Customizing a Trust to Reflect Your Own Investment Philosophy

One of the most fascinating aspects of my practice is working with clients who expose me to so many different case studies of how wealth is grown, maintained, or dissipated. What I’ve seen demonstrates that different investment approaches, over time, carry dramatically different potential and risks, and produce substantially different results.

Along those lines, this week I enjoyed a long lunch with a close friend who works in the high net worth department of a local trust company.  The conversation turned to how he invests his own money.  Surprisingly, his personal account departs markedly from conventional asset allocation wisdom one often sees expressed in ETF-based “Mini-Swensen” portfolios.  Instead, he owns positions about fifteen individual securities.  He succinctly observed that wealth is built through concentrated positions, and only preserved through broad-based allocations.

Similarly, it called to mind an article I’d read earlier this week by James Ledbetter in The New Yorker, “Is Passive Investing Hurting the Economy?”  Ledbetter’s article discussed a recent paper published by the Olin Business School at the University of Washington in St. Louis. The basic idea was that as passive investing in capitalization-weighted indices increases, price signals corrode, and this creates negative externalities in the real economy.

It started me wondering whether too much passive, low-cost, diversified investing might be a bad thing.  Does this approach guarantee mediocrity?  These questions are delightful wormholes that reward closer consideration – but not today!

What we should consider carefully today is that when a person establishes a trust, they’re opting in to a set of default rules about how those trust assets will be invested.  Sometimes, those default rules are likely to work tolerably well.  Other times, however, they’re a severe mismatch with the person’s goals for the trust.

Let’s play this out, shall we?

Kentucky’s law regarding trust investments requires trustees to act as “prudent investors.”  What does this mean? You’ll find the answer in a statute blandly titled “Standards for bank or trust company acting as fiduciary.”

In relevant part, this statute requires a trustee:

• To act “as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances” of the trust
• To exercise reasonable care, skill, and caution – in context of the account portfolio and as part of an overall investment strategy, which should incorporate risk and return objectives reasonably suitable for the trust
• To diversify the investments of the account unless, under the circumstances, it is prudent not to do so

Nonetheless, the statute also provides that the trustee’s duties as a prudent investor are subject to the rule that in investing trust funds, the trustee has the power expressly or impliedly granted by the terms of the account, and has a duty to the beneficiaries to conform to the terms of the trust agreement directing or restricting investments by the trust company.

It’s worthwhile to unpack these provisions very carefully if you are a person creating a trust to accomplish particular purposes, because they set the default rules about how a trustee will invest trust assets if you don’t provide otherwise.

If you don’t provide otherwise, the trustee is going to act cautiously and diversify the trust investments. If you have strong investment convictions, or if you want the trust to accomplish certain purposes, this may be a problem for you.

For instance, what if you became very wealthy holding a concentrated position?

If so, it’s rather likely that the position will have large embedded capital gains.  If you want the trustee to prioritize capital gains reduction over reducing its own potential liability for holding the concentrated position, you should state so clearly in the trust agreement.

Your concentrated position might be so large that it gives you and your descendants an influential (or even controlling) voice in the company’s governance, management, and dividend policy.  If you want the corporate governance potential of that concentrated position preserved (or expressed in a particular manner), you should likewise make clear provisions for that in the trust agreement.

What if you believe that certain asset classes at certain times (e.g., long-term government debt) are hazardous for long-term wealth preservation at particular times (for instance, in the US from the 1950s through the early 1980s)?

If so, then you’d want to provide careful instructions for the trust’s fixed income investment policy.

What if you believe that certain asset classes aren’t socially responsible (as you define “social responsibility”)?

If so, you’d want to specify which asset classes (e.g., defense contractors, tobacco companies) you want excluded from the trust’s portfolio.

What if the trust’s primary purpose is to preserve a minimum source of financial reserves for a surviving child or sibling, but otherwise, grow purchasing power for grandchildren, nieces, or nephews?

In that instance, expressly authorizing concentrated positions for a portion of the trust’s portfolio might make sense.

As you can see, there is a very broad array of instances when the objectives for a trust and its settlor aren’t well served by the statutory default rules for trust investing.

With thoughtful, customized drafting, however, you can opt out of these rather bland, “down the middle of the fairway” default rules, and instead use the trust to carry out your investment philosophy when you’re not there to do it yourself.

Because trustees tend to be even more allergic to their own liability than they are to investment risk, I believe the pragmatic way to incorporate your own investment philosophy into a trust agreement is to provide for an advisory committee to the trustee.

The advisory committee would be authorized to direct the trustee on matters of asset allocation, security selection, and other investment decisions – and, critically, the trustee would be released from any and all liability for acting at the direction of the advisory committee.  Then, the trust agreement would provide clear instructions to the advisory committee customized to reflect the settlor’s investment philosophy and objectives.

This approach makes sense even if, initially, the trustee and the sole investment advisor are the same person, because in the future, a replacement or successor trustee might require directions from the advisory committee.