Steven Smith: Trust Portfolios: Part 3 |

Steven Smith: Trust Portfolios: Part 3

Steven SmithStocks
By Steven SmithStocks

Last month, we began examining how the Uniform Prudent Investor Act (UPIA) impacts a typical trust. To appreciate the trustees decision-making processes, we must recognize that the UPIA to which they are legally obligated is deeply informed by modern portfolio theory (MPT). For example, the act requires proper diversification as described by MPT. Today, well explore other factors we havent yet considered.Risk and return MPT states that potential returns are tied to risk. Guided by that principal, trustees must balance the beneficiaries collective requirements for returns with their overall tolerance for risk including their varying time frames for using trust proceeds. To complicate this requirement, the UPIA specifies risk/return balance as a non-delegable duty that must be undertaken by the trustees although a qualified consultant may provide guidance. (In general, the UPIA encourages delegation to prudent experts.)For example, withdrawal portfolios must minimize volatility because of their difficulty in recovering from bear markets. Yet, real growth requires exposure to volatility (risk) suggesting at least a 60 percent allocation to riskier assets for long-term portfolios. The trustees must balance the needs of those beneficiaries who are withdrawing against those with a long-time horizon.Asset allocationMPT also assumes that asset allocation particularly the ratio of risky assets to less risky assets is the primary determinant of returns. Experts disagree about how big a role asset allocation plays in performance compared to stock picking and market timing. But because MPT is incorporated into the UPIA, trust investors must accept this proposition.In designing the allocation policy, the trustees must consider the historical returns and risk of the major asset classes. Next, they should assign fixed percentages to each class and periodically rebalance to maintain the policy until a change in beneficiaries needs dictates a new allocation.DiversificationMPT distinguishes between systematic and unsystematic risk. Systematic, or market, risk results from macro phenomena: business cycles, geopolitical events and inflation. Unsystematic risk is particular to an individual firm or industry. Sufficient diversification virtually eliminates unsystematic risk, leaving primarily systematic risk.Traditionally, a diversified portfolio held 20 to 35 carefully selected securities. Recent research demonstrates, however, that true diversification requires hundreds or thousands of securities: efficient and systematic exposure to a comprehensive range of major and sub asset classes, capturing returns from all markets.Since the UPIA literally places no restrictions on what a portfolio may hold, trustees or their managers can employ any appropriate vehicle to carry out investment policy. That means our trustees should consider international stocks, as well as value and small cap stocks, which, research shows, tend to outperform the market throughout longer time horizons.InflationA trust can serve multiple generations of beneficiaries during a long period of time. Accordingly, use of both capital appreciation and income vehicles must take into account the effects of inflation on future purchasing power.Total returnTrust law distinguishes between capital gains and income. Sales profits cannot be paid to income beneficiaries except as discretionary principal payments. But MPT recognizes no such distinction growth is growth.The UPIAs companion law, the Uniform Principal and Income Act, allows total return thinking. Statutory guidelines permit trustees to treat principal as income and vice-versa. And trustees may convert to a total return trust eliminating the distinction between principal and income and paying out fixed percentages of the trusts value to income beneficiaries.Efficient MarketsLegally, trustees may employ either active or passive strategies. However, in embracing the efficient market hypothesis (beating the market is difficult, if not impossible) the UPIA strongly encourages anchoring portfolios with passive vehicles, such as index funds. And indexing, being substantially less expensive than active management, goes a long way toward fulfilling the trustees cost-control requirement.Steven R. Smith, JD, CFP is the principal of RightPath Investments & Financial Planning, Inc. a fee-only Registered Investment Advisory firm in Frisco. If you have any questions or comments, contact Steve at (970) 668-5525 or (Specific investments or resources mentioned are illustrations only and are not recommendations. Past performance does not guarantee future results.)

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