Abstract
Trust beneficiaries are best served when trustees select investment portfolio management approaches that enhance (1) the probability of achieving settlor objectives; and (2) beneficiary utility. Investors and fiduciaries would like to know, prior to implementation, the probable consequences of decisions to incur extra costs and taxes by rebalancing the portfolio to maintain investment policy guidelines and asset allocation targets. Two issues, in particular present themselves. Are there rule-of-thumb rebalance strategies that are optimal under all asset management regimes and market conditions; and, do past empirical results constitute a credible basis for making decisions regarding future rebalance elections? If terminal wealth has value because of remainder interest considerations, the trustee will select asset management and rebalance strategies to augment the utility of final dollar values. If, however, the settlor does not have these preferences, any unspent money may merely represent lost consumption opportunities for current beneficiaries. The choice of a rebalancing strategy is a function of beneficiary utility as constrained by the settlor’s guidelines memorialized in the trust instrument. This essay argues that, although rebalance strategy is a critical bridge between asset allocation and trust distribution policy, there appears to be no universally optimal rule of thumb regarding either asset management approaches or the rebalance strategies designed to maintain them.
Portfolio Management Elections: Asset Allocation & Rebalancing Strategies
A commonly used technique for achieving a well-diversified portfolio (i.e., a portfolio with risk/reward characteristics reasonably suitable to the trust) is asset allocation. Asset allocation defines an appropriate opportunity set of investments (i.e., stocks, bonds, cash) and selects the proportion or weighting of each investment within the portfolio. 1 Indeed, a portfolio may be defined as a grouping of assets; and, portfolio management may be defined as the set of tools and techniques used to make assets evolve in such a way that the trust’s economic objectives are reached while respecting beneficiary needs and legitimate expectations under the settlor’s constraints, preferences and guidelines. 2
This essay focuses on one such technique—trustee asset rebalancing strategies. It argues that the future evolution of the trust’s wealth may be greatly affected by the rebalance strategies employed by trustees; and, given the economic consequences of such elections, trustees should use an appropriate degree of care, skill, and caution in selecting and implementing a portfolio rebalancing strategy. Furthermore, the essay suggests that trustees should avoid a priori decisions regarding the optimality of a specific rebalancing strategy. 3
It is difficult to achieve the luxury of a “rule of thumb” for portfolio rebalancing because of (1) the heterogeneity of trust instruments with respect to “…the purposes, terms, distribution requirements, and other circumstances of the trust;” 4 and, (2) the uncertainty of the underlying return generating process of risky investments. Not only might a rebalancing strategy that is optimal for one historical period be disastrous in the next; but also, a rebalance strategy that is optimal for a portfolio with one set of statistical characteristics (means, variances and correlations) may be disastrous for a portfolio with a different set. Likewise, it is perilous to apply rules derived from strategies for managing an asset-class / broadly diversified capital market portfolio (e.g., a portfolio of index funds) to portfolios based on more narrow sector / industry building blocks, or to portfolios based on individual tradable financial assets (stocks, bonds, futures contracts).
The selection of a suitable rebalance strategy takes shape within a legal context in that the tools and techniques suitable for a long term trust—e.g., a dynasty trust lacking specific distributional requirements, may greatly differ from those used to administer a trust required to make periodic cash distributions—e.g., a QTIP trust. The rebalance strategy’s selection and implementation process also takes shape within academic and administrative contexts. Trustees, and advisors to whom they may delegate investment functions, see only the single historical path of realized returns (results), and cannot see the true but unobservable process that generates these results. By analogy, it is as if they see only a sequence of numbers, but have only the vaguest idea that rolls of one or more dice generate the numbers. They must try to fit data to models under conditions of uncertainty regarding the distribution of future returns. Under such conditions, trustees cannot be guarantors of results; 5 but, should enhance the probability of financial success by following an academically sound decision making process. Rebalancing elections are also administrative concerns in that they are one of several tools (including tax management techniques, monitoring frequency elections, performance reporting conventions, etc.) that the trustee considers. Rebalancing elections, however, are critical with respect to assuring continued alignment of the portfolio with the risk and return objectives of the trust. 6 The goal is to develop a suitable and prudent overall asset management strategy that is legally defensible, academically sound, and administratively reasonable.
Approaches to Asset Management: Fixed Mix, Tactical, and Drift
Typically, asset allocation guidelines fall into either a “fixed mix” structure 7 in which the portfolio maintains constant exposures to the risks and returns of the selected asset classes in both bull and bear market conditions; or, into a “tactical allocation” structure in which minimum and maximum levels of exposure are set for each asset class. In the latter case, the expectation is that the trustee will tilt the asset allocation weights according to market conditions, with the magnitude of the tilt conditioned upon his or her market forecasts and upon his or her confidence in the forecast’s accuracy. 8 The fixed mix sets specific asset weighting targets while the tactical allocation structure sets ranges over which asset weightings are allowed to vary. 9
One interesting form of tactical asset allocation that is not based on market prognostications is the “insured portfolio” approach (commonly known as “portfolio insurance”). 10 Portfolio insurance sets a floor below which the investor’s wealth should not penetrate. Commonly, this floor is 20% or 30% below the initial portfolio value. In addition to the floor value, the tactical allocation range sets a ‘multiplier’ value. When the trust’s wealth is above the floor value, the multiplier is applied to the surplus to determine the portfolio’s stock market exposure. For example, a $1 million portfolio may have a floor value of $800 thousand and a multiplier of 4. The surplus is ($1,000,000 - $800,000) or $200,000 x 4 = $800,000. Thus, at time zero, the portfolio is allocated $800 thousand to risky investments (stocks) and $200 thousand to risk free investments (T-Bills). If the portfolio’s value moves up over time (i.e. the surplus increases) the proportion of the portfolio subject to stock market exposure also increases—a bigger cushion allows the trustee to take more risk; if the portfolio value decreases, the multiplier forces the trustee to unwind stock exposure by moving into T-Bills. Under a severe bear market condition (i.e., the portfolio loses 20% of its initial dollar value), the remaining $800 thousand is invested in T-Bills to avoid further loss. The insured portfolio approach is “active” in the sense that it responds to market conditions, but “passive” in the sense that its response is based on actual rather than predicted economic circumstances. Stock price forecasting is not a part of an insured portfolio management system.
Trustees may choose to employ active strategies to generate investment returns (focused, security selection strategies), passive strategies (broadly diversified, market-based returns provided by indexed investment vehicles) or a combination of each. 11 The question of how best to manage the aggregate portfolio is different from the question of how best to generate investment returns. Portfolio management concerns itself with asset management policy over the applicable planning horizon; by contrast, generating period-by-period return concerns itself with security selection and market timing options. 12 Rebalancing policy is, in many ways, a bridge between the two components requiring trustees to think about how changes in investment values affect overall portfolio objectives. 13 Irrespective of the investment options selected to generate returns within each asset class, there remains the question of the management approach for the aggregate portfolio. A passive portfolio management approach is a buy-and-hold or ‘drift’ approach. 14 Although ‘benign neglect’ is not often considered prudent, this approach to trust administration, as will be demonstrated later, may be prudent for certain types of trusts.
An active portfolio management approach can take a variety of forms including tactical asset allocation (tilting the portfolio towards asset classes with higher forecasted returns); rebalancing to the fixed mix targets; or rebalancing according to the portfolio insurance multiplier’s ‘surplus’ leverage factor. At first blush, it seems that fixed-mix rebalancing, portfolio insurance, and tactical asset allocation are first cousins because each requires the trustee (or investment manager) to take active portfolio management steps. However, in practice, tactical asset allocation is a market trend anticipating strategy. By contrast, the portfolio insurance approach to asset management is a trend following strategy. Tactical asset allocation takes a prospective view of the market; portfolio insurance takes a retrospective view of the market; and rebalancing to a fixed mix does not, in general, require a market viewpoint.
1 Restatement Third §227 Comment ‘g’ Risk and the requirement of diversification: “Asset allocation decisions are a fundamental aspect of an investment strategy and a starting point in formulating a plan of diversification. They deal with the categories of investments to be included in a trust portfolio and the portions of the trust estate to be allocated to each. These decisions are subject to adjustment from time to time as changes occur in economic conditions or expectations or in the needs or investments objectives of the trust.”
2 Amenc, Noel & Le Sourd, Veronique, Portfolio Theory and Performance Analysis (Wiley Finance Series, 2003), p. 6.
3Restatement Third §227 Comment ‘h’ Prudent investment: theories and strategies: “…there are endless variations in reasonable strategies for investing and for the prudent management of risk, with a variety of legitimate theories of investment to support and incorporate into these strategies.”
4 Restatement Third §227 General Standard of Prudent Investment.
5 Uniform Prudent Investor Act §8 Comment: “Trustees are not insurers. Not every investment or management decision will turn out in the light of hindsight to have been successful. Hindsight is not the relevant standard.”
6 Fabozzi, Frank J., Focardi, Sergio M. & Kolm, Petter N., Financial Modeling of the Equity Market (Wiley, 2006), p. 88: “After the asset allocation decision (a strategic decision), portfolio rebalancing (a tactical decision) is probably the second most important decision for an investment portfolio.”
7 Also known as “constant mix.”
8 Note that the fixed mix is static but “objective” while the tactical allocation is dynamic but “subjective.” Some commentators believe that it is better to keep the portfolio approach “objective,” and to change the asset allocation guidelines only as a response to changes in the circumstances or financial goals of the investor. The danger of basing portfolio management on “subjective” criteria is an overreaction to transitory market conditions—investing too aggressively following an up market trend (ignoring risk) and investing too conservatively following a down market trend (avoiding risk). The danger of a fixed mix strategy, however, is that it fails to take full advantage of the current information set which may contain variables with predictive content for the investor.
9 The fixed-mix allocation is sometimes termed long-term or ‘strategic’ asset allocation. By contrast, tactical asset allocation is a response to market predictions for the forthcoming period: “Tactical asset allocation (TAA) … involves making short-term adjustments to asset class weights based on short-term predictions of relative performance among asset classes….TAA creates active risk….In exchange for active risk, the manager using TAA expects to earn positive active returns that sufficiently reward the investor for the risk taken.” Pinto, Jerald E., & McLeavey, Dennis, W., “Strategic Asset Allocation Concepts,” CFA Institute, CFA Level III Readings in Portfolio Management, (2005), p.283.
10 Perold, Andre F., & Sharpe, William F., “Dynamic Strategies for Asset Allocation,” Financial Analysts Journal (January-February, 1988), pp. 16-27. The intellectual roots of this strategy can be traced to Fischer Black and others. See, for example, Black, Fischer, “Individual Investment and Consumption under Uncertainty,” Portfolio Insurance, A Guide to Dynamic Hedging, edited by Donald L. Luskin (John Wiley & Sons, 1988), pp. 207-225.
11 Treynor, Jack L. & Black, Fischer “How to Use Security Analysis to Improve Portfolio Selection,” Journal of Business (January, 1973), pp. 66-86. The Treynor/Black article describes prudent methods for blending broadly diversified indexed investments with “active views” on a subset of available securities. Depending on the level of confidence in a manager’s price forecasts (parameter uncertainty regarding alpha), the trustee can mix actively managed and passive (indexed) investment management approaches in various degrees. Unlike the Treynor/Black article, this essay is neutral with respect to the debate over active vs. passive investment approaches. It concerns itself primarily with aggregate portfolio management techniques rather than with the probability that unique investment insights can yield excess alpha in a relatively efficient market for tradable financial assets.
12Restatement Third §227 comment ‘d’ General requirements of care and skill: “the trustee must give reasonably careful consideration to both the formulation and the implementation of an appropriate investment strategy, with investments to be selected and reviewed in a manner reasonably appropriate to that strategy.”
13 It should be noted that a purely “bottom up” security selection approach to generating investment returns may also approximate a passive portfolio management approach. This is because decision making focuses primarily on treasure hunting for good investments rather than on macro issues of aggregate portfolio design. Investments come and go from the portfolio not because they fulfill asset allocation or risk control functions, but merely because they are deemed to be undervalued or overvalued relative to alternatives within the investment opportunity set. Bottom up stock picking is usually considered to be the most active of investing styles because the investment manager is making a series of pure bets; and it is ironic that it entails a measure of passive portfolio drift because of the absence of guidelines. At the limit, a bottom up security selection approach transforms investment policy into a one-dimensional search for attractive investment returns. Success, in such a context, is primarily determined by future investment results. Investment results, unfortunately, are random variables; and unconstrained bottom up security selection may often be a prelude to fiduciary surcharge action. This is why, for example, the American College of Trust and Estate Counsel’s “Guide for ACTEC Fellows Serving as Trustees [ ACTEC Notes (Vol. 26, 2001), pp. 313-327] states: “it is generally not recommended that a stockbroker be selected as a delegated agent under the UPIA” [Uniform Prudent Investor Act]. See, also, Collins, Patrick J., “The Lawyer as Trustee: Working with Brokers, Investment Advisors & Financial Planners.” Maryland Bar Journal (September, 2002).
14 Alternately, this approach is termed a ‘benign neglect’ or a ‘let-it-run’ approach. A seminal article written by Robert Kirby in 1984 discusses a passive portfolio approach known as a “coffee can” portfolio. Initially, specific stocks are actively selected based on the investor’s determination of a company’s long-term prospects. However, once the selection has occurred, the stock certificates are put into a “coffee-can” which is placed out of sight for a lengthy period of time. Kirby speculates that active investment management is unlikely to add value once the portfolio is implemented. The investor either has the ability to select stocks for the long haul, or he doesn’t. If such ability is present, then why incur trading costs by buying and selling during the interim periods? Kirby, Robert G. “The Coffee Can Portfolio,” The Journal of Portfolio Management (Fall, 1984), pp. 76-80.
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