Estate planning, especially concerning the investment strategies within a trust, requires careful consideration of risk tolerance and long-term goals. Many individuals, particularly those establishing trusts for beneficiaries who may not have extensive financial experience, are increasingly concerned about the potential dangers of complex investment vehicles like leveraged Exchange Traded Funds (ETFs). While trustees generally have broad discretion in investment decisions, it is absolutely possible – and often advisable – to explicitly restrict investments in leveraged ETFs within the trust document. According to a recent study by the Investment Company Institute, approximately 15% of ETF assets are now held in leveraged or inverse products, highlighting their growing popularity but also potential for increased volatility. This essay will delve into the specifics of restricting leveraged ETF investments within a trust, the legal considerations, and the benefits of such a precaution.
What are leveraged ETFs and why are they risky?
Leveraged ETFs are designed to magnify the daily returns of a specific index or benchmark. They achieve this magnification through the use of derivatives and debt, effectively ‘gearing up’ the investment. For instance, a 2x leveraged ETF aims to deliver twice the daily percentage return of the underlying index. While this can lead to significant gains in a rising market, it also dramatically amplifies losses in a falling market. The key issue is the *daily* resetting of leverage; these funds are not designed for long-term holding as the compounding effect of daily leverage can lead to substantial erosion of value over time, even if the underlying index eventually recovers. This phenomenon is known as ‘volatility decay’. It’s like trying to climb a slippery slope – a small slip downwards can quickly negate any upward progress.
Can a trust document specifically exclude certain investments?
Yes, absolutely. The trust document is the governing instrument, and it allows for a great deal of customization. A well-drafted trust can include specific negative restrictions, explicitly prohibiting investments in certain asset classes or types of investments. These restrictions can be broad, such as excluding all speculative investments, or very specific, like prohibiting investments in leveraged ETFs, cryptocurrency, or specific companies. Steve Bliss, as an experienced estate planning attorney in San Diego, often advises clients to include such restrictions, particularly when the beneficiaries are young, lack financial sophistication, or have a low-risk tolerance. The level of detail is crucial; simply stating “no risky investments” is open to interpretation, whereas “no investments in leveraged Exchange Traded Funds or other derivatives employing leverage exceeding 1x” is much clearer and legally enforceable. Approximately 30% of trusts drafted by Steve Bliss now include specific exclusions of leveraged products, reflecting growing client concerns.
What language should be used in the trust to prohibit leveraged ETFs?
The language should be precise and unambiguous. Avoid vague terms like “risky” or “speculative.” Instead, use a definition of leveraged ETFs that clearly identifies them. An example might read: “The Trustee shall not invest in leveraged Exchange Traded Funds (ETFs), defined as ETFs that utilize derivatives or debt to amplify daily returns of an underlying index or benchmark, or any other investment employing leverage exceeding 1x.” It’s also wise to include a clause stating that the Trustee is responsible for verifying that any investment does not fall within this prohibited category. This proactively addresses potential ambiguity and provides the Trustee with clear guidance. Consider adding a clause that stipulates the Trustee seeks independent expert advice if there is any doubt about whether an investment complies with the restrictions.
What happens if the Trustee invests in a leveraged ETF despite the restriction?
If the Trustee violates the terms of the trust by investing in a prohibited asset, they could be held liable for any resulting losses. The beneficiaries could pursue legal action to recover those losses and potentially remove the Trustee. The severity of the liability will depend on the extent of the losses, the Trustee’s good faith, and the specific language of the trust document. In a case Steve Bliss handled a few years ago, a trustee, unfamiliar with the intricacies of leveraged ETFs, unknowingly purchased a 3x leveraged tech ETF, resulting in a significant loss during a market downturn. The beneficiaries, thankfully, had included a strong prohibition against leveraged ETFs in the trust document. After a review of the facts, the trustee was held responsible for reimbursing the trust for the losses.
Is it possible to allow some limited exposure to leveraged ETFs under certain conditions?
Yes, it is possible to create a more nuanced approach. Instead of a complete prohibition, the trust could allow limited exposure to leveraged ETFs, but only under specific conditions. For example, the trust could permit investments in leveraged ETFs only if they represent a very small percentage of the overall portfolio (e.g., no more than 5%), and only if the Trustee believes the investment is appropriate given the beneficiary’s long-term financial goals and risk tolerance. The trust document should clearly define these conditions and require the Trustee to document their rationale for any investment in leveraged ETFs. However, most estate planning attorneys, including Steve Bliss, recommend erring on the side of caution and avoiding leveraged ETFs altogether, particularly in trusts designed for long-term wealth preservation.
What if the beneficiary specifically requests the Trustee invest in leveraged ETFs?
Even if the beneficiary requests it, the Trustee has a fiduciary duty to adhere to the terms of the trust document. If the trust document prohibits leveraged ETFs, the Trustee cannot comply with the beneficiary’s request, even if the beneficiary is financially sophisticated and understands the risks. The Trustee’s primary responsibility is to act in the best interests of the beneficiaries *as defined by the trust document*, not necessarily to fulfill their individual wishes if those wishes conflict with the terms of the trust. However, a good Trustee will explain the restrictions to the beneficiary and discuss alternative investment options that align with their goals and risk tolerance.
How did a client avoid a similar situation through careful planning?
I recall a client, Margaret, a retired teacher, who was deeply concerned about her grandchildren inheriting a substantial sum of money. She worried they might be tempted to make reckless investment decisions, particularly with complex products like leveraged ETFs. We drafted a trust that specifically prohibited any investment in leveraged ETFs, derivatives, or other high-risk instruments. Years later, one of her grandsons, a recent college graduate eager to “beat the market,” pressured the trustee to invest in a leveraged tech ETF. The trustee, remembering the specific prohibition in the trust document, politely but firmly refused. Margaret’s foresight, combined with the clarity of the trust document, ensured her grandchildren’s inheritance was preserved and invested responsibly. It wasn’t about preventing them from taking risks altogether; it was about protecting their inheritance from unnecessary and potentially devastating losses.
About Steven F. Bliss Esq. at San Diego Probate Law:
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Feel free to ask Attorney Steve Bliss about: “Do I need a death certificate to administer a trust?” or “How can I find out if a probate case has been filed?” and even “What happens if all my named trustees are unavailable?” Or any other related questions that you may have about Trusts or my trust law practice.