Global geopolitical concerns have contributed to an unstable economy and increasingly volatile markets. Excessive volatility adds even more complexity for fiduciaries and their investment advisors — particularly those who rely on historical precedents to identify and manage risk.

Fiduciaries invest for growth and income based on trust objectives, while also adhering to a prudent investor standard. Maintaining balance requires a focused investment policy that addresses asset allocation, income and growth, risk expectations, time horizon for anticipated distributions and unique holdings, such as concentrated positions. Because the prudent investor standard requires management of risk, not avoidance of risk, trustees must consider factors that include inflation, illiquidity, rising taxes and market volatility.

Investment managers who adhere to fiduciary standards typically rely on modern portfolio theory (MPT) to determine the optimal allocation of investments across a variety of asset classes. According to MPT, it's possible to construct optimal portfolios offering the maximum possible expected return for a given level of risk. Based on historical precedents, MPT incorporates average risk, return and correlation assumptions to determine the optimal allocation among asset classes over an extended duration.¹ Advisors will generally optimize the asset allocation for one of the following objectives:

1. Risk minimization. The objective is to construct a portfolio designed to achieve a given level of return with the lowest expected volatility (risk); or
2. Return optimization. The objective is to construct a portfolio designed to maximize expected return for an acceptable level of risk.

Many clients, however, expect their advisors to do both — avoid or minimize risk and optimize returns — through active management of asset allocation, manager and asset selection and hedging decisions. This expectation isn't necessarily realistic.

Forecast Tools

So, what should fiduciaries do? For those adopting MPT, an assumption of future volatility is a required input to the asset allocation process. Advisors typically measure the standard deviation of monthly returns of an index, or group of indices, representing a broad asset allocation over the past three, five or 10 years and consider this a baseline for future volatility. The implication is that average volatility over the next five to 10 years will probably resemble the average volatility over the past five to 10 years. While volatility forecasts based on historical data may prove to be accurate over long periods of time — and applicable to longer term trusts — they do very little to help make decisions during shorter time periods when volatility moves beyond the range of expected outcomes.

As an alternative to MPT, advisors are increasingly using tools designed to forecast near-term volatility. The impact of outlier events, such as tsunamis and tornadoes, may be impossible to predict. However, the Chicago Board Options Exchange (CBOE) Volatility Index (VIX)² may detect an increase in volatility due to other situations, such as deteriorating credit quality in various market sectors. The VIX, also known as the “fear index,” measures what the market's expectation of volatility of the S&P 500 Index³ is over the next 30 days. While the VIX tends to move with sharp unpredictability, its general trend and the speed at which it changes can indicate accelerating or decelerating risk environments. Other indicators of financial stress, such as credit spreads or money flows, can help identify the root cause of changing trends in volatility. In combination, these signals can help to identify increasing or decreasing risks, as well as gauge the magnitude of risk so that advisors can adjust their allocations accordingly.

While MPT is useful for setting a long-term asset allocation strategy and investment policy, it does little to address short-term decisions in response to excess volatility. Therefore, fiduciaries and their investment advisors may benefit from deliberately choosing between different tools to forecast short-term or long-term market stress and corresponding risks to the portfolio. One approach may be better suited than another to protect trust principal by avoiding untimely liquidations for distributions. Volatility impacts trusts differently, depending on the type of trust. Here are some examples of trusts that can be adversely affected by volatility:

• Annuity trusts (for example, grantor retained annuity trusts and charitable lead annuity trusts), especially if they're newly created with substantial early decreases in value, or they require payment of annuities regardless of market conditions;
• Short-term trusts (or trusts expected to terminate shortly) that don't have sufficient time to benefit from a recovery in the market;
• Charitable remainder unitrusts, charitable lead unitrusts and non-charitable unitrusts with payouts at required times (typically based on prior year-end or beginning-of-year values) when the portfolio's value has decreased significantly; and
• Private foundations that require calculating and paying out annual qualifying distributions during fluctuations in the market.

Trusts with little-to-no anticipated distributions in the short term (for example, some dynasty trusts) are less affected by volatility and may rely more heavily on historical risk assumptions that are designed to match a longer investment horizon.

Managing trust portfolios during times of excessive volatility can be difficult. Choosing the most suitable method or approach to forecast volatility can help manage risk.

— This article is designed to provide general information about ideas and strategies. It is for discussion purposes only since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy. The content represents thoughts of the authors and does not necessarily represent the position of Bank of America. U.S. Trust Bank of America Private Wealth Management operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC.

Endnotes

1. Modern portfolio theory (MPT) relies upon an assumption that suggests that total risk within a portfolio can be reduced by introducing assets that are expected to generate returns that are uncorrelated with other assets in the portfolio or the stock market in general. MPT doesn't address market or “systemic risk.” Systematic risk is part of a security's risk that's common to all securities of the same general class (stocks and bonds) and so can't be eliminated by diversification. An appropriate degree of risk, in expectation of return, is unavoidable. Specific or “event risk” is particular to the investment or asset class. Diversification helps manage event risk, not necessarily eliminate it. Diversification doesn't ensure a profit or protect against loss in declining markets. Asset allocation can't eliminate the risk of fluctuating prices and uncertain returns.
2. The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) now is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500 Index option bid/ask quotes. VIX uses near-term and next-term out-of-the money S&P 500 Index options with at least eight days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.
3. The S&P 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.