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 MODERN PORTFOLIO THEORY AND
INTERNATIONAL INVESTMENTS UNDER
THE UNIFORM PRUDENT INVESTOR ACT

Fredric J. Bendremer"

Editors' Synopsis: This Article analyzes how the Uniform Prudent

Investor Act has modernized the law of fiduciary investing while
preserving the traditionalfiduciary duties of the trustee. The author
examines Modern Portfolio Theory as a basisfor diversificationand the
role of internationalinvestments within fiduciary portfolios. Among
otherthings, the authoradvisesfiduciariesto considercertainqualitative
factors in making international investments in addition to theoretical
predictionsof MPT.

I. INTRODUCTION
II. UNIFORM PRUDENT INVESTOR ACT
III. MODERN PORTFOLIO THEORY
IV. INTERNATIONAL INVESTMENTS
V. CONCLUSION

I. INTRODUCTION

The Uniform Prudent Investor Act (the "UPIA") was approved by the
National Conference of Commissioners on Uniform State Laws in 1994
and has been adopted in whole or in part in a majority of the states.'

Fredric J.Bendremer (fjb@law.bendremer.com) is a member of the

bars of
Massachusetts and Florida, and practices in Weston, Massachusetts. He earned his J.D. in
1988 from the University of Miami School of Law and was Executive Editor of the
University of Miami Law Review. In addition, Mr. Bendremer holds an LL.M. in banking
and financial law from Boston University School of Law, where he was awarded the Alumni
Award for Academic Achievement. He also received an M.P.A., as well as his B.S. with
high honor, from Northeastern University.
IStates that have adopted the UPIA in whole or in part include Alaska, Arizona,
Arkansas, California, Colorado, Connecticut, District of Columbia, Hawaii, Idaho, Illinois,
Indiana, Iowa, Kansas, Maine, Massachusetts, Maryland, Michigan, Minnesota, Missouri,
Nebraska, New Hampshire, New Jersey, New Mexico, North Carolina, North Dakota, Ohio,
 35 REAL PROPERTY, PROBATE AND TRUST JOURNAL

Although the UPIA significantly modernizes the legal principles governing

fiduciary portfolio management, it also reaffirms the traditional fiduciary
duties of a trustee. Thus, while fiduciaries are given broad authority to
structure and manage investment portfolios under the UPIA, the UPIA
leaves largely intact their duty of care and duty of loyalty.

Modem Portfolio Theory ("MPT") is an investment strategy and

quantitative method by which portfolio managers seek to achieve a
specified level of return while minimizing investment risk. Utilizing MPT,
portfolio managers analyze the expected returns, correlations, and standard
deviation of returns on their investments and diversify their portfolios in a
manner consistent with the MPT risk/return model. Under MPT, an
investment portfolio is evaluated on the basis ofthe overall performance of
the portfolio, rather than on the basis of the performance of any particular
asset or assets in the portfolio.

MPT is an essential underpinning of the UPIA. Accordingly, under the

UPIA, a fiduciary investment portfolio is evaluated on the basis of the
overall performance of the portfolio. Consequently, in those jurisdictions
that have adopted the UPIA, modem principles of money management,
rather than arcane principles of trust law, provide the criteria for evaluating
a fiduciary's performance in structuring and managing an investment
portfolio.

The United States capital markets now represent only about one-half
of the world's capital markets. International markets thus offer significant
investment opportunities. Because international markets operate
independently of United States markets, albeit to varying degrees,
international markets have the potential to contribute substantially to the
overall performance of an investment portfolio. Participation in interna-
tional markets also can serve as a hedge against declines in the perfor-
mance of United States markets.

To some extent, therefore, diversification into international markets

may not only be reasonable and prudent, but may be required under the
UPIA's prudent investor rule. International markets, however, are not a

Oklahoma, Oregon, Pennsylvania, Rhode Island, Utah, Vermont, Virginia, Washington,

West Virginia, Wyoming.
WINTER 2001 Modern Portfolio Theory and InternationalInvestments 793

monolithic, fungible vehicle for purposes of diversification of fiduciary

portfolios. Accordingly, fiduciaries must consider qualitative as well as
quantitative factors in making international investments and should not
rely unduly on the theoretical predictions of MPT.

II. UNIFORM PRUDENT INVESTOR ACT

The UPIA provides: "A trustee shall invest and manage trust assets as
a prudent investor would, by considering the purposes, terms, distribution
requirements, and other circumstances of the trust. In satisfying this
standard, the trustee shall exercise reasonable care, skill, and caution." 2
The UPIA's prudent investor rule is consistent with section 227 of the
Restatement (Third)of Trusts and is reminiscent of the prudent person or
prudent man rules that have pervaded fiduciary law in many jurisdictions
for years.3 The UPIA, however, defines the prudent investor rule in the
context of authorizing, and in some cases mandating, specific investment
and management practices. Consequently, the UPIA's prudent investor
rule can be significantly different in effect from the prudent person or
prudent man rules.

While the UPIA reaffirms the traditional fiduciary duties applicable to

fiduciaries who manage investment portfolios, it simultaneously sets forth

2 UNIF. PRUDENT INVESTOR ACT § 2(a), 7B U.L.A. 289 (1994) [hereinafter UPIA].

The principles set forth in Section 2 of the UPIA are the "heart of the Act." UPIA § 2 cmt.
Subsections (a), (b), and (c) are modeled on Section 227 of the Restatement (Third) of
Trusts (1992) [hereinafter RESTATEMENT (THIRD)], and on the 1991 Illinois statute, 760 ILL.
COMP. STAT. ANN. 5/5a (2000).
3 "The trustee is under 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. (a) This standard requires the exercise of reasonable
care, skill, and caution .. " RESTATEMENT (THIRD), supra note 2, § 227. Harvard College
v. Amory, 26 Mass. (9 Pick.) 446 (1830), generally is considered the primordial case in this
area. Therein, the Supreme Judicial Court of Massachusetts stated:
All that can be required of a trustee to invest, is, that he shall conduct himself
faithfully and exercise a sound discretion. He is to observe how men of prudence,
discretion and intelligence manage their own affairs, not in regard to speculation,
but in regard to the permanent disposition of their funds, considering the probable
income, as well as the probable safety of the capital to be invested.
Id. at 461 (footnote omitted).
 35 REAL PROPERTY, PROBATE AND TRUST JOURNAL

a number of methods of satisfying those duties. The inclusion of such

methods in the UPIA reflects a strong sentiment that trust law and the law
of fiduciary duty should recognize modem economic and financial
realities.

One of the central provisions of the UPIA states the contemporary

view that a fiduciary's "investment and management decisions respecting
individual assets must be evaluated not in isolation but in the context of the
trust portfolio as a whole and as a part of an overall investment strategy
having risk and return objectives reasonably suited to the trust. ' 4 The
UPIA also provides that the fiduciary shall consider "the role that each
investment or course of action plays within the overall trust portfolio,
which may include financial assets, interests in closely held enterprises,
tangible and intangible personal property, and real property."5 In addition,
under the UPIA, the circumstances that a fiduciary must consider in
investing and managing trust assets include general economic conditions,
effects of inflation or deflation, and expected tax consequences of
investment decisions or strategies.6

Another central provision of the UPIA directs that "[a] trustee shall

4 UPIA,supra note 2, § 2(b). Again, Section 227(a) of the Restatement

(Third) of
Trusts contains a consistent formulation. That provision states that the prudent investor
standard "is to be applied to investments not in isolation but in the context of the trust
portfolio and as a part of an overall investment strategy, which should incorporate risk and
return objectives reasonably suitable to the trust." RESTATEMENT (THIRD), supra note 2, §
227(a). According to the comments to the UPIA, "[a]n investment that might be imprudent
standing alone can become prudent if undertaken in sensible relation to other trust assets,
or to other nontrust assets .... Subsection (b) also sounds the main theme of modem
investment practice, sensitivity to the risk/return curve." UPIA, supra note 2, § 2(b) cmt.
5 UPIA, supra note 2, § 2(c)(4).
6 See id. § 2(c). On the subject of tax considerations, the comments to the UPIA state:
Tax considerations, such as preserving the stepped up basis on death under
Internal Revenue Code § 1014 for low-basis assets, have traditionally been
exceptionally important in estate planning for affluent persons. Under the present
recognition rules of the federal income tax, taxable investors, including trust
beneficiaries, are in general best served by an investment strategy that minimizes
the taxation incident to portfolio turnover. . . . In a regime of pass-through
taxation, it may be prudent for the trust to buy lower yielding tax-exempt
securities for high-bracket taxpayers, whereas it would ordinarily be imprudent
for the trustees of a charitable trust, whose income is tax exempt, to accept the
lowered yields associated with tax-exempt securities.
Id. § 2(c) cmt. (citation omitted).
WINTER 2001 Modern Portfolio Theory and InternationalInvestments 795

diversify the investments of the trust unless the trustee reasonably

determines that, because of special circumstances, the purposes of the trust
are better served without diversifying. 7 The diversification requirement
is bolstered by the provision in the UPIA stating that a fiduciary "may
invest in any kind of property or type of investment." 8 The fiduciary must,
however, comply with the standards of the UPIA and make "a reasonable
effort to verify facts relevant to the management and investment of trust
assets" for which the fiduciary is responsible.9

A third central provision of the UPIA relates to delegation. Under the

UPIA, "[a] trustee may delegate investment and management functions that
a prudent trustee of comparable skills could properly delegate under the
circumstances."' In delegating investment and management functions,
however, the fiduciary must "exercise reasonable care, skill, and caution in
selecting the agent" and "establishing the scope and terms of the delega-

7 Id. § 3. Section 227(b) of the Restatement (Third) of Trusts similarly mandates

diversification, stating: "In making and implementing investment decisions, the trustee has
a duty to diversify the investments of the trust unless, under the circumstances, it is prudent
not to do so." RESTATEMENT (THIRD), supra note 2, § 227(b). The Restatement (Third) of
Trusts took "the significant step of integrating the diversification requirement into the
concept of prudent investing.... The message of the [Restatement (Third) of Trusts],
carried forward in Section 3 of [the UPIA], is that prudent investing ordinarily requires
diversification." UPIA, supra note 2, § 3 cmt.
8 UPIA, supra note 2, § 2(e). As set forth in the comments to the UPIA,
Subsection 2(e) clarifies that no particular kind of property or type of investment
is inherently imprudent .... The premise of subsection 2(e) is that trust
beneficiaries are better protected by the Act's emphasis on close attention to
risk/return objectives as prescribed in subsection 2(b) than in attempts to identify
categories of investment that are per se prudent or imprudent.
Id. § 2(e) cmt.
9 Id.§ 2(d).
10 Id.§ 9(a). The Restatement (Third) of Trusts repealed the nondelegation rule of
Section 171 of the Restatement (Second) of Trusts and replaced it with the following:
A trustee has a duty personally to perform the responsibilities of trusteeship
except as a prudent person might delegate those responsibilities to others. In
deciding whether, to whom, and in what manner to delegate fiduciary authority in
the administration of a trust, and thereafter in supervising agents, the trustee is
under a duty to the beneficiaries to exercise fiduciary discretion and to act as a
prudent person would act in similar circumstances.
RESTATEMENT (THIRD), supra note 2, § 171; see UPIA, supra note 2, § 9 cmt. The prudent
investor rule of Section 227 of the Restatement (Third)of Trusts incorporates this standard.
See RESTATEMENT (THIRD), supra note 2, § 227; UPIA, supra note 2, § 9 cmt.
 35 REAL PROPERTY, PROBATE AND TRUST JOURNAL

tion."" Not surprisingly, the fiduciary also must monitor the agent's
activities." Provided the fiduciary complies with the UPIA's delegation
provisions and standards, the fiduciary "is not liable to the beneficiaries or
to the trust for the decisions or actions of the agent."' 3 In addition, by
accepting the delegation, the "agent owes a duty to the trust to exercise
reasonable care to comply with the terms of the delegation."' 4

A number of the UPIA's provisions represent a departure from trust

law that has developed, albeit inconsistently, over the years. In fact, in
certain jurisdictions, the provisions of the UPIA discussed above would be
directly contrary to traditional trust law. For example, in some jurisdic-
tions, a fiduciary's investment and management decisions respecting
individual assets have been evaluated in isolation, rather than in the
context of the trust portfolio as a whole.'5 In those jurisdictions, the poor
performance of an individual investment could subject the fiduciary to
liability if the fiduciary's selection of the investment was determined to be
unreasonable. 6 In addition, the contribution of a particular investment or
course of action to the entire portfolio's performance was not a tenable
defense to claims against the fiduciary.

While for many years trust law and the courts generally have required
fiduciaries to practice diversification, 7 the UPIA codifies the diversifica-
tion requirement and further adopts MPT as the essential underpinning of

11UPIA, supra note 2, § 9(a)(1)-(2).

12 See id. § 9(a)(3).
131d. § 9(c).
" Id. § 9(b).
15See, e.g., First Ala. Bank of Montgomery v. Martin, 425 So. 2d 415, 427-28 (Ala.
1982) (holding that a trustee's investment in a number of equity and debt securities was
imprudent in light of the nature of such securities).
16 See, e.g., In re Bank of N.Y., 323 N.E.2d 700, 704 (N.Y. 1974) (stating that
"[wihether a trustee is to be surcharged in these instances, as in other cases, must
necessarily depend on a balanced and perceptive analysis of its consideration and action in
the light of the history of each individual investment, viewed at the time of its action or its
omission to act").
17See,e.g., First Ala. Bank of Huntsville v. Spragins, 515 So. 2d 962, 964 (Ala. 1987)
(holding that a trustee's investment of a majority of trust assets in bank stock was a violation
of fiduciary duty).
WINTER 2001 Modern Porfolio Theory and InternationalInvestments 797

that requirement. 8 In addition, in stark contrast to the UPIA's liberal

provisions on permissible investments, many jurisdictions traditionally
have restricted the types of investments that a fiduciary can make. "Legal
lists" specifically setting forth permissible investments have not been
uncommon. Moreover, in some instances, investing in a certain type of
asset, such as second mortgages or subordinated debt, constituted a per se
violation of state law.' 9

Finally, in contrast to the UPIA's liberal delegation provisions, many

jurisdictions traditionally have limited or categorically proscribed a
fiduciary's delegation of investment and management functions.2"
Trustees generally had the duty not to delegate to others the performance
of acts they could reasonably be required to perform personally. 2'
Discretionary functions thus often were deemed nondelegable, and
ministerial functions were the only matters that could be the subject of

18 Noteworthy is the fact that in 1979, the Secretary of Labor issued regulations under
the Employee Retirement Income Security Act of 1974 ("ERISA") providing that an ERISA
fiduciary must act as a prudent investment manager under MPT rather than the common law
of trusts. See 29 C.F.R. § 2550.404a-1 (1982); see also Laborers Nat'l Pension Fund v. N.
Trust Quantitative Advisers, 173 F.3d 313, 317-18 (5th Cir. 1999) (stating that MPT is the
correct standard for determining whether a trustee has breached its fiduciary duty with
respect to investment management). The Uniform Principal and Income Act, promulgated
by the National Conference of Commissioners on Uniform State Laws in 1997, similarly
recogizes the critical role of MPT in the investment and management of trust assets.
See Jeffrey N. Gordon, The Puzzling Persistence of the ConstrainedPrudentMan
Rule, 62 N.Y.U.L. REv. 52, 87 (1987).
20 See In re Younker, 663 N.Y.S.2d 946 (N.Y. Sur. Ct. 1997). The court discussed
New York's historically stringent nondelegation rules, along with their recent relaxation:
Although the law concerning investment powers in New York has continuously
evolved since it was first addressed over 100 years ago, the law regarding
delegation of such powers has not been changed. For many years, delegation was
prohibited by statute unless expressly authorized by the governing instrument.
The legislature altered this long-standing proscription in the recently enacted
Prudent Investor Act, which effects sweeping changes in fiduciary investment
responsibility (citations omitted).
Id. at 948; see also Robert J. Aalberts and Percy S. Poon, The New Prudent Investor Rule
and Modern Portfolio Theory: A New Directionfor Fiduciaries,34 AM. Bus. L.J. 39, 51
(1996) (examining, among other things, the evolution of the prudent investor rule).
21 RESTATEMENT (SECOND) OF TRUSTS § 171 (1959).
 35 REAL PROPERTY, PROBATE AND TRUST JOURNAL

delegation.22

III. MODERN PORTFOLIO THEORY

MPT represents a body of financial, economic, and mathematical

knowledge that suggests that through appropriate structuring of an
investment portfolio, investment risks may be minimized without
compromising potential returns. The development of MPT generally is
attributed to the scholarly work of Harry Markowitz in the early 1950s.23
John Tobin also contributed substantially to MPT's development.24

MPT is central to the UPIA's diversification requirement. In addition,

the UPIA's provisions with respect to evaluation of the portfolio as a
whole, formulation of portfolio risk/return, contributory effects of each
investment, broadening the scope of permissible investments, and
delegation are all at least in part attributable to the recognition of MPT.
An understanding of MPT thus is essential to the proper investment and
management of a fiduciary portfolio under the UPIA.25 Only upon
obtaining such an understanding can the fiduciary consider an international

22 See John H. Langbein, The Uniform PrudentInvestor Act and the Future of Trust
Investing, 81 IOWA L. REV. 641, 651 (1996). In recognition of the difficulties that inhere in
distinguishing between discretionary and ministerial functions, the comments to the
Restatement (Second) ofTrusts included a list of factors that could be of importance to the
analysis. See RESTATEMENT (SECOND) OF TRUSTS § 171 cmt. d (1959). The Restatement
(Second) of Trusts was explicit, however, that the power to select investments was
nondelegable. See id. cmt. h. The Restatement (Third) of Trusts, as well as more modem
uniform laws and actual statutes, both federal and state, dramatically expanded trustees'
delegation powers. See RESTATEMENT (THIRD), supra note 2, § 171.
3See Harry Markowitz, Portfolio Selection, 7 J. FIN. 77 (1952).
24 See James Tobin, Liquidity Preference as Behavior Toward Risk, 25 REv. ECON.
STUD. 65 (1958). Other scholars have since further developed and refined MPT. The
capital asset pricing theory represents one such refinement and expansion. See John
Lintner, Security Prices, Risk, and Maximal Gains from Diversification, 20 J. FIN. 587
(1965); John Lintner, The Valuation of Risk Assets and the Selection of Risky Investments
in Stock Portfoliosand Capital Budgets, 47 REV. ECON. & STAT. 13 (1965); William F.
Sharpe, CapitalAsset Prices: A Theory of Market Equilibrium Under Conditionsof Risk,
19 J. FIN. 425 (1964).
25 See generally GORDON J. ALEXANDER ET AL., FUNDAMENTALS OF INVESTMENTS (3d
ed. 2000) (positing that diversification is necessary to realize certain, high returns);
RICHARD A. BREALEY, AN INTRODUCTION TO RISK AND RETURN FROM COMMON STOCKS (2d
ed. 1983) (maintaining that the most effective investment portfolio will balance both passive
and active elements so as to achieve the highest rate of return with the lowest level of risk).
WINTER 2001 Modern Portfolio Theory andInternationalInvestments 799

component to the portfolio.

All fiduciary portfolios do not have the same level of risk tolerance
and investment objectives. Fiduciaries must consider a host of factors in
determining the appropriate parameters of an investment portfolio. The
most fundamental criteria in determining such parameters are the purposes,
terms, and distribution requirements of the trust. Once a fiduciary
determines the appropriate levels of desired return and risk tolerance, the
fiduciary can utilize MPT.

Essentially, MPT is a quantitative method of identifying the appropri-

ate components of an investment portfolio such that the overall portfolio
conforms to applicable risk/return parameters. The objective of MPT is to
obtain the desired investment results, or range of results, while diminishing
the risk to which the portfolio would be subject otherwise.

Two of the basic criteria underlying MPT are expected return and
standard deviation of return.26 That investors prefer a higher return and a
lower standard deviation of return is widely understood.27 A portfolio
comprising high expected return assets, however, generally has a high
degree of risk and thus a high standard deviation of return. Accordingly,
such a portfolio is usually imprudent for a fiduciary. By selecting portfolio
components with various rates of return and standard deviations, a
fiduciary can use MPT to match the desired rate of return while reducing
the standard deviation that ordinarily would accompany that rate of return.

Under MPT, two important types of risk associated with a security are
systematic risk and nonsystematic risk.2" Systematic risk involves the
general movements of the market that can have an adverse consequence on
an individual security within that market.29 Nonsystematic risk relates to
the particular risks associated with the issuer of individual securities, such
as poor earnings performance, adverse circumstances in the issuer's

26
See Stanley J. Kon, Modern Portfolio Theory: Implicationsfor Prudent Investment
Strategies, in INTERNATIONAL MUTUAL FUNDS & THE PRUDENT INVESTOR ACT: A GUIDE
FOR THE FIDUCIARY app. at 124 (Federated Investors 1995).
27 See id.
28 See Aalberts & Poon, supra note 20, at 58-59.
29
See id. at 59.
 35 REAL PROPERTY, PROBATE AND TRUST JOURNAL

business, and shareholder litigation against the issuer."a In the lexicon of

MPT, a portfolio that is not substantially immunized against nonsystematic
risk is subject to uncompensated risk.3'

One of the principal means of immunizing a portfolio against

nonsystematic risk, and thus eliminating uncompensated risk, is diversifi-
cation. 2 Diversification is a critical element of MPT. Although diversifi-
cation within one market cannot eliminate systematic risk, diversification
among issuers and markets lowers the standard deviation of the entire
portfolio. In diversifying the portfolio, the fiduciary considers the
correlation of all of the securities in the portfolio to each other and
frequently to an objective performance measurement such as the Standard
& Poor's 500 Index ("S&P 500"). The essence of MPT is to diversify on
the basis of expected return, correlation, and standard deviation of return.

Diversification is measured by the correlation of individual securities

and market indices using numbers that range in value from -1.0 to 1.0."
The latter represents perfect positive correlation and the former represents
perfect negative correlation. Perfect positive correlation means that two
components move in exact tandem.34 Perfect negative correlation means
that the movement of one component is cancelled out or offset by the
movement of the other component.35 A correlation with a value near zero
indicates that the components are uncorrelated. Both perfect positive
correlation and perfect negative correlation are undesirable for purposes of
diversification. If a portfolio is properly diversified, the portfolio
components should perform with a degree of independence; lower
correlations are critical to the portfolio's diversification characteristics.

Individual securities, markets, and market indices all have historic

returns and standard deviations of return. The fiduciary must thus consider
such data in formulating the proper level of risk/return for a given
portfolio, as well as current economic, financial, and political factors that
bear on portfolio risk/return. MPT may seek to replicate the results of a

30 See id. at 58.

31 See Kon, supra note 26, app. at 127.
32 See Langbein, supra note 22, at 648.
33 See Kon, supra note 26, app. at 125, n.4.
34 See id.
35 See id.
WINTER 2001 Modern Portfolio Theory and InternationalInvestments 801

benchmark such as the S&P 500 or another objective measure of

performance.3 6 Presumably, all securities and portfolio components would
have upward sloping historical and projected returns." Each investment
and market exposure would thus be differentiated by its rate of return,
correlation, and standard deviation. The fiduciary would then structure
individual security holdings and differing market components of the
portfolio to match the desired level of return to the minimal standard
deviation of return.

As a mathematical matter, in its own context, MPT demonstrates that

a fiduciary can manipulate the portfolio's components to replicate the
performance of a given benchmark or other level of return while simulta-
neously lowering risk.3" In fact, MPT can graphically display incremental
risk reduction resulting from a gradual introduction of diversifying
investments into the portfolio while maintaining or even enhancing
performance levels. Ultimately, the portfolio reaches an optimal level.
The "efficient frontier" is the term often associated with optimal portfolio
allocations corresponding to given levels of risk and return. If the
fiduciary deviates from an optimal investment selection and allocation, that
affects both potential return and risk.

IV. INTERNATIONAL INVESTMENTS

Whether domestic or international, markets generally do not perform

in precisely the same manner. Because market indices represent general
market performance, they also vary in performance. As discussed above,
the UPIA requires diversification in order to protect against losses in the
event that an individual security or market declines.39 MPT further
requires diversification to ensure that investment returns reach the same
level without the attendant risk that otherwise would apply. Because the

36
See id. app. at 126-27.
37 Conceivably, a fiduciary could employ certain hedging or other sophisticated
financial techniques in connection with a given portfolio. In that case, some investments
may not have either positive historical or projected returns under the then current economic
and financial conditions.
38 See Jeffrey S. Glaser, The Capital Asset PricingModel: Risk Valuation, Judicial
Interlpretation,and Market Bias, 50 Bus. LAW. 687, 696 (1995).
9 See UPIA, supra note 2, § 3.
 35 REAL PROPERTY, PROBATE AND TRUST JOURNAL

UPIA incorporates the principles of MPT, the dual purposes of diversifica-

tion apply to fiduciary portfolio investment and management.

Indices such as the Dow Jones Industrial Average, the S&P 500, the
NASDAQ Composite, and the Russell 2000 represent equity markets in the
United States.40 Generally, market capitalization determines the securities
represented by a given index, with certain exceptions. 4' A number of
indices represent markets for debt securities in the United States, including
those published by Lehman Brothers and Merrill Lynch.4 2

Well-known indices, such as the FT-SE 100, the Nikkei 225, the DAX-
30, and the CAC40, track particular foreign markets.43 Alternatively, a
fiduciary can analyze foreign markets more generally by using an index
such as the Morgan Stanley Capital International ("MSCI") Europe,
Australia and Far East Index, which represents large capitalization foreign
stocks of developed countries.44 As in the case of the United States,
indices are available for foreign stocks of various market capitalizations in
several markets, ranging from large and small capitalization stocks in
developed countries to emerging market stocks in less developed countries.
The latter includes the MSCI Emerging Markets Free Index.45 Similarly,
indices are available to monitor the performance of foreign debt securities,
such as the Lehman Brothers Global Bond Index.46

Given that United States capital markets represent only about one-half
of the world's capital markets, approximately one-half of the world's
capital markets comprise foreign securities.4 7 While the United States
domestic securities markets have varying risk/return characteristics, as a
general matter, United States market indices are strongly correlated to each

40 See HENRY SHILLING, THE INTERNATIONAL GUIDE TO SECURITIES MARKET INDICES

258-59 (1996).
41 See generally HOWARD M. BERLIN, THE HANDBOOK OF FINANCIAL MARKET

INDExES, AVERAGES, AND INDICATORS (1990) (discussing market evaluators that influence
technical
42 analysts).
See SHILLING, supra note 40, at 644-87.
43 See id. at 261-605.
44 See id. at 630.
4- See id. at 626.
46
See id. at 702.
41 See HAL S. SCOTT & PHILiP A. WELLONS, INTERNATIONAL FINANCE 49 (4th ed.
1997).
WINTER 2001 Modern Portfolio Theory and InternationalInvestments 803

other.48 When considering international investments, the diversification

analysis thus hinges on the correlation of foreign securities markets to
United States markets, which will vary according to the particular market.
International markets often have their own unique characteristics, which
are influenced by local business cycles, interest rates, inflation, govern-
ment policies, exchange rates, and trade balances.49 In general, however,
the correlations of foreign markets to United States markets are sufficiently
low to provide the opportunity for effective diversification."

Because foreign markets have varying rates of returns and risk

characteristics, the fiduciary must take special care in integrating foreign
securities into the fiduciary portfolio. Moreover, the fiduciary must
consider the specific nature of the investment. For example, foreign
securities that a fiduciary may purchase include foreign equity and debt
securities, represented by the securities themselves or exchange-traded
American Depository Receipts or Global Depository Receipts. 5 Further,
many fiduciaries are "qualified institutional buyers" and thus also may
purchase by way of offerings under Rule 144A of the Securities and
Exchange Commission.52 In addition, the fiduciary may purchase
derivative instruments pertaining to, among other things, foreign securities,
indices, currencies, and interest rates. Parties who wish to participate in
certain foreign investments without actually purchasing the investment also
may engage in private derivative transactions that synthesize an actual
purchase.

When purchasing foreign securities, particularly those denominated in

a foreign currency, fiduciaries also should be aware that foreign exchange
fluctuations pose a special risk.53 In essence, the underlying asset has its
associated local market risk. Foreign exchange risk upon the sale of the

48 See generally DAVID K. EITEMAN ET AL., MULTINATIONAL BUSINESs FINANCE at

362-363 app. (8th ed. 1998) (explaining shifts in the efficient frontier resulting from
international
49 investment).
See id. app. at 363.
50
See Kon, supranote 26, app. at 125-26.
51 See ErrEMAN ET AL., supra note 48, at 375; ScoTT & WELLONS, supra note 47, at
107-17.
52 See 17 C.F.R. § 230.144A (2000) (defining "qualified institutional buyer" and
providing for the private resale of securities to institutions).
53 See ErTEMAN ET AL., supra note 48, at 341.
 35 REAL PROPERTY, PROBATE AND TRUST JOURNAL

asset is separate and distinct from local market risk. For example, the local
market price could increase while the currency of the asset's denomination
depreciates. Such circumstances could result in a loss even though the
local market price of the asset has appreciated. Dividends and other
distributions also are subject to such risk.

Clearly, some participation in foreign markets is appropriate for

fiduciaries to ensure appropriate diversification.54 Of course, the trust
terms, purposes, distribution requirements, and other circumstances of the
trust must permit such participation. In fact, given the potential for
diversification and the consequent risk reductions without impairment of
returns, one could argue that the UPIA's prudent investor rule requires
investment in foreign securities.55 That is, a fiduciary potentially could be
held liable for failing to invest in foreign securities as part of the fiduciary
portfolio.56 The question then arises as to whether the fiduciary has
sufficient resources available to invest, manage, and otherwise successfully
monitor international investments.

In the case of large United States financial institutions, a fiduciary may

have sufficient internal resources for international investing. In that case,
the fiduciary could maintain international investments within the common
trust funds or employee benefit funds of the financial institution, as
appropriate. With larger individual trusts, it is likewise possible to
maintain international portfolio components with specific foreign

54 Little quantitative data is available on the extent to which fiduciaries are diversifying
through the use of foreign securities. A recent study surveyed 239 Iowa banking institutions
with trust functions about a number of trust management matters, including whether the
institutions' trusts held foreign equity securities or foreign mutual funds. Of those
surveyed, 61 responded. Thirty-nine percent of the respondents indicated that they held
trust funds with foreign equities, and fifty-two percent indicated that they held trust funds
with foreign mutual funds. Nevertheless, in each case, only an extreme minority of trust
funds at such institutions actually held such foreign equities or foreign mutual funds.- For
further discussion of the Iowa study, see Martin D. Begleiter, Does the Prudent Investor
Need the Uniform Prudent InvestorAct-An EmpiricalStudy of Trust Investment Practices,
51 U. ME. L. REV. 27 (1999).
55 See, e.g., UPIA, supra note 2, §§ (2)-(3) (providing that a trustee should evaluate
risk and
56
return objectives and normally should diversify).
See Prefatory Letter from Professor John H. Langbein, Yale Law School, to Eugene
F. Maloney, Esq., Senior Vice President and Corporate Counsel, Federated Investors, dated
December 15, 1995, in INTERNATIONAL MUTUAL FuNDs & THE PRUDENT INVESTOR ACT:
A GUIDE FOR THE FiDucIARY (Federated Investors 1995).
WINTER 2001 Modern Portfolio Theory and InternationalInvestments 805

securities. To the extent that the financial institution maintains proprietary

international mutual funds, the fiduciary may wish to utilize such mutual
funds in connection with its fiduciary portfolios.

Under section 2(d) of the UPIA, the fiduciary must make a reasonable
effort to verify facts relevant to the investment and management of trust
assets.57 Thus, a fiduciary utilizing in-house resources for foreign
investments must be certain that those resources are sufficient to meet the
UPIA's standards.5 Many fiduciaries for whom maintaining such in-house
resources is not feasible would take advantage of the delegation provisions
set forth in section 9 of the UPIA.59 Conceivably, such delegation could
apply to the use of an outside investment management firm to manage
foreign investments. However, the use of a mutual fund with foreign
holdings probably is more prevalent.

A mutual fund generally has extensive resources at the investment

advisor level to manage foreign investments. Given the usual cost
efficiencies of mutual funds, in-house expertise, and the availability of
performance histories, mutual funds are an attractive vehicle for holding
international components of a fiduciary portfolio.6" Moreover, most
mutual funds themselves are diversified within a particular market or
region and thus are not subject to undue net asset value fluctuation based
on one or even several individual securities or local markets.

The UPIA has established the permissibility of international investing.

Nevertheless, the fiduciary still must determine which foreign securities or
mutual funds to purchase. As set forth above, the fiduciary remains
subject to the prudent investor rule, the UPIA's version of the traditional
standard of accountability for investment decisions. While section 2(b) of
the UPIA states that the fiduciary's performance must be assessed on the
basis of the portfolio as a whole, section 2(a) of the UPIA still requires the
fiduciary to exercise prudence in the form of reasonable care, skill, and

57 See UPIA, supra note 2, § 2(d).

58 See id. § 2 cmt.
59
See id. § 9.
60 See Langbein, supra note 32, at 655. Trusts also may invest in mutual funds for
diversification purposes. See RESTATEMENT (THIRD), supra note 2, § 227 cmt. m; UPIA,
supranote 2, § 3 cmt.
 35 REAL PROPERTY, PROBATE AND TRUST JOURNAL

caution. 61

Selecting foreign investments for inclusion in a fiduciary portfolio is

dependent upon several factors, including the terms, purposes, distribution
requirements, and other circumstances of the trust; the application of MPT;
and to some extent, the subjective judgment of the fiduciary, consistent
with the UPIA's prudent investor rule. Under MPT, an infinite number of
combinations of investments exist that could constitute an optimal
portfolio. Presumably, to achieve a specified level of return with the
lowest possible standard deviation of return, the fiduciary could utilize
myriad combinations of domestic and international securities and other
investments. Thus, even when using MPT, the fiduciary must exercise a
degree of subjective judgment. Importantly, the fiduciary must keep in
mind that MPT is in fact what its name suggests: theory. As such,
applying MPT does not guarantee favorable results.

While the UPIA adopts modem portfolio theory, it does not exculpate
fiduciaries who unduly rely on its theoretical predictions or who fail to
recognize its shortcomings.62 The fiduciary must be cognizant of the fact
that expected returns, correlations, and standard deviations of return are all
based on historical data. Moreover, correlations and standard deviations,
as statistical measurements, are not sufficient to describe the relevant data
completely even if the historical data were invariant in time. Therefore,
reliance on MPT implies a belief that historical data will remain constant
in the future and that correlations and standard deviations are sufficiently
descriptive of that data. The fiduciary must thus be aware that the
predicted results of MPT are qualified in that regard. One also should note
that section 2(c) of the UPIA requires the fiduciary to consider general
economic conditions in connection with the portfolio. 63 Moreover, solely
under an application of the UPIA's prudent investor rule, the fiduciary
should consider a host of other factors when making investment decisions
in the international context."

61 See UPIA, supra note 2, §§ 2(a)-(b).

62 See id. § 3 cmt.
63
See id. § 2(c)(1).
6 Several scholars have advocated further refinements of MPT to account for variables
excluded from the MPT analysis. So-called arbitrage pricing theory, for example, attempts
to account for the effects of macroeconomic factors such as interest rates and investor
confidence. See Terence C. Langetieg, An Application of a Three-FactorPerformance
WINTER 2001 Modern Porifolio Theory and InternationalInvestments 807

In addition to economic conditions, a fiduciary should consider the

political, foreign exchange, financial, liquidity, legal, and regulatory issues
that pertain to a given international investment, market, or region.6 5
International investments are always subject to systematic risk. Also, the
fiduciary must consider the period of time that the MPT historical data
represents. Many international markets, for example, have existed for a
relatively short period of time compared to United States markets.

The fiduciary also should be aware that many international markets

have far fewer securities in terms of both number of issuers and shares.
Thus, the sample size and collection period for the historical data may be
significantly less than comparable historical data for United States
markets. Accordingly, the overall reliability of historical data on
individual securities or markets may be significantly inferior to that of the
United States securities or markets. The fiduciary also should not lose
sight of the fact that certain foreign securities included in relevant market
indices are not necessarily available to United States purchasers.
Aggregate market capitalizations of individual foreign markets also are
invariably smaller than that of the United States.

MPT does not take into account more than expected return, correlation,
and standard deviation of return. Thus, while a theoretically infinite
number of portfolio combinations could produce the same result, in fact,
the risks do not appear identical. The fiduciary must make a judgment,
consistent with the prudent investor rule, on a portfolio combination that
is prudent and reasonable. One may suggest that although the UPIA adopts
MPT, a fiduciary's erring on the side of caution in following MPT's
dictates may in fact be prudent. That is, the fiduciary may wish to utilize
MPT for general guidance but place more weight on qualitative factors
than MPT alone would suggest.

While some foreign markets have generated impressive returns, the

United States capital markets have been strong on a historical basis and

Index to Measure Stockholder Gainsfrom Merger, 6 J. FIN. EcoN. 365 (1978); Stephen A.
Ross, The Arbitrage Theory of CapitalAsset Pricing,13 J.ECON. THEORY 341 (1976). The
UPIA, however, does not embrace any particular variant of MPT or alternative approach to
investment selection and allocation of portfolio components.
65 See EITEMAN ET AL., supra note 48, at 336-38, 371.
 35 REAL PROPERTY, PROBATE AND TRUST JOURNAL

have a longer track record than most other markets. Further, the economic,
financial, liquidity, legal, regulatory, and other risks and circumstances of
United States markets have been generally favorable. Under MPT, the
fiduciary could emphasize foreign investments rather than United States
investments while still maintaining a theoretically high level of return and
lower level of risk. Nevertheless, one would still expect fiduciaries to
favor United States investments for both qualitative and quantitative
66
reasons.

Considering the UPIA's adoption of MPT, the UPIA's endorsement of

delegation, and the general awareness that most fiduciaries are not
equipped to invest in and manage foreign securities directly, the UPIA
appears to suggest that mutual funds may be most appropriate for foreign
investments.67 It is a truism, however, that not all international mutual
funds are alike. Rather, international mutual funds may invest in
completely different securities, markets, and regions, or may blend two or
more of the foregoing. Thus, the fiduciary may include more than one
international mutual fund within the portfolio under the principles of the
UPIA and MPT, and thereby achieve greater diversification. Regardless of
whether a fiduciary uses in-house resources, investment management
companies, or proprietary or nonproprietary mutual funds, the UPIA
requires the fiduciary to analyze its international investments on a
qualitative and quantitative basis using prudence and reasonable care, skill,
and caution.68

V. CONCLUSION

The UPIA has modernized the law of fiduciary investing while

preserving the traditional core fiduciary duties of the trustee. The UPIA
provides for the evaluation of fiduciaries on the basis of the portfolio as a
whole rather than individual investments. In structuring and managing the
portfolio, the UPIA requires the fiduciary to consider the role that each
investment or course of action plays within the overall trust portfolio.

66 If an investor seeks to replicate an index or other objective performance measure-

ment, including within the portfolio the type of securities that underlie the index or other
objective performance measurement appears most efficacious.
67 See UPIA, supra note 2, § 3 cmt.
68
See id. §2.
WINTER 2001 Modern Portfolio Theory and InternationalInvestments 809

Further, the UPIA generally requires diversification and the application of

MPT and provides that fiduciaries may hold virtually any investment. The
UPIA also authorizes delegation of investment and management decisions
subject to certain standards.

The UPIA adopts MPT as one of the principal bases for diversification.
MPT is an investment strategy, quantitative method, and model by which
a portfolio manager may calculate an optimal allocation among investment
alternatives using expected return, correlation, and standard deviation of
return. The underlying data of MPT are based on historical performance
with the implicit assumption that historical performance reflects future
performance parameters. In theory, an MPT-structured portfolio should
achieve a specified level of return with an optimally minimized standard
deviation of return. Fiduciaries also may utilize MPT to replicate the S&P
500 or another objective performance measurement while lowering the
corresponding risk.

Inclusion of international investments within a fiduciary portfolio is

appropriate and may indeed be required under the UPIA and MPT.
International investments further the diversification purposes of the UPIA;
accordingly, they may offset declines in the United States markets.
Moreover, MPT suggests that participation in foreign markets is an
effective vehicle by which the fiduciary may maintain or enhance expected
return of an investment portfolio while minimizing risk. Foreign markets
may offer attractive returns, but they may have qualitative risk factors that
the relevant historical data do not represent. Accordingly, utilizing MPT
alone, and thus omitting consideration of such qualitative risk factors, does
not appear to be consistent with the UPIA's prudent investor rule.