Fixed Income: Four Ways to Invest

Posted On April 28, 2015 By Admin In Portfolio Management /

Fixed Income is an essential piece of our portfolio construction, a component which can provide cash flow, stability, and diversification to balance out the risk on the equity side of the portfolio. Although fixed income investing might seem dull compared to the excitement of the stock market, there are actually many different categories of fixed income and ways to invest. As an overview, we’re going to briefly introduce the various tools we use in our fixed income allocations.

1) Mutual Funds. Funds provide diversification, which is vitally important in categories with elevated risks such as high yield bonds, emerging market debt, or floating rate loans. In those riskier areas, we want to avoid individual securities and will instead choose a fund which offers investors access to hundreds of different bonds. A good manager may be able to add value through security selection or yield curve positioning.

While we largely prefer index investing in equities, the evidence for indexing is not as conclusive in fixed income. According to the Standard & Poor’s Index Versus Active (SPIVA) Scorecard, only 41% of Intermediate Investment Grade bond funds failed to beat their index over the five years through 12/31/2014. Compare that to the 81% of domestic equity funds which lagged their benchmark over the same five year period, and you can see there may still be an argument for active management in fixed income.

2) Individual Bonds. We can buy individual bonds for select portfolios, but restrict our purchases to investment grade bonds from government, corporate, and municipal issuers. The advantage of an individual bond is that we have a set coupon and a known yield, if held to maturity. While there will still be price fluctuation in a bond, investors take comfort in knowing that even if the price drops to 90 today, the bond will still mature at 100. It’s difficult for a fund manager to outperform individual bonds today if their fund has a high expense ratio. You cannot have a 1% expense ratio, invest in 3% and 4% bonds, and not have a drag on performance.

Those are the advantages of individual bonds, but there are disadvantages compared to funds, including liquidity, poor pricing for individual investors, and the inability to easily reinvest your interest payments. Most importantly, an investor in individual bonds will have default risk if we should happen to own the next Lehman Brothers, Enron, or Detroit. Bankruptcies can occur, and that’s why we only use individual bonds in larger portfolios where we can keep position sizes small.

3) Exchange Traded Funds (ETFs). ETFs offer diversified exposure to a fixed income category, but often with a much lower expense ratio than actively managed funds. ETFs can allow us to track a broad benchmark or to pinpoint our exposure to a more narrow category, with strict consistency. Fixed income ETFs have lagged behind equity ETFs in terms of development and adoption, but there is no doubt that bond ETFs are gaining in popularity and use each year.

4) Closed End Funds (CEFs). CEFs have been around for decades, but are not well known to many investors. Closed End Funds have a manager, like a mutual fund, but issue a fixed number of shares which trade on a stock exchange. The result is a pool of assets which the fund can manage without worry about inflows or redemptions, giving them a more beneficial long-term approach. With this structure, however, CEFs can trade at a premium or a discount to their Net Asset Value (NAV). When we can find a quality fund trading at a steep discount, it can be a good opportunity for an investor to make a purchase. Unfortunately, CEFs tend to have higher volatility than other fixed income vehicles, which can be disconcerting. We don’t currently have any CEF holdings as core positions in our portfolio models, but do make purchases for some clients who have a higher risk tolerance.

Where fixed income investing can become complicated is that within each category (such as municipal bond, high yield, international bond, etc), you also have to compare these four very different ways of investing: mutual funds, individual bonds, ETFs, or CEFs. They each have advantages and risks, so it’s not as easy as simply choosing the one with the highest yield or the strongest past performance. And that’s where we dive in to each option to examine holdings, concentrations, duration, pricing and costs.

There are other ways to invest in fixed income, such as CDs, or annuities, and we can help with those, too. But most of our fixed income investing will be done with mutual funds and ETFs. In larger portfolios, we may have some individual bonds, but will always have funds or ETFs for riskier categories.

Investors want three things from fixed income: high yield, safety, and liquidity. Unfortunately, no investment offers all three; you only get to pick two. Where we aim to create value is through a highly diversified allocation that is tactical in looking for the best risk/reward categories within fixed income.

Our Investment Process

Posted On April 1, 2015 By Admin In Portfolio Management / 1 Comment

Growth Versus Value: An Inflection Point?

Posted On March 30, 2015 By Admin In Portfolio Management /

Over time, Value stocks outperform Growth stocks. There are a number of reasons why this has held true over the history of the market. Value stocks may include sectors which are currently out of favor and inexpensive. Investors, on the other hand, are sometimes willing to pay too much for a sensational growth story rather than a boring, blue chip company. Often, those great sounding stocks flame out rather than shooting higher as hoped. The result is that the long-term benefit of value strategies has persisted.

Although the “Value Anomaly” is a historical fact, it hasn’t worked in all periods, and we’re at such a point in time now. Growth has actually outperformed value over the past decade. Even though growth beat value in only 5 of the past 10 calendar years, the cumulative difference is notable. Over the past 10 years, the Russell 1000 Growth fund (IWF) has returned an annualized 9.18% versus 7.10% for the Russell 1000 Value (IWD). And so far this year, Growth (IWF) is up 5%, whereas Value (IWD) has gained only 0.63%.

The last time growth showed a marked divergence from value was the 90’s. And at that time, we saw the valuations of growth companies rise to unsustainable levels. This largely occurred in the tech sector, where for example, we saw Cicso trade for more than 200 times earnings, and become the most valuable company in the world in 2000. Eventually, growth corrected with the bursting of the tech bubble, and we saw value stocks return to favor. These are the cycles of the market, as inevitable as the seasons, although not as consistent, predictable, or rational!

I don’t think we’re in bubble territory for the market today, but some popular growth names have certainly started to become expensive and value is looking like a relative bargain. Looking at the top 10 stocks in the both indices, the growth stocks have an average PE of 27, versus 17 for the 10 largest value companies. Some of that difference is Facebook, #4 on the Growth list, with a PE of 75. However, the difference in valuation is across the board. Two of the largest value companies, Exxon Mobil and JPMorgan Chase have a PE of only 11.

So, what are the take-aways from the Growth/Value divergence?

Growth has outperformed value in recent years. This will not continue forever.
Our portfolios are diversified, owning both growth and value segments. We have a slight tilt towards value, which we will continue. When value returns to favor, this will benefit not only pure value funds, but will also likely help dividend strategies, low volatility ETFs, and fundamentally-weighted funds.
As the overall market becomes more expensive, I would expect to see that we will move from a unified market, where all stocks move up or down together, to a more segmented market, where stocks move more based on their valuation and fundamentals. Global macro-economics have been the primary driver of stock prices in recent years, but this should abate somewhat as the recovery continues.

We won’t know if we’ve reached an inflection point, where value will overtake growth, until well after the fact. Growth can’t outperform indefinitely, and as investors become more cautious, value stocks will start to look more and more attractive. That’s what we’re seeing in the market today and why we started to increase our value holdings in 2015.

Source of fund data: Morningstar, through 3/27/2015

Get Off the Sidelines: 3 Ways to Put Cash to Work

Posted On February 9, 2015 By Admin In Portfolio Management /

I know there are many investors who have a lot of cash on the sidelines. They may have raised cash fearing a pullback in 2014. Or maybe they made contributions to their IRA and didn’t invest the money because the market was at or near a high. Others sold positions once they reached their price targets and have been sitting in cash ever since.

Looking at today’s valuations, it’s a lot tougher to find bargains that seemed plentiful a few years ago. Unfortunately, holding cash cost investors plenty last year, when the S&P 500 Index was up more than 13%. And that’s the problem with trying to time the market with your purchases: you can miss a lot of upside by being on the sidelines, even if you’re out for a relatively short period.

If you have a significant level of cash in your portfolio that will not be needed in the next couple of years, it probably makes sense to put your cash to work. And while there’s no guarantee (ever) that the market will be higher in a month or a year from now, that’s the uncertainty that we have to accept in order to make more than the risk-free rate over time.

I can understand that putting a lot of cash to work at once is daunting when the market is up like it is today. So rather than thinking in black and white terms of all-in or all-out, let’s consider three strategies to help you get that excess cash invested prudently.

1. Dollar Cost Average. We invest in three tranches, 90 days apart, investing 1/3 of the cash position each time. This gives us the advantage of getting an average price over time. If prices drop, we can pick up more shares at a lower price.

Dollar Cost Averaging worked well in the second half of 2014, as we had cash to invest in October when the market was down 7%. Of course, there are also times when the market rises, and the lowest prices were available at the first trade date. In that case, Dollar Cost Averaging can increase your average cost basis.

2. ETF Limit Orders. One of the advantages of Exchange Traded Funds (ETFs) compared to Mutual Funds is the ability to use limit orders. If you believe there might be a pullback in 2015, place a limit order to buy ETFs at a set price or percentage below the current values.

For example, if you think there might be an 8% correction, we could set limit orders that are 8% below the current price of each ETF. This way we have a plan in place that will automatically invest cash if the market does in fact drop. Even though there is no guarantee we will have such a drop, this is still a much better plan than saying “Let’s wait and see what happens”, because when the market is down, people don’t feel good about making purchases. And recently, any corrections in the market have been short-lived, so there has been only a small window of opportunity.

3. Use “Low Volatility” ETFs. If the primary concern is market volatility, there are Low Volatility products can help reduce that risk today. These are funds which quantitatively select stocks from a broader index, choosing only the stocks which are exhibiting a lower level of fluctuations and risk. Low volatility funds are available in most core categories today, such as large cap, small cap, foreign stock, and emerging markets.

Over time, a Low Volatility index may be able to offer similar returns to a traditional index, but with measurably lower standard deviation of returns. These ETFs have been available for only a couple of years, so this belief is largely based on back testing, and there’s no guarantee this strategy will work in the immediate future.

We should also note that a Low Volatility strategy is likely under perform in Bull Markets (think late 90’s, or 2009), and could lag other strategies for an extended period of time. Additionally, Low Volatility does not prevent losses, so the strategy could certainly lose money like any other equity investment in a bear market.

With those caveats in mind, I am happy to use Low Volatility funds if they give an investor some more comfort with their equity positions and the willingness to put cash to work. Time will tell if these funds are successful in achieving their stated objectives, but in my opinion, Low Volatility funds are among the more compelling ideas offered to investors in the past several years.

Each of these three strategies has advantages and disadvantages, and there is no magic solution to the conundrum of how to get cash off the sidelines today. My role is to work with each investor to find the best individual solution to move forward and have a plan to accomplish your personal goals. Luckily, we have a number of tools and techniques available to help address your concerns.

Indexing Wins Again in 2014

Posted On February 2, 2015 By Admin In Portfolio Management /

2014 was another strong year for Index funds. According to the Wall Street Journal, only 13% of actively managed large cap funds exceeded the 13.7% total return of the S&P 500 Index for the year. It seems like each year, when index funds outshine active managers, we hear different excuses why. This time, market breadth was blamed, as a high correlation of returns meant that there were few stand-out stocks for managers to make profitable trades. In previous years, we heard managers complain about a “junk rally”, or that “our style is out of favor this year”. And of course, each year, we also hear why the new year is going to finally be a stock pickers market.

We use index funds as the core of our Good Life Wealth model portfolios. Indexing works. I think the misconception about indexing is that it means settling for average returns or that it’s a lazy approach. The reality is that using index funds actually increases your chances of achieving good performance. Index funds outperform 60-80% of actively managed funds over the long-term.

Of course, some actively managed funds do beat the indices. Why not just select those funds? Unfortunately, past returns are not a reliable indicator of future performance. We know this is true – and not just my opinion – through the Standard and Poors Persistence Scorecard, which rigorously measures the persistence of fund performance. Updated in December, the Persistence Scorecard found that of 421 domestic equity funds in the top quartile (top 25%) over five years, only 20.43% remained in the top quartile for the subsequent five-year period.

Top Quartile funds based on 5-year performance (as of September 2009). Over the next 5 years, through September 2014:

20.43% of the funds remained top quartile
19.95% fell into the second quartile
22.33% dropped into the third quartile
27.09% sunk to the bottom quartile
10.21% of the funds were merged or liquidated

If long-term performance was a reflection of manager skill, why are so few funds able to continue to be above average? The results above suggest that instead of high-performing funds remaining at the top, their subsequent returns are almost randomly distributed. In fact, top quartile funds are more likely to be at the bottom (27%) than to remain at the top (20%). And surprisingly, 10% of those top funds don’t even exist in five years. Unfortunately, buying that 5-star fund that has been killing the market often turns out to be a poor decision in a few years time. Then the investor switches to a new hot fund, and the cycle of hope and disappointment begins again.

Indexing avoids these pitfalls. It’s a smart way to invest. And when you look at the tax efficiency of index funds compared to active funds, indexing looks even smarter. (Don’t even ask about the tax consequences of trading mutual funds every couple of years.) But using index funds isn’t a once and done event. We carefully create our asset allocation each year in consideration of valuations, risks, and potential returns for the year ahead. Even when we don’t make any changes to the portfolio models, we still monitor client portfolios and rebalance annually to make sure your holdings stay in line with our target weightings. Perhaps most importantly, the indexing approach allows investors to focus their energy on saving and planning decisions, rather than monitoring managers or searching for the next hot fund.

Are Equities Overvalued?

Posted On January 5, 2015 By Admin In Behavioral Finance, Portfolio Management /

In last week’s blog, we reviewed the fixed income market and discussed how we are positioned for the year ahead. Today, we will turn our attention to the equity portion of our portfolios. Perhaps the top question on most investors’ minds is whether the 5-year bull market can continue in 2015. At this point, are equities overvalued or do they still have room to run?

I don’t think it’s useful to try to make predictions about what the market will do in the near future, but I’m certainly interested in understanding what risks we face and what areas may offer the best value for our Good Life Wealth model portfolios. We use a “Core + Satellite” approach which holds low-cost index funds as long-term “Core” positions, and tactically selects “Satellite” funds which we believe may enhance the portfolio over the medium-term (12-months to a couple of years).

The US stock market was a top performer globally in 2014. The S&P 500 Index was up over 13% for the year, and US REITs (Real Estate Investment Trusts) returned 30%. Those are remarkable numbers, especially on the heels of a 32% return for the S&P in 2013. With six years in a row of positive returns, valuations have increased noticeably for US stocks. The S&P now has a forward P/E (Price/Earnings ratio) of 18, slightly above the long term average of 15-16.

While US stocks are no longer cheap, that doesn’t automatically mean that the party is over. With a strong dollar, foreign investors are continuing to buy US equities (and enjoyed a greater than 13% gain in 2014, in their local currency). The US economic recovery is ahead of Europe, where growth remains elusive and structural challenges are firmly in place. Compared to many of the Emerging Market countries, the US economy is very stable. Emerging economies face a number of economic and political issues, and struggle with declining energy prices, often their largest export.

US Stocks remain the most sought-after. While today’s P/E is above average, “average” is not a ceiling. Bull Markets can certainly exceed the average P/E for an extended period. And given today’s unprecedented low bond yields, it’s tough to make a comparison to past stock markets; equities are the only place we can hope to find growth. Current valuations are not in bubble territory, but it seems prudent to set lower expectations for 2015 than what we achieved in the previous five years. And of course, stocks do not only go up; there are any number of possible events which could cause stocks to drop in 2015.

Given the current strength of the US market, you might wonder why we own foreign stocks at all. They certainly were a drag on performance in 2014. In Behavioral Finance, there is a cognitive error called “recency bias”, which means that our brains tend to automatically overweight our most recent experiences. For example, if we did a coin-toss and came up with “heads” four times in a row, we’d be more likely to bet that the fifth toss would also be heads, even though statistically, the odds remain 50/50 for heads or tails.

Checking valuations is a important step to avoid making these types of mistakes. Looking at the current markets, Foreign Developed Stocks do indeed have better value than US stocks, with a P/E of 15.5 versus 18. And Emerging Market stocks, which were expensive a few short years ago, now trade at an attractive P/E of 13. We cannot simply look at which stocks are performing best to create an optimal portfolio allocation. Diversification remains best not just because we don’t know what will happen next year, but because we want to buy tomorrow’s top performers when they are on sale today.

Our greatest tool then is rebalancing, which trims the positions which have soared (and become expensive), to purchase the laggards (which have often become cheap). So we’re making very few changes to the models for 2015, because we want to own what is cheap and want to avoid buying more of what is expensive, even if it does continue to work. We will slightly reduce International Small Cap, and add the proceeds to US Large Cap Value. US Small Cap has become quite expensive, but small cap value now trades at a bit of a discount (or is less over-valued, perhaps), so that is another shift we will make this year.

Each year, I do an in-depth review of our portfolio models and I always find the process interesting and worthwhile. This year, looking at relative valuations in equities reminds me that our best path is to remain diversified, even if owning out-of-favor categories appears to be contrarian in the short-term.

The Dangers Facing Fixed Income in 2015

Posted On December 30, 2014 By Admin In Portfolio Management /

Although returns were largely positive, 2014 did little to ease the risks in Fixed Income, and in some categories, made the situation decidedly more precarious. Looking at the funds and ETFs I follow, municipal bonds, foreign bonds, and long-term treasuries saw their yields fall, with prices markedly higher. Bonds with the longest duration experienced the greatest change in price.

We are now several years into a low interest rate environment which central banks, like the Federal Reserve, manufactured through their interest rate policies and quantitative easing (bond buying) mechanisms. The market consensus was that these depressed interest rates were like a coiled spring, ready to shoot higher and eventually cause bond investors to endure painful losses. The flip side of some bonds gaining 10-20% in value this year is that if interest rates were to increase by 1-2% in 2015, those same investors could potentially see 20% or higher losses in their positions.

A strong return in 2014 creates a challenging situation – if those categories were overvalued before, they’re even more expensive now. Although the potential for interest rate risk is now higher than ever, the market is beginning to recognize that without increased signs of inflation, we might be stuck with these low rates for an unprecedented number of years. While the yield on the US 10-year Treasury is around 2.2% today, the equivalent 10-year government bond yields less than 1% in Germany, Japan, and a number of other countries. To accept such a low rate suggests that deflation remains a greater concern than inflation for investors in some locations.

Investors positioned defensively in short-term bonds, floating rate, high yield bonds, or TIPS, all lagged the Barclays Aggregate Bond Index in 2014. How should we position for 2015 then? In our Good Life Wealth model portfolios, we are taking a three-prong approach.

1) We don’t try to predict interest rates or speculate on bonds. The role of Fixed Income in our portfolios is to mitigate the risk of our Equity positions. We are looking to have lower interest rate risk (“duration”) than the overall bond market. This means we will make less if interest rates continue to fall, but we will also lose less if or when rates eventually rise.

2) We will underweight areas where yields are too low to compensate for the potential risks. For now, this means we avoid foreign and US treasuries and TIPS. We keep cash to a minimum, to 1% or the amount required for 12 months of withdrawals.

3) We consider each Fixed Income category in terms of its potential rewards and risks. For example, a fund with an SEC yield of 3 and a duration of 3, would have a ratio of 1; a fund with a yield of 2 and a duration of 4, would have a ratio of 0.5, which is less desirable. That’s not to say that we can simplify our selection process to a single step, but it does help inform how quickly we would recover from potential losses, so we can be better positioned if interest rates were to rise.

Although bond prices can be volatile in the short-term, the beauty of bonds is that their Yield to Maturity is a very strong predictor of how the bonds will behave over their lifetime. Our primary focus then is on the opportunity each bond category will provide over time rather than what might occur in the short-term.

With US Stocks sitting at or near all-time highs, bonds may be an after-thought for some investors. And with today’s paltry yields, it’s no wonder. However, bonds have an important role in protecting our portfolios and creating income to contribute to our total return. We’re not going to ignore the risks in bonds, so you can count on our Fixed Income allocation to continue to be tactical in the years ahead.

Year-End Tax Loss Harvesting

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

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.

Socially Responsible Investing

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

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.

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.