Highlights:

  • Trustees who manage investment portfolios are held to high standards.
  • Trustees must adhere to the principles of modern portfolio theory or risk being surcharged for unprofitable investments.
  • Trustees who prudently delegate investment responsibilities are not liable for the actions of the trust investment advisor.

“Trusting you is my decision.  Proving me right is your choice.”

– Prakhar Sahay

I used to do a good deal of public speaking.  More recently, however, I have not been able to find the time to do so.  That changed this past week, when I was honored to speak to The Milwaukee Estate Planning Forum.  The subject of my presentation was the expertise and higher standard of care required when managing investments that are held in the name of a trust. 

Once reserved for the wealthy, trusts have also become a common-place component of estate plans for a broader demographic of individuals and couples. The increased popularity of trusts is well deserved.  The establishment of a trust can (i) simplify the management and investment of assets during life, (ii) help avoid the time and expense associated with court-administered probate upon death, and (iii) protect the assets we leave to our loved ones from creditors, ex-spouses, as well as their own poor decisions.  

One of the most difficult aspects of establishing a trust is to decide who will succeed you as trustee after your death or in the event of a disability that keeps you from serving as the trustee.  A trust company can be an excellent choice, but not always.  Some trust companies require large account balances, impose restrictions on what types of assets the trust can own and, in some cases, charge prohibitively high fees. 

A second common option is to name a professional advisor, such as an attorney, accountant or a financial advisor as the successor trustee.  At the same time, many advisors are understandably reluctant to take on this responsibility for a variety of reasons.  Employers often prohibit advisors from serving as a trustee.  An advisor who serves as a trustee has to be very careful to avoid conflicts of interests.  (Attorneys who draft trust agreements naming the attorney as the trustee need to be especially cautious in this regard.)  Financial advisors that serve as a trustee of a trust-client must comply with the SEC’s “Custody Rule,” which can be expensive and time consuming.

A third choice is to name a descendant, trusted family member or friend as the successor trustee.  This option can make sense if the individual chosen will be the sole beneficiary of the trust, and can be counted on to administer and distribute the trust wisely.  If not, an alternative choice for trustee is advisable.

Finding a person who has the wisdom to decide when trust assets should be distributed to a beneficiary, and is also qualified to manage the trust investments, can be difficult.  As I discussed in an earlier blog post, trust law imposes a high standard on trustees who manage investment portfolios.

The degree of expertise required to comply with those standards is often underappreciated.  Under the laws of virtually every state, trustees are directed to manage trust portfolios in a manner that is consistent with Modern Portfolio Theory (“MPT”). 

The groundwork for MPT was introduced in 1952 by Nobel Laureate Harry Markowitz.  MPT is based on the premise that (i) the stock market is efficient, (ii) investors are rational, and (iii) rational investors will seek the highest return possible for a given level of risk.  MPT eschews focusing on the risk and return outlook of investments individually and instead favors developing integrated portfolios of diversified investments that maximize total expected return for a given level of risk.

The principles that underlie MPT aren’t universally accepted.  Behavioral economists have asserted that investors often act irrationally, and that MPT underestimates the major impact that human behavior and biases can have on market behavior.  Other researchers have suggested that the stock market is not perfectly efficient.  Rather it appears that there are certain risk factors that can drive above-market returns, and that some market sectors are more effective at capturing those factors than others.

MPT has evolved in response to this research.  Today, a more advanced version of MPT is available, informed by insights developed on several fronts, including tactical asset allocation (“TAA”) and so-called smart beta, which utilize quantitative models founded in academics, statistics, and historical evidence to direct how portfolio investments are allocated.  

TAA, for example, is a rules-based investment approach that attempts to tactically adapt investment portfolios to reflect changes in economic and market conditions.  You can learn about The Milwaukee Company’s Tactical Asset Allocation strategies HERE.

Most individuals and even some corporate trustees do not possess the investment acumen that is required by current law to manage trust portfolios.  As a result, unqualified trustees run the risk of being surcharged if the trust’s investments perform poorly.  Accordingly, for many trustees it is more prudent to delegate the responsibility for portfolio management to a professional investment advisor whose management style is consistent with the principles of modern trust law.

Fortunately, unlike the common law, modern trust law supports a trustee’s decision to delegate investment responsibility to a trust investment advisor.  Further, in most cases the trustee will not be liable for the investment decisions of the trust investment advisor — provided the trustee exercises reasonable care, skill, and caution in (i) selecting the advisor, (ii) establishing the scope and terms of the advisor’s engagement, and (iii) periodically reviewing the agent’s performance.  Trustees who delegate investment responsibility should also require the management agreement provide that the trust’s investments will be managed in accord with MPT.

Thank you for reading. 

Mr. Market Commentator

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