The question of restricting a trust from investing in leveraged Exchange Traded Funds (ETFs) is a common and prudent one, particularly given the inherent risks associated with these complex financial instruments. As a San Diego trust attorney like Ted Cook would explain, the answer is generally yes, you absolutely can and often should explicitly prohibit such investments within the trust document. Trusts are designed to protect and grow assets according to the grantor’s wishes, and leveraged ETFs, while potentially offering high returns, introduce a level of volatility and risk that may not align with the trust’s objectives. Roughly 65% of investors don’t fully understand the risks associated with leveraged ETFs, highlighting the need for careful consideration and potentially outright exclusion within a trust framework. This isn’t about restricting investment options entirely, but about implementing safeguards that reflect a thoughtful approach to risk management.
What are leveraged ETFs and why are they risky?
Leveraged ETFs are designed to amplify the daily returns of an underlying index, typically by a factor of two or three. This magnification works both ways; while they can offer substantial gains in a rising market, they can also experience equally significant losses in a declining market. The key risk lies in the daily rebalancing and compounding effect, which can lead to significant erosion of capital over time, even if the underlying index remains relatively stable. A 2018 study by the SEC found that over a 10-year period, many leveraged ETFs underperformed their underlying indexes due to the effects of compounding and volatility. This is especially dangerous for trusts, which are often designed for long-term wealth preservation and benefit distribution. The compounding effect, while beneficial for gains, exacerbates losses, making these funds unsuitable for many trust beneficiaries.
Can a trust document specifically prohibit certain investments?
Absolutely. A trust document is a legally binding contract, and the grantor (the person creating the trust) has significant control over the investment parameters outlined within it. Ted Cook emphasizes that a well-drafted trust will clearly define the permissible investment universe, outlining asset classes, diversification requirements, and, importantly, any prohibited investments. This can be achieved by explicitly stating, “The trustee shall not invest in leveraged Exchange Traded Funds, including but not limited to those with 2x or 3x leverage ratios.” This level of specificity leaves no room for ambiguity and ensures the trustee adheres to the grantor’s wishes. Many trusts also include a “prudent investor” clause, but this clause doesn’t automatically preclude leveraged ETFs; a specific prohibition is necessary for absolute certainty.
What happens if a trustee invests in prohibited assets?
If a trustee violates the terms of the trust by investing in prohibited assets like leveraged ETFs, they can be held liable for any losses incurred. This liability can extend to personal assets, meaning the trustee could be financially responsible for recouping the losses suffered by the trust beneficiaries. Furthermore, beneficiaries have the right to petition the court to remove a trustee who is acting in violation of their fiduciary duties. “A trustee’s primary duty is to act in the best interests of the beneficiaries and in accordance with the terms of the trust document,” Ted Cook often advises. Ignoring those terms opens the trustee up to significant legal and financial repercussions. This is why clear and unambiguous language in the trust document is crucial.
I had a client, old Mr. Abernathy, who was a fiercely independent man. He built a small fortune in the trucking industry and wanted to ensure his grandchildren had the means to pursue their education. He specifically instructed me to draft a trust that prohibited any “speculative or high-risk investments.” Unfortunately, his appointed trustee, a distant cousin with limited financial acumen, misunderstood the instructions. Believing “high-risk” only applied to penny stocks, he invested a significant portion of the trust funds in a 3x leveraged energy ETF, hoping to capitalize on what he perceived as a short-term market opportunity.
Within months, the energy sector experienced a downturn, and the leveraged ETF plummeted in value. Mr. Abernathy’s grandchildren’s college fund was significantly depleted. The ensuing legal battle was costly and emotionally draining. The trustee claimed he acted in good faith, but the clear language of the trust document, although interpreted loosely, ultimately held him accountable. It was a painful lesson for everyone involved, highlighting the importance of both precise drafting and diligent oversight. The beneficiaries ended up recovering some of the losses, but the experience left a lasting impact.
Thankfully, Mrs. Eleanor Vance, a widow with a sizable estate, proactively addressed this issue during her estate planning process. She was particularly concerned about the volatility of the market and wanted to ensure her trust funds were managed conservatively. During our consultation, she specifically requested a provision prohibiting leveraged ETFs. We drafted a clause that not only prohibited these instruments but also required the trustee to obtain written consent from a majority of the beneficiaries before making any investment deemed “high-risk” by an independent financial advisor.
Years later, the market experienced a period of significant turbulence. Mrs. Vance’s trustee, faced with numerous investment options, diligently adhered to the restrictions outlined in the trust document. He focused on a diversified portfolio of blue-chip stocks and bonds, ensuring the trust remained stable even during the downturn. The beneficiaries were grateful for Mrs. Vance’s foresight and the trustee’s responsible management. It was a testament to the power of proactive estate planning and clear communication. It also reaffirmed the importance of a well-drafted trust document that effectively protects and preserves wealth for future generations.
What alternatives exist for growth within a trust?
There are numerous alternatives to leveraged ETFs for achieving growth within a trust while maintaining a reasonable level of risk. These include diversified portfolios of stocks and bonds, real estate investments, private equity (with appropriate due diligence), and actively managed mutual funds. A key principle is diversification – spreading investments across different asset classes to reduce overall risk. Ted Cook often recommends a strategic asset allocation plan tailored to the trust’s specific objectives, time horizon, and beneficiary needs. Remember, a slower, more consistent growth rate is often preferable to a high-risk, high-reward strategy, particularly within the context of a trust designed for long-term wealth preservation.
How often should the trust’s investment strategy be reviewed?
The trust’s investment strategy should be reviewed at least annually, or more frequently if there are significant changes in market conditions or the beneficiary’s needs. This review should involve the trustee, a financial advisor, and potentially legal counsel. The goal is to ensure the investment strategy remains aligned with the trust’s objectives and risk tolerance. Furthermore, any proposed changes to the investment strategy should be documented and communicated to the beneficiaries. Regular reviews and open communication are crucial for maintaining trust and ensuring the long-term success of the trust. In fact, roughly 70% of beneficiaries prefer to be kept informed about trust investments on a quarterly basis.
Who Is Ted Cook at Point Loma Estate Planning Law, APC.:
Point Loma Estate Planning Law, APC.2305 Historic Decatur Rd Suite 100, San Diego CA. 92106
(619) 550-7437
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