An Index Fund is the Next Best Thing to a Blind Trust


Last week Chief Justice John Roberts recused himself from a patent case that was argued in December when he discovered that his financial holdings created a potential bias. There is no reason to doubt that the initial oversight was inadvertent, but (as noted in the SCOTUSblog story linked above) one watchdog group has called on justices to sell their holdings in individual companies. The website of the group, Fix the Court, states that only three justices (Roberts, Breyer, and Alito) currently hold stock in individual firms. Fix the Court proposes that all of the justices should divest from individual firm stocks in favor of blind trusts.

If that’s a good proposal for Supreme Court justices, what about other government officials? With many questions being raised about the potential conflicts of interest of President-elect Trump and his super-rich cabinet, should they all be required to divest ownership in the shares of individual companies—as Rex Tillerson has committed to do with respect to his Exxon-Mobil shares should he be confirmed as Secretary of State?

In this column, I explain why for most well-to-do government officials, ownership of a broad-based diversified portfolio provides most of the conflict-avoidance benefits of putting their assets in a blind trust.

Index Funds for Supreme Court Justices

Let me begin by noting what seems to me a technical error or, more charitably, an overstatement by Fix the Court, which equates divestment of individual stocks with placing assets in a blind trust. In fact, there are a range of intermediate steps between ownership of stock in individual firms and a blind trust. Suppose that Justice X has her assets in three main baskets: 1) her home; 2) a savings account; and 3) shares in a broad-based diversified index fund like, say, the Vanguard 500. That’s decidedly not a blind trust. Justice X knows what assets she owns.

However, the index fund mostly solves the recusal problem created by ownership of shares in individual firms. In a case between Apple and Samsung, say, Justice X is invested in both parties. In a case that could benefit online retailers at the expense of bricks-and-mortar stores or vice-versa, again, there is no substantial bias because the index fund invests in both.

To be sure, a justice who owns—and knows she owns—shares in an index fund knows that a ruling that broadly favors equity investors over bondholders in some industry or across the board will work to her benefit. But in practice this risk will be mitigated by two factors. First, such cases are very rare by comparison with cases pitting the interests of one firm against another. And second, I omitted from my catalogue of Justice X’s assets what is likely to be a fourth basket: retirement savings.

Supreme Court justices can participate in the Federal Employees Retirement System, which, in addition to some fixed benefits also includes the ability to invest in the federal Thrift Savings Plan (TSP), which works more or less in the same way that a 401(k) plan works for private-sector employees. A federal employee can select and adjust an allocation among equities, government bonds, and corporate bonds. Standard investment advice tells people early in their career to invest heavily in equities but to shift to bonds as retirement approaches because of the risk of market volatility. Accordingly, a typical Supreme Court justice will likely have a substantial position in bonds that counteracts any bias towards stocks created by her index fund holdings (plus the equity component of the TSP). In principle, a justice could shift her allocation to or from equities based on foreknowledge of a ruling, but that would go well beyond having a bias; it would be insider trading.

Accordingly, it seems that Supreme Court justices don’t need blind trusts. They just need to avoid holdings in individual firms. That seems like an easy fix.

Holdings for Executive Officials

What about other government officials? With some exceptions, federal law criminalizes participation by federal officers and employees in decisions that will have a substantial impact on their finances. The risks here differ depending on the nature of the government agency.

An officer or employee of a chiefly regulatory agency would be most likely to encounter a conflict if she owned stock in a particular company that has business before the agency or if the company’s competitors have business before the agency. The Senate appears poised to confirm multiple Trump nominees despite the fact that their background checks and ethics clearances remain incomplete, but confirmation does not eliminate ethical obligations. Trump administration officials would still be subject to criminal liability once in office if they participate in decisions substantially affecting their financial holdings (absent disclosure and a waiver per an exception in the statute). Violations of the law can result in a one-year prison sentence. Willful violations can result in five years in prison.

Employees and officers of the Federal Reserve face the same sorts of potential conflicts with respect to the Fed’s regulatory functions, but they have an additional source of conflict because of the Fed’s role in setting interest rates. I noted above that the Supreme Court will almost never be called upon to make a ruling that will systematically benefit bondholders at the expense of stockholders or vice-versa, but the Fed routinely makes these sorts of judgments. Even without holdings in individual companies, a Fed policy maker could be tempted to make policy that benefits himself due to the particular allocation of his portfolio. The risk is greatly mitigated by the collective nature of the Fed decision-making structure, but even so, prudence here would suggest not just that high-ranking Fed officials hold diversified portfolios but that they hold truly blind ones, in which they do not know allocation percentages.

The President

What about the president? The federal conflict-of-interest statute doesn’t apply to the president. That does not mean, as President-elect Trump claimed in an interview with The New York Times in November, that “the president can’t have a conflict of interest.” It just means that his conflicts of interest don’t violate the statute. There is still the Emoluments Clause. Moreover, as Trump seemed to acknowledge in the same interview, there are sound policy grounds for the president to avoid actual or apparent conflicts of interest. How might he do so?

I have previously explained that despite the personal nature of Trump’s business holdings, he could divest by irrevocably selling the right to license his name, so long as he is willing to forgo what I called the “corruption premium.” Thus far, there is no indication that he is willing to do so, but let’s imagine that he were. To avoid further conflicts would Trump need to put his assets into a blind trust or would a diversified portfolio suffice?

Trump’s super-wealthy status could bear on the answer. Suppose that a president were regular-well-to-do by American standards, say someone like Bernie Sanders, whose retirement savings was recently estimated at $700,000. A President Sanders (who is about to be inaugurated in some other corner of the multiverse) would wisely have his money diversified between stocks and bonds because of the risk of market volatility. Trump is five years younger than Sanders, but even if Trump were older, his portfolio should include more short-term risk because he is super-wealthy.

The stock market lost more than half of its value during the 2008 financial crisis (judged from the October 2007 peak). Such an event could recur and it could take a long time for the market to recover. The difference between retiring on $700,000 and retiring on $350,000 is not exactly the difference between sipping champagne and eating cat food, but it is very substantial.

Given the opacity of Trump’s personal finances, his true net worth is a matter of some debate but it’s probably in the billions. For him, the right investment strategy is quite different from the Sanders strategy. Even if stocks were to lose half of their value over some period of years, that will not affect Trump’s lifestyle in retirement. One can live as gaudy a lifestyle on $2 billion as on $4 billion because of what economists call the diminishing marginal utility of wealth. Unlike the nest egg of a merely well-to-do retiree, which will be drawn down as his retirement progresses, the fortune of a super-rich person will largely be preserved and handed down to the next generation.

If in the very long run stocks are a better investment than bonds, then the super-rich should have a portfolio that is allocated more towards stocks than should the merely well-to-do. Doing so ensures that the heirs of the super-rich receive the largest possible inheritances. (And, if Trump and congressional Republicans have their way, transfers of such estates to those heirs will soon be completely tax-free.)

Accordingly, it’s probably not necessary for Trump, upon selling an irrevocable license to his name, to put his assets in a blind trust. It would be enough to put them in an index fund or the equivalent, because Trump would know that a sensible trustee would be investing his assets mostly in stocks anyway.

By contrast with alternative-universe President Sanders, a President Trump who divested his personal assets would have some incentive to favor policies that are good for stock prices at the expense of bonds, but that’s mostly monetary policy, which is left to the Fed, not the president. Fiscal policy could have some impact on share prices versus interest rates, but only indirectly, and these effects are quite small compared with the gigantic conflicts of interest created by our own actual-universe President-elect Trump’s apparent decision not to divest from his personal businesses.