Statutory Consideration: Section 2(c)(5) of the Uniform Prudent Investor Act directs, “A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.” In response to this duty, a prudent trustee will adopt a policy
Diversification Overview: “There is no simple rule for identifying how much diversification is enough. The 1992 Restatement says: ‘Significant diversification advantages can be achieved with a small number of well-selected securities representing different industries [though] broader diversification is usually to be preferred in trust investing.’… Modern portfolio theory divides risk into the categories of ‘compensated’ and ‘uncompensated’ risk.”(Uniform Prudent Investor Act, Section 3 Comments) Diversification through the number of securities held and the variety of industry sectors and asset classes within the portfolio reduces the overall risk of the portfolio because asset price movements are not uniform. An event that would negatively affect one portfolio holding may have little to no effect on (and could potentially enhance) the performance of others. A prudent investor will take steps to diversify the trust assets, so that “uncompensated” risk is minimized or eliminated.
Security Level Diversification: A generally accepted rule of thumb suggests that any security representing greater than 5.0% of the portfolio should be evaluated to determine what level of “firm-specific” or counterparty risk might exist. (Obviously when pooled investment products are being used, like Mutual Funds or Exchange Traded Funds (ETFs), this 5.0% rule of thumb would not apply because these pooled products are themselves diversified.)
Sector Level Diversification: Besides reducing the risk associated with individual securities, a prudent trustee will also diversify amongst the industry sectors of the stocks represented. The sector allocation of the broad market can be used as a benchmark, but each investment advisor will have their own rationale for over or under-allocating capital to these sectors. An annual review of the portfolio holdings against the largest 5 economic sectors can be done to determine if further explanation from the advisor is warranted. It is NOT the case that the trustee should legislate the high and low allocations to these sectors. That is the job of the advisor. It is the trustee’s responsibility to note areas of material deviation and seek explanation from the advisor when a marked departure from “the market” is found.
Asset Class Level Diversification: A prudent trustee will further diversify amongst asset classes. There is general agreement within the investment industrial complex of the major asset classes to be included in a diversified portfolio. An annual confirmation from the advisor that they reaffirm the asset allocation of the portfolio is appropriate and expected for the targeted return and it will serve to fulfill this level of the diversification inquiry.
Compliance Library: A prudent trustee will develop a record that demonstrates they have reviewed the liquid assets held within the portfolio to confirm that there is a reasonable level of diversification at the (1) security level, (2) sector level, and (3) asset class level.
Josh Yager, Esq., CFP®, ChFC®
Anodos helps individual trustees save time, reduce their personal risk, and fulfill their fiduciary duties. We do this by helping trustees develop and maintain a series of governance documents which demonstrates they have fulfilled each of their duties of care. We also will act as an expert witness to defend our clients’ findings in court. What makes us unique is that trustee governance support is all we do. We do not manage money, sell insurance, or accept referral fees. We don't have a horse in the race.
We help trustees save time, reduce risk, and fulfill their fiduciary duties. What makes us unique is that trustee governance support is all we do.