What Are Today’s Projected Returns?

Posted On June 18, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning, Portfolio Management /

One of the reasons I selected the financial planning software we use, MoneyGuidePro, is because it offers the ability to make projections based on historical OR projected returns. Most programs only use historical returns in their calculations, which I think is a grave error today. Historical returns were outstanding, but I fear that portfolio returns going forward will be lower for several reasons, including:

Above-average equity valuations today. Lower dividend yields than in the past.
Slower growth of GDP, labor supply, inflation, and other measures of economic development.
Higher levels of government debt in developed economies will crowd out spending.
Very low interest rates on bonds and cash mean lower returns from those segments.

By using projected returns, we are considering these factors in our financial plans. While no one has a crystal ball to predict the future, we can at least use all available information to try to make a smarter estimate. The projected returns used by MoneyGuidePro were calculated by Harold Evensky, a highly respected financial planner and faculty member at Texas Tech University.

We are going to compare historical and projected returns by asset class and then look at what those differences mean for portfolio returns. Keep in mind that projected returns are still long-term estimates, and not a belief of what will happen in 2017 or any given year. Rather, projected returns are a calculation of average returns that we think might occur over a period of very many years.

Asset Class	Historical Returns	Projected Returns
Cash	4.84%	2.50%
Intermediate Bonds	7.25%	3.50%
Large Cap Value	10.12%	7.20%
Small Cap	12.58%	7.70%
International	9.27%	8.00%
Emerging Markets	8.85%	9.30%

You will notice that most of the expected returns are much lower than historical, with the sole exception of Emerging Markets. For cash and bonds, the projected returns are about half of what was achieved since 1970, and even that reduced cash return of 2.50% is not possible as of 2017.

In order to estimate portfolio returns, we want two other pieces of data: the standard deviation of each asset class (its volatility) and the correlation between each asset class. In those areas, we are seeing that the trend of recent decades has been worse for portfolio construction: volatility is projected to be higher and assets are more correlated. It used to be that International Stocks behaved differently that US Stocks, but in today’s global economy, that difference is shrinking.

This means that our projected portfolios not only have lower returns, but also higher volatility, and that diversification is less beneficial as a defense than it used to be. Let’s consider the historical returns and risks of two portfolios, a Balanced Allocation (54% equities, 46% fixed income), and a Total Return Allocation (72% equities, 28% fixed income)

Portfolio	Historical Return	Standard Deviation	Projected Return	Standard Deviation
Balanced	8.53%	9.34%	5.46%	10.59%
Total Return	9.18%	12.20%	6.27%	14.23%

That’s pretty sobering. If you are planning for a 30-year retirement under the assumption that you will achieve historical returns, but only obtain these projected returns, it is certainly going to have a big impact on your ability to meet your retirement withdrawal needs. This calculation is something we don’t want to get wrong and figure out 10 years into retirement that we have been spending too much and are now projected to run out of money.

As an investor, what can you do in light of lower projected returns? Here are five thoughts:

Use projected returns rather than historical if you want to be conservative in your retirement planning.
Emerging Markets are cheap today and are projected to have the highest total returns going forward. We feel strongly that they belong in a diversified portfolio.
We can invest in bonds for stability, but bonds will not provide the level of return going forward that they achieved in recent decades. It is very unrealistic to assume historical returns for bond holdings today!
Investors focused on long-term growth may want more equities than they needed in the past.
Although projected returns are lower than historical, there may be one bright spot. Inflation is also quite low today. So, achieving a 6% return while inflation is 2% is roughly comparable in preserving your purchasing power as getting an 8% return under 4% inflation. Inflation adjusted returns are called Real Returns, and may not be as dire as the projected returns suggest.

Does Rebalancing Improve Returns?

Posted On April 22, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Like flossing, we’re told that we need to rebalance because it’s good for us. But does rebalancing improve returns? Like many financial questions, the unsatisfying answer is “it depends”. Today we are going to take a deeper dive into rebalancing, when it works, when it doesn’t, and why it is still a good idea.

You might choose a 60/40 allocation (60% stocks, 40% bonds) because that portfolio has certain risk and return characteristics which fit your needs. Over time, as the market moves, your portfolio is likely to diverge from its original allocation; rebalancing is placing the trades to restore your original 60/40 allocation.

If we assume that stocks grow at 8% and bonds at 3%, what would happen if you did not rebalance? With a higher return, the stocks would become a bigger portion of the portfolio. In fact, after 30 years, your allocation would have shifted from 60/40 to 86/14. It should be noted right at the outset that under the straight-line assumption of stocks outperforming bonds, your performance would be higher by never rebalancing. Selling stocks to maintain a 40% weighting in bonds would slow your growth.

However, if you wanted an aggressive portfolio, you wouldn’t have started with a 60/40 allocation. We should recognize from the outset that the primary goal of rebalancing is not to enhance returns but to maintain a target allocation.

But since the stock market does not move in a straight line and give us exactly 8% returns every year, rebalancing may have a benefit in taking advantage of temporary price disruptions. If the the market tumbles, rebalancing will buy stocks at those low prices. And when the market runs up and is high, rebalancing can sell overvalued stocks and add to the safety of bonds.

What is key to rebalancing, but poorly understood by investors, is that the frequency of rebalancing is a crucial consideration. There’s not just one way to rebalance. Let’s consider a couple of scenarios.

1) In a trending market, where stocks move in one direction for a long time, the more frequently you rebalance, the worse return you create.

For example, let’s imagine a Bull Market where stocks grow by 10% each quarter, and bonds only gain 0.75% per quarter. If you started with $100,000 in a 60/40 portfolio, and did nothing, you would have $129,059 at the end of one year. But if you rebalanced each quarter, your return would be $127,682. Here, rebalancing quarterly would have reduced your returns by $1,376.

But you thought rebalancing was supposed to enhance returns? When a market trend continues for a long period, you would be better off sticking with the trend, rather than rebalancing against the trend.

2) Interestingly, rebalancing also makes returns worse in prolonged bear markets, too.

Same situation: 60/40 portfolio with $100,000. Now let’s imagine a one-year Bear Market where stocks fall by 10% per quarter and bonds gain 0.75% per quarter. Without rebalancing, your portfolio would fall from $100,000 to $80.579. If you rebalanced each quarter, you would have made things even worse, with a drop from $100,000 to $79,076. Rebalancing would have extended your losses by $1,503, or 1.87%.

By rebalancing in a prolonged Bear Market, you were adding to stocks, even as they continued to lose value.

3) While rebalancing hurts returns in directional markets, it can improve returns in markets which are fluctuating. In this third example (still $100,000 in a 60/40 allocation), we assume that bonds return 0.75% per quarter, but that stocks go down 10%, then up 10%, then down 10% and then up 10%.

After one year, with no rebalancing, you’d have $100,019. If you rebalanced quarterly, you would have $100,482. That’s a nice difference in a basically flat market. While rebalancing hurts returns if there is a steady trend, it can improve returns when markets vacillate between positive and negative periods.

So what do we do? Not rebalancing (ever) is not a good choice because you will diverge from your risk preferences. We try to strike a balance in our rebalance frequency by doing it only once a year, and only when a position deviates by more than 5% from target levels.

By rebalancing annually, we allow for longer trends, since Bull or Bear markets can certainly last for at least 12 months. So if you see other firms that brag about rebalancing monthly or quarterly, please understand that more frequent rebalancing is not necessarily better or any guarantee that it will increase returns. As we have shown, there are reasons why more frequent rebalancing could actually make things worse in a Bear Market, which is right when you would want the most defense.

Additionally, we need to consider the costs of rebalancing. Besides transaction costs, in a taxable account, short-term gains are taxed as ordinary income. We hold our positions for at least 12 months before rebalancing to get preferential long-term rates. More frequent rebalancing could be creating an unnecessary tax bill.

With extremely low yields today, it may make sense for some young, aggressive investors to consider being 100% in stocks. Then rather than focusing on rebalancing, you can take advantage of market drops by dollar cost averaging with new purchases. However, even in a 100% stock portfolio, you still have target weights in categories such as Large Cap, Small Cap, International, Emerging Markets, Real Estate, etc. And often it still makes sense to rebalance when one of those categories has a large move up or down.

Once you have accumulated some wealth, whether that is $300,000 or $3 million, you really have to think about how you would feel if the market fell by 50%. From a behavioral perspective, having a target allocation and a rebalancing process means that you have created a framework, a discipline, for how you will respond to the inevitable Bull and Bear market cycles. And the process of rebalancing – to buy low and sell high – is definitely preferable to our innate response, which is often to buy when there is euphoria and to throw in the towel when the market plunges.

Hopefully, you now understand that rebalancing is not a guarantee to enhance returns. In fluctuating markets, it can help you buy low and sell high. But in long-trending markets, the more frequently you rebalance, the more you will reduce your returns, whether it is a Bull Market or a Bear Market. So we can’t blindly just say that rebalancing is good, we have to use it intelligently.

TIPS: Not Attractive Yet

Posted On April 10, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

I love TIPS, but I’m going to tell you why you should not own them today. Treasury Inflation Protected Securities (TIPS) are government bonds, backed by the US Treasury. They pay two ways: a fixed interest rate (coupon) paid every six months, and an adjustment to your principal based on the Consumer Price Index (CPI-U). The dollar amount of interest increases when CPI goes up.

TIPS are considered by many to be a nearly “ideal” investment. Most traditional bonds have a set face value of $1,000, which creates inflation risk. The $1,000 you will get back 10 years from now will not have the same purchasing power as $1,000 does today. This inflation risk is nullified by TIPS. And it doesn’t even matter what inflation is: whether it is 1% or 10%, your purchasing power will be preserved by TIPS. It’s a remarkable benefit which makes TIPS “safer” at preserving wealth than a CD or savings account, while carrying none of the market risk of stocks.

At my previous firm, we had tens of millions of dollars invested in TIPS as a core fixed income holding. At my urging, we sold almost all of these bonds between 2012 and 2013. Why? As interest rates fell, the prices of TIPS skyrocketed. Yields on TIPS became negative; investors were willing to pay so much for these bonds that they were guaranteed to not keep up with inflation. Our clients had made a handsome profit in TIPS, but would have made less than inflation if we continued to hold. So we sold the TIPS and moved into other types of bonds.

The yield on TIPS are determined by auction, and the Treasury presently issues 5-year, 10-year, and 30-year TIPS. Institutional investors compare TIPS yield to fixed rate Treasury Bonds. For example, the most recent 10-Year TIPS auction on March 31, 2017 produced a yield of 0.466% (plus inflation). Compared this to the current yield on a fixed 10-Year note of about 2.3% and you get an inflation expectation of 1.8% over the next 10 years.

For big banks, this creates arbitrage opportunities if they think that the market inflation expectations are wrong. This arbitrage mechanism means that the rate on TIPS will likely be tied closely to regular Treasury Interest Rates.

For investors, if you think that we were going to have extreme inflation over the next 10 years, you would prefer to invest in the TIPS rather than the 2.3% fixed rate 10-Year note. But that is speculation, and I am not interested in speculating on inflation rates, thinking that we know more than all of Wall Street.

However, the forces which drove down interest rates and gave us a reason to sell our TIPS at high prices appear to be reversing. The Federal Reserve has started to raise interest rates, which may mean that last summer’s 1.6% 10-Year yield was the top of a 30-year bond Bull Market. As interest rates rise, the price of existing bonds will drop. And that will be painful for holders of 10 year and especially 30 year bonds, including TIPS.

Back when you could buy TIPS and earn 2%, 3% or more above inflation, that was a compelling return for a very low risk bond. Today, the yields on TIPS are less than 0.5% on the 5 and 10 year TIPS and below 1% on the 30 year TIPS. In 2 of the 3 auctions in 2016, the yields on the 5-year TIPS were negative. These rates are simply too low to include in our portfolios. Add in the risk of rising interest rates (= falling bond prices), and the appeal of 10 and 30 year TIPS are gone for me.

There is an alternative to TIPS which do not carry the risk of rising rates: I-Series Savings Bonds. Like TIPS, I-Bonds are linked to CPI-U and also carry a fixed rate of return. You purchase and redeem I-Bonds through TreasuryDirect.gov. They are issued as 30-year bonds, but you can redeem them anytime after 1 year (3 months interest penalty if redeemed in the first 5 years). Since you can redeem them directly with the government, you don’t have to worry about market losses caused by rising interest rates. If there are better alternatives in 5 years, you could simply cash out your I-Bonds and take your money elsewhere.

I-Bonds would be a logical alternative to TIPS, except for two big problems: 1) The current fixed rate is zero. Since 2010, it has been zero for most of the time, briefly reaching only 0.10% or 0.20%. 2) Each taxpayer is limited to buying $10,000 of I-Bonds a year and you cannot own them in an IRA or brokerage account. Still, if the fixed rate on I-Bonds were the same as TIPS, I would buy those first, before buying any TIPS.

There may come a time when it will be attractive to buy I-Bonds or TIPS. For now, interest rates are too low and inflation is not an immediate risk. Still, there are many appealing benefits to these bonds. While preserving purchasing power is the primary difference to other bonds, from a portfolio construction standpoint, there are other benefits, including extremely low default risk, relatively low volatility, and much lower correlation to equities than corporate bonds.

Today, I think we can get a higher return by taking on some credit risk versus government bonds, whose interest rates have been held down by central banks. It has been nearly 10 years now since the peak of the mortgage/financial crisis, but we are just now starting to emerge from a global Zero Interest Rate Policy. That unwinding will take many years and will have a big impact on fixed income for years to come.

10 Ways to Wreck Your Portfolio

Posted On March 19, 2017 By Scott Stratton, CFP(R), CFA In Behavioral Finance, Portfolio Management /

Over the years, I’ve seen hundreds of portfolios and 401(k) accounts, and observed investors make tons of mistakes. Admittedly, I have made many of these errors on my own as well, just to double check! Here’s your chance to learn from others’ losses. But, if you still insist that you want to ruin your rate of return, go ahead and make these 10 mistakes…

1) Rely on Past Performance. You invest with winners, not losers! Just find the top performing fund offered by your 401(k) and put all your money in there. That’s why they say past performance is a guarantee of future returns, or something like that.

2) Don’t diversify. Have you seen that Chinese Small-Cap BioTech fund? Why invest in the whole market when you can bet on one tiny, minuscule sliver?

3) Ignore the fact that 80% of actively managed funds under perform their benchmark over five years. You’re going to pick funds from the other 20%. Indexing is for people who are willing to settle for average.

4) Put as much money as possible into your company stock. It’s beat the S&P 500 for X number of years, therefore you’d be stupid to ever take your money out of company stock or to cash in your options. And since you work there, you know more about this investment than anyone. Just like the employees at Nortel, Worldcom, and Enron.

5) To avoid paying taxes, don’t sell your winners. Don’t rebalance or sell overvalued shares. Later, if the stock is down 40% you can pat yourself on the back: “Thank God I didn’t sell when it was up and have to pay 15% tax on my gains. I dodged that bullet!”

6) Never sell your losers either. The loss isn’t real until you sell, and the most important thing is to protect your ego. If you hold on, eventually, you should get your money back. So what if another fund returns 60% while you are waiting for yours to rebound 30%? (Says the guy who has old General Motors shares that are worthless from when the company filed for bankruptcy and wiped out their stockholders.)

7) Do it yourself. Don’t use funds or ETFs, pick individual stocks yourself! It will be fun and easy. Just look at all those smiling people on the commercials for online brokers, they’re getting rich from their kitchen tables! Anyone can beat those fancy investment managers with their extensive training, huge research departments, and decades of experience. And if you spend all day watching your portfolio, it magically grows faster!

8) You know when to get in and out of the market. It’s not market timing if you know what you’re doing. When the market is down, it’s a bad market, so don’t buy then. Wait until the market goes back up before you make your purchases. You should toss out a detailed 20-year financial plan if your gut tells you. And by gut, of course, we mean CNBC, Fox News, or whatever you watched in the preceding 48 hours.

9) When the market is down, your funds are horrible, the managers incompetent, and the market is rigged. When your portfolio is up, it’s because of your brilliant mind for finance. You are investing for decades, but if your portfolio doesn’t go up every single quarter something is horribly wrong with your approach. Change everything you own when this happens.

10) All the good investments are reserved for the wealthy. You can only become rich by investing in complicated, non-transparent private placements or limited partnerships in oil, real estate, leasing, or something you cannot explain in less than three minutes. And it’s rude to ask how much these programs charge, that’s so gauche. On a related note, you should always buy penny stocks that you hear about through an email.

I know no one really wants to wreck their portfolio, but from my vantage point, a lot of our investment pains appear self-inflicted. I can help you avoid these ten mistakes and many, many others. Even more important than avoiding errors, together we can create a financial plan and investment program that will be tailored to your goals, rather than focusing on what the market might do this month or this year.

Professional advice. Comprehensive financial planning. Evidence-based investment management. Ongoing evaluation, monitoring, and adjustment. Those are our tools to help investors succeed. That doesn’t mean that there won’t be years when the market is down, but it does mean we will be better prepared and much less likely to make the mistakes which can make things worse.

Do Top Performing Funds Persist?

Posted On February 27, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

How do you pick the funds for your 401(k)? I know a lot of people will look at the most recent performance chart and put their money into the funds with the best recent returns. After all, you’d want to be in the top funds, not the worst funds, right? You’d want to invest with the managers who have the most skill, based on their results.

We’ve all heard that “past performance is no guarantee of future results”, and yet our behavior often suggests that we actually believe the opposite: if a fund has out-performed for 1, 3, or 5 years, we believe it is due to manager skill and the fund is indeed more likely to continue to out-perform than other funds.

But is that true? Do better performing funds continue to stay at the top? We know the answer to this question, thanks to the people at S&P Dow Jones Indices, who twice a year publish their Persistence Scorecard (link).

Looking at the entire universe of actively managed mutual funds, they rank fund performance by quartiles, with the 1st quartile being the top performing 25% of funds, and the 4th quartile being the bottom 25% of funds.

Let’s consider the “Five Year Transition Matrix”, which ranks funds over five years and then follows how they perform in the subsequent five year period. For the most recent Persistence Scorecard, published in December 2016, this looks at funds’ five-year performance in September 2011, and then how they ranked five years later in September 2016.

Here’s how the top quartile of all domestic funds fared in the subsequent 5-year period:
20.09% remained in the top quartile
18.93% fell to the second quartile
20.56% fell to the third quartile
27.80% fell to the bottom quartile
10.75% were merged or liquidated, and did not exist five years later

The sad thing is that if you picked a fund in the top quartile, there was only a 20% chance that your fund remained in the top quartile for the next five years. But there was a more than 38% chance that your top performing fund became a worst performing fund or was shut down completely in the next five years.

Another interesting statistic: the percentage of large cap funds that stayed in the top half for five years in a row was 4.47%. If you simply did a coin flip, you’d expect this number to be 6.25%. The number of funds that stayed in the top half is slightly worse than random.

The Persistence Scorecard is a pretty big blow to the notion of picking a fund based on its past performance. And it’s significant evidence that we should not be making investment choices based on Morningstar ratings or advertisements touting funds which were top performers.

Should you do the opposite? I wish it was as simple as buying the bottom-performing funds, but they don’t fare any better. Funds in the bottom quartile had a similarly random distribution into the other three quartiles, but had a much higher chance of being merged or liquidated.

There are a couple of possible explanations for funds’ lack of persistence:

Styles can go out of favor; a “value” manager may out-perform in one period and not the following period. Hence a seemingly perpetual rotation of leaders.
Successful managers may attract large amounts of capital, making them less agile and less likely to out-perform.
There may be more randomness and luck to managers’ returns, rather than skill, than they would like to have us believe.

Unfortunately, the S&P data shows that for whatever reason, there is little evidence for persistence. Investors need a more sophisticated investment approach than picking the funds which had the best performance. The Persistence Scorecard highlights why performance chasing doesn’t work for investors: yesterday’s winners are often tomorrow’s losers.

What to do then? We focus on creating a target asset allocation, using a core of low-cost, tax efficient index ETFs and a satellite component of assets with attractive fundamentals. What we don’t do is change funds every year because another fund performed better than ours. That kind of activity has the potential for being highly damaging to your long-term returns.

I hope you will take the time to read the Persistence Scorecard. It will give you actual data to understand better why we say past performance is no guarantee of future results.

Diversification and Regret

Posted On February 6, 2017 By Scott Stratton, CFP(R), CFA In Behavioral Finance, Portfolio Management / 1 Comment

Diversification is one of the key principles of portfolio management. It can reduce idiosyncratic risks of individual stocks or sectors and can give a smoother performance trajectory, or as financial analysts prefer to say, a “superior risk-adjusted return” over time. Everyone sees the wisdom of not putting all your eggs in one basket, but the reality is that diversification can sometimes be frustrating, too.

Being diversified means holding many different types of investments: stocks and bonds, domestic and international stocks, large cap and small cap, traditional and alternative assets. Not all of those assets are going to perform well at the same time. This leads to a behavioral phenomenon called Tracking Error Regret, which some investors may be feeling today.

When their portfolio lags a popular benchmark, such as the Dow Jones Industrials or the S&P 500, Investors often regret being diversified and think that they should get out of their poorly performing funds and concentrate in those funds which have done better. (Learn about the benchmarks we use here.)

It’s understandable to want to boost performance, but we have to remember that past performance is no guarantee of future results. Many people receive a snapshot from their 401(k) listing their available funds with columns showing annualized performance. Consider these two funds:

	3-year	5-year	10-year	Expense Ratio
S&P 500 ETF (SPY)	11.10%	13.55%	6.88%	0.10%
Emerging Markets ETF (VWO)	2.83%	-0.07%	2.24%	0.15%

Source: Morningstar, as of 2/06/2017

Looking at the performance, there is a clear hands-down winner, right? And if you have owned the Emerging Markets fund, wouldn’t you want to switch to the “better” fund?

These types of charts are so dangerous to investors because they reinforce Performance Chasing and for diversified investors, cause Tracking Error Regret. Instead of looking backwards at what worked over the past 10 years, let’s look at the Fundamentals, at how much these stocks cost today. The same two funds:

	Price/Earnings	Price/Book	Dividend Yield	Cash Flow Growth
S&P 500 ETF (SPY)	18.66	2.65	2.21%	0.33%
Emerging Markets ETF (VWO)	12.34	1.51	3.37%	5.09%

Source: Morningstar, as of 2/06/2017

Now this chart tells a very different story. Emerging Market Stocks (EM) cost about one-third less than US stocks, based on earnings or book value. EM has a 50% higher dividend yield and these companies are growing their cash flow by 5% a year, versus only 0.33% a year for US companies.

I look at the fundamentals when determining portfolio weightings, not past performance. If you only looked at the performance chart, you’d miss seeing that EM stocks are cheap today and US stocks are more expensive. That is no guarantee that EM will beat the S&P 500 over the next 12 months, but it is a pretty good reason to stay diversified and not think that today’s winners are bound to continue their streak forever.

Performance chasing often means buying something which has become expensive, frequently near the top. That’s why I almost never recommend sector funds or single country funds (think Biotech or Korea); the investment decision is too often based on recent performance and those types of funds tend to make us less diversified rather than more diversified.

Staying diversified means that you will own some positions which are not performing as well as others in your portfolio. When the S&P 500 is having a great year, a diversified portfolio often lags that benchmark. But, when the S&P 500 is down 37% like it was in 2008, you may be glad that you own some bonds and other assets.

We use broadly diversified ETFs and mutual funds, with a willingness to rebalance and buy those positions when they are down. We have a value bent to our weightings and are willing to own assets like Emerging Markets, even if they haven’t been among the top performers in recent years. Staying diversified and focusing on the long-term plan means that you have to ignore Tracking Error Regret and Performance Chasing. Just remember that you can’t drive a car forward by looking in the rear-view mirror.

Why We’re Adding Alternatives for 2017

Posted On January 1, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

For 2017, we are adding a 10% allocation to Alternatives to our Premier Wealth Management model portfolios (those over $250,000). The 10% allocation will be taken pro rata from both equity and fixed income categories. A 60/40 portfolio, for example, will have 6% taken from equities and 4% from fixed income, for a new allocation that is 54% Equities, 36% Fixed, and 10% Alternatives. We made some trades in December during our year-end tax reviews, and will make the rest of the trades in the next week.

Why Alternatives? The goal of Alternatives is to provide a positive return without being tied to the stock market or interest rates. Our aim is to diversify your portfolio further with a source of uncorrelated returns. Ideally, this can provide a smoother ride and dampen our portfolio volatility. (See Morningstar on Alternatives: When, Why, and Which Ones?)

That’s the goal, but investing in Alternatives poses its own set of unique challenges. Unlike stocks and bonds, there are many types of “Alternative” investment strategies. Alternatives is a catch-all category that encompasses everything from Real Estate, Gold, Commodities, Futures, Long/Short Equity, Arbitrage, to any other Hedge Fund process. And then there are multi-strategy funds which may combine four, five, or more unrelated strategies or managers.

Even within one category, some funds may do quite well and other funds poorly in the same year. That is a much smaller risk in equities, where, for example, most large cap funds are going to have a positive return when the S&P 500 Index is up and a negative return when the Index is down. In Alternatives, there is a wide dispersion of returns even within a single category.

Our view of Alternatives, then, is that it is a satellite holding that we want to employ tactically, rather than a core strategy that we hold at all times. We think the environment of 2017 could be just such a time to want to include Alternatives.

We enter the year with equities at or near their all-time highs and valuations somewhat above their historical averages. 2016 gave us a very nice return in US stocks: 9.5% in the S&P 500 and 19.4% in the small cap Russell 2000. The maxim that “the market climbs a wall of worry” definitely was the case in 2016. While the market confounds expectations frequently, valuations, not sentiment, are our guide to how we weight segments in our allocation. Valuations today, both relative and absolute, suggest diversifying from US stocks.

In fixed income, we saw a remarkable summer low in interest rates, with the 10-Year Treasury trading at a 1.6% yield. The second half of the year was painful for bondholders, with interest rates rising a full 1% on the 10-Year. It was such a dramatic move that we think it would be a mistake to think that interest rates can continue to increase at a linear projection of the past six months. Still, we may have just seen the end of the 30 year Bull market in bonds and that suggests expected returns going forward will be both lower and more volatile than historic returns.

Our goal within each portfolio is not only to grow your wealth, but to protect and preserve what you already have. Our modelling of adding the 10% allocation to Alternatives suggests that we can potentially reduce portfolio volatility and improve the risk/reward characteristics of our models. While that is no guarantee that returns will be positive in 2017, I want you to know that we are constantly monitoring, studying, and looking for quantifiable ways to better manage your money.

When would you not want Alternatives? If you went back to the lows of March 2009, the start of the current Bull Market, adding Alternatives would have held back your performance. They aren’t aiming to generate double digit returns, which you can sometimes get in equities on a snap-back like 2009. But that’s not where we are in January 2017. Today, with US stocks and bonds looking a bit expensive, we are looking to strengthen our defensive. (ICYMI, our Four Investment Themes for 2017)

As always, I’m happy to chat about your goals, the state of the market, or what we do in our investment management process. Give me a call or drop me a note. One of the reasons why we write about investing in the blog, is to communicate to everyone at the same time and then when we do have our next meeting or call, we can focus 100% on you and not the market.

Bonds at a Discount: CEFs on Sale

Posted On November 21, 2016 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Since the election, bond yields have risen and prices have fallen in anticipation of increased government spending and an uptick in inflation. The yield on the 10-year Treasury was 2.33% on Friday, almost a full percent higher than the all-time low, set only a few months ago in July. When bond prices fall, many investors will sell their funds at the end of the year to harvest losses and redeploy their capital into other bond funds.

The annual tax-loss harvesting creates a unique opportunity for investors to look at Closed End Funds. Closed End Funds (CEFs) are an alternative to bond mutual funds. They are similar to mutual funds in that they are diversified, professionally managed baskets of stocks or bonds. In a regular mutual fund, you buy and sell shares directly from the fund company, whereas with a CEF, you buy or sell shares on a stock exchange with other buyers or sellers. There are a fixed number of shares, so a CEF manager can focus on managing their portfolio without the impact of money flowing in or out of the fund.

This works very well for bond strategies, and indeed many CEFs have an income focus and pay dividends monthly or quarterly. Today, there are many CEFs that pay 4-6% tax-free, or 5-10% taxable. They range from high investment grade credit ratings to junk bonds. Some have been around for decades.

Here is a comparison of Closed End Funds with Mutual Funds:

Closed End Funds	Mutual Funds “open end”
Professionally managed basket of stocks, bonds, etc.	Professionally managed basket of stocks, bonds, etc.
Fixed number of shares	Unlimited number of shares
Buy/sell on an exchange	Buy/sell from the fund company
Price may be at a premium or discount to NAV	Price equals net asset value (NAV)
Manager does not need to buy or sell securities; fixed pool of money	Manager must buy or sell to meet inflow or outflow of cash
May use leverage	Typically not leveraged

Many people have not heard of CEFs because they generally don’t advertise. The managers cannot raise new money, and their management fee is fixed, usually around 1% of assets. The fund manager has no incentive to advertise, so CEFs remain a secret of the investment community. When these CEFs trade at a discount to the underlying value of the assets, you may be able to buy the equivalent of $1,000 of bonds for $950 or $900 dollars. And that is what is happening right now – tax-loss harvesting is widening the discounts of many bond CEFs.

We generally don’t use CEFs in our portfolio models because they tend to have more price fluctuation than mutual funds. Besides the change in NAV, the discount or premium can change by as much as 10% or more in any year. But when that discount widens to 10% plus, that is often a good entry point for investors who are willing to hold the funds for long-term and who don’t mind a bit of additional volatility.

However, not all CEFs are created equal! There are many different strategies, and they have many more moving parts than mutual funds. We have an in depth process for choosing our CEFs and have been investing in these for more than a decade. If you are looking to increase your portfolio income, let’s talk about if Closed End Funds might be a good fit for you.

Four Investment Themes for 2017

Posted On November 14, 2016 By Scott Stratton, CFP(R), CFA In Portfolio Management / 2 Comments

Each November and December, I undertake a complete review of our Premier Wealth Management Portfolio Models and make tactical adjustments for the year ahead. We have five risk levels: Conservative (roughly 35% equities / 65% fixed income), Balanced (50/50), Moderate (60/40), Growth (70/30), and Aggressive (85/15).

Our investment process is tactical and contrarian. Each year we look for those market opportunities which have attractive and low valuations, and increase our weighting to those segments, while decreasing those categories which appear more expensive. We include Core positions, which offer broad diversification and are the essential and permanent foundation of our portfolios. And we purchase Satellite positions which we feel offer a compelling current opportunity in a more narrow or niche investment category. Typically, there are 12-15 positions in total, consisting of Exchange Traded Funds (ETFs) and Mutual Funds.

While we are not afraid to make changes to our models, we believe that when it comes to trading, less is more. We want to minimize taxable sales and especially to avoid short-term capital gains. That’s why we only change the models once a year, although we also believe that more frequent trading would be likely to be detrimental rather than return enhancing.

For 2017, our portfolio changes will be based on three considerations:
1) Relative valuations (reducing expensive stocks and adding to the inexpensive segments).
2) Replacing our holdings in a few categories, where another fund appears to offers a better risk/return profile.
3) Our world view of the markets in 2017, which is more focused on identifying risk than trying to predict the top performing investments. No matter what, diversification remains more valuable than our opinions about investment opportunities.

Here then are our four investment themes for 2017:

1) Low for Longer
Although interest rates may have bottomed in 2016, it does not appear that there will be a V-shaped recovery. We think interest rates, inflation, Domestic and Global GDP will all remain quite low for 2017.

2) Full Valuations
US Equities are no longer cheap. Years of central banks holding interest rates near zero (or actually negative in some countries this year) has forced investors into risk assets. This has driven up PE multiples. And while I would not call this a bubble, you can’t say that the US market is cheap today. That means that equity growth going forward is likely to be tepid.

Low bond yields pushed investors into dividend stocks, specifically to consumer staples and utilities, which are perhaps the most “bond-like”. These categories seem to be especially bloated and could underperform.

Turning to bonds, the yield on the 10-Year Treasury has increased from 1.6% to 2% in the past three months. Time will tell, but could this summer have been the peak of the 30-year bull market in bonds? I don’t know, but when yields are this low, prices on long-term bonds can move dramatically. We invest in bonds for income and stability and to balance out the equity risk in our portfolios. We’re not interested in using bonds to speculate on the direction of interest rates.

While there may not be an equity level of risk in bonds, it is safe to say that the price of bonds globally is higher in 2016 than it has ever been before. Bonds are much less attractive than five years ago, although we find some pockets that interest us and may at least give us a chance of exceeding inflation and earning a positive real return on our money.

3) Leadership Rotation
I believe we are going to see a very gradual shift in three areas:

A) From Growth to Value. Since 2009, growth stocks have dominated value stocks. This tends to be cyclical, but over the long-term, value has outperformed. We see a widening valuation gap between popular growth stocks, some of which are trading at PEs of 100 or higher, and out of favor value companies. Value is showing signs of life in 2016, and we think that there will be mean reversion at some point that favors value.

B) From Domestic to Emerging. Over the past 5 years, US stocks have reigned. Boosted by a strong dollar and a global flight to quality, US stocks have outperformed others and become more expensive than international stocks. Emerging markets have languished and are now trading at a big discount to developed markets. But emerging economies have higher growth rates and overall, have less debt and more favorable demographics than developed markets. While volatility will be higher, Emerging markets could greatly outperform if you are looking out 10 or 20 years from now.

C) From Bonds to Commodities. In 2016 we have already seen a rebound in oil, gold, and other commodity prices. After years of commodity prices falling, have we put in a bottom? We don’t have commodities in our models currently, but when inflation and interest rates start to pick up, I expect to see commodities gain and bonds suffer. That’s why the bull market in bonds may well end at the same time as the bear market in commodities. 2017 may be a good year to start diversifying for long-term investors.

4) High Risk, Low Return
With full valuations in equities and very low interest rates in bonds, expected returns for a Balanced or Moderate allocation are likely to be noticeably lower than historical returns. While volatility has been actually very mild for the past several years, investors should not be lulled into thinking that their portfolios will continue to grind higher without the possibility of a 10% or 20% correction.

Unfortunately, in today’s global economy, it seems less likely that a traditional diversification, for example, adding small cap and international stocks, will provide any sort of defense in the next bear market. We are expanding our investment universe to look for alternative strategies which can offer a true low correlation to equities. When the market is booming or even just recovering (like 2009), equities are often the top performers. But in a high risk, low return environment, we want some positions that offer the potential for positive returns with lower, different, or uncorrelated risks. If you want to explore these in greater detail, see our new Defensive Managers Select portfolio model.

These four investment themes are important considerations for how we position for 2017. You can get investments anywhere and they are becoming a low-cost commodity. However, what you cannot get anywhere is insight, personal service, and a custom-tailored individual financial plan. Investments are interesting, but we view them as a means to an end. Investments should accomplish your financial goals with the absolute least amount of risk necessary. The more interesting angle is how we can use investments to fulfill your plan just for you.

How to Invest if Income Taxes Increase

Posted On September 26, 2016 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Is there really any doubt that income taxes will be going up at some point in the future? Deficits are growing ($590 Billion for 2016 alone) and there is no interest in Washington in reducing expenditures. Given the magnitude of Federal spending, even if a balanced budget were possible, the reduction in cash flow would crush the economy and send unemployment through the roof. We’re addicted to our spending.

Politicians have realized that even the faintest hint of “raising taxes” would be career suicide. This means that increasing marginal tax rates (except on those making over $250,000) is impossible. But raising tax revenue by “closing loopholes for the rich” is considered a heroic undertaking. There are a lot of proposals out there right now to increase tax revenue, and you don’t have to be Bill Gates or Warren Buffet to be impacted.

Many of these “loopholes for the rich” benefit middle class professionals. Chances are that if you are reading this, you’re going to be paying higher taxes in the years ahead. Even if your marginal tax bracket remains the same, your effective tax rate – the total amount of taxes you pay – could rise with these proposals:

Eliminate the Stretch IRA for beneficiaries who inherit an IRA.
Close the Roth conversion process which allows the “back-door Roth IRA”.
Create Required Minimum Distributions for Roth IRAs.
Cut the estate tax exemption from $5.45 million to $3.5 million and increase the rate from 40% to a range of 45% to 65%.
Eliminate the step-up in cost basis on inherited assets.
Add a 4% surtax on income over $5 million.
Cap itemized deductions to 28% of your income.
Create a capital gains schedule that requires an asset be held for 6 years to qualify for the lowest long-term capital gains rate of 20%. Increase capital gains taxes on assets held less than 6 years.
Increase the Social Security payroll tax from 12.4% to 15.2%.
Increase the payroll tax ceiling from $118,500 (2016) to $250,000. Or eliminate the cap altogether.
Apply the payroll tax to passive income, so business owners are taxed the same on distributions and dividends as they would be on salary.
A proposal in July from Ohio congressman James Renacci would lower the corporate income tax and add a consumption tax, or European-style VAT.
Limit the mortgage interest deduction, which disproportionately benefits wealthier home owners because it requires itemized deductions. One proposal is to replace the deduction with a smaller tax credit.
Place a cap on tax-deferred accounts. For example a 62-year old with $3.2 million in tax-deferred accounts would be ineligible to make further contributions. Other proposals suggest caps as low as $500,000.

Although this is an election year, I do not view this as a political issue. Whoever is elected to the Presidency and to Congress will have to deal with reducing deficits. While some candidates propose to cut taxes, this would dramatically increase the debt, which already stands at $19 Trillion. When interest rates eventually rise, a significant portion of our annual tax revenue could be needed solely for paying interest on our debt. So, I view tax cuts as not only unrealistic, but dangerously inflating a problem our children will ultimately have to bear.

If effective tax rates are going higher, what can you do to keep more of your investment return?

1) Tax efficiency will be more valuable. Using low-turnover ETFs, asset location, and tax loss harvesting can lower your tax liability. Reduce tax drag and keep gross income under $250,000, if possible. See: 6 Steps to Save on Investment Taxes.
2) Tax-free may be more preferable than tax-deferred. If you think your tax rate in retirement will be the same or higher than today, there is less benefit to investing in a Traditional 401(k) or IRA. Preference goes to the Roth 401(k) or Roth IRA. See: To Roth or Not to Roth.
3) Tax-free municipal bonds will be even more attractive when compared to taxable bonds.
4) Rather than allowing capital gains to accumulate for years and become an enormous tax bill in the future, it may be wise to harvest gains in years when you are in a lower tax bracket, up to the threshold of your current tax rate.
5) Don’t negate reduced tax rates for qualified dividends and long-term capital gains by placing those investments into an IRA or Annuity where the distributions will be taxed as ordinary income.