More than two years after the crash of 2008, advisors are still grappling with the fallout and are seeking new solutions to manage volatility. With a 50% drop in the S&P, followed by the flash crash of 2010, the fear index spiked to new heights. In a Jefferson National survey from last year, a clear majority of advisors-roughly two-to-one-said tactical management is the right approach for this tough market. Of nearly 1,000 respondents, 68% of the advisors surveyed felt pressure to revise their asset management strategies, 66% said clients were more confident in a tactical strategy, and 63% were more likely to employ a tactical strategy.
The basic building blocks of good investing won't change: establish a goal, create a plan, follow a disciplined approach and don't overreact. But in today's volatile market, more advisors are moving to the disciplined use of a tactical-asset management strategy, instead of relying strictly on traditional buy-and-hold.
The Tax-Efficient Frontier
Here's a challenge. Tactical strategies can generate higher taxes owed by the client. The solution: Creating the tax-efficient frontier. New research shows that tax deferral can potentially increase returns on tax-inefficient assets by as much as 100 basis points without any subsequent increase in risk, simply by locating assets based on their tax treatment. Tax-inefficient assets, including bond funds, REITs and many hedge-like funds, generate ordinary income or short-term capital gains, currently taxed at rates as high as 35%. And actively managed investments are often hit hardest-short-term capital gains tax plus the possible added cost of multiple transaction fees.
Creating the tax-efficient frontier could be as simple as putting all tax-efficient assets in taxable vehicles, and all tax-inefficient assets in tax-deferred vehicles. But in the real world, U.S. tax law places restrictions on contributions to tax-deferred qualified accounts. This can be a major hurdle for highly compensated individuals.
In 2010, 401(k) plan limits were $16,500 (plus catch up contributions of $5,500 for individuals over 50) and IRA limits were $5,000 ($6,000 over age 50).
So how can you implement a tactical strategy to help smooth the ride for your clients, while making the move to the tax-efficient frontier? Three different advisors give their take on the benefits of using the power of tax deferral with a more active investing approach.
"If the market is truly random, why risk capital by investing in it at all?" asks Teri Weigel, principal and chief compliance officer of Purcell Advisory Services. Her answer: "Markets don't always need to move up for investors to profit. With the right tactical strategy in place to reduce risk, preserve assets and capture gains, volatility can be a very generous friend."
Modern portfolio theory is based on three tenets: the belief that investor behavior is rational, historical return distributions are normal and market upside volatility is as important as its downside counterpart. "But at Purcell, we focus on post-modern portfolio theory,' where semi-standard deviation has a heavier weight than standard deviation, and where investor behavior is not rational," Weigel says. "We think black swan events are likely to happen more frequently going forward, and that means moving beyond buy and hold."
Purcell's actively-managed investment programs are developed to take advantage of market volatility, and its investment team conducts extensive due diligence to find the best tactical strategies for inclusion in their line up of risk-averse tactical investment choices and continuously monitors for adherence to their defined objectives.
"Our investment programs are structured more like absolute return strategies so that whichever direction the market moves, the opportunity for gain is there, over time," Weigel says. While the firm's tactical approach has helped advisors and their clients outperform the market, they still face a big hurdle.
"As active managers, our capital gains are all short term and will be taxed as ordinary income unless assets are located in a tax-deferred vehicle," she says. For her high-net-worth clients who need tax-deferred vehicles beyond their qualified plans, Weigel has uncovered a new trend in the annuity industry. Simple, low-cost, no-load variable annuities allow her clients to unlock the potential for greater performance and achieve the tax-efficient frontier.
Chance for Success
"Think about your most important goals: raising your children, staying healthy, your relationships, your career," says Brian Schreiner, vice president of Schreiner Capital Management, Inc., a fee-only RIA and money manager which serves financial professionals.
Schreiner notes that with a passive strategy an individual is just holding on to the market with all its ups and downs. "Many investors simply aren't willing to accept this kind of volatility. The advisors who work with us have more confidence that a tactical strategy has greater potential to improve their returns and minimize risk-especially in today's volatile market." The firm's flagship investment strategy, Classic Sectors, has surpassed the S&P 500 Index by 22% since its inception in 1996. "Most importantly," Schreiner says, "is that it has done so while taking about 40% less risk than the index."
Schreiner adds that his clients are "attracted to the discipline of our system." While his active approach will generate some short term capital gains for clients, he says: "If we can manage risk and preserve capital for risk-averse investors the tax bill is secondary." Still, there's no doubt that minimizing taxes on tactical strategies can bring greater benefit to clients and enhance their portfolio's performance. That's when the tax-efficient frontier comes into play.
Schreiner has always found tax-deferral options limited, especially for his high- net-worth investors. He believes they are the ideal candidates for using a low-cost, flat-insurance fee VA to achieve the tax-efficient frontier.
A Bull Market for Trading
Dedicating nearly three decades to studying the market and managing investments, Steve Blumenthal, founder, president and chief executive officer of CMG Capital Management, believes that investor's portfolios should always include a diversified blend of e_SDHpabsolute return strategies. But he is convinced that it's crucial to invest differently during long-term secular bear markets, than during long-term secular bull markets.
"If the market was undervalued, I'd increase exposure to a more traditional, longer-term buy-and-hold focus. But that just isn't the case today," Blumenthal says. He adds that it is important to increase portfolio weightings to include strategies that can make money in a volatile environment. "Active management is about capital preservation, achieving above average returns, and non-correlation to the general equity and fixed income markets for enhanced diversification. Adding this to a portfolio can provide tremendous value," Blumenthal says. "At CMG, it's our job to bring the due diligence, research, experience, and the trading discipline to help our clients gain access to absolute return strategies."
Combining the esoteric strategies of hedge funds with transparency and daily liquidity is a powerful proposition, but the tax implications can be steep.
By applying the principles of the tax-efficient frontier, Blumenthal uses a tax-deferred vehicle to let the gains grow and enhance performance potential in a meaningful way. And for his high-net-worth clients who may find it difficult for you to get substantial assets into a qualified account, Blumenthal also relies on a no-load VA. He chooses one with a flat-insurance fee that keeps costs low, and a broad selection of funds to manage any market challenge, preserve principal and help clients earn more for the long term.
Right Fit for Tough Market
Looking back at the past decade, "a long-only portfolio did not win the day. For the last 10 years, the S&P 500 has returned 1.41% when annualized. That's not buy and hold, it's buy and hope!" Weigel says. "And while we can't predict the future of taxes, it's hard to imagine how the government can provide the services and economic stimulus that it's promised without some kind of tax hike. That makes it even more important to find flexible and efficient investment vehicles that offer the benefits of tax deferral."
Schreiner agrees. "In this challenging environment, we are seeing three trends: a greater demand for tactical strategies, a greater focus on a holistic approach to financial advice, and a greater tax-awareness when it comes to portfolio construction."
But there has never been a better time for an advisor to grow their business, Blumenthal says. "Provide that different advisor experience for your clients by integrating proven active absolute return strategies into their portfolios," he says. While a relatively new concept to many advisors, endowments such as Penn, Harvard and Yale have been allocating to the absolute return space for many years, with the benefit of tax-free growth. "Today there are liquid, non-correlating alternative solutions available for all investors," he adds. "And the ability to implement active strategies on a tax-deferred basis, where suitable, is powerful."
Combining tactical management with tax-deferral can unlock the potential for greater performance. It can help clients complete their long-term investing strategy and reach their goals faster. In today's challenging environment, where every single basis point of performance counts, the tax-efficient frontier looks like the right fit for a tough market.
Laurence P. Greenberg is president of Jefferson National. For more information, visit www.jeffnat.com.