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How should a trust fund be invested? This is a tricky question, but Warren Buffett, one of the greatest investors of all time, has offered an answer.

In his 2014 annual letter to Berkshire Hathaway shareholders, he wrote: "My advice to the trustee couldn't be more simple: Put 10 per cent of the cash in short-term government bonds and 90 per cent in a very low-cost [equity] index fund."

When he recommended this approach, Mr. Buffett outlined why it would be advantageous for the beneficiary. In fact, it can also be good for everyone else involved as well. Let me explain why.

Why it's good for beneficiaries

Bonds provide a buffer. If a trust holds bonds when the beneficiary is receiving income from the trust, withdrawals can come from the bonds if the stock market crashes.

If the withdrawals only came from stocks during such crises, a great deal of capital could wind up flowing out of the trust when stock prices are low. This would result in the beneficiary receiving less income over the life of the trust.

Given that, you can understand why Mr. Buffett recommends holding at least some bonds, especially of the safest, most liquid types. But how about the heart of his recommendation – a 90-per-cent allocation to equity index funds?

Over the long run, history shows that stocks are the highest-returning asset, so a high exposure to them is desirable. The question is how to best capture these returns – with index funds or professional investment managers.

Academic studies rule in favour of index funds. The research finds that the returns of most money managers gravitate toward the market average because it's hard to consistently pick the top performing stocks every year. But since money managers' fees are typically a lot higher than those charged by index funds, most professionals are destined to underperform index funds over the long run.

S&P Global Inc., which produces indexes such as the Standard and Poor's 500 Index, has tracked the performance of the pros at mutual funds for 15 years now. In the case of U.S. stocks, S&P's latest scorecard reports that "over the 15-year period ending December 2016, 92.1 per cent of large-cap, 95.4 per cent of mid-cap, and 93.2 per cent of small-cap managers trailed their respective [indexes]."

Why it's also good for others

A mix of bonds and equity index funds may also be advisable for the person who funds the trust (the settlor) and the person who administers the trust (the trustee).

The settlor benefits from greater peace of mind in knowing that investment performance won't be subject to the uncertainties of a discretionary investment approach.

Trustees benefit because they face less chance of litigation. The risk of lawsuits has become more of a concern in recent years following amendments to trust laws that require trustees to follow the "prudent investor rule."

The prudent investor rule is usually interpreted to mean that the trustee must make sensible decisions, such as investing at acceptable risk levels and using diversification. An investment adviser can be hired but the trustee is still responsible for the directions given to the adviser.

A 2016 Ontario court case illustrates what this means in practice. In Mowry v. Groome, the executor was removed and ordered to pay $350,000 because he told the investment adviser that the trust's objective was 90-per-cent speculative, which resulted in the portfolio becoming overconcentrated in the energy sector just before it crashed.

If Mr. Buffett's approach had been followed, the fund would have been diversified and less likely to have suffered such steep losses. And it would have been more defensible, given the backing of evidence-based studies. Thus, a court of law would more likely have found it compliant with the prudent investor rule.

The use of bonds and equity index funds in a trust's portfolio appears to be in the best interests of beneficiaries, settlors and trustees. For these three groups, they remove a lot of uncertainties while providing long-run returns better than the majority of professional money managers.

Larry MacDonald is an economist, author and financial writer.

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The Canadian Press