Year-End Tax Loss Harvesting

Posted On December 15, 2014 By Admin In Portfolio Management /  

IMG_0443

Each December, I review taxable accounts and look at each investor’s tax situation for the year.  I selectively harvest positions with a loss so those losses may offset any capital gains realized by sales or distributed by your funds this year.  If realized losses exceed gains, $3,000 of the losses may be applied against your ordinary income and any excess loss is carried forward into future years.

Depending on the time of your purchases, some investors have small losses in International and Emerging Market stocks for the year.  Although these positions may be down and have lagged US stock indices, I’m not suggesting that we abandon an allocation to these categories altogether.

What we can do is swap from one ETF (or mutual fund) to another ETF or fund in the same category.  This enables us to maintain our overall target allocation while still harvesting the loss for tax purposes.  And thankfully, with a proliferation of low-cost ETFs available in most categories today, it is easier than ever to make a tax swap while maintaining our desired investment allocation.

Tax loss harvesting reduces taxes in the current year, but is primarily a deferral mechanism, as new purchases at a lower cost basis will have higher taxes in the future.  Still, there is a value to the tax deferral, plus a possibility that an investor might be in a lower tax bracket in retirement or could avoid capital gains altogether by leaving the position to their heirs or through a charitable donation.

Most of our ETFs have no taxable capital gains distributions for 2014, a nice feature of ETFs compared to actively managed mutual funds, many of which are generating sizable distributions, even for new shareholders.  Focusing on individual after-tax returns is another way we can add value for our clients.

If you’d like to study tax loss harvesting in greater detail, I recently read an excellent article, Evaluating The Tax Deferral And Tax Bracket Arbitrage Benefits Of Tax Loss Harvesting, by Michael Kitces.

Read More

Socially Responsible Investing

Posted On August 18, 2014 By Admin In Portfolio Management /   1 Comment

Canadice 2014

Socially Responsible Investing (SRI) has taken off in recent years as many investors want to align their portfolio to reflect their personal beliefs.  Fortunately, it is becoming easier to access high quality SRI investments and we are happy to incorporate our clients’ wishes whenever possible. This year, the amount invested in SRI funds surpassed $100 Billion and I think it’s safe to say that SRI has moved from being a small niche to a mainstream approach.

I want to emphasize two very important considerations for anyone contemplating adopting SRI principles for their portfolio.  First, you may want to support an idea or sector, such as Solar Energy.  You might think that by buying stock in a solar company, you are supporting that company, but you’re not actually providing new capital.  Other than in an Initial Public Offering (IPO), trading shares is just buying and selling between investors in the open market.  Although solar power is a great idea, many investors suffered losses in recent years when the stock market eventually recognized that solar panels had become a commoditized product with low profit margins. If you want to buy individual stocks, be sure that you buy the company based on its investment fundamentals and not just because you believe in the idea or think it will be “the next big thing”.  Otherwise, you’d be better off investing in regular funds and using your profits to make donations to the causes you want to support.

For most investors, I suggest you avoid individual stocks altogether and instead choose from the many Socially Responsible funds and ETFs that are available today.  This brings me to my second recommendation: when selecting an SRI Fund, always look at its holdings, weightings, and diversification. SRI guidelines limit which stocks a fund manager can select. For example, they may be prohibited from owning alcohol, tobacco, nuclear power, or defense companies. As a result, SRI funds are often heavily weighted in just two or three sectors of the economy. Today, many (if not most) SRI funds have their largest holdings in the technology industry. Concentrated funds can look attractive when those sectors are performing well, but often perform very poorly when their top sectors tumble.  Make sure your funds are well diversified and that you are not buying a sector fund in disguise.

For a core US equity holding, consider the iShares KLD 400 Social Equity (ticker: DSI).  This is an index Exchange Traded Fund (ETF) that holds the 400 largest US companies that have been screened for positive environmental, social, and governance qualities.  If you currently have a large cap mutual fund in your portfolio, you could use DSI as a replacement to add an overlay of socially responsibility, while maintaining a liquid and diversified portfolio.  With an expense ratio of 0.50%, it is a relatively cheap way to build a core SRI equity position compared to most actively managed mutual funds.

I would, of course, use several other SRI funds to build out a more complete portfolio.  While equity investing tends to get most of the attention in SRI, investors should also consider their fixed income holdings.  When you own the bond of a company or government, you are in fact a lender who has provided capital and receives interest from that entity.  So if you decide to embrace the Socially Responsible Investing approach, don’t forget to also include your bond funds.  Alternatively, you could work with an advisor such as myself to help select individual bonds and build a bond ladder for your portfolio.

Unfortunately, I do not expect an SRI portfolio to outperform a traditional asset allocation, and anticipate it may even lag over time. SRI reduces sector diversification, but also SRI funds tend to have a higher expense ratio than the ETFs we use for our core equity positions. Still, I admire what SRI aims to accomplish, which is to tell corporate management that as owners, shareholders demand companies do the right thing for the environment, human rights, and society. It’s clear that corporate lapses can contribute to increased risks for our economy, not to mention for the company itself. Too many mutual funds and ETFs are not proactively using their capacity as the largest shareholders to advocate for improved corporate governance. That’s a bigger issue than I can tackle as an advisor and investor, but my hope is that SRI will help apply pressure to corporate boards to do better.

Read More

6 Steps to Save on Investment Taxes

Posted On June 17, 2014 By Admin In Portfolio Management /   1 Comment

For new investors, taxes are often an afterthought.  Chances are good that your initial investments were in an IRA or 401(k) account that is tax deferred.  If you had a “taxable” account, the gains and dividends were likely small and had a negligible impact on your income taxes.  Over time, as your portfolio grows and you have more assets outside of your retirement accounts, taxes become a bigger and bigger problem.  Eventually, you may find yourself paying $10,000 a year or more in taxes on your interest, dividends, and capital gains.

A high level of portfolio income may be a good problem to have, but taxes can become a real drag on the performance of your portfolio and eat up cash flow that you could use for better purposes.  Luckily, there are a number of ways to reduce the taxes generated from your investment portfolio and we make this a special focus of our process at Good Life Wealth Management.  We will discuss six of the ways that we work with each of our clients to create a portfolio that is tax optimized for their personal situation.

1) Maximize contributions to tax-favored accounts.  While the 401(k) is the obvious starting place, investors may miss other opportunities for investing in a tax advantaged account.  Since these have annual contribution limits, every year you don’t participate is a lost opportunity you cannot get back later.  In addition to your 401(k) account, you may be eligible to contribute to a:

  • Roth or Traditional IRA;
  • SEP-IRA if you have self-employment or 1099 income;
  • “Back-door” Roth IRA;
  • Health Savings Account (HSA).

Also, don’t forget that investors over age 50 are eligible for a catch-up contribution to their retirement accounts.  For 2014, the catch-up provision increases your maximum 401(k) contribution from $17,500 to $23,000.

2) Use tax-efficient vehicles.  Actively managed mutual funds create capital gains distributions as managers buy and sell securities.  These capital gains are taxable to fund shareholders, even if you just bought the fund one day before the distribution occurs.  These distributions are irrelevant in a retirement account, but can be sizable when the fund is held in a taxable account.

To reduce these capital gains distributions, we use Exchange Traded Funds (ETFs) as a core component of our equity holdings.  ETFs typically use passive strategies which are low-turnover and they may be able to avoid capital gains distributions altogether.  It used to be difficult to estimate the after-tax returns of mutual funds, but thankfully, Morningstar now has a tool to evaluate both pre-tax and after-tax returns.  Go to Morningstar.com to get a quote on your mutual fund, then click on the “Tax” tab to compare any ETF or fund to your fund.  I find that even when a fund and ETF have similar pre-tax returns, the ETF often has a clear advantage when we compare after-tax returns.

One last factor to consider: many mutual funds had loss carry-forwards from 2008 and 2009.  So you may not have seen a lot of capital gains distributions in the 2010-2012 time period.  By 2013, however, most funds had used up their losses and resumed distributing gains, some of which were substantial.

3) Avoid Short-Term Capital Gains.  Short-term gains, from positions held less than one year, are taxed as ordinary income, whereas long-term gains receive a lower tax rate of 15% (or 20% if you are in the top bracket).  We try to avoid creating short-term capital gains whenever possible, and for this reason, we rebalance only once per year.  We do our rebalancing on a client-by-client basis to avoid realizing short-term gains.

4) Harvest Losses Annually.  From time to time, a category will have a down year.  We will selectively harvest those losses and replace the position with a different ETF or mutual fund in the same category.  The losses may be used to offset any gains harvested that year.  Additionally, with any unused losses, you may offset $3,000 of ordinary income, and the rest will carry forward to future years.

A benefit of using the loss against other income is the tax arbitrage of the difference between capital gains and ordinary income.  For example, if you pay 33% ordinary tax and 15% capital gains, using a $3,000 long-term capital loss to offset $3,000 of ordinary income is a $540 benefit ($3,000 X (.33-.15)).

5) Consider Municipal Bonds.  We calculate the tax-equivalent rates of return on tax-free municipal bonds versus taxable bonds (i.e. corporate bonds, treasuries, etc.) for your income tax bracket.  With the new 3.8% Medicare tax on families making over $250,000, tax-free munis are now even more attractive for investors with mid to high incomes.

6) Asset Location.  This is a key step.  Not to be confused with Asset Allocation, Asset Location refers to placing investments that generate interest or ordinary income into tax-deferred accounts and placing investments that do not have taxable distributions into taxable accounts.  For example, we would place high yield bonds or REITs into an IRA, and place equity ETFs and municipal bonds into taxable accounts.  This means that each account does not have identical holdings, so performance will vary from account to account.  However, we are concerned about the performance of the entire portfolio and reducing the taxes due on your annual return.

If these six steps seem like a lot of work to reduce taxes, that may be, but for us it is second-nature to look for opportunities to help clients keep more of their hard-earned dollars.  The actual benefits of our portfolio tax optimization process will vary based on your individual situation and can be difficult to predict.  However, a 2010 study by Parametric Portfolio Associates calculates that a tax-managed portfolio process can improve net performance by an average of 1.25% per year.

Tax management is a valuable part of our process.  And even if, today, your portfolio doesn’t generate significant taxes, I’d encourage you to think ahead.  Prepare for having a large portfolio, and take the steps now to create a tax-efficient investment process.

Read More

Three Studies for Smart Investors

Posted On June 1, 2014 By Admin In Portfolio Management /  

Over the last several years, my investment approach has become more systematic and disciplined.  In place of stock picking or manager selection, I believe clients are better served by a focus on strategic asset allocation. Today, we offer investors a series of 5 portfolio models, using ETFs (Exchange Traded Funds) and mutual funds. This approach offers a number of benefits, including diversification, low cost, transparency, and tax efficiency.

This evolution in approach occurred gradually as a result of continued research, personal experience, and pursuing the goal of a consistent client experience.  In my previous position, I managed $375 million in client portfolios, performing investment research, designing asset allocation models, rebalancing and implementing trades.  I am grateful for having this experience and want to share the reasons why I believe investors are best served by the approach we’re using today.

My investment approach is underpinned by three academic studies.  These studies look at long-term investment performance, are updated annually, and offer great insight into what is actually working or not working for investors. As an analyst, I am very interested in what data tells us, and how this may differ from what we think will work or what should work in theory.  But even if you aren’t a numbers geek like me, these studies instruct us about investor behavior and where you should focus your efforts and energy.  I’m going to give a very brief summary of each study and include a link if you’d like to read more.

Published semi-annually, SPIVA looks at all actively managed mutual funds and calculates how many active managers outperform their benchmarks. The long-term results are consistently disappointing.  As of December 31, 2013, 72.72% of all large cap funds lagged the S&P 500 Index over the previous five years.

Sometimes, I hear that Small Cap or Emerging Market funds are better suited for active management because they invest in smaller, less efficient markets.  This sounds plausible, but the numbers do not confirm this.  The data from SPIVA shows that 66.77% of small cap funds lagged their benchmark and 80.00% (!) of Emerging Market funds under performed over the past five years.

The lesson from SPIVA is that using an index fund or ETF to track a benchmark is a sensible long-term approach.  Indexing may not be exciting or produce the best performance in any given year, but it has produced good results over time and reduces the risk that we select the wrong fund or manager.  Our approach is to use Index funds as a core component to our portfolio models.

The other conclusion I draw from SPIVA is that if large mutual fund companies, with hundreds of analysts, cannot consistently beat the benchmark, it would be foolish to think that a lone financial advisor picking individual stocks could do better.

After looking at SPIVA, it may occur to investors that 20-35% of funds actually did beat their benchmarks over 5 years.  Why not just pick those funds?  Why settle for average when you can be in a top-performing fund?

The S&P Persistence Scorecard looks at mutual funds over the past 10 years.  At the 5-year mark, the scorecard ranks funds in quartiles by performance and looks at how the funds’ returns were in the subsequent five years. This tells us if a top performing fund is likely to remain a leader.

Looking at all US Equity funds, we start with the funds which were in the top quartile in September 2008. Below is breakdown of how those top quartile funds ranked in the subsequent five years, through September 30, 2013:
1st Quartile:  22.43%
2nd Quartile  27.92%
3rd Quartile:  20.53%
4th Quartile:  16.71%
Merged/Liquidated:  12.41%

Of the funds in the 1st Quartile in 2008, only 22% remained in the top category in the following 5 years.  29%, however, fell to the bottom quartile or were merged or liquidated in the following 5 years.  So, if your method is to go to Morningstar and find the best performing fund, please be warned,past performance is no guarantee of future results.  In fact, the Persistence Scorecard tells us that not only is past performance not a guarantee, it isn’t even a good indicator of future results.  The results above aren’t much different than a random chance of 1 in 4 (25%).  Albeit disappointing and counter-intuitive, the reality is that past performance offers virtually no predictive information.

Now in its 20th year, QAIB compares mutual fund returns to investor returns.  The reason why they differ is because of the timing of investors’ contributions and withdrawals from mutual funds.  For example, people may think that it is safer to invest when the market is doing well and they buy at a high.  Or, investors chase last year’s hot sector and sell out of a fund that is at a low and just about to turn around.  Investor decisions are consistently so poor that we can actually measure the gap between the average investor’s return and the benchmark.  You might want to sit down for this one – over the 20 year period through 2013, the S&P 500 Index returned 9.22% annually, but the average investor return from equity mutual funds was only 5.02%.  The behavior gap cost investors 4.20% a year over two decades.
We can draw three very important conclusions from QAIB:
– We should avoid trying to time the market (buy/sell);
– Chasing performance is more likely to hurt returns than improve returns;
– Without a disciplined approach, including a target asset allocation and monitoring/rebalancing process, what may feel like a good investment decision at the time may ultimately prove to be a poor choice in hindsight.

These three studies are so important that I carry excerpts from the reports with me to discuss with investors. They’re fundamental to my investment approach, and hopefully, their significance can easily be grasped and appreciated by all our clients.

While we’ve focused exclusively on investment philosophy in this post, I would be remiss to not add that the benefits of working with a CFP(R) practitioner are not limited to portfolio management.  A comprehensive financial plan includes many elements, such as savings/debt analysis, risk management, tax strategies, and estate planning.  The investment management component tends to get the greatest attention, but the other elements of a personal financial plan are equally important in creating a foundation for your financial security.

Read More