Changes in prudent investor standards in the 1990s freed trustees to delegate investment functions to investment advisors and investment managers. Recently, the market has been uncertain, leaving trustees without clear-cut investment opportunities. There is now a greater focus on how one invests rather than what is the “best” investment or asset class. The result: These days, many trustees and their investment advisors see themselves less as stock pickers and more as overseers who hire and manage professional investment managers who do the actual investing.
Professional investment managers are better able to keep an ear close to the ground. Their staff visit companies regularly and speak with executives, digging deep into a company's affairs to understand where that company is, where it's going and what its financial condition truly is. Taking such a close look is an important precaution against investing in companies with accounting abnormalities. Investment managers also often offer sound portfolio construction and risk-management techniques.
The job of the trustee, then, is to manage the process of prudent investing. First, trustees identify the goals and objectives of a particular trust and its beneficiaries.1 For instance, for a charitable remainder unitrust from which the client wants a steady stream of income that will grow over a life expectancy of 20 years, the trustee must assure that there is sufficient liquidity to meet income payments, while investing for growth.
Then, with the help of an investment advisor, the trustee formulates an investment strategy or policy and asset allocation model, unique to the trust. The investment advisor helps determine the appropriate asset allocation model and risk tolerance based on the trust's objectives. The investment policy should be put in writing and clearly state the aims and guidelines for the trust portfolio; it also should document the trustee's diligence in choosing the appropriate asset allocation model and clarify special considerations (for example, no investments in the tobacco industry, or the fixed income portion of the portfolio contains only high-grade bonds).
An investment strategy should provide for the proper risk/return profile, liquidity and tax results. Too often, trustees don't have a focused approach to investing. They unwisely retain specific investments for sentimental reasons or because they lack confidence in or understanding of other investments. It is not uncommon for families to try to dictate to independent or family member trustees that a high concentration of stock in a particular company be retained because the grantor acquired his wealth through the company's success or it was simply a favorite of the grantor.
The third step: Together, the trustee and investment advisor (who helps devise the overall strategy and asset allocation model) select one or more investment managers. In meeting this obligation, the trustee must exercise, as the Restatement (Third) of Trusts says, “the required degree of care, skill, or caution.”2 Translated into practice that means the trustee should ensure each investment manager's strategy is consistent with a trust's investment plan. The investment managers should receive a copy of the investment policy so that they understand their mandate and where the manager fits in with the other trust investments. For example, certain hedge funds and private equity funds can cause significant tax consequences because they generate unrelated business taxable income (UBTI) under Internal Revenue Code Section 512. A charitable remainder trust can lose its tax-exempt status in a year in which it receives UBTI or a non-grantor charitable lead trust can have its income tax deductions reduced by the amount of the UBTI. Some hedge funds and private equity funds are specifically designed to avoid UBTI. There may be other situations in which a private equity fund may require capital calls. The owner/investor of the fund is required to make additional payments for a period of time, or may receive “phantom income” (taxable income with no distributions). These situations may be contrary to the trust's objectives. The inability to meet capital calls can create substantial investment penalties or may create liquidity problems to meet discretionary or mandatory distributions. The imposition of phantom income (in a non-grantor trust) also may create liquidity problems.
Lastly, the trustee should closely monitor the investment manager's decisions and strategies to determine if they remain sound and consistent.
Managers often concentrate on specific asset classes (such as growth or value equities of small-, mid- and large-cap categories), sectors (either by business or region), emerging markets, international equities, fixed income (both taxable and non-taxable) or alternative investments (including private equities and hedge funds). The asset allocation model devised for a particular trust may require a manager for each asset class. If so, the managers' different methods should not significantly overlap or work against one another. The individual holdings of each manager may be either substantially the same or so highly correlated to one another that the portfolio is not as diversified as the trustee intends. Generally, the size of the portfolio (for example, over $50 million) dictates whether two or more managers for each asset class are needed.
These days, there are about 24,000 registered investment managers worldwide.3 How does a trustee select a manager with an approach and philosophy suited for a trust, or determine the percentage of trust assets to place with that manager? Using both qualitative and quantitative factors, trustees can identify managers who are capable of maintaining superior levels of risk-adjusted returns — sufficient return to justify the cost and degree of risk taken by the manager4 over market cycles. These factors, five “Ps,” offer some guidance:
Philosophy: A manager's investment philosophy must be compatible with the trust's objectives, concerns and risk tolerance; he also should have the ability to construct a portfolio consistent with that philosophy. For example, a manager may conservatively invest in specific large-cap companies that pay out higher than average dividends. This approach may be well-suited for a particular trust because it tends to have moderate risk and growth with tax-favored qualified dividend income.
Process: A manager has in place an effective and ethical process to implement his investment philosophy, including day-to-day investment procedures and an experienced and knowledgeable team with a history of working together successfully. Criteria for evaluating empirical research and determining the competency of research analysts should be an integral part of his process. One way to measure the value added by the analyst's research would be to set, for each analyst, performance benchmarks that can be assessed over time.
Portfolio Construction: The construction of a client portfolio, both its strategies and concentration, should follow sound risk management practices and generate positive results when risk is taken. A manager with the ability to realize returns and limit downside risk is particularly important for trustees whose major consideration is the preservation of trust principal.
Performance: A manager should be able to identify performance weaknesses and correct them, as well as show a consistency of returns over time relative to the accepted benchmarks, that is to say, target return based on risk tolerance. For example, a manager invests against a certain benchmark, such as S&P 500 index. His skill as a manager is reflected, in part, by his ability to produce greater returns, in excess of his management fees, at reduced risk. Otherwise, investors can choose to go with index funds instead. Also, a manager should be consistent in his philosophy and invest according to his stated time horizon. He does not engage in “style drift” to compensate for short-term market conditions and show immediate favorable performance. Certain asset classes out perform others at specific times. A manager should invest in those assets that are consistent with his philosophy and not invest for short-term results to “beef up” his current performance results for marketing or sales purposes.
People: Accomplished managers have a passion for their work. How to gauge that passion? By seeing they take the extra time and steps to increase the likelihood of a portfolio's success. For instance, a manager and his staff meet regularly with corporate executives to properly gauge their competency, business plan and integrity. Staff visit to observe the day-to-day activities of a business and its employees.
It's critical for the trustee and investment advisor to monitor both the portfolio and investment managers. One way of administering on-going risk and maintaining superior risk-adjusted returns is by reviewing asset reallocation, performance and changes in a manager's approach. The trustee should set a baseline for the return of the entire portfolio, as well as its subcomponent individual manager portfolios, against the trust's goals. Failure to maintain standards, unreliable investment strategies, or a modification in a trust's circumstances or objectives may be a reason to change managers. For instance, there are changes in circumstances such as when an annuity term ends for a grantor retained annuity trust or a charitable lead annuity trust and the property is held in further trust for the children where annuity payout requirements no longer exist. Also, there may be an increase or decrease in income needs for a spouse/beneficiary of a qualified terminable interest property (QTIP) trust. These changes may necessitate replacing a manager.
While the Prudent Investor Rule clearly states that the delegation of investment duties may be appropriate, it likewise notes that a trustee (with professional advice, if necessary) must define the trust's objectives and formulate or approve of investment strategies.5 This should reduce the likelihood that investment performance will fall below expectations and ensure that market conditions rather than a lack of prudence or diligence determine results.
In the mid- to late nineties, investors routinely expected double-digit returns. During the last few years, these assumptions have given way to more modest goals. Managing beneficiaries' expectations can be challenging and the failure to do so can lead to disputes. Beneficiaries will have difficulty prevailing in their challenges, though, if trustees act with care and diligence by laying out trust objectives, devising sound investment policies and allocation models, and hiring and monitoring investment managers to implement the strategies. Unfavorable market conditions may cause performance levels to drop below beneficiaries' expectations, but trustees should be able to support their actions by developing a sensible investment policy and implementing it properly.6
The author thanks Jeffrey Frederick of the U.S. Investment Solutions Group at The Citigroup Private Bank for his help with this article.
- Restatement (Third) of Trusts, Section 227, Comment j. Duty with respect to delegation. “With professional advice as needed, the trustee personally must define the trust's investment objectives. The trustee must also make the decisions that establish the trust's investment strategies and programs, at least to the extent of approving plans developed by agents or advisers.”
- Ibid. Also, Section 171 of the Restatement suggests that there may be a breach of fiduciary duty if a trustee fails to delegate. “A trustee's discretionary authority in the matter of delegation may be abused by imprudent failure to delegate as well as by making an imprudent decision to delegate. Abuse of discretion may also be found in failure to exercise prudence in the degree or manner of delegation. Prudence thus requires the exercise of care, skill, and caution in the selection of agents and in negotiating and establishing the terms of delegation. Significant terms of a delegation include those involving the compensation of the agent, the duration and conditions of the delegation, and arrangements for monitoring or supervising the activities of agents.” Restatement of Trusts (Third), Section 171, General Comment a. Fiduciary duty and discretion.
- U.S. Securities and Exchange Commission and North American Securities Administrators Association.
- Restatement (Third) of Trusts, Section 227 f. (1)
- Restatement (Third) of Trusts, Section 171, Comment h. Power to make investments.
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