A trust fiduciary's duty to implement capital preservation strategies using financial derivative techniques

Real Property, Probate and Trust Journal, Spring 2001 by Borkus, Randall H

The historical view of prudence was inflexible and constrained a fiduciary's ability to implement competent financial management of trust corpus.27 Moreover, under the historical standard, a fiduciary had to avoid innovative investment tools that would have been viewed as "speculative" in nature.28 In summary, the restriction on managing trust corpus under the prudent man standard was an albatross-an inadequate, dead standard that cost trust beneficiaries both income and principal.29

III. MODERN PORTFOLIO THEORY

A. In the Beginning

In the early 1950s, Harry Markowitz published his landmark paper Portfolio Selection, which has become the generally accepted origin of modern portfolio theory within the financial and economic community.30 The legal community's acceptance of modern portfolio theory came much slower, but following decades of empirical evidence, legal thought regarding contemporary trust doctrine has begun to join the mainstream.31

Investors have always known intuitively "not to put all their eggs in one basket."32 Still, it was Markowitz who first conceived the idea of asset diversification.33 Markowitz set himself apart from other economists by developing specific quantitative models to measure a portfolio's composite risk and expected return.34 Through the use of his quantitative models,35 Markowitz showed the world of finance how diversification36 worked to reduce portfolio risk while maximizing return.37

B. Diversification

Diversification is important because it dilutes the volatility of individual security prices and assists in prudent corpus management.38 The specific risk of a single stock is generally higher than the risk of a group of stocks comprising a portfolio.39 Additionally, a diversified portfolio generally is considered prudent because the expected rate of return increases without substantially increasing the portfolio's overall risk.40

Diversification allows an investor to include more volatile investments without subjecting the portfolio to significantly higher risk.41 For instance, a general stock mutual fund is the simplest example of a diversified portfolio.42 The ultimate goal of modem portfolio theory is to balance portfolio risks and returns through diversification.43 Therefore, by diversifying, trustees can fulfill their fiduciary duties to trust beneficiaries.44

Diversification is fundamental to the optimal management of assets45 and is supported under section 227 of the Restatement (Third).46 Diversification creates an advantage for fiduciary success because of the expanded universe of investment options available.47 Conversely, a fiduciary is not mandated to use diversification when general economic conditions so dictate or if applicable statutes would be violated.48

Overall, diversification makes taking advantage of pre-packaged diversified portfolios, such as mutual funds, which aid in increased returns without increasing corpus risk, easier for fiduciaries.49 Diversification also increases fiduciaries' responsibilities to become significantly more knowledgeable about financial management as contemporary expectations of their performances continue to rise.