Will Small Caps continue to rally under Trump Presidency?

Small Cap stocks are a long-time favorite of many individual investors and portfolio manager. The asset class jumped 38% since the last election. Will Small Caps continue to rally under Trump Presidency? Can they maintain their momentum?

The new president Trump started with promises for domestic business growth, lower taxes, and deregulation. While details are still unclear, if implemented correctly, these policies can bring significant benefits to small size companies.

The recent growth comes after five years of sluggish performance. Before the 2016 election, the Russell 2000 had underperformed S&P 500 500 by almost 2% annually, 11.59% versus 13.44%.  Small-cap stocks have been very volatile and fragmented. As a result, many active managers have underperformed passive index strategies.

 

Low tax rates

The average US corporate tax rate is 39.1% which includes 35% federal tax and 4.1% average state tax. USA has the highest corporate tax among OECD countries, which have an average of 29% tax rate. While large multinationals with their corporate lawyers can take advantage of cross-border tax loopholes, the same is not possible for smaller businesses. Dropping the tax rate to the suggested 20% will give small caps a breath of fresh air. It will allow them to have more available cash, which they can use for hiring more talent, R&D or dividends.

Deregulation

Regulations are typically set to protect the consumer and the environment from businesses which prioritize profit margins over safety. Therefore, lifting regulations will be a tricky game. If the streamlining leads to more competition, better customer experience, less bureaucracy, and faster processing of business requests to governing bodies, then deregulation will help smaller business thrive further and be more competitive.

 Infrastructure

I drive a lot around the San Francisco Bay Area and can ensure you that every highway with “80” in the name is in dire need of major TLC. The same story is probably true for many major cities and industrial centers. If the executed correctly, the infrastructure policy can boost small business growth. Local companies can bid for infrastructure projects or participate as subcontractors. Improved infrastructure can also help goods and produce to arrive faster and safer and ultimately drive down cost.

Domestic production incentives

With the current strong dollar and liberal trading policy, the small business has struggled to compete against imports, which rely heavily on cheap labor and often on local government subsidies. Certain industries like textile and electronics are almost non-existent in the US.

Nevertheless, I think setting embargos and trade wars with other countries will be a step in the wrong direction. Alternatively, The US government should support industries that offer innovative, high quality, customized and niche products, which can dominate the global markets.

 

While the markets are currently optimistic about the success of the new economic policies, things can still go wrong. The markets had a long rally since the end of the bear market in March 2009. At the current level, both large and small-cap companies have reached rich valuations, and stock prices are factoring the proposed economic policies. The stock market may react abruptly if the new administration fails to deliver their promises.

Some of the side effects of the new policies need to be in consideration as well.

Rising interest rates

The 10-year Treasury jumped from 1.5% in July 2016 to 2.47% today. While high-interest rates have been welcomed by many market players, they can hurt the small business’ ability to get new loans. Many companies rely on external financing to fund their daily business activities, R&D, and expansions. Higher interest rates will increase the cost and affect the bottom line of those companies that traditionally use loans as part of their business and have less access to internal resources.

Another caveat in this topic is the proposed change to eliminate the interest as a tax deduction. While still up-in-the-air, this proposal will further affect those companies that depend on external loans for financing.

Inflation

Inflation is healthy for the economy when it’s a result of organic economic growth, innovation, productivity, and consumer demand. However, if let out of control, inflation will undermine the purchasing power of the dollar, push down consumer demand and increase the cost of domestic goods and services.

Strong dollar

Small cap companies are traditionally focused on the local US market. However, a strong dollar can make imports more price competitive against local products. The strong dollar also affects negatively business relying on exports. It makes US exports more expensive in local currencies.

Immigration

It’s a known fact that US firms tap into a foreign talent to fill out jobs that are not in high supply by domestic job seekers. Usually, the biggest portion of visa workers goes to larger companies. However, stricter immigration laws can still hurt the ability of small firms to hire foreign talent and compete against their larger rivals. Many tech start-ups, financial and biotech companies rely on foreign visa workers to fill out certain roles whenever they cannot find qualified US candidates. Agriculture and tourism businesses also depend on foreign workers to fill in seasonal positions. Tighter immigration rules will force these companies to increase salaries to remain competitive. Higher salaries will drive higher cost and lower profit margins.

 

Conclusion

While we are in a standby mode, the market continues to be nervous in anticipation of the direction of the new policies. For those interested in small-cap stocks, I would suggest looking for companies with an innovative business model, solid R&D and high-quality metrics like ROA and ROE. Those companies are likely to be more resilient in the long run, and less depended on policy changes.

 

Final words

If you have any questions about your existing investment portfolio, reach out to me at [email protected] or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

Municipal Bond Investing

Municipal Bond Investing

What is a Municipal Bond?

Municipal bond investing is a popular income choice for many Americans.  The muni bonds are debt securities issued by municipal authorities like States, Counties, Cities, and related businesses. Municipal bonds or “munis” are issued to fund general activities or capital projects like building schools, roads, hospitals, and sewer systems. The size of the muni bond market has reached 3.7 trillion dollars. There are about $350 billion of Muni bond issuance available every year.

To encourage Americans to invest in Municipal Bonds, US authorities had exempted the muni bonds’ interest (coupon income) from Federal taxes. In some cases, when the bondholders reside in the same state where the bond was issued, they can also be exempted from state taxes.

Types of Municipal Bonds

Municipal entities issue general obligation bonds to finance various public projects like roads, bridges, and parks. General obligation bonds are backed by the full faith and credit of the issuing municipality.  Usually, they do not have a dedicated revenue source. The local authorities commit their abundant resources to pay off the bonds. Municipals rely on their unlimited power to tax residents to pay back bondholders.

Revenue bonds are backed by income from a particular project or source. There is a wide diversity of types of revenue bonds, each with unique credit characteristics. Municipal entities frequently issue securities on behalf of borrowers such as water and sewer services, toll bridges, non-profit colleges, or hospitals. These underlying borrowers typically agree to repay the issuer, who pays the interest and principal on the securities solely from the revenue provided by the conduit borrower.

Taxable Bonds. There is a smaller but growing niche of taxable municipal bonds. These bonds exist because the federal government will not subsidize the financing of certain activities, which do not significantly benefit the general public. Investor-led housing, local sports facilities, refunding of a refunded issue, and borrowing to replenish a municipality’s underfunded pension plan, Build America Bonds (BABs) are types of bond issues that are federally taxable. Taxable municipals offer higher yields than those of other taxable sectors, such as corporate or government agency bonds.

Investment and Tax Considerations

Tax-Exempt Status

With their tax-exempt status, muni bonds are a powerful tool to optimize your portfolio return on an after-tax basis.

Muni Tax Adjusted Yield

So why are certain investors flocking into buying muni bonds? Let’s have an example:

An individual investor with a 35% tax rate is considering an AA-rated corporate bond offering a 4% annual yield and an AA-rated municipal bond offering a 3% annual yield. All else equal, which investment will be more financially attractive?

Since the investors pays 35% on the received interest from the corporate bonds she will pay 1.4% of the 4% yield to taxes (4% x 0.35% = 1.4%) having an effective after-tax interest of 2.6% (4% – 1.4% = 2.6%). In other words, the investor will only be able to take 2.6% of the 4% as the remaining 1.4% will go for taxes. With the muni bond at 3% and no federal taxes, the investor will be better off buying the muni bond.

Another way to make the comparison is by adjusting the muni yield by the tax rate. Here is the formula.

Muni Tax Adjusted Yield = Muni Yield / (1 – tax rate) = 4% / (1 – 0.35%) = 4.615%

The result provides the tax-adjusted interest of the muni bond as if it was a regular taxable bond. In this case, the muni bond has 4.615% tax-adjusted interest, which is higher than the 4% offered by the corporate bond.

 The effective state tax rate

Another consideration for municipal bond investors is the state tax rate. Most in-state municipal bonds are exempt from state taxes, while out-of-state bonds are taxable at the state tax level. Investors from states with higher state tax rates will be interested in comparing the yields of both in and out-of-state bonds to achieve the highest after-tax net return. Since under federal tax law, taxes paid at the state level are deductible on a federal income tax return, investors should, in fact, consider their effective state tax rate instead of their actual tax rate. The formula is:

Effective state tax rate = State Income Tax rate x (1 – Federal Income Tax Rate)

Example, if an investor resides in a state with 9% state tax and has 35% federal tax rate, what is the effective tax rate:

Effective state tax rate = 9% x (1 – .35) = 5.85%

If that same investor is comparing two in- and out-of-state bonds, all else equal, she is more likely to pick the bond with the highest yield on net tax bases.

AMT status

One important consideration when purchasing muni bonds is their Alternative Minimum Tax (AMT) status. The most municipal bond will be AMT-free. However, the interest from private activity bonds, which are issued to fund stadiums, hospitals, and housing projects, is included in the AMT calculation. If an investor is subject to AMT, the bond interest income could be taxable at a rate of 28%.

Social Security Benefits

If investors receive Medicare and Social Security benefits, their municipal bond tax-free interest could be taxable. The IRS considers the muni bond interest as part of the “modified adjusted gross income” for determining how much of their Social Security benefits, if any, are taxable. For instance, if a couple earns half of their Social Security benefits plus other income, including tax-exempt muni bond interest, above $44,000 ($34,000 for single filers), up to 85% of their Social Security benefits are taxable.

Diversification

Muni bonds are a good choice to boost diversification to the investment portfolio.  Historically they have a very low correlation with the other asset classes. Therefore,  municipal bonds returns have observed a smaller impact by developments in the broader stock and bond markets.

For example, municipal bonds’ correlation to the stock market is at 0.03%. Their correlation to the 10-year Treasury is at 0.37%.

Interest Rate Risk

Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate goes up, muni bond prices will go down. And reversely, as the interest rates decline, the bond prices will rise. When you invest in muni bonds, you have to consider your overall interest rate sensitivity and risk tolerance.

Credit Risk

Like the corporate world, municipal bonds and bond issuers receive a credit rating from major credit agencies like Moody’s, S&P 500, and Fitch. The credit rating shows the ability of the municipality to pay off the issued debt. The bonds receive a rating between AAA and C, with AAA being the highest possible and C the lowest. BBB is the lowest investment-grade rating, while all issuance under BBB is known as high-yield or “junk” bonds. The major credit agencies have different methodologies to determine the credit rating of each issuance. However, historically the ratings tend to be similar.

Unlike corporations, which can go bankrupt and disappear, municipals cannot go away. They have to continue serving their constituents. Therefore, many defaults end up with debt restructuring followed by continued debt service. Between 1970 and 2014, there were 95 municipal defaults. The vast majority of them belong to housing and health care projects.

In general, many investors consider municipal debt to be less risky. The historical default rates among municipal issuances are a lot smaller than those for comparable corporate bonds.

Limited secondary market

The secondary market for municipal bonds sets a lot of limitations for the individual investor. While institutional investors dominate the primary market, the secondary market for municipal bonds offers limited investment inventory and real-time pricing. Municipal bonds are less liquid than Treasury and corporate bonds. Municipal bond investing tends to be part of a buy-and-hold strategy as most investors seek their tax-exempt coupon.

Fragmentation

The municipal bond market is very fragmented due to issuances by different states and local authorities. MUB, the largest Municipal ETF, holds 2,852 muni bonds with the highest individual bond weight at.45%. The top 5% holdings of the ETF make 1.84% of the total assets under management. For comparison, TLT, a 20-year old Treasury ETF, has 32 holdings with the largest individual weight at 8.88%. The top 5% make up 38.14% of the assets under management.

Incentive Stock Options

Incentive Stock Options

What is an Incentive Stock Option?

Incentive stock options (ISOs) are a type of equity compensation used by companies to reward and retain their employees. ISOs have more favorable tax treatment than non-qualified stock options. While similar to NQSOs, they have a few major differences:

  • ISOs are only granted to company employees.
  • They can only be vested for up to $100,000 of underlying stock value each year
  • ISO must expire after ten years
  • They are not transferrable
  • Long-term capital gain tax is due on the difference between the selling price and exercise price under certain conditions. To receive this tax benefit, ISO holder has to keep the stock for one year and one day after the exercise date and at least two years and one day from the grant date.
  • If the sale date does not meet the above requirements, ISO is disqualified as such and treated as NSO. In that case, you will owe ordinary income tax and short / long-term capital gain taxes
  • Options granted to shareholders with 10% or more ownership must be priced at least at 110% of the Fair Market Value and not be vested for five years from the date of the grant.
  • Alternative Minimum Tax is applicable on the difference between market price and exercise price in the year of exercise. You have to report the difference (also known as the bargain element) to IRS. This may have an impact on your final tax at the end of the year, depending on various other deductions.

Key dates

if you own ISOs, you need to keep track of these important dates:

Grant Date – the date when the options were awarded to you
Vesting Date – the date from when the options can be exercised
Exercise Date – the date when the options are actually exercised
Expiration Date – the date after which the options can no longer be exercised

Important price levels

In addition, you also need to keep a record of the following prices:

Exercise price or strike price – the value at which you can buy the options
Market price at exercise date – the stock value on the exercise date
Sell price – stock value when held and sold after the exercise date
Bargain element – the difference between market price and exercise price at the time of exercise

Tax Considerations of Incentive Stock Options

The granting event of ISOs does not trigger taxes. Receivers of incentive stock options do not have to pay taxes upon their receipt.

Taxes are not due on the vesting date, either. The vesting date opens a window for up to 10 years by which you will be allowed to exercise the ISO.

ISO exercise is not a tax event from the IRS perspective if you meet the holding period requirements by selling your stock after one year and a day after exercise and two years and a day after the grant date. Depending on when you sell the stock after the exercise date, six main scenarios can occur:

Scenario 1

You exercise your options and keep them. No tax due; however, you will have to make an adjustment for Alternative Minimum Tax for the amount of your bargain element.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at the exercise price of $10. Your tax rate is 25%. On the exercise date, you exercise the options and decide to keep the shares indefinitely. The market price on that day is $15.

You are not required to report any additional ordinary income.

However, you must adjust your AMT for $5,000.

(15 – 10) x 1,000 = $5,000.

Scenario 2

You exercise your options and sell them in the same year, less than 12 months from the exercise date. This disqualifies your ISO and converts it to NSO. You will have to report ordinary income on your bargain element and short-term capital gain or loss taxes on the difference between the selling price and the market price at the exercise date. You do not need to adjust for AMT if you sell your ISO within the same calendar year.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for three months in the same calendar when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

No AMT adjustment is due since you sold your shares in the same calendar year.

Scenario 3

You exercise your options and sell them in the next year, but less than 12 months from the exercise date. Your selling price is less than the market price at exercise. Since you sell less than a year after the exercise, your ISO is disqualified. Because your selling price is lower, IRS allows you to adjust your bargain element to the lower price

Example: Let’s assume that you are granted 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for five months until the next calendar year when the price drops to $12 and then sell all your shares.

Your original bargain element is $5,000

(15 – 10) x 1,000 = $5,000.

Since the price dropped from $15 to $12, you are allowed to adjust down your bargain element to $2,000 and add it as additional ordinary income.

(12 – 10) x 1,000 = $2,000.

Since your tax rate is 25%, you will owe an additional $500 for taxes on $2,000 of extra income.

$2,000 x 25% = $500

Your total due to IRS will be $500.

You will also have to report an adjustment of -$3,000 ([12 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 4

You exercise your options and sell them in the next year, but less than 12 months from the exercise date. Your sell price is higher than the market price at exercise. Since you sell less than a year after exercise, your ISO is disqualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 11 months in the next year…when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

 

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 5

You exercise your options and sell them after one year from the exercise date, but less than 24 months from the grant date. Since you sell less than two years after the grant date, your ISO is disqualified.

You will owe ordinary income and long-term capital gain taxes. Your total due to IRS will be $1,700

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 18 months in the next year when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 15% = $450

Your total due to IRS will be $1,700

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 6 

You exercise your options and sell them after one year from the exercise date, and after 24 months from the grant date. Since you meet the requirements for ISO, your sale is qualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for twelve months after the exercise date and 24 months after the grant date when the price goes up to $18 and then sell all your shares.

You are allowed to report $8,000 of long term capital gain.

(18 – 10) x 1,000 = $8,000.

You will also owe $1,250 on your $8,000 of long-term capital gains at either 0, 15%, or 20%. Most people will have to pay 15% (See my posting about short and long term capital gains and losses)

$8,000 x 15% = $1,250

Your total due to IRS will be $1,250.

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

How to minimize the tax impact of Incentive Stock Options?

  1. Meet the holding period requirements for one year after exercise and two years after the grant date. This will give you the most favorable tax treatment.
  2. Watch your tax bracket. Your tax rate increases as your income grow. Depending on the vesting and expiry conditions, you may want to consider exercising your options in phases to avoid crossing over the higher tax bracket. Keep in mind that tax brackets are adjusted every year for inflation and cost of living.
  3. AMT breakeven – you can exercise just the right number of shares to remain below the AMT tax level. Most accounting software will be able to calculate the exact amount.
  4. Use AMT credits when applicable. In the years when you pay AMT, you can rollover the difference between your AMT and regular tax due as a credit for futures years. The caveat is that AMT credit can only be used in the years when you pay regular taxes.
  5. You can donate or give as a gift your low-cost base stocks acquired through the exercise of ESO. You have to follow the holding period requirement to get the most favorable tax treatment.

Non-Qualified Stock Options

Non-qualified stock options

What are Non-qualified stock options?

Non-qualified Stock Options (NSOS) are a popular type of Employee Stock Options (ESO) and a favorite tool by employers to reward and retain workers. NSOs are a contract between the employee and the employer giving the employee the right but not the obligation to purchase company stocks at a pre-determined price in a set period.

Non-qualified Stock Options are similar to exchange-traded call options (ETO) in the way they allow their owner to benefit from the rise of the company stock. However, there are significant differences. There is no public market for NSOs. They can be extended for up to 10 years, while most exchange-traded options expire within a year or two. Additionally,  the employer sometimes can change the strike price of the NSOS while this is not possible for ETO.

Another popular equity compensation is an Incentive Stock Option. Click here to learn more about ISOs

Who gets Non-qualified stock options?

Non-qualified stock options are usually granted to company employees, but they can also be given to vendors, clients, and the board of directors. They can be exercised at any time between their vesting date and expiration date. They offer more flexibility than Incentive Stock Options but have less favorable tax treatment. The key requirement set by the IRS for NSOs is that the exercise price can never be less than the fair market value of the stock as of the grant date. While that can be pretty straightforward for publicly traded corporations, there are several valuation caveats for privately held companies.

Keep track of these important dates

If you own Non-qualified Stock Options, you have to be very strategic and keep track of all dates associated with the contract. You should get a copy of your option agreement and read it carefully. The devil is in the details.

The dates you need to remember are:

  • Grant Date – the date when the options were awarded to you
  • Vesting Date – the date from when the options can be exercised
  • Exercise Date – the date when the options are actually exercised
  • Expiration Date – the date after which the options can no longer be exercised

In addition, you also need to keep a record of the following prices:

  • Exercise price or strike price – the value at which you can buy the options
  • Market price at exercise date – the stock value on the exercise date
  • Sell price – stock value when held and sold after the exercise date
  • Bargain element – the difference between market price and exercise price at the time of exercise

 

 Taxes for Non-qualified stock options

The granting event of NSO does not trigger taxes. Therefore, receivers of non-qualified stock options do not have to pay taxes upon their receipt.

Taxes are not due on the vesting date either. The vesting date opens a window up to the expiration date by when you will be allowed to exercise the NSO.

NSO exercise is the first tax event from an IRS perspective. Depending on when you sell the stock after exercise three main scenarios can occur:

Scenario 1

You exercise your options and sell them immediately at the market price. You owe taxes on the difference between the market price and exercise price multiplied by the number of shares

Example: Let’s assume that you are granted NSO equal to 1,000 shares at an exercise price of $10. Your tax rate is 25%. On the exercise date, you sell your shares immediately. The market price on that day is $15.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

5,000 x 25% = $1,250

Your total due to IRS will be $1,250

Scenario 2

You exercise your options and sell your company share a few months later (but less than 12 months) at the current price on that day.

First, you owe taxes on the difference between the market price and exercise price multiplied by the number of shares. Second, you also owe short-term capital gain taxes on the difference between the selling price and the market price on the exercise date multiplied by the number of shares.

Example: Let’s assume that you are granted NSO equal to 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for three months when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $750 dollars on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

Scenario 3

You exercise your options and sell your company shares one year later at the current price on that day.

First, you owe taxes on the difference between the market price and exercise price multiplied by the number of shares $5,000 ((15 – 10) x 1,000) as additional ordinary income. Second, you also owe long-term capital gain taxes on the difference between the sale price and the market price on the exercise date multiplied by the number of shares.

Example: Let’s assume that you are granted NSO equal to 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for twelve months when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $450 dollars on your $3,000 of long-term capital gains at either 0, 15% or 20%. Most people will have to pay 15% (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 15% = $450

Your total due to IRS will be $1,700

Tax Impact Summary

  • The receiver of non-qualified stock options will pay taxes on the difference between the stock market value and exercise price at the time of NSO exercise. The value has to be reported as an additional ordinary income.
  • If stocks are sold immediately after exercise at the current market value, you only owe taxes on the difference between market and exercise value.
  • In case you decide to keep the stocks you will owe long-term or short-term capital gains taxes depending on your holding period.
  • If the stock goes down after exercise and you choose to sell, you can report a short-term or long-term capital loss. You can use this loss to offset other capital gains. You can also use up to $3,000 of capital losses to offset ordinary income (like salary, commissions, interest). The remainder of the loss in excess of $3,000 can be rolled over in future years.

IRC § 83(b) election

IRC § 83(b) election allows companies to offer an early exercise of stock options. When making this election employees will pay income taxes on the fair value of their stock options. The early election is especially lucrative for founders and employers of early-stage startups with low fair market value.

This election is rarely done due to the difficulty in calculating the value of the options. If you can determine the value at the time of the grant and decide to pursue this road, you will owe taxes on the fair market value of your options at the grant date. But no income tax will be due at the time of vesting. Another disadvantage of this strategy is the risk of the employee stock price falling below the level at the time of the grant. In this scenario, it would have been advantageous to wait until the vesting period.

What can you do to minimize your tax impact?

  1. Prioritize long-term vs. short-term holding period. Selling shares after holding them for more than 12 months will trigger long-term capital gains which have favorable tax rates over short-term capital gain rates.
  2. Exercise your options as close to the exercise price as possible. However, companies often set very low exercise price, and this strategy may not be viable.
  3. Watch your tax bracket. Your tax rate increases as your income grow. Depending on the vesting and expiry conditions, you may want to consider exercising your options in phases to avoid crossing over the higher tax bracket. Keep in mind that tax brackets are adjusted every year for inflation and cost of living.
  4. You can also donate or give as a gift your low-cost base stocks acquired through the exercise of NSO
  5. If the NSO options are transferable, usually restricted to family members, you can consider giving them away as a donation or a gift

MLP Investing – Risks and benefits

MLP Investing

MLP investing is popular among retirees and income-seeking investors.  In this article, we will break down the benefits, risks and tax implications of investing in MLPs.

What is an MLP?

Managed Limited Partnerships (MLPs) have grown in popularity in the past several years. Many U.S. energy firms have reorganized their slow-growing, but stable cash flow businesses, such as pipelines and storage terminals, into MLPs.

MLPs are very attractive to income-seeking investors. They must pass at least 90% of their income to their partners (investors). As a whole, the MLP sector offers on average 6% annual yield with some MLPs reaching over 15%.

Companies that operate as MLPs tend to be in very stable, slow-growing industries, such as pipelines and energy storage. The nature of their business offers few opportunities for price appreciation. On the other hand, cash distributions are relatively stable and predictable giving the MLPs features of both an equity and fixed income investment.

The number of public MLPs increased dramatically in the past 20 years. There were more than 18 IPOs in 2014 from almost zero in 1984.      

MLP Legal structure

There are two types of MLP owners – general and limited partners. General partners manage the day-to-day operations of the partnership. All other investors are limited partners and have no involvement in the company’s activities. MLPs technically have no employees.

MLP investors buy units of the partnership. Unlike shareholders of a corporation, they are known as “unitholders.”

Each unitholder is responsible for paying their share of the partnership’s income taxes. Unitholders are required to file K-1 forms in each state where the MLP operates, regardless of the size of revenue generated from that state. This filing requirement makes the direct MLP ownership.

Additionally, open-end funds like traditional ETFs are restricted from investing more than 25% of their portfolio in MLPs. Therefore most ETFs choose a C-corporation or ETN structure in order to track the MLP market.

Distributions

MLPs provide generous income to their investors. The average yield is around 6% as some small MLPs pay up to 15%. The distributions from MLP consist of non-qualified dividends, return on capital, and capital gains.

Since MLPs pass through 90% of their income to unitholders, each type of distribution has different tax treatment.

Dividends are taxed at the ordinary income tax level, up to 39.6% plus 3.8% for Medicare surcharge.

Capital gains are taxable as either long-term or short-term. Long-term capital gains have favorable tax treatment with rates between 0, 15% and 20%. Short-term gains are taxed at the ordinary income level.

The largest portion of MLP distributions comes as a return on capital. The benefit comes from the MLPs use of depreciation allowances on capital equipment, pipelines, and storage tanks, to offset net income. Return on capital distributions are tax deferred. Instead of being immediately taxable, distributions decrease the cost basis of the investment. Taxes are only due to these distributions when investors sell their units. In fact, investors can defer paying taxes indefinitely by keeping their shares.

Tax Impact

MLP distributions are not sheltered from taxes in retirement accounts. According to the Unrelated business taxable income (UBTI) rule, unitholders will owe taxes on partnership income over $1,000 even if the units are held in a retirement account.

Individual MLP holdings, ETFs, mutual funds and CEFs are most suitable for long-term buy and hold investors in their taxable investment accounts. Those investors can benefit from the tax-deferred nature of the cost of capital distributions, which will decrease their cost basis over time. They will pay taxes only when they sell their units. Investors can avoid paying taxes indefinitely or until cost basis reaches zero. In that case, they will owe taxes on the return of capital distributions at the long-term capital gain rate.

Short-term investors may consider ETNs for their better index tracking. All distributions from ETNs are taxable as an ordinary income level and do not provide any preferential tax treatment.

Risk considerations with MLP Investing

MLPs drive their revenue from the volume of transported energy products. Their business is less dependent on the fluctuations of the commodity prices compared to other oil & gas companies. Historically, MLPs as a group is less volatile than the broader energy sector. MLP price tends to have a direct correlation with the partnership distributions. Higher payouts drive higher prices while lowers distributions push the price down.

Between September 2010 and October 2016, the largest MLP ETF, AMLP had a standard deviation equal to 14.8%. As a comparison, the largest energy ETF, XLE, had a standard deviation of 19.61%.

MLPs are often treated as an alternative investment due to their considerable ownership of real assets. They also have a lower correlation with the broad equity and fixed income markets while simultaneously having characteristics of both. AMLP has 0.57 correlation with S&P 500 and -0.16 to the 20-year treasury.

MLP Investing options

Direct ownership

As of March 31, 2016, 118 energy MLPs were totaling $304 billion in market capitalization.

The most popular index tracking the MLP space is Alerian MLP. The index has 44 constituents and $298 billion market capitalization.

There are ten companies dominating the sector. They make up close to two-thirds of the Alerian MLP Index. The remainder consists of hundreds of small and mid-size partnerships.  

Direct MLP ownership is a popular strategy for yield-seeking investors. The direct investing also provides the most beneficial tax treatment of MLP distributions – tax deferral.

However, the biggest drawbacks of direct investing are the large tax filing cost and exposure to a single company.

Investors interested in direct ownership in MLPs should consider buying a basket of partnerships to diversify their risk more efficiently. They should also weight the tax benefits of direct ownership versus the cost of year-end tax filing.

ETFs and ETNs

MLP ETFs and ETNs have the most complex legal and tax structure of any other ETFs. Due to these complexities, most funds are structured as ETNs.

There are 28 MLP ETFs and ETNs currently listed on the exchange. Their total Asset Under Management (AUM) is $17.7 billion with the top 4 ETFs dominating the space with total AUM equal to $15.9 billion. 

AMLP

AMLP is the most popular and liquid MLP ETF. It tracks the Alerian MLP index. AMLP is the first ETF to address the complexity of direct MLP ownership.  This ETF offers a broad diversification to the largest publicly traded MLPs.

AMLP offers simplified tax filing by issuing standard 1099 form. Because of its legal structure, AMLP can pass the tax-deferred treatment of MLP distributions to its investors.

To satisfy the legal restrictions on ownership, AMLP is structured as a corporation, not an actual ETF.  AMLP pays taxes at the corporate level. The structure requires the fund to accrue the future tax liabilities of unrealized gains in its portfolio. Doing this is causing the fund to trail its underlying Alerian Index during bull markets and beat it during down periods.

AMJ

AMJ is the next most popular fund in this category. It is structured as an exchange-traded note.

ETNs are an unsecured debt instrument structured to track an underlying index’s return, minus management fees. Unlike exchange-traded funds, ETNs do not buy and hold any the underlying assets in the indexes they track. They represent a promise by the issuing bank to match the performance of the index.

AMJ is issued by JP Morgan and capped at the market value of $3.885 billion. Investors in AMJ have credit exposure to JP Morgan in case they are not able to pay the performance of the index.

Due to the lack of actual MLP ownership, AMJ can replicate the performance of the Alerian MLP index much closer than AMLP.

AMJ also issues single 1099 tax form. However, all its distributions are taxable as ordinary income, for up to 39.6% plus 3.8% of Medicare surcharge. AMJ distributions do not have the preferential tax treatment of AMLP and individual MLP ownership.

This ETF is suitable for short term investors willing to bet on the MLP sector and not interested in any potential income and tax benefits.

EMLP

EMLP is the only traditional ETF in this group. Because of the regulatory restrictions, EMLP holds only 25% stake in MLPs and the remaining 32% in Energy, 40% in Utilities and 2% in Basic Materials. Unlike the other funds, EMLP has a broader exposure to companies in the energy infrastructure sector. According to the prospectus, the fund invests in publicly traded master limited partnerships and limited liability Canadian income trusts,, pipeline companies, utilities, and other companies that derive at least 50% of their revenues from operating or providing services in support of infrastructure assets such as pipelines, power transmission and petroleum and natural gas storage in the petroleum, natural gas and power generation industries.

Mutual Funds

The three Oppenheimer mutual funds are dominating this niche. They manage almost 50% of the $20b AUM by MLP mutual funds.

The MLP mutual funds tend to have higher fees than most ETFs. They utilize the corporate structure which allows them to transfer the majority of the income and tax advantages to their shareholders.

Closed-End Funds

Closed-End funds (CEF) are another alternative for investing in the MLP sector. Similarly to mutual funds,  CEFs are actively managed. The difference is that they only issue a limited number of publicly traded shares.

Most MLP closed-end funds use leverage between 24% to 40%  to boost their income. These funds borrow money in order to increase their investments.

 

CEFs shares often trade at premium or discount from the NAV of their holdings. When purchased at a discount they can offer potential long-term gains to interested investors.

MLP CEFs also use the c-corp structure. They issue a 1099 form and pass current income and return on capital to their investors allowing for tax-deferral benefits on the distributions.

 

Investing in Small Cap Stocks

Small Cap Stocks

Small cap stocks are an important part of a diversified investment portfolio. They had provided high historical return and diversification, which are key factors in the portfolio management process.

Many flagship companies started as small businesses in a local market and evolved to large multinational corporations. Some of these success stories include McDonalds, which opened its first restaurant in Des Plaines, Illinois to become one of the biggest food chains in the world.

Research has shown that small-cap stocks overperformed a large cap over an extended period.

The below chart shows 15-year performance between IWM, Russell 2000 Small Cap ETF and SPY, S&P 500 Large Cap ETF. For that period IWM surged by 164% while SPY rose by 67%.

 

Once we include dividends, the 15-year annualized return of a small cap blend strategy becomes 8.66% versus 6.71% for a large cap strategy.

If we extend our period to 40 years (1975 – 2015), the small cap generated 14.25% annualized return while large cap produced 11.66%.

Investing in small companies comes with many caveats.  Even though they bring potentially high returns, they also impose high risk and uncertainty.

Small cap stocks market capitalization

Small cap companies have a market capitalization between $300 million and $2 billion dollars. Overall, the small size market is very fragmented. There are thousands of publicly traded small-size companies, but they only make 10-15% of the total market. The definition of a small-cap company varies widely among index providers and portfolio managers. Standard & Poor’s tracks their own S&P 600 Small Cap Index while FTSE Russell tracks the Russell 2000 Small Cap Index.

Very often, small companies are managed by their original founders.  They are usually new and innovative companies with competitive strengths in a particular local market or a specific product. It is not uncommon for companies to go back and forth between small, mid and large-cap rankings depending on their business cycle.

Niche market

Small cap companies often operate in a niche market where they have a distinct competitive advantage. Small businesses have a unique product or service, which they offer on either national or local level.  Unlike their bigger counterparts, which offer a variety of products in different geographies, small size companies tend to be more focused, with one or two flagship products. A particular example can be Coca Cola versus Red Bull. Coca-Cola offers hundreds of varieties of beverages worldwide while Red Bull offers only one type of energy drink.

Regularly small companies will start from a local market and grow nationwide.  Starbucks is a great example of a local coffee shop that moved up the ranks and became one of the top 100 large company in the USA and the world.

Small businesses with a unique product will often become an acquisition target for a larger corporation that wants to gain a presence in a growing higher margin market. Great example for that is PepsiCo acquiring Gatorade. PepsiCo wanted to get access to the fast growing market of sports drinks and instead of developing their own line; they decided to purchase an already established brand.

Growth potential

Small cap companies often have higher revenue growth than large size ones. Their competitive advantages, innovative strategy, flexibility and market positioning allows them to grow faster. It is easier to increase 25% when you start at $10 million of revenue versus $25% at $ 1 billion of revenue. Many times small companies do not even have a competition in their market niche. Think of Facebook before they went public. It is common for small firms to grow their revenue between 25% and 50% annually for several consecutive years.

Volatile prices

Investing in small cap stocks is risky. The high potential return of small caps comes with greater risk. The share price of small companies is more volatile and subject to larger swings than those of bigger companies.

IWM, the biggest small-cap ETF, has a beta of 1.22 to the equity market. As the comparison, the beta of SPY, the most traded large-cap ETF, is equal to 1. Beta measures the volatility of a security compared to the market as a whole. IWM beta of 1.22 shows that the ETF is historically 22% more volatile than the overall market.

Another measure of volatility is a standard deviation. It illustrates how spread out are the historical returns compared to the average annualized return of the investments. In our case, the 15-year standard deviation of IWM is 19.73% versus 14.14% for SPY.

As I mentioned earlier, the average 15-year return for a small cap stock is 8.66%. With a standard deviation equal to 19.73%, an average annual return can go between -11.07% and 28.39%. For SPY the average range is between -7.43% and +20.85% with annualized return of 5.25%. Based on this historical data we can claim that the small cap market has a much wider probability of returns. The high upside comes with a bigger downside.

Limited access

Small cap stocks lack the liquidity and trading volume of the large public corporations. This makes them more vulnerable to large price swings in short periods.

In times of economic recession, small companies can take a bigger hit in their earnings and may take a longer time to recover. Ten or fifteen percent decline in revenues can have a much more adverse impact on a small company than a larger one.

Due to their limited access to equity markets and loan financing, small size companies have a higher risk to go into bankruptcy if they run out of money.

Many small firms are start-ups with one innovative product and untested business models. Their dependency on just one product or service puts them in a very high-risk category in cases when the product or service does not appeal to their target customer base.

Inefficient market

Traders and portfolio managers often ignore small-cap companies. The focus is usually on large size companies, which frequently have 5 to 10 analysts following their earnings.  In fact, research analysts cover very few of the 2,000 stocks in the Russell 2000 index. Therefore, it is common that a small company does not have a full coverage by any industry analysts. This lack of interest and publicity produces conditions for inefficient pricing.   Active investors with a focus on the small cap market can scan the universe for undervalued and mispriced stocks and generate higher returns based on their valuation techniques and knowledge of the market.

Diversification

Investing in small cap companies can significantly contribute to the diversification of your portfolio.  Even though small stocks have a higher risk than larger ones, their correlation to the overall market is lower. A small blend strategy has 0.86 correlation to the overall US stock market and 0.56 to the broader international stock market.

A correlation equal to 1 shows the highest strength of the relationship between two asset categories. In the case of small cap, the correlation of 0.86 shows a weaker link with the overall market. Small cap prices does not fluctuate in the same magnitude and pace as the large cap companies.  While there is some influence by S&P 500, they follow an independent path.

 

How to invest in small cap stocks

Individual stocks

You can invest in small size companies by buying them directly on the open market. There are over 2,000 listed small size companies in various industries and stages of their business cycle. Naturally, you cannot invest in all 2,000 stocks. You have to find a way to narrow down your criteria and select stocks based on certain factors. Very few small companies have analyst coverage. Therefore investing in small caps stocks will require doing your own research, analysis, and valuation.

When you invest in any company directly, being that a small or large size, you have to keep in mind that concentrated positions can adversely affect your portfolio performance if that company has a bad year or goes bankrupt. While everyone’s risk sensitivity is different, I would recommend limiting the range of each individual stock investment to 1% – 2% of your portfolio.

Tax Impact

For the best tax impact, I recommend putting small cap stocks either in taxable or Roth IRA accounts. Small cap companies have higher expected return combined with a higher expected volatility. If you hold your stocks in a taxable account, you can take advantage of tax loss harvesting opportunities if a particular stock in your portfolio is trading at lower levels than original purchase price. Tax loss harvesting is not available in Roth IRA, Traditional IRA, and 401k accounts. I

If you have small-cap stocks with solid long-term return prospects, keeping them in a taxable account will also allow you to pay the favorable long-term capital gain tax when you decide to sell them.

Having stocks in a Roth IRA account will have even better tax treatment – zero tax at the time of sale.

Passive indexing

ETFs and index mutual funds are the top choice for passive small cap investing. They provide a low-cost alternative for investors seeking a broader exposure to the small cap market. Small cap ETFs come in different shapes and forms. The table below shows a list of the most traded small cap ETFs with AUM above $500 million:

List of Small Cap ETFs

TICKER

FUND NAME EXPENSE RATIO AUM SPREAD % 1 YEAR 5 YEAR 10 YEAR SEGMENT

AS OF

IWM iShares Russell 2000 ETF 0.20% $27.79B 0.01% 5.69% 12.28% 6.01% Equity: U.S. – Small Cap 10/26/2016
IJR iShares Core S&P Small Cap ETF 0.07% $20.83B 0.03% 7.35% 14.16% 7.56% Equity: U.S. – Small Cap 10/26/2016
VB Vanguard Small-Cap Index Fund 0.08% $13.94B 0.03% 5.59% 13.14% 7.40% Equity: U.S. – Small Cap 10/26/2016
VBR Vanguard Small Cap Value Index Fund 0.08% $8.16B 0.04% 7.31% 14.20% 6.77% Equity: U.S. – Small Cap Value 10/26/2016
IWN iShares Russell 2000 Value ETF 0.25% $6.72B 0.01% 9.39% 12.17% 4.82% Equity: U.S. – Small Cap Value 10/26/2016
IWO iShares Russell 2000 Growth ETF 0.25% $6.35B 0.02% 1.92% 12.31% 7.01% Equity: U.S. – Small Cap Growth 10/26/2016
VBK Vanguard Small-Cap Growth Index Fund 0.08% $4.93B 0.04% 3.50% 11.36% 7.25% Equity: U.S. – Small Cap Growth 10/26/2016
IJS iShares S&P Small-Cap 600 Value ETF 0.25% $3.85B 0.03% 10.26% 14.31% 6.57% Equity: U.S. – Small Cap Value 10/26/2016
SCHA Schwab U.S. Small-Cap ETF 0.06% $3.78B 0.04% 5.46% 13.03% Equity: U.S. – Small Cap 10/26/2016
IJT iShares S&P Small-Cap 600 Growth ETF 0.25% $3.47B 0.08% 4.41% 13.74% 8.42% Equity: U.S. – Small Cap Growth 10/26/2016
DES WisdomTree SmallCap Dividend Fund 0.38% $1.59B 0.12% 11.96% 14.36% 6.35% Equity: U.S. – Small Cap 10/26/2016
FNDA Schwab Fundamental US Small Co. Index ETF 0.32% $1.04B 0.06% 6.38% Equity: U.S. – Small Cap 10/26/2016
SLYG SPDR S&P 600 Small Cap Growth ETF 0.15% $807.64M 0.27% 4.61% 13.74% 9.00% Equity: U.S. – Small Cap Growth 10/26/2016
VTWO Vanguard Russell 2000 Index Fund 0.15% $675.74M 0.06% 5.67% 12.19% Equity: U.S. – Small Cap 10/26/2016
XSLV PowerShares S&P SmallCap Low Volatility Portfolio 0.25% $651.46M 0.09% 12.43% Equity: U.S. – Small Cap 10/26/2016
SLYV SPDR S&P 600 Small Cap Value ETF 0.15% $610.42M 0.21% 10.46% 14.43% 7.38% Equity: U.S. – Small Cap Value 10/26/2016
SLY SPDR S&P 600 Small Cap ETF 0.15% $512.80M 0.25% 7.10% 13.99% 8.19% Equity: U.S. – Small Cap 10/26/2016

Benchmark

One of the main differences between small-cap ETFs is the index they track. Each of the three main Small Cap Indexes is constructed differently.

Russell 2000 (IWM) includes the bottom 2,000 of the largest 3,000 publicly traded companies. The average market cap of the constituents of Russell 2000 is equal to $1.9 billion. The median is 698 million. And the largest stock has a market cap of $6 billion.

S&P 600 Index (IJR) tracks a smaller subset of the market. It includes only 600 companies.  As of April 2016, the market capitalization of companies included in the Index ranged from US$ 400 million to US$ 1.8 billion. S&P 600 also sets additional requirements for liquidity, public float, sector and financial viability.

CRSP SmallCap index (VB) tracks the 2%-15% percentile of the total market. It has 1,462 companies. The smallest company has a market capitalization of $21 million; the largest has $7.9 billion. The average size is $1.85 billion. The median is $1.44 billion. It is worth noting that VB tracked Russell 2000 Index through May 16, 2003; MSCI US Small Cap 1750 Index through January 30, 2013; CRSP US Small Cap Index thereafter

Focus

Another big difference between Small Cap ETFs is their segment focus. There are three main segments – small cap blend, growth, and value. The blend strategy invests in the wide universe of small caps, which mechanically tracks the designated index. The value strategy tracks a specific group of companies that have a  certain level of Price to Earnings, Price to Sales, Price to Book, dividend yield, and other fundamental ratios. Growth strategy invests in a group of stocks that meet certain criteria for price, revenue and earnings growth.

Tax Impact

ETFs and index funds have more favorable tax treatment than actively traded mutual funds. Due to their passive nature and legal structure, these funds rarely release capital gains and losses to their shareholders. Therefore, investors looking to optimize taxes in their investment portfolio should consider these type of funds.

Active investing

This strategy includes investing in actively managed mutual funds. These funds are run by management teams. They normally charge higher fees than comparable ETF to cover for the trading, administrative, marketing and research expenses.  Mutual funds follow a benchmark, which is usually one of the three main indices described earlier – S&P 600, Russell 2000 or CSRP Small Cap Index. Because of their higher fees than comparable ETFs, fund managers are often expected to outperform their benchmark.

Active funds normally focus in one of the three main segments – blend, growth or value. The fund managers utilize a formal selection process that identifies a number of companies, which meet certain proprietary criteria. The end goal is to select those companies that will achieve a higher return than the undying benchmark. Since the characteristics of value vs. growth strategy can be subjective, it is not an unusual that the same company is owned by both value and growth oriented funds.

In the past 7-8 years, many of the active managers have been criticized for underperforming the market. Part of the reason is that we experienced a very long market rally driven by a small number of flagship companies.

Tax Impact

Actively managed mutual funds have a more complex tax structure. They must transfer most of their dividends and capital gains and losses to their shareholders. Mutual funds will often have large amounts of long or short-term gains and losses released in December regardless how long you had kept in your portfolio, to avoid paying additional taxes I recommend placing your actively managed mutual funds in tax deferred and tax exempt accounts. Another alternative is to look for tax-managed funds. They tend to have a low turnover ratio and tend to report long-term gain and losses less frequently.

 

10 Ways to reduce taxes in your investment portfolio

10 Ways to reduce taxes in your investment portfolio

Successful practices to help you lower taxes in your investment portfolio

A taxable investment account is any brokerage or trust account that does not come with tax benefits. Unlike Roth IRA and Tax-Deferred 401k plans, these accounts do not have many tax advantages. Your contributions to the account are with after-tax dollars. This is money you earned from salary, royalties, the sale of a property, and so on. All gains, losses, dividends, interest, and other income from any investments are subject to taxes at the current tax rates.  In this post, we will discuss several successful practices that can help you lower taxes in your investment portfolio

Why investors put money into taxable accounts? They provide flexibility and liquidity, which are not available by other retirement accounts. Money is readily accessible for emergencies and unforeseen expenses. Many credit institutions take these accounts as a liquid asset for loan applications.

Since investment accounts are taxable, their owners often look for ways to minimize the tax impact at the end of the year. Several practices can help you reduce your overall tax burden.

1. Buy and Hold

Taxable investment accounts are ideal for buy and hold investors who don’t plan to trade frequently. By doing that investors will minimize trading costs and harvest long-term capital gains when they decide to sell their investments. Long-term capital gains are taxable at a favorable rate of 0%, 15% or 20% plus 3.8% Medicare surcharge. In contrast, short-term gains for securities held less than a year are taxed at the higher ordinary income level.

Individuals and families often use investments accounts for supplemental income and source of liquidity. Those investors are usually susceptible to market volatility. Diversification is the best way to lower market risk. I strongly encourage investors to diversify their portfolios by investing in uncorrelated assets including mid-cap, small-cap, international stocks, bonds, and real assets.

2. Invest in Municipal Bonds

Most municipal bonds are exempt from taxes on their coupon payments. They are considered a safer investment with a slightly higher risk than Treasury bonds but lower than comparable corporate bonds.

This tax exemption makes the municipal bond suitable investment for taxable accounts, especially for individuals in the high brackets category.

3. Invest in growth non-dividend paying stocks

Growth stocks that pay little or no dividends are also a great alternative for long-term buy and hold investors. Since the majority of the return from stocks will come from price appreciation, investors don’t need to worry about paying taxes on dividends. They will only have to pay taxes when selling the investments. 

4. Invest in MLPs

Managed Limited Partnerships have a complex legal and tax structure, which requires them to distribute 90% of their income to their partners. The majority of the distributions come in the form return on capital which is tax-deferred and deducted from the cost basis of the investments. Investors don’t owe taxes on the return on capital distributions until their cost basis becomes zero or decide to sell the MLP investment.

One caveat, MLPs require K-1 filing in each state where the company operates, which increases the tax filing cost for their owners.

 5. Invest in Index Funds and ETFs

Index funds and ETFs are passive investment vehicles. Typically they track a particular index or a benchmark. ETFs and index funds have a more tax-efficient structure that makes them suitable for taxable accounts. Unlike them, most actively managed mutual funds frequently trade in and out of individual holdings causing them to release long-term and short-term capital gains to shareholders.

6. Avoid investments with a higher tax burden

While REITs, taxable bonds, commodities, and actively managed mutual funds have their spot in the investment portfolio, they come with a higher tax burden.

The income from REITs, treasuries, corporate and international bonds is subject to the higher ordinary income tax, which can be up to 39.6% plus 3.8% Medicare surcharge

Commodities, particularly Gold are considered collectibles and taxed at a minimum of 28% for long-term gains.

Actively managed funds, as mentioned earlier, periodically release long-term and short-term capital gains to their shareholders, which automatically triggers additional taxes.

7. Make gifts

You can use up to $14,000 a year or $28,000 for a couple to give to any number of people you wish without tax consequences. You can make gifts of cash or appreciated investments from your investment account to family members at a lower tax bracket than yours.

8. Donate 

You can make contributions in cash for up to 50% of your taxable income to your favorite charity. You can also donate appreciated stocks for up to 30% of AGI. Consequently, the value of your donation will reduce your income for the year. If you had a good year when you received a big bonus, sold a property or made substantial gains in the market, making donations will help you reduce your overall tax bill for the year.

9. Stepped up cost basis

At the current law, the assets in your investment account will be received by your heirs at the higher stepped-up basis, not at the original purchase price. If stocks are transferred as an inheritance directly (versus being sold and proceeds received in cash), they are not subject to taxes on any long-term or short-term capital gains. Your heirs will inherit the stocks at the new higher cost basis.  However, if your investments had lost value over time, you may wish to consider other ways to transfer your wealth. In this case, the stepped-up basis will be lower than you originally paid for and may trigger higher taxes in the future for your heirs.

10. Tax-loss harvesting

Tax-loss harvesting is selling investments at a loss. The loss will offset gains from other the sale of other securities. Additionally, investors can use $3,000 of investment losses a year to offset ordinary income. They can also carry over any remaining amounts for future tax filings.

 

 

How to find and choose the best financial advisor near me?

How to find and choose the best financial advisor near me?

Last update, August 2020……….Seeking a financial advisor near you is a significant step in achieving your personal and financial goals. Financial advisors have been instrumental in helping clients maintain well balanced, disciplined, long-term focused approach towards their personal finances and retirement planning. Finding the right financial advisor near you is like finding a personal doctor. There are very high chances that you will stick with that person for a long time. In this article, we will give you several suggestions on how to find and choose the best financial advisor near me?.

What is a financial advisor?

A financial advisor is a professional who provides financial guidance regarding a broad range of topics, including investment management, risk management, financial, retirement, college, tax, estate, and legacy planning.

Furthermore, they will make recommendations and provide services based on your specific financial needs and long-term financial goals. Your financial advisors will help you resolve specific financial circumstances —such a taking a comprehensive view of your finances, preparing for retirement, buying a house, and managing your investments.

So how to pick your financial advisor near you?

The financial industry has done a great job confusing the public with various job titles and certificates. Financial advisors can call themselves financial planners,  investment advisors, wealth advisors, financial coaches, wealth managers, and brokers. Additionally, insurance agents, accountants, and lawyers provide some type of financial advice to their clients.

So let’s breakdown several questions you need to ask when you are looking for a  financial advisor near you.

Are you fiduciary?

There are two main models under which financial advisors offer their services – Registered investment advisor (RIA) and broker-dealers.

RIAs are independent fee-only investment companies that often provide both financial planning and investment management services. They charge a flat fee or a percentage of the client’s assets under management. RIAs are usually boutique companies with one founder and a few employees. Moreover, independent advisors have a fiduciary duty to work in their customers’ best interests. Most RIAs provide holistic goal-based financial advice based on their clients’ particular economic circumstances, lifestyle, and risk tolerance. If you prefer to receive personalized fiduciary financial services, then the RIA model is probably the best fit for you.

Brokers offer commission-based financial services. They receive compensation based on the number of trades placed in their client accounts. The agents often belong to large banking institutions like Wells Fargo and JP Morgan Chase. Other times they are independent houses offering a broad range of services, including insurance, accounting, tax, and estate planning. Brokers and sales agents do not always have a legal fiduciary duty to work in their clients’ best interests. Fortunately, they face certain standards regarding suitability and best interest.

What is your education

What is your financial advisor’s education? Make sure that you are comfortable with your new advisor’s credentials and educational background.  Many financial professionals hold at least a bachelor’s or master’s degrees in Finance or Accounting. For those that lack the financial education or work experience, regulators require passing series 65 for RIAs and series 7 and 63 for brokers. Additionally, there are three popular financial certificates – CFA, CFP, and CPA, Advisors that hold any of the certificates that have gone through a significant training and learning process.

Chartered Financial Analyst

CFA is a professional designation given by the CFA Institute. The exam measures the competence and integrity of financial analysts. Candidates have to pass three levels of exams covering areas such as accounting, economics, ethics, money management, and security analysis.

CFA is considered the highest-ranked financial certificate and widely recognized across the globe. CFA program takes at least three years and requires passing the three-level exam. Level 1 exam is offered twice a year in June and December. Level 2 and 3 are offered only once a year in June. Candidates also need to pass strict work requirements regarding their work experience in the investment decision-making process.

Certified Financial Planner

CFP refers to the certification owned and awarded by the Certified Financial Planner Board of Standards, Inc. The CFP designation is awarded to individuals who complete the CFP Board’s initial and ongoing certification requirements. Individuals desiring to become a CFP professional must take extensive exams in the areas of financial planning, taxes, insurance, estate planning, and retirement. The exam is computer-based taken over three days.  Attaining the CFP designation takes experience and a substantial amount of work. CFP professionals must also complete continuing education programs each year to maintain their certification status. 

Certified Public Accountant

CPA is a designation given by the American Institute of Certified Public Accountants to those who pass an exam and meet work experience requirements. CPA designation ensures that professional standards for the industry are enforced. CPAs are required to get a bachelor’s degree in business administration, finance or accounting. They are also required to complete 150 hours of education and have no less than two years of public accounting experience. CPAs must pass a certification exam, and certification requirements vary by state. Additionally, they must complete a specific number of continuing hours of education yearly.

Why is education important?

While receiving a degree in Finance, Accounting, or Economics or passing a test doesn’t always guarantee that the person has the right set of skills to be an advisor, the lack of any of these credentials should be a warning sign for you.

What is your work experience

If you are planning to give your retirement savings in the hands of a financial advisor, make sure that this person has prior financial experience. Some of you may remember the commercial with the DJ who was imposing as a financial advisor. Would you want to work with this guy? He might be a great person, but it’s your money, after all. Do your due diligence before you meet them for the first time? LinkedIn is a great place to start your search.

Do you provide personalized service?

You are looking for a financial advisor because you have specific needs and financial circumstances. Find out if your financial advisor is willing to listen and learn about your objectives. Does he or she have a gameplan that you will help you achieve your financial goals, preserve your wealth, and allow you to be financially independent?

Can you describe your Investment Management Style?

Do you know your advisor’s investment style? Does your advisor regularly trade in your account or is more conservative and rebalance once or twice a year? It is essential to understand your advisor’s investment style. Frequent trading can increase your trading cost substantially. On the other hand, not trading at all will bring your portfolio away from your target allocation and risk tolerance.

Some advisors prefer to work only with ETFs. Others like using actively managed mutual funds. A third group favors trading single stocks and bonds. All strategies have their benefits and shortcomings. ETFs come with lower fees and broad diversification. Active mutual funds seek to beat their benchmark with lower risk. However, they may lack tax-efficiency if sitting in investment accounts. Finally,  trading single stocks provides a high upside but offer less diversification.

What is your custodian

Who is your advisor’s custodian? Custodians are the financial companies that actually hold your assets. Most RIAs will use a custodian like Pershing, Fidelity, TD, Schwab, or Interactive Brokers. Your advisor’s custodian, to a large extent, will determine (or limit) the selection of ETFs and funds available for investing. Additionally, custodians may have different rules, document requirements, technology platforms, and transaction fees.

How big is your firm?

How large is the company that your advisor works for? Some advisors are one-man-shop. They consist of their founder and potentially one or two assistants or paraplanners. Other advisors, including RIAs, could be a part of a much larger regional or national network. Smaller companies have more flexibility but less capacity. Bigger companies have more bureaucracy but may have more resources.

 Do you coach your clients?

What have you learned from your advisor in the past few years or even at the last meeting?

Advisor’s role is not only to manage investments but also to coach and educate clients about best financial practices, tax changes, market developments, estate planning, college savings, and such.

Additionally, many advisors offer workshops to clients and prospects where they talk about the economy, retirement planning, tax strategies, and other financial topics.

How are you going to communicate with me?

How is your financial advisor communicating with you? Is your advisor responsive?  Communication is an essential part of the advisor-client relationship. The best financial advisors always stay in touch with their clients. Remember what I said earlier, advisors are like doctors. You need to meet at least once a year. So during your meeting, talk to them about your progress in achieving your goals. Also, get updates on your portfolio performance. And finally, update them regarding any changes in your life.

Also, financial advisors have to protect their clients’ privacy. Make sure your advisor uses secured channels to send and receive sensitive information.

How is your advisor handling client queries? Can you speak to your advisor personally if you have an urgent question or unexpected life event? Or do you need to call 1-800 number and wait for your turn in line?

What technology do you use?

Is your financial advisor tech-savvy or old school? The current environment of constant tech innovations provides a broad range of tools and services to financial advisors and their clients.

New sophisticated financial planning software lets advisors change plan inputs just with one click of the mouse. This software allows clients to have access to their personal financial plans to amend their financial goals and personal information. Therefore, clients can see in real-time the progress of their financial plans and make better financial decisions.

Account aggregation tools allow clients to pull different accounts from various financial providers under one view. The aggregated view helps both advisors and customers to see a comprehensive picture of the client’s finances with only one login.

Financial planning for physicians

Financial planning for physicians

Introduction to Financial planning for physicians

Being married to a physician has allowed me to obtain an understanding of the unique challenges of financial planning for physicians.   In this post, I will discuss several practices that can help physicians and other healthcare professionals achieve financial prosperity.

What sets financial planning for physicians apart?

Doctors begin their careers and start earning an income much later than the average person.  If a physician is accepted to a medical school immediately following completion of an undergraduate degree, she will be in her mid-20s when she graduates from medical school.   After medical school, physicians must continue clinical training in their chosen specialty.  The residency training period ranges from 3 to 7 years depending on the specialty.  During this time, new doctors make a modest salary, work long hours, and cover overnight on-call shifts in exchange for clinical training.

Once launching their career, doctors receive above-average compensation and have almost zero risks of unemployment. These privileges, however, come with some serious caveats.

As of 2015, graduating physicians start their careers with an average student loan of $183,000. This is equal to $1,897 of monthly payments over ten years or $927 over thirty years, at 4.5% interest. If I remove the lowest 20% of the medical students that come out of school with zero or small loan amounts, the average debt figure jumps to $230,000. Which is a total of $286,000 due on principal and interest on a 10-year loan and 420,000 on a 30-year one. Student loans become repayable after medical school graduation.

1. Start saving for retirement early.

Doctors have a shorter working life than the average person. They start their careers ten years after most people. During these ten years, doctors don’t earn a significant salary and accumulate a large amount of education-related debt.

It is critical that young doctors start saving for retirement while they are in residency. During residency, the new doctors receive a salary between $40,000 and $70,000. Many employers offer both tax-deferred 401k and Roth 401k accounts. Depending on your financial situation you should consider maximizing both plans with priority on your Roth over tax-deferred contributions.

2. Maximize your retirement contributions.  

You have to maximize their retirement contributions to compensate for the extra ten years of school and residency.

Physicians working in hospitals and large healthcare systems will very likely have the option to open a tax-deferred 401k plan. As of 2020, these programs allow their participants to contribute up to $19,500 a year. Most employers offer matching contributions for up to a certain amount.

Some health systems offer pension plans, which guarantee a pension after certain years of service. These plans are a great addition to your retirement savings if you are willing to commit to your employer for 10 or 20 years.

Additionally, some government and state-run hospitals even offer 457 plans in conjunction with a 401k plan, allowing participants to super save and defer a double

Doctors who run a private practice should consider investing in solo 401k plans. These plans allow for the maximum pretax contributions, once as an employee and once as an employer.

Doctors earning significant cash flow in private practice should also consider adding a defined benefit plan to their 401k. This combination is a powerful saving tool. However, it requires the help of an accredited actuary. Contact your financial advisor if you want to learn about this option.

In addition to contributing to employer-sponsored retirement plans, doctors should consider setting aside a portion of their earnings to taxable (brokerage or saving) accounts. The contributions to these accounts are made on an after taxes basis. Taxes are due on all dividends, interest, and capital gains.   The most significant benefit of these funds will be their liquidity and flexibility with no income restrictions.

 3. Manage your taxes.

High earning doctors need to consider managing their tax bill as one of their top priorities. Tax implication can vary depending on income level, family size, and property ownership. Hiring a CPA, a tax attorney or a financial planner may help you reduce or optimize some of your tax dues.

A successful tax planning strategy will include a combination of retirement savings, asset allocation, tax deductions, and estate planning.

4. Balance your budget.

After ten years of vigorous study, sleepless nights, and no personal life, doctors are thrown back in the normal life where they can enjoy the perks of freedom and money. As much you are excited about your new life, do not start it with buying a Lamborghini or an expensive condo on South Beach. In other words, do not overspend. Even if you got a great job with an excellent salary and benefits, you need to remain disciplined in your spending habits. Stay focused on your long-term financial goals. Leave enough money aside for retirement savings, rent or mortgage payments, loan payments, living expenses, college savings for your children and an emergency fund.

5. Manage your student loans

The cost of a medical degree is one of the highest amonsgt other professions. For that reason many dpctors graduate with massive student loans. 0How to best manage your student debt depends on a combination of factors including your credit score, federal or private loan, loan maturity, interest rates, monthly payments, and current income. Stay on top of your student debt. Do not lose track of due dates and interest rates.

For those looking for help reducing their debt, here are some options:

  • Loan repayment options from employers. Many private, federal, state and city health care organizations offer loan repayment options as an incentive to retain their doctors. Those options are frequently dependent on years of service and commitment to work for a certain number of years. These programs vary from employer to employer.
  • Loan forgiveness. Under the Public service loan forgiveness program (PSLF) launched in 2007, full-time employees at federal, state or local government agencies, as well as nonprofit workers at an organization with a 501(c)(3) designation, are eligible for loan forgiveness after paying 120 monthly payments. The first applicants will be able to benefit from this program in 2017.
  • Working in underserved areas. Some states offer loans forgiveness for doctors working in underserved areas. The conditions and benefits vary state by state but in essence, works similar to the PLSF program.
  • Loan consolidation and refinancing. If you have two or more private student loans, you may want to consider loan consolidation. If you pay high interest on your current loans, think about refinancing it at a lower rate. Your new loan availability depends on your credit history, income, and general macroeconomic factors.

Under the current tax law, all forgiven loans are subject to taxes as ordinary income. Take it into consideration when applying for loan forgiveness.

6. Watch your credit score.

Physicians need to monitor and understand their credit score. Known also as the FICO score, it is a measure that goes between 300 and 850 points. Higher scores indicate lower credit risk. Each of the three national credit bureaus, Equifax, Experian, and TransUnion, has a proprietary database, methodology, and scoring system. It is not uncommon to find small or even substantial differences in credit scores issued by three agencies. Many times, creditors will use the average of the three value to assess your creditworthiness.

Your FICO score is a sum of 64 different measurements. And each agency calculates it slightly differently. As a general rule, your FICO score depends mostly on the actual dollar amount of your debt, the debt to credit ratio and your payment history. Being late on or missing your loan payments and maximizing your credit limits can negatively impact your credit score.

You can get your score for free from each one of the bureaus once a year. Additionally, many credit cards provide it for free. Keep in mind that their FICO score will come from one of these three agencies. Don’t be surprised if your second credit card shows a different value.  Your other bank is probably using a different credit agency.

7. Take calculated risks.

Doctors are notorious for their high-risk tolerance and attitude toward investing in very uncertain endeavors. While this is not always a bad thing, make sure that your investments fit into your overall long-term financial plan. Do not bet all your savings on one risky venture. Use your best judgment in evaluating any risky investments presented to you. High returns always come with high risk for a loss.

8. Get insurance.

Having insurance should be your top priority to take care of yourself and your family in case of unforeseen events. There is an extensive list of risks you have to consider,  for instance – health, disability, life, unemployment, personal umbrella, and malpractice insurance.

Fortunately, some of them might be covered by your employer. A lot of organizations offer a basic package at no cost and premium package at added subsidized price. Take advantage of these insurance packages to buy yourself protection in times of emergency.

For instance, if you are a surgeon or dentist and get a hand injury, you may not be able to work for a long time. Having disability insurance can help you have an additional income while you recover.

If you run your practice, having malpractice insurance will help cover the cost if you get sued by your patients.

Final words

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at [email protected] or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

4 Steps to determine your target asset allocation

4 Steps to Determine your target asset allocation

One of the financial advisors’ primary responsibilities is to determine and document their clients’ target asset allocation. The target allocation serves as a starting point and guideline in diversifying the client portfolio and building future wealth. Clients’ unique financial goals, lifestyle, investment horizon, current and expected income, and emotional tolerance to market turbulence will impact their future asset allocation.

The target investment mix is not constant. It can shift from more aggressive to more conservative or vice versa with substantial changes in lifestyle, family status, personal wealth, employment, and age.

Assess your risk tolerance

Most advisors use questionnaires to evaluate their client’s risk tolerance. The length of these surveys varies from advisor to advisor. Furthermore, some assessments are available online for free. The idea behind all of them is to determine the investor’s tolerance to market volatility, and unpredictable macroeconomic and life events.

Individuals with high-risk tolerance have the emotional capacity to take on more risk. They can endure significant market swings in order to achieve a higher future return.

On the opposite side, investors with low-risk tolerance are willing to sacrifice higher returns for safer, low volatility assets which will have smaller swings during turbulent markets.

A free risk tolerance test is available here:

https://www.calcxml.com/calculators/inv01?skn=#top

Regardless of which test you take, if you answer all questions consistently, you should expect to get similar results.

Advisors, of course, should not rely solely on test results. They need to know and understand their clients. Advisors must have a holistic view of all aspects of client’s life and investment portfolio.

 

Set your financial goals

Your financial goals are another critical input to determine your target investment mix. Your goals can stretch anywhere from a couple of months to several decades. They can be anything from paying off your debt, buying a house, planning for a college fund, saving for a wedding, a trip or retirement, making a large charitable donation, and so on.

Each one of your goals will require a different amount of money for completion.

Having your goals in place will define how much money you need to save in order to reach them. The range of your goals versus your current wealth and saving habits will determine your target asset allocation.

More aggressive goals will require more aggressive investment mix.

More balanced goals will call for more balanced investment portfolio.

Sometimes, investors can have a conflict between their financial goals and risk tolerance. An investor may have low to moderate risk tolerance but very aggressive financial goals. Such conflict will ultimately require certain sacrifices – either revising down the investor’s financial goals or adjusting his or her willingness to take on more risk.

Define your investment horizon

Your investment horizon and the time remaining to your next milestone will significantly impact your investment mix.

529 college fund plan is an excellent example of how the investment horizon changes the future asset mix. Traditional 529 plans offer age-based investment allocation. The fund is initially invested in a higher percentage of equity securities. This original investment relies on the equities’ higher expected return, which can potentially bring higher growth to the portfolio. Over time, as the primary beneficiary (the future student), approaches the first year in college, the money in the 529 plan will gradually be re-allocated to a broadly diversified portfolio with a large allocation to fixed income investments. The new target mix can provide more safety and predictable returns as the completion of the goal approaches.

The same example can apply for retirement and home purchase savings or any other time-sensitive goal. The further away in time is your goal; the stronger will be your ability to take on more risk. You will also have enough time to recover your losses in case of market turmoil. In that case, your portfolio will focus on capital growth.

As the completion time of your goal approaches, your affinity to risk will decrease substantially. You also won’t have enough time to recover your losses if the market goes down considerably. In this situation, you will need a broadly diversified portfolio with refocusing on capital preservation.

 

 Know your tax bracket

The investors’ tax bracket is sometimes a secondary but often crucial factor in determining asset allocation. The US Federal tax rate ranges from 10% to 39.6% depending on income level and filing status. In addition to Federal taxes, individuals may have to pay state and city taxes.

Investors can aim to build a tax-efficient asset allocation.  They can take advantage of the preferential tax treatment of different financial securities among various investment account types – taxable, tax-deferred, and tax-exempt accounts. 

For instance, they may want to allocate tax-efficient investments like Municipal bonds, MLPs, ETFs and Index funds to taxable accounts and higher tax bearing investments like Gold, Bonds, and REITs into tax-advantaged accounts.

In any case, investors should attempt to achieve the highest possible return on an after-tax basis. Building a tax-efficient investment portfolio can add up to 1% or more in performance over an extended period.

A Guide to Investing in REITs

Investing in REITs

On August 31, 2016, S&P 500 will introduce a new sector – Real Estate. Up until now real estate companies, also known as REITs,  belonged to the Financial sector. They were in the company of large financial and insurance corporations. The new category will have 27 stocks, $567 billion of market capitalization and an approximate weight of 3% of the total S&P 500 market value.

With the addition of Real Estate as a separate sector in S&P indices, many active managers will have to aline their current portfolios with the new sector structure.

What is a REIT?

A real estate investment trust (REIT) is a company that owns and manages income-producing real estate. It represents a pool of properties and mortgages bundled together and offered as a security in the form of unit investment trusts.

REITs invest in all the main property types with approximately two-thirds of the properties in offices, apartments, shopping centers, regional malls, and industrial facilities. The remaining one-third is divided among hotels, self-storage facilities, health-care properties, prisons, theaters,  golf courses and timber.

The total market capitalization of all publicly-traded REITs is equal to $993 billion. The majority of it, $933 billion belongs to Equity REITs and the remainder to Mortgage and other financing REITs.

There are 219 REITs in the FTSE NAREIT All REITs Index. 193 of them trade on the New York Stock Exchange

Legal  Status

REITs are subject to several regulations. To qualify as a REIT, a real estate firm must pay out 90% of its taxable income to shareholders as dividends. The REIT can deduct the dividends paid to shareholders from its taxable income. Thus their income is exempt from corporate-level taxation and passes directly to investors. Other important regulations include:

  • Asset requirements: at least 75% of assets must be real estate, cash, and government securities.
  • Income requirements: at least 75% of gross income must come from rents, interest from mortgages, or other real estate investments.
  • Stock ownership requirements: shares in the REIT must be held by a minimum of 100 shareholders. Five or fewer individuals cannot (directly or indirectly) own more than 50% of the value of the REIT’s stock during the last half of the REIT’s taxable year.

Distributions

Dividend distributions for tax purposes are allocated to ordinary income, capital gains, and return on capital, each of them having different tax treatment. REITs must provide shareholders with guidance on how to treat their dividends for tax purposes.  The average distribution breakdown for 2015 was approximately 66% ordinary income, 12% return on capital, and 22% capital gains.

REITs distributions have grown substantially in the past 15 years. The total REIT distributions in 2000 were under $8 billion dollar. Just between 2012 and 2015, REITs distribution rose up from $28.8 billion to $44.9 billion, or 44%.

Tax implicationsThe majority of REIT dividends are considered non-qualified dividends and taxed as ordinary income, up to the maximum rate of 39.6 percent, plus a separate 3.8 percent Medicare surtax on investment income.

Capital gains distributions are taxable at either 0, 15 or 20 percent tax rate, plus the 3.8 percent surtax.

Return-on-capital distributions are tax-deferred. They reduce the cost basis of the REIT investment.

When a REIT distributes dividends received from a taxable REIT subsidiary or other corporation, those distributions are taxed at the qualified dividend rate of 0, 15, or 20 percent, plus the 3.8 percent surtax.

Timber REITs

One REIT sector makes an exception from the above rule. Timber REITs have a favorable tax treatment from the IRS. Distributions from timber REITs such as RYN, PCL, PCN & WY are considered long-term capital gains and therefore are taxable at the lower capital gain rate (0, 15% or 20% plus 3.8% Medicare surcharge).

 Economic Cycle 

Individual REIT sectors have different sensitivity to cyclical factors.  Industrial, hotel, and retail REITs have the biggest exposure to economics cycles. Their occupancy and rental rates are extremely sensitive to economic conditions. Cyclical downturns in the economy, recession, and weak consumer spending, can significantly hurt the revenue stream of these REITs.

On the other hand, health care REITs tend to have long-term rental agreements and are more sheltered from market volatility.

Interest Rates

Since many REITs use bank loans and other external financings to expand their business, they have benefitted significantly from the current low-interest-rate environment. Furthermore, many yield-seeking investors turned to REITs for higher income. If low-interest rates remain, REITs will likely expand their base to a broader range of market participants.

Interest rates can impact REIT’s performance differently depending on two main factors – debt and lease duration.

Loan maturities

As a result of the current low rates, many REITs have increased their leverage and therefore have high sensitivity to interest changes. If interest rates rise, REITs with near-term loan maturities will need to refinance at higher rates. Thus their interest payments will go up, which will lead to less cash available for dividends. Therefore, REITs with higher levels of debt and short-term maturities will perform worse than REITs with less debt and long-dated maturity schedules.

At the same time, REITs with lower debt levels relative to their cash flows, all else equal, will perform better in a rising-rate environment.

Lease duration

While higher interest rates would affect all REITs, industry subsectors would be affected differently, depending on lease durations. REITs with shorter lease durations will perform relatively better in a rising-rate environment because they can seek higher rents from tenants as rates rise than could REITs with longer lease durations. The higher rents can offset the negative impact of higher interest expense. Hotel REITs usually have the shortest lease durations, followed by multifamily properties and self-storage.

Healthcare, office, and retail REITs usually sign long-term leases. Therefore rising interest rates will potentially hurt these REITs due to their inability to adjust rental contracts to offset rising costs.

Risk and return

Real Estate Investment Trusts historically have been more volatile than S&P 500. The 40-year standard deviation of the REIT’s sector is 17.16% versus 16.62% for the S&P 500 and 10.07% for the 10-year Treasury. During this 40-year period, REITs achieved a 13.66% cumulative annual return versus 11.66% for S&P 500 and 7.39% for the 10-year Treasury. (www.portfoliovisualizer.com)

Furthermore, the 10-year (2006-15) standard deviation of the REIT sector is 22.01% versus 18.02% for the S&P 500 and 9.54% for 10-year Treasury. For the same period, REITs reported 7.83% cumulative annual return versus 6.96% for S&P 500 and 4.57% for 10-year Treasury. (www.portfoliovisualizer.com)

Among the best five-year REIT sector performers were Retail, Self-Storage, and Industrial. For the same period, worst performers were Mortgage, Hotel and Office RETS.

Valuations

With respect to pricing, REITs are reaching high valuations levels. The current Price to Fund to Operations ratio is hovering around 18, which is slightly above the historical average of 16. While the P/FFO ratio remain reasonable compared to historical figures, further price rally in REITs not supported by the increase in cash flows may impose a significant risk for sector overheating.

Diversification

Even though REITs are publicly traded companies, very often they are considered an alternative asset due to their weak relationship with the other asset classes – equities and fixed income. US REITs have a relatively low correlation with the broader stock market. The 40-year correlation is equal to 0.51, while the 10-year correlation is  0.73. The correlation between REITs and 10-year Treasury is equal to -0.06, while that with Gold is 0.09.

This low correlation with other asset classes makes the REITs a solid candidate for a broadly diversified investment portfolio.

 

Investing Strategies

Directly

There are 219 publicly-traded REITs. 27 of them are included in the S&P 500 index. If you decide to invest in a single REIT or basket of REITs, you need to consider company-specific risk, management, sub-sector, regional or national market exposure, leverage, lease duration, history, and distribution payments.

Real Estate ETFs

VNQ

VNQ dominates the REITs ETF space as the largest and second-cheapest ETF. It includes a broad basket of 150 securities. The ETF tracks the MSCI US REIT Index, which includes all domestic REITs from the MSCI US Investable Market 2500 Index. This ETF doesn’t include any mortgage, timber, and tower REITs. It has an expense ratio of 0.12% (second lowest to SCHH). It has $32.4 billion of assets under management and Morningstar rating of 4. The fund holds a diversified portfolio across all property sectors. Retail REITs are the largest holding, at 25% of assets, Specialized REITs make up 16.50%, office, 12.6% residential, 15.7%, healthcare, 12.3%, diversified, 8%, hotel and resort, 5.3%, and industrial, 4.7% REITs.

IYR

IYR tracks the Dow Jones U.S. Real Estate Index. It is the most diversified REIT ETF. Unlike other ETFs which hold only equity REITs, IYR holds mortgage, timber, prison and tower REITs including companies like American Tower, Weyerhaeuser Co, Annaly Capital Management NLY and Crown Castle International Corp. IYR has three stars by Morningstar and has an expense ratio of 0.45%. IYR’s holdings are broken by Specialized REITs, (27.09%), Retail, 19.74%, Residential, 12.70%, Office, 10.00%, Health Care, 9.88%, Mortgage REITs, 4.90%, Industrial, 4.56%, Diversified, 4.51%, Hotel & Resort, 3.56%, Real Estate Services, 2.06%

ICF

ICF tracks an index of the 30 largest publicly traded REITs excluding mortgage and tower REITs. The design of this index capitalizes on the relative strength of the largest real estate firms and the conviction for consolidation in the real estate market. The ETF includes Retail REITs, 24.84%, Specialized REITs, 18.71%, Residential, 18.08%, Office, 15.23%, Health Care, 14.41%, Industrial, 5.79%, Hotel & Resort REITs, 2.56%.

RWR / SCHH

RWR / SCHH are the smallest of the five funds. They track Dow Jones US Select REIT Index. The index tracks US REITs with a minimum market cap of $200 million. The index also excludes mortgage REITs, timber REITs, net-lease REITs, real estate finance companies, mortgage brokers and bankers, commercial and residential real estate brokers and real estate agents, homebuilders, hybrid REITs, and large landowners of unimproved land. The funds’ portfolio holds a diversified range of REITs across property sectors similar to other ETFs.

SCHH has the lowest expense ratio of 0.07% all REITs ETFs while RWR has an expense ratio of 0.25%.

Performance 

Comparing the performance of the top ETFs in the past ten years, we can see a clear winner. VNQ is leading by price return, total return, and Sharpe Ratio.  Next in line are RWR and ICF. IYR takes the last spot.

Having the largest number of holdings, VNQ overweights small size REITs relative to the industry average. Hence it benefited from the smaller REITs outpacing the growth of their bigger competitors.

IYR did not benefit from being the most diversified REIT ETF. The mortgage and specialized REITs have lagged behind the performance of the traditional equity REITs.

Mutual Funds

Mutual funds are actively managed investment vehicles. They typically use an index as their benchmark.  The goal of the fund manager is to outperform their benchmark either on a risk adjusted or absolute return basis.  The fund manager can decide to overweight a particular REIT if he or she believes the company will outperform the benchmark. Many times the managers will look for mispricing opportunities of individual REITs.

Active funds usually charge higher fees than passively managed ETFs due to higher research, management, administrative and trading costs. However, many investors believe that after subtracting their fees, active managers cannot beat the market in the long run.

In my analysis, I selected a pool of five actively managed funds which are open to new investors and have an expense ratio less than 1% – VGSLX,  DFREX, TRREX, CSRSX and FRESX.

All five funds have high ratings from Morningstar and robust historical performance.

VGSLX and DFREX have the largest number of holdings, 150 and 149 respectively, and maintain the lowest expense ratio. Both funds lean more towards small and micro-cap REITs relative to the average in the category.

The other three funds, TRREX, CSRSX and FRESX manage smaller pools of REITs. CSRSX and FRESX have the highest turnover: 58% and 34% respectively.

Performance

While the 1-year returns are quite variable, the long-term performance among the five funds is relatively consistent. Vanguard REIT Index Fund, VGSLX,  has the lowest fee and the highest 10-year return of 7.6%. Cohen & Steers Realty Shares Fund, CSRSX, is second with 7.5% annual return. CSRSX has the lowest 10-year standard deviation of 25.2%. VGSLX edges slightly ahead with the highest Sharpe Ratio of 0.39. Vanguard and DFA funds benefitted from low expense ratio and larger exposure to mid and small size REITs, which had better 10-year performance than larger REITs.

It is worth noting that the 10-year Sharpe Ratio for all REITs sector is lower than the Sharpe Ratio of S&P 500. The Sharpe Ratio calculated the risk-adjusted returns of a particular investment. In this case, the risk-adjusted returns of REIT lag behind the overall equity market.

When you consider investing in REITs mutual funds,  pay attention to management style, expense ratio, turnover, dividends, the number of holdings, and their benchmark.

Where to allocate REITs investments?

REITs are often attractive for their high dividend income. As I mentioned earlier, the majority of the REITs distributions are treated as ordinary income and therefore taxed at the investors’ tax rate. Investors in high tax brackets can pay up to 39.6% rate plus 3.8% Medicare surplus tax on the investment income.

Because of their unfavorable tax status, most REITs may not be suitable for taxable investment accounts.  Tax-sensitive investors may want to consider placing REITs in Tax Advantage accounts like Roth IRA, Traditional IRA, and 401k.

Since timber REITs receive favorable tax treatment, they are an exception from the above rule. Investors may choose to hold them in taxable investment accounts.

There are two scenarios under which REITs could be an appropriate fit for a taxable account.

First, investors in the lower tax bracket will be less impacted by the tax treatment of the REITs income.

Second, investing in REITs with a history of making significant capital gain and return on capital distributions. These types of payments have more favorable tax treatment at the lower long-term capital gains tax rate.

Introduction to portfolio diversification

Introduction

Portfolio diversification is one of the main pillars of retirement planning. The old proverb “Never put all your eggs in one basket” applies in full strength to investing.

Even the Bible talks about diversification. Ecclesiastes 11:2 says “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.”

Wealth and asset managers use diversification as a tool to reduce overall portfolio risk. Diversification of investments with little correlation to one another allows the portfolio to grow at various stages of the economic cycle as the performance of the assets moves in different directions.

What is portfolio diversification?

According to the Securities and Exchange Commission (SEC): “The Magic of Diversification. The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.” – https://www.sec.gov/investor/pubs/assetallocation.htm

By combining low correlated and uncorrelated assets in a portfolio and being disciplined over an extended period, you aim to achieve the highest return per certain level of risk.

Diversification reduces your exposure to a single company or an asset class. As assets move up and down each year, a diversified portfolio will allow you to build a cushion for losses and avoid being dependent on one security in case it loses its value or has a rocky year.

The financial history remembers many examples of fallen stocks, such as Enron and Lehman Brothers. The employees of these companies who invested heavily in their employer’s stock without diversifying lost a significant amount of their retirement savings.

Correlated Investments

Correlated investments move in similar fashion driven by related factors. Owning two or more securities from the same industry or with similar risk profile does not contribute to your portfolio diversification. Hence, these securities will concentrate your exposure to the same market factors. 

These three pairs are an example for correlated stocks – Coca-Cola and Pepsi, Target and Costco, Verizon and AT&T. While there are some differences in their business model and historical performance, the pairs are exposed to the same economic factors, industry drivers, and consumer sentiments.

Uncorrelated Investments

The combination of uncorrelated investments decreases the overall portfolio risk

The classic example of uncorrelated investments is stocks, bonds, and gold. Historically these large asset categories have moved independently from each other.  Their returns were influenced by different events and economic drivers.

Even within the equity space alone, investors can significantly improve their portfolio diversification by looking at companies in various industries and exposure to regional and international markets.

The pair – Amazon and PG&E is a model for uncorrelated companies. Amazon is a global online marketplace that sells discretionary consumer items. Amazon business is dependent on the economic cycle and consumer spending sentiments. PG&E is a California-based utility company that provides electricity and gas to its customers. PG&E customers (being one of them) have a limited choice for service providers. Amazon competes with many large and small-size, local and foreign companies. PG&E has virtually no competition apart from renewable sources. Amazon has expansive market potential. PG&E growth is constrained to its local market. Therefore the difference between their core business models reflects on their historical price performance and risk profile. Their shares’ price depends on different factors and hence fluctuates independently.

Sharpe Ratio

Before we continue, I want to introduce a key performance metric in asset management called Sharpe Ratio. The ratio got its name from its creator the Nobel laureate William F. Sharpe.

The Sharpe ratio measures the excess return per unit of risk of an investment asset or a portfolio.  It is also known as the risk-adjusted return.

This is the formula:

Sharpe Ratio

 

 

 

Where:

Rp is the Return of your security or portfolio.

Rf is the risk-free return of a US Treasury bond

σp is the standard deviation of your portfolio. Standard deviation measures the volatility of your portfolio returns.

 

The Sharpe ratio allows performance comparison between separate portfolios and asset classes with different return and risk. As a rule of thumb, the Sharp metric penalizes portfolios with higher volatility.

Take a very simplified example; portfolio ‘A’ has 5% return and standard deviation of 10%. Portfolio ‘B’ has 6% return and standard deviation of 15%. The risk-free rate is 1%

‘A’ portfolio: Sharpe Ratio is equal to (5% – 1%)/10% = 0.4

‘B’ portfolio: Sharpe Ratio is equal to (6% – 1%)/15% = 0.33

Portfolio ‘A’ has the higher Sharpe ratio and therefore the higher risk-adjusted return. Despite its lower return, it benefited from its lower volatility.

Even though ‘B’ had a higher return, it was penalized for having a higher risk.

 

Test 1

We will continue the explanation of the benefits of diversification with an example with real securities.

We will use two ETFs – SPY which tracks the US Large Cap S&P 500 Index and IEF, which follows the performance of the 10-year US Government bond. Let’s create three portfolios – one invested 100% in SPY,  second invested 100% in IEF and third with 50%/50% split between both funds. Each portfolio starts with hypothetical $1 million. We track the performance for ten years (January 1, 2006, to December 31. 2015).

 

One key assumption is that at the end of each year we will rebalance the 50/50 portfolio back to the original target. We will sell off the excess amount over 50% for the overweight ETF, and we will buy enough shares from the underweight ETF so we can bring it back to 50%.

Results

Ticker Initial Balance Final Balance Average Return Standard Deviation Best Year Worst Year Max. Drawdown Sharpe Ratio US Market Correlation
IEF $1,000,000 $1,698,866 5.44% 6.46% 17.91% -6.59% -7.60% 0.68 -0.30
50/50 $1,000,000 $2,002,079 7.19% 7.11% 13.11% -9.45% -20.14% 0.86 0.87
SPY $1,000,000 $2,010,149 7.23% 15.23% 32.31% -36.81% -50.80% 0.47 1.00

Diversification2_1

 

The 100% SPY portfolio has the highest return of 7.23% and best overall final balance ($2.01m). The SPY portfolio has the largest gain in a single year, 32.3% but also the biggest yearly loss of -36.8%. It also has the highest measure of risk. Its standard deviation is 15.2%.  Its risk-adjusted return (Sharpe ratio) has the lowest value of 0.47.

IEF has the lowest return of the three portfolios, 5.44% but also has the “best” worst year, -6.6% and the lowest risk, 6.5%. Sharpe ratio is 0.68, higher than that of SPY.

The  50/50 portfolio has an average return of 7.19%, only 0.03% less than SPY alone. It has a standard deviation of 7.1%, only 0.65% higher than that of the 100% EIF. its market correlation is 0.87. Most importantly, the 50/50 portfolio has the highest risk-adjusted return, equal to 0.86.

The 50/50 portfolio illustrates the benefits of diversification. It provides almost the same return as the 100% large-cap portfolio with much lower risk and better returns consistency.

Test 2

In the second example, we will introduce two more portfolios.

Portfolio #4 holds 100% GLD. GLD is the largest and most liquid  ETF in the gold market.

In portfolio #5, we will split SPY and IEF into 45% each and will add 10% in Gold ETF. Same rules apply. Once a year we rebalance the portfolio to the original target allocation 45/45/10.

Results

Ticker Initial Balance Final Balance Average Return Standard Deviation Best Year Worst Year Max. Drawdown Sharpe Ratio US Market Correlation
IEF $1,000,000 $1,698,866 5.44% 6.46% 17.91% -6.59% -7.60% 0.68 -0.30
50/50 $1,000,000 $2,002,079 7.19% 7.11% 13.11% -9.45% -20.14% 0.86 0.87
SPY $1,000,000 $2,010,149 7.23% 15.23% 32.31% -36.81% -50.80% 0.47 1.00
GLD $1,000,000 $1,967,041 7.00% 19.20% 30.45% -28.33% -42.91% 0.39 0.07
45/45/10 $1,000,000 $2,028,238 7.33% 7.05% 13.92% -8.01% -16.75% 0.88 0.81

 Diversification4

 

The GLD portfolio has the highest volatility. Its standard deviation is 19.20%. It has the lowest risk-adjusted return of 0.39 and a second-lowest return of 7%.

Let’s look at our fifth portfolio – 45% SPY, 45% IEF and 10% GLD. The new portfolio has the highest return of 7.33%, the highest final balance of $2.28m, second lowest standard deviation of 7.05% and the highest risk-adjusted return of 0.88. It also has a lower correlation to the US market, 0.81.

Recap

Portfolio #5 is the clear winner of this contest. Why? We build a portfolio of uncorrelated assets, in this case, gold, 10-year Treasury, and large-cap stocks. Subsequently, we not only received an above average annual return, but we also achieved it by decreasing the risk and minimizing the volatility of our portfolio.

These hypothetical examples illustrate the benefits of diversification. Among them are portfolio risk mitigation, reduced volatility, higher risk-adjusted return, and more efficient capital preservation.

 

Asset correlation

So how do you determine the relationship between assets? Any financial software can provide you with this data.

If you are good at math and statistics, you can do parallel performance series for your securities and find the correlation between them.

There are a couple of free online tools, which you can use as well.

Beta

One easy way to get a sense of the correlation of your securities to the general stock market is Beta. Most financial websites like Google Finance and Yahoo Finance will give you this metric. Beta shows you the stock volatility compared to S&P 500. That said, the beta of S&P 500 is always 1. So for instance, if the beta of your stock is 2, you should expect twice as much volatility of your stock as compared to S&P 500. If the beta is 0.5, you would expect half of the volatility. If the beta is -0.5, then your stock and S&P will be negatively correlated. When one goes up, the other one will go down.

A quick search in Good Finance brought me these results for the securities we discussed earlier.

Beta for IEF is -0.20, SPY is 1, GLD is 0.07, Coca Cola, 0.51, Pepsi, 0.44, Target, 0.63, Costco, 0.55, Verizon, 0.22, AT&T, 0.29, Amazon, 1.1 and PG&E, 0.17,

Few other companies and ETFs of interest are: TLT, 20-year T-bond Index, -0.59, VNQ, REIT Index, 0.81, VYM, Vanguard High Dividend ETF, 0.81, USMV, iShares Low Volatility ETF, 0.68,  Google, 1.03, Facebook, 0.76, Wal-Mart, 0.19, Starbucks, 0.80, McDonalds, 0.51. Walt Disney, 1.32, Bank of America, 1.74.

The beta of the stocks can vary depending on market conditions, economic and business cycles. I recommend using in combination with other metrics like standard deviation, R-square, and Sharpe Ratio. This approach will help you gauge the expected volatility of your stock.

How many assets should you ideally keep in your portfolio?

Some theories call for 7-10 broad asset classes. This method is ideal for smaller-size portfolios. It will help control trading and rebalancing costs.

Other theories call for 20-25 asset classes. This approach is best suitable for large-size portfolios with more complex structure.

A regular portfolio should include these three groups with their subclasses.

Equity includes Large Cap, Mid Cap, Small Cap, Micro Cap, International Developed and Emerging Markets. In addition to that, you can add growth, value, dividend, low volatility, and momentum strategies.

Fixed Income includes US Treasuries, Municipal Bonds,  Investment Grade Corporate Bonds, High Yield, Preferred Stock, International, and Emerging Market Bonds

Alternative Investments include Real Estate, Precious Metals, Commodities, Infrastructure, Private Equity, Hedge Funds.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

 

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation, and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions.  Various sources may provide different figures due to variations in methodology and timing. Image copyright: 123RF.com

 

 

 

How to build your 401k plan

How to build your 401k plan

401k plans are a powerful savings tool for retirement

With total assets reaching $4.8 trillion dollars 401k plans are the most popular retirement vehicle and are increasingly used by employers to recruit and retain key talent.  401k accounts allow employees to build their retirement savings by investing a portion of their salary. Contributions to the plan are tax-deductible, thus reducing your taxable income,  and the money allocated grows tax-free. Taxes are due upon withdrawal of funds during retirement years. In this article, I will discuss how to build your 401k plan.

Does your employer offer a 401k plan?

If you recently joined a new company, find out whether they offer a 401k plan. Some employers offer automatic enrollment, and others require individual registration.

Many companies offer a matching contribution up to a set dollar amount or percentage.

Contributions are usually deducted from each paycheck, but employees can also opt to contribute a lump sum.  The 2016 limit is $18,000 plus a $6,000 “catch-up” contribution for people age 50 and above.

How to decide on your investment choices

Employers must provide ongoing education and training materials about retirement savings plans.

401k plans can offer anywhere between 5 and 20 different mutual funds which invest in various asset classes and strategies.  Your choice will be limited to the funds in your plan. Hence you can not invest in stocks or other financial instruments.

The fundamental goal is to build a diversified and disciplined portfolio with your investment choices. Markets will go up and down, but your diversified portfolio will moderate your risk in times of market turmoil.

Index Funds

Index Funds are passively managed mutual funds. They track a particular index by mirroring its performance. The index funds hold the same proportion of underlying stocks as the index they follow. Many indexes are tracking large-cap, mid-cap, small-cap, international and bond indices. One of the most popular categories is the S&P 500 Index funds.

Due to their passive nature index funds are usually offered at a lower cost compared to actively managed funds. They provide broad diversification with low portfolio turnover. Index funds do not actively trade in and out of their positions and only replace stocks when their benchmark changes. Index funds are easy to buy, sell and rebalance.

Actively Managed Mutual Funds

Actively managed mutual funds are the complete opposite of index funds. A management team usually runs each fund. The mutual funds have a designated benchmark, such as the S & P 500, Russell 2000,  and MSI World. Often the management team aims to beat the benchmark either by a greater absolute or risk-adjusted return. Overall active funds trade more often than index funds. Their portfolio turnover (frequency of trading) is bigger because managers take an active approach and invest in companies or bonds with the goal of beating their benchmark.

There is a broad range of funds with different strategies and asset classes. Some funds trade more actively than others. Even funds that follow the same benchmark can gravitate towards a particular sector, country or niche. For instance, a total bond fund might be more concentrated into government bonds, while another fund may invest heavily in corporate bonds.

Active funds charge higher fees than comparable index funds. These fees cover salaries, management, administrative, research, marketing, and trading costs. Funds investing in niche markets like small-cap and emerging market will have higher costs. Fees are also dependent on the size of the fund and its turnover strategy.

It’s critical to do at least a basic research before you decide which fund to purchase. Morningstar.com is a great website for mutual fund information and stats.

Target Retirement funds

These are mutual funds that invest your retirement assets according to a target allocation based on your expected year of retirement. The further away you are from retirement, the more your target fund asset allocation will lean toward equity investments. As you get closer to retirement, the portion of equity will go down and will be replaced by fixed income investments. The reason behind target retirement funds is to maintain a disciplined investment approach over time without being impacted by market trends.

One significant drawback of the retirement funds is that they assume your risk tolerance is based on your age. If you are a risk taker or risk averse, these funds may not represent your actual financial goals and willingness to take the risk.

In addition to that, investors also need to consider how target retirement funds fit within their overall investment portfolio in both taxable and tax-advantaged accounts.

Most large fund managers offer target retirement funds. However, there are some large differences between fund families. Some of the discrepancies come from the choice of active versus passive investment strategies and fees.

Without endorsing any of the two providers below I will illustrate some of the fundamental differences between Vanguard and T. Rowe Price Target Retirement funds.

Vanguard Target Retirement funds

Vanguard Target Retirement funds offer low-cost retirement fund at an expense ratio of 0.15%. All funds allocate holdings into five passively managed broadly diversified Vanguard index fund.

Vanguard Target Retirement 2015 2025 2035 2045
Total Stock Market Index 28.44 39.86 48.75 54.07
Total Intl Stock Index 19.01 26.56 32.45 35.9
Total Bond Market II Index 30.32 23.66 13.23 7.05
Total Intl Bond Index 13.37 9.92 5.57 2.98
Short-Term Infl-Protected Sec Index 8.86
% Assets 100.00 100.00 100.00 100.00
By asset class
Equity 47.45 66.42 81.2 89.97
Fixed Income 52.55 33.58 18.8 10.03

T. Rowe Target Retirement funds

On the other spectrum are T. Rowe retirement funds. Their funds have a higher expense ratio. They charge between 0.65% and 0.75%. All target funds invest in active T. Rowe mutual funds in 18 different categories. T. Rowe target funds are a bit more aggressive. They have a higher allocation to equity and offer a wider range of investment strategies.

T. Rowe Target Retirement Fund 2015 2025 2035 2045
New Income 24.38 17.34 10.64 6.74
Equity Index 500 22.15 14.85 9.31 7.41
Ltd Dur Infl Focus Bd 11.01 3.53 0.54 0.53
International Gr & Inc 5.04 6.68 7.85 8.35
Overseas Stock 5.01 6.64 7.82 8.3
International Stock 4.42 5.78 6.8 7.26
Emerging Markets Bond 3.55 2.47 1.43 1.01
Growth Stock 3.43 11.74 17.84 20.26
International Bond 3.42 2.44 1.51 0.98
High Yield 3.26 2.32 1.42 0.91
Value 3.1 11.31 17.36 19.75
Emerging Markets Stock 2.88 3.87 4.49 4.71
Real Assets 2.1 2.78 3.28 3.5
Mid-Cap Value 1.85 2.46 2.95 3.12
Mid-Cap Growth 1.78 2.35 2.73 2.9
Small-Cap Value 0.93 1.23 1.48 1.55
Small-Cap Stock 0.88 1.15 1.41 1.53
New Horizons 0.72 0.94 1.1 1.12
% Assets 100 100 100 100
By Asset Class
Equity 54.29 71.78 84.42 89.76
Fixed Income 45.62 28.1 15.54 10.17

Which approach is better? There is no distinctive winner. It depends on your risk tolerance.

Vanguard funds have lower expense ratio and a lower 10-year return. However, they have a lower risk.

T. Rowe funds have higher absolute and risk-adjusted return but also carry more risk.

10-year Performance Analysis, 2045 Target Retirement Fund

  Standard 10-year Sharpe
Fund Name Deviation Return  Ratio
VTIVX Vanguard Target 2045 14.65 5.48 0.36
TRRKX T. Rowe Target 2045 15.82 5.89 0.38

 *** Data provided by Morningstar

Most 401k plans will offer only one family of target funds, so you don’t have to decide between Vanguard, T. Rowe or another manager. You will have to decide whether to invest in any of them at all or put your money in the index or active funds. For further information, check out our dedicated article on target date funds

ETFs

ETFs are a great alternative to index and active mutual funds. They are liquid and actively trade on the exchange throughout the day.

As of now, very few plans offer ETFs. One of the main concerns for adding them to retirement plans is the timeliness of trade execution. Right now this problem is shifted to the fund managers who only issue end of day price once all trades are complete.

I expect that ETFs will become a more common choice as they grow in popularity and liquidity. Many small and mid-size companies that look for low-cost solutions can use them for them as an alternative to their for their workplace retirement plans.

Company stock

Many companies offer their stock as a matching contribution or profit sharing incentive in their employee 401k plan. Doing so aligns employees’ objectives with the company’s success.  While this may have positive intentions, current or former employees run the risk of having a large concentrated position in their portfolios.  Even if your company has a record of high returns, holding significant amounts of company stock creates substantial financial risk during periods of crisis because one is both employee and shareholder.  Enron and Lehman Brothers are great examples of this danger.  Being overinvested in your company shares can lead to simultaneous unemployment and depletion of retirement savings if the business fails.

Allocation mix

You will most likely have a choice between a family of target retirement funds and a group of large-cap, mid-cap, small-cap, international developed, emerging markets stocks, a REIT, US government, corporate, high yield and international bond funds.

Your final selection should reflect your risk tolerance and financial goals. You should consider your age, family size, years to retirement, risk sensitivity, total wealth, saving and spending habits, significant future spending and so on.

You can use the table below as a high-level guidance.

401k asset allocation mix

Data source: Ibbotson Associates, 2016, (1926-2015). Past performance is no guarantee of future results. Returns include the reinvestment of dividends and other earnings. This chart is for illustrative purposes only. It is not possible to invest directly in an index. For information on the indexes used to construct this table, see footnote 1. The purpose of the target asset mixes is to show how target asset mixes may be created with different risk and return characteristics to help meet an investor’s goals. You should choose your investments based on your particular objectives and situation. Be sure to review your decisions periodically to make sure they are still consistent with your goals.
Source: https://www.fidelity.com/viewpoints/retirement/ira-portfolio?ccsource=email_monthly

Final recommendations

Here are some finals ideas how to make the best out of your 401k savings:

  • At a minimum, you should set aside enough money in your 401k plan to take advantage of your employer’s matching contribution. It’s free money after all. However, the vesting usually comes with certain conditions. So definitely pay attention to these rules. They can be tricky.
  • 2016 maximum contribution to 401k is $18,000 plus $6,000 for individuals over 50. If you can afford to set aside this amount, you will maximize the full potential of retirement savings.
  • If your 401k plan is your only retirement saving, you need to have a broad diversification of your assets. Invest in a target retirement fund or mix of individual mutual funds to avoid concentration of your investments in one asset class or security.
  • If your 401k plan is one of many retirement saving options – taxable account, real estate, saving accounts, annuity, Roth IRA, SEP-IRA, Rollover IRA or a prior employer’s 401k plan, you will need to have a holistic view of your assets in order to achieve a comprehensive and tax optimized asset allocation.
  • Beware of hidden trading costs in your plan choices. Most no-load mutual funds will charge anywhere between 0.15% and 1.5% to manage your money. This fee will cover their management, administrative, research and trading costs. Some funds also charge upfront and backload fees. As you invest in those funds your purchase cost will be higher compared to no-load funds.
  • If you hold large concentrated positions of your current or former employer’s stock, you need to mitigate your risk by diversifying the remainder of your portfolio.

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at [email protected] or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

A beginner’s guide to retirement planning

uide to retirement planning

Many professionals feel overwhelmed by the prospect of managing their finances. Often, this results in avoidance and procrastination– it is easy to prioritize career or family obligations over money management.  Doing so puts off decision making until retirement looms.  While it is never too late to start saving for retirement,  the earlier you start, the more time your retirement assets have to grow.  There are several things you can do to start maximizing your retirement benefits.  In this posting, I will present my beginner’s guide to retirement planning.

Start Early 

It is critical to start saving early for retirement. An early start will lay the foundation for a healthy savings growth.

With 7% average annual stock return, $100,000 invested today can turn into almost $1.5m in 40 years. The power of compounding allows your investments to grow over time.

The table below shows you how the initial saving of $100,000 increases over 40 years:

Year 0        100,000
Year 10        196,715
Year 20        386,968
Year 30        761,226
Year 40     1,497,446

Not all of us have $100k to put away now. However, every little bit counts. Building a disciplined long-term approach towards saving and investing is the first and most essential requirement for stable retirement.

Know your tax rate

Knowing your tax bracket is crucial to setting your financial goals. Your tax rate is based on your gross annual income subtracted by allowable deductions (ex: primary residence mortgage deductions, charitable donations, and more).

See below table for 2016 tax brackets.

Guide to retirement planning

 

Jumping from a lower to a higher tax bracket while certainly helpful for your budget will increase your tax liabilities to IRS.

Why is important?  Understanding your tax bracket will help you optimize your savings for retirement.

Knowing your tax bracket will help you make better financial decisions in the future. Income tax brackets impact many aspects of retirement planning including choice of an investment plan, asset allocation mix, risk tolerance, tax level on capital gains and dividends.

As you can see in the above table, taxpayers in the 10% and 15% bracket (individuals making up to 37,650k and married couples filing jointly making up to $75,300) are exempt from paying taxes on long-term capital gains and qualified dividends.

Example: You are single. Your total income is $35,000 per year. You sold a stock that generated $4,000 long-term capital gain. You don’t owe taxes for the first $2,650 of your gain and only pay 15% of the remaining balance of $1,350 or $202.5

Conversely, taxpayers in the 39.6% tax bracket will pay 20% on their long-term capital gains and qualified dividends. A long-term capital gain or qualified dividend of $4,000 will create $800 tax liability to IRS.

Tax bracket becomes even more important when it comes to short-term capital gains. If you buy and sell securities within the same year, you will owe taxes at your ordinary income tax rate according to the chart above.

Example: You make $100,000 a year. You just sold company shares and made a short-term capital gain of $2,000. In this case, your tax bracket is 28%, and you will owe $560 to IRS. On the other hand, if you waited a little longer and sold your shares after one year you will pay only $300 to IRS.

Know your  State and City Income Tax

If you live in the following nine states, you are exempt from paying state income tax:  Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, New Hampshire and Tennessee.

For those living in other states, the state income tax rates vary by state and income level.  I’ve listed state income tax rates for California and New York for comparison.

California income tax rates for 2016:

1% on the first $7,850 of taxable income.

2% on taxable income between $7,851 and $18,610.

4% on taxable income between $18,611 and $29,372.

6% on taxable income between $29,373 and $40,773.

8% on taxable income between $40,774 and $51,530.

9.3% on taxable income between $51,531 and $263,222.

10.3% on taxable income between $263,223 and 315,866.

11.3% on taxable income between $315,867 and $526,443.

12.3% on taxable income of $526,444 and above.

 

New York State tax rates for 2016:

4% on the first $8,400 of taxable income.

4.5% on taxable income between $8,401 and $11,600.

5.25% on taxable income between $11,601 and $13,750.

5.9% on taxable income between $13,751 and $21,150.

6.45% on taxable income between $21,151 and $79,600.

6.65% on taxable income between $79,601 and $212,500.

6.85% on taxable income between $212,501 and $1,062,650.

8.82% on taxable income of more than $1,062,651.

 

City Tax

Although New York state income tax rates are lower than California, those who live in NYC will pay an additional city tax. As of this writing, the cities that maintain city taxes include New York City, Baltimore, Detroit, Kansas City, St. Louis, Portland, OR, Columbus, Cincinnati, and Cleveland. If you live in one of these cities, your paycheck will be lower as a result of this added tax.  The city tax rate varies from 1% and 3.65%.

Create an emergency fund

I recommend setting up an emergency fund that will cover six to 12 months of unexpected expenses. You can build your “rainy day” fund overtime by setting up automatic monthly withdrawals from your checking account. Unfortunately, in the current interest environment, most brick and mortar banks offer 0.1% to 0.2% interest on saving accounts.

Some of the other options to consider are saving account in FDIC-accredited online banks like Discover or Allied Bank, money market account, short term CD, short-term treasuries and municipal bonds.

Maximize your 401k contributions

Many companies now offer 401k plans to their employees as a means to boost employee satisfaction and retention rate. They also provide a matching contribution for up to a certain amount or percentage.

The 401k account contributions are tax deductible and thus decrease your taxable income.  Investments grow tax-free. Taxes are due during retirement when money is withdrawn from the account.

Hence, the 401k plan is an excellent platform to set aside money for retirement. The maximum employee contribution for 2016 is $18,000.  Your employer can potentially match up to $35,000 for a total joint contribution of $53,000. Companies usually match up to 3% to 5% of your salary.

401K withdrawals

Under certain circumstances, you can take a loan against your 401k or even withdraw the entire amount.  Plan participants may decide to take a loan to finance their first home purchase. You can use the funds as last resort income during economic hardship.

In general, I advise against liquidating your 401k unless all other financial options are exhausted.  If you withdraw money from your 401k, you will likely pay a penalty.  Even if you don’t pay a penalty, you miss out on potential growth through compounded returns.

Read the fine print

Most 401k plans will give you the option to rollover your investments to a tax-deferred IRA account once you leave your employer. You will probably have the opportunity to keep your investments in the current plan. While there are more good reasons to rollover your old 401k to IRA than keep it (a topic worth a separate article), knowing that you have options is half the battle.

Always read the fine print of your employer 401k package. The fact that your company promises to match up to a certain amount of money every year does not mean that the entire match is entirely vested to you.  The actual amount that you will take may depend on the number of years of service. For example, some employers will only allow their matching contribution to be fully vested after up to 5 years of service.   If you don’t know these details, ask your manager or call HR. It’s a good idea to understand your 401k vesting policy, particularly if you just joined or if you are planning to leave your employer.

In summary, having a 401k is a great way to save for retirement even if your employer doesn’t match or imposes restrictions on the matching contributions. Whatever amount you decide to invest, it is yours to keep. Your money will grow tax-free.

Maximize your Roth IRA

Often neglected, a Roth IRA is another great way to save money for retirement.  Roth IRA contributions are made after taxes. The main benefit is that investments inside the account grow tax-free. Therefore there are no taxes due after retirement withdrawals. The Roth IRA does not have any age restrictions, minimum contributions or withdrawal requirements.

The only catch is that you can only invest $5,500 each year and only if your modified adjusted gross income is under $117,000 for single and $184,000 for a couple filing jointly. If you make between $117,000 and $132,000 for an individual or $184,000 and $194,000 for a family filing jointly, the contribution to Roth IRA is possible at a reduced amount.

 

How to decide between Roth IRA and 401k

Ideally, you want to maximize contributions to both plans.

As a rule of thumb, if you expect to be in a higher tax bracket when you retire then prioritizing Roth IRA contributions is a good move.  This allows you to pay taxes on retirement savings now (at your lower taxable income) rather than later.

If you expect to retire at a lower rate (make less money), then invest more in a 401k plan.

Nobody can predict with absolute certainty their income and tax bracket in 20 or 40 years.  Life sometimes takes unexpected turns. Therefore the safe approach is to utilize all saving channels. Having a diverse stream of retirement income will help achieve higher security, lower risk and balanced after tax income.

I suggest prioritizing retirement contributions in the following order:

  1. Contribute in your 401k up to the maximum matching contribution by your employer. The match is free money.
  2. Gradually build your emergency fund by setting up an automatic withdrawal plan
  3. Maximize Roth IRA contributions every year, $5,500
  4. Any additional money that you want to save can go into your 401k plan. You can contribute up to $ 18,000 annually plus $6,000 for individuals over 50.
  5. Invest all extra residual income in your saving and taxable investment account

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions.  Various sources may provide different figures due to variations in methodology and timing.

A beginner’s guide to ETF Investing

Guide to ETFs

What is an ETF?

ETF stands for an exchange-traded fund. The fund is a passively managed marketable security that tracks an index, a commodity, or a pool of bonds. ETFs trade on the stock exchange, and their price fluctuate throughout the day.

By design, ETFs do not produce positive alpha. Alpha is the difference between the fund and the benchmark performance.  They strictly follow their index, and as a result, their alpha is always zero.

ETFs popularity spiked in the past several years due to the rise of robo-advisers, an increase in competiton, and lowe management fees. At the same time, many emblematic active managers underperformed their benchmarks and saw significant fund outflows.

ETF history

The ETF industry was born as a result of the market crash in October 1987. The initial goal behind ETFs was to provide liquidity and mitigate volatility for market participants. Over the last 20 years, they became a favorite investment vehicle for individual investors and asset managers. Today, globally, there are 6,870 ETF products on 60 exchanges and over $5 trillion of assets under management.

ETF vs. Mutual Fund

The media and investors often compare ETFs with mutual funds.  In contrast with ETFs, the mutual fund managers actively look for securities in an attempt to beat their designated benchmark.

ETFs typically have higher daily liquidity and lower fees than most mutual funds.  This makes them an attractive alternative for many individual investors.

Underlying Index

There are significant variations in the index composition between indices tracking the same asset class.  The ETFs structure and performance reflect these differences.

In the small-cap space, for example, IJR tracks the S&P 600 Small-Cap index, and IWM follows Russell 2000 Small Cap index. As the name suggests, the S&P index has 600 constituents, while the Russell index has 2,000 members. While there are many similarities and overlaps between the two, there are also significant variations in their returns, risk, and sector exposure.

In the Emerging market space, indices provided by MSCI include South Korea in their list of emerging market countries. At the same time, indices run by FTSE exclude South Korea and have it in their developed country list.

Investors seeking to manage their exposure to a particular asset class through ETFs need to consider the index differences and suitability against their overall portfolio.

 Fees

The fees are the cost associated with managing the fund – transaction cost, exchange fees, administrative, legal, and accounting expenses. They are subtracted from the fund performance. The costs are reported in the fund prospectus as an expense ratio. They can be as low as 0.08% and as high as 2% and more. The percentage represents the total amount of management fees over the value of assets under management.

Consider two ETFs that follow the same index.  All else equal, the ETF with the lower fee will always outperform the ETF with the higher one.

Liquidity

The ETF liquidity is critical in volatile markets and flash-sales when investors want to exit their position.

Asset under management, daily volume, and bid/ask spread drive the ETF liquidity. Larger funds offer better liquidity and lower spread.

The liquidity and the spread will impact the cost to buy or sell the fund. The spread will determine the premium you will pay to purchase these funds on the stock exchange. The discount is what you will need to give up to sell the ETFs. The lower the spread, the smaller difference between purchase and sale price will be. Funds with less spread will have lower exit costs.

Exchange Traded Notes

Exchange Traded Notes are an offshoot of the ETFs products. ETNs are structured debt instruments that promise to pay the return on the tracking assets. This structure is very popular for Oil, Commodity, and Volatility trading. They offer flexibility and easy access for investors to trade in and out of the products.

I believe that long-term investors should avoid Exchange Traded Notes (ETNs), volatility (VIX) ETFs, inverse, and leveraged (2x and 3x Index) ETFs and ETNs products. While increasing in popularity and liquidity, they are not appropriate for long-term investing and retirement planning. These types of funds are more suitable for daily and short-term trading. They incur a higher cost and have a higher risk profile.

Smart Beta ETFs

Smart Beta ETFs are also increasing in popularity. While the name was given for marketing purposes, this particular breed of ETFs uses a single or multi-factor approach to select securities from a pre-defined pool – S&P 500, Russell 2000, MSCI world index, or others.

The Single Factor ETFs like Low Volatility or High Dividend are strictly focusing on one particular characteristic. They offer a low-cost alternative to investing in a portfolio of income generating or less volatile stocks.

The multi-factor ETFs are a hybrid of active and index management. ETF providers have established an in-house index that will follow the rules of their multi-factor model. The model will select securities from an index following specific parameters with the intention of outperforming the index. The fund will buy only the securities provided by the model. The multi-factor ETFs are competing directly with mutual funds, which use similar techniques to select securities. However, they have a lower cost, better transparency, and an  easy entry point.

Currency Hedged

Currency Hedged International ETFs is another newcomer in the space. Their goal is to track a foreign equity index by neutralizing the currency exposure. They can be attractive to investors with interest in international markets who are concerned about their FX risk.  Some of the more popular funds in this category include HEDJ, which tracks Europe developed markets, and DXJ, which follows Japan exporting companies.

How to invest?

ETFs are a great alternative to all investment accounts. Due to their passive management, low turnover, and tax-advantaged structure, they are a great option for taxable and brokerage accounts.

For now, they have not made their way to corporate 401k plans, where mutual funds are still dominating. I am expecting this to change as more small and mid-size companies are looking for low-cost solutions for their workplace retirement plans.

Tax-sensitive investors, however, need to consider all circumstances before adding ETF holdings to their portfolio. Their tax treatment follows the tax treatment of their underlying assets.

6 Proven strategies for volatile markets

Proven strategies for volatile markets

What are some of the proven strategies for volatile markets? The truth is nobody likes to lose money. Especially money that is earmarked for retirement, vacation, real estate purchase, or college education. Today’s volatile markets can be treacherous for inexperienced (and even experienced) investors.  Successful investors must remain focused on the strength of their portfolio and the potential for future growth.

The stock market can be volatile.

The first instinct when the market drops is to sell your investments. Well, in reality, this may not always be the right move. Selling your stocks during market selloff may limit your losses, may lock in your gains but also may lead to missed long-term opportunities. Emotional decisions do not bring a rational outcome.

How low can the market go?  The largest-ever percentage drop by the S&P 500 index occurred on October 19, 1987 (known as The Black Monday) when the S&P 500 dropped by -20.47%. The next biggest sell-off happened on October 15, 2008, when the S&P 500 lost –9.03%. In both cases, the stock market continued to be volatile for several months before reaching a bottom. The bottom was the start of a new bull market. Both times, the stock market recovered to reach historic highs in a few years.  In the past seven years, the S&P 500 rose up by 14.8%, which is almost double the historical average of 7%.

So what can you do when the next market crash happens?

I want to share six strategies that can help you through the turbulence and support the long-term growth of your portfolio.

1. Keep calm and carry on

One of the most proven strategies for volatile markets is staying callm. Significant drops in stock value can trigger panic—and fear-based selling to limit losses is the wrong move.  Here’s why: frequently these market selloffs are followed by broad market rallies. As long as you are making sound investment choices, patience and the ability to tolerate paper losses will earn you more in the long run.

2. Be realistic: Don’t try to time the market

Many investors believe that they can time the market to buy low and sell high. In reality, very few investors succeed in these efforts.

According to a study by the CFA Institute Financial Analyst Journal, a buy-and-hold large-cap strategy would have outperformed, on average, about 80.7% of annual active timing strategies when the choice was between large-cap stocks, short-term T-bills and Treasury bonds.

3. Stay diversified

Diversification is essential for portfolio preservation and growth. Diversification, or spreading your investments among different asset categories (stocks, bonds, real estate, commodities, precious metals, etc.) minimizes risk.

Uncorrelated asset classes react uniquely during turbulent markets and economic cycles.

For example, fixed income securities and gold tend to rise during bear markets when stocks fall. Conversely, equities rise during economic expansion.

4. Focus on your long-term goals

Personal financial goals stretch over several years. For investors in their 20s and 30s financial goals can go beyond 30 – 40 years. Staying disciplined—maintaining a high credit score, minimizing debt, and developing a savings plan–is the best way to achieve your goals.

Market crises come and go, but your goals will most likely remain the same. In fact, most goals have nothing to do with the market. Your investment portfolio is just one of the ways to achieve your goals.

5. Use tax-loss harvesting

If you own taxable accounts, you can take advantage of tax-loss harvesting opportunities. You can sell securities at depressed prices to offset other capital gains made in the same year. Also, you can carry up to $3,000 of capital losses to offset other income from salary and dividends. The remaining unused amount of capital loss can also be carried over for future years for up to the allowed annual limit.

To take advantage of this option you have to follow the wash sale rule. You cannot purchase the same security in the next 30 days. To stay invested in the market you can substitute the depressed stock with another stock that has a similar profile or buy an ETF.

6. Be opportunistic

Market swings create opportunities for purchasing securities at a discounted price.

Not surprisingly the renowned investor Warren Buffet‘s famous words are “Buy when everyone else is selling” and “When it’s raining gold, reach for a bucket, not a thimble.”

Market selloffs rarely reflect the real long-term value of a company. Usually, selloffs are triggered by market news, political events, and most recently by algorithmic errors. Market drops during volatile times are an excellent opportunity for investors to buy their favorite stocks at a lower price.