In most states, trustees of irrevocable trusts are required to comply with the Uniform Prudent Investor Act (UPIA), which is designed to protect trust assets and make them productive. Guardians and conservators may likewise fall under UPIA.
Nationally recognized for our expertise in helping clients comply with the UPIA, we understand that a critical aspect to the UPIA is the concept of investment risk. Section 2(b) of the Model UPIA Act (the original act adopted by most states) says, “a trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust” (emphasis added). Notice that the trustee is responsible for establishing investment risk guidelines for the management of the trust assets. This is one of the biggest differences between trust investing and personal investing. A trustee must monitor and manage the risk of the portfolio.
How is risk of loss in a portfolio managed? The most common measures of risk in the investment industry–”beta” (which measures volatility relative to its benchmark) and “standard deviation” (which is an absolute measure of volatility)–do not necessarily measure the risk of periodic loss. In our experience, a far better measure of risk is semi-standard deviation. The semi-standard deviation ignores all volatility around the mean except that resulting from actual losses. Hence, the larger the semi-standard deviation, the larger the exposure to loss.
Let’s illustrate how that works using the scatter diagram to the left that covers a period from the inception of the Prudent Investor Network (PIN) Conservative Portfolio to the most recent month. The horizontal axis represents risk of loss and the vertical axis represents annualized return. As expected, the yellow dot representing CDs sits on the left margin, meaning there is no risk of loss. Interestingly, look how far right the red dot is on the graph! It shows that the S&P 500 Index had only slightly higher returns than CDs while experiencing high periodic losses. The blue diamond represents the average balanced fund that typically consists of about 60% stock and 40% bonds. By diversifying in both stocks and bonds, the average balanced fund experienced about one-third less risk of loss than the S&P 500 Index, yet enjoyed higher returns. Finally, notice the green dot representing the PIN portfolio, which complied with UPIA’s mandate to monitor and manage the risk of loss. It exposed investors to under half the risk of loss of the S&P 500 Index, while outperforming both the S&P and Average Balanced Fund! Of course, past performance is not a guarantee of future results, there are risks inherent with all investments, and there is no assurance our objectives will be achieved.
We help clients understand and comply with the risk management requirements in the UPIA.
¹ The Citigroup 6-Month Certificate of Deposit index is an unmanaged index of certificates of deposits maturing in six months. Citi reports returns net of expenses. The impact of taxes is not included. It is not possible to invest directly in an index.
² The Standard & Poor’s 500 Index (S&P 500) is an unmanaged broad index of 500 leading U.S. stocks representing the overall market. Calculations assume dividends and capital gains are reinvested and do not include any expenses, including transaction and/or custodial charges, management fees, nor the impact of taxes. Expenses would have the effect of decreasing historical performance results. It is not possible to invest directly in an index.
³ The PIN Conservative Portfolio began November 30, 2001. The charts track the actual results of PIN’s first client in its “Conservative” Portfolio Model from November 30, 2001 through June 30, 2003; from July 1, 2003 to the present, it represents the average performance of all clients in the PIN Conservative Portfolio. PIN’s performance includes dividends and is net of all fees, including management fees. Individual results will vary depending on factors such as date invested and cash added to or withdrawn from the account. It should be noted that past performance does not guarantee of future results. There are risks inherent with all investments and there is no assurance objectives will be achieved.
⁴ The Average Balanced Fund is the average fund of the Morningstar Moderate Allocation Category of mutual funds, commonly known as balanced funds due to their diversification between stocks and bonds (typically in a ratio of roughly 60% stocks to 40% bonds).