prudent investor rule.” Under the Restatement (Third) of Trusts (Restatement Third), the prudent investor rule states that “[t]he trustee has a duty to the beneficiaries to invest and manage the funds of the trust as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances of the trust.” This concept is important because a trustee manages a trust for the benefit of the beneficiaries. Trust investments must be made with the beneficiaries in mind, and the management of the trust assets must be kept to some standard.
And so the prudent investor rule has become a fiduciary standard-- trustees can invest in virtually anything, as long as it can be shown to be prudent under the circumstances and in light of the portfolio as a whole. But recently a new trend has emerged in what is now considered to be a prudent investment for trusts--alternative investment classes. Alternative investments are investments “other than traditional investments in fixed income and publicly traded equity securities.”  These investments include hedge funds, private equity, real estate, and commodities. These assets are used for a variety of reasons, with the objective of increasing overall portfolio return. But as a recently new development, the long-term benefits of these investments to personal trusts remain largely untested. The question therefore posed is, To what extent are alternative investments part of the prudent investor's portfolio, and should they bear a permanent, and even mandatory, place in trust and fiduciary investing?
This paper will detail the history of a trustee's accepted investment practice and will use this history as a backdrop for the analysis of modern-day investment decisions by investment managers. This analysis will include the development of modern uniform laws and the common law, as explained by the Restatements. Special attention is paid to the development of modern portfolio theory and efficient market theory, as both are key to the development of the prudent investor rule and key to an investment manager's decision in selecting appropriate investments for trust assets, including alternative investments. The paper will analyze the role alternatives have played in other types of fiduciary accounts and what the performance of those investments has looked like over the past decade, including during the 2008 financial crisis. The paper concludes that alternative investments will be accepted as a standard-bearer for trust investments; these investments will stop being viewed as “alternative” and indeed will become mainstream and necessary. And for good reason--particularly in light of the volatility experienced by lay and professional investors alike over the past decade, hedges and noncorrelated investment strategies are a necessary part of the fiduciary portfolio.

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