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There is growing interest within the investment community in what are known as "index" or "market" funds. These are mutual or other investment funds that have abandoned the traditional attempt to "beat the market" by picking and choosing among securities-buying stocks or bonds that they believe to be undervalued' and selling those they believe to be overvalued. Instead, they create and hold essentially unchanged a portfolio of securities that is designed to approximate some index of market performance such as the Standard & Poor's 500. The S&P 500 is a hypothetical portfolio consisting of 500 major nonfinancial companies on the New York Stock Exchange weighted by the market value of each company's total outstanding shares. Batterymarch Financial Management Corporation in its Market Portfolio holds a 250-stock selection from the S&P 500 designed to track the performance of the S&P 500 very closely. Two major banks, American National Bank and Trust Company of Chicago and Wells Fargo Bank, have created market funds in their trust departments. And several large pension funds, including those of several Bell Telephone Companies and of Exxon, have recently placed a portion of their assets in such funds.

The rise of the market fund reflects growing dissatisfaction with the performance of conventional investment funds, which sacrifice diversification and incur heavy research and transaction costs in an apparently vain effort to outperform the broad market indices such as the S&P 500. We shall examine in a little while the basis for this disillusionment with conventional investment management. For now it is sufficient to note that the disillusionment exists, seems to be on the increase, and has given impetus to the market-fund approach.

An important question, and the focus of this article, is the extent to which a trustee may invest in a market fund without thereby violating the legal standards that govern the investment of trust assets. The question is a particularly timely one in view of the new pension reform law. That law not only appears to impose on pension funds the traditional limitations governing trust investments but also forbids the waiver of these limitations. In the case of ordinary trusts the limitations that the law places on trust investments are often not terribly important, because they are waivable by the trust instrument and commonly are waived. But the pension reform law does not permit waivers. Therefore, it becomes critically important to determine the requirements of trust law with respect to investment in market funds.

Part I of this article describes briefly the evolution of trust law as it relates to the trustee's investment duties. Part II considers the evidence for regarding market-fund investment as superior to the conventional investment strategies that a trustee might follow. Part III demonstrates that the existing law of trusts is sufficiently flexible to permit the investment of trust assets in an appropriate market fund, despite the relative novelty of this investment vehicle. Part IV considers specific market-fund investment vehicles that might be suitable for trust investment.

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