Optimizing Liquid Alternatives with the Power of Tax Deferral
by Laurence GreenbergMr. Greenberg is President of Jefferson National, innovator of the industry’s first flat-insurance fee variable annuity with the largest selection of underlying tax-deferred funds. Connect with him by e-mail: [email protected]. For more information, please visit www.jeffnat.com or call 1-866-WHY-FLAT (866-949-3528).
The market’s value has reached new peaks since the crash of 2008. In the past 12 months alone, the S&P 500 is up more than 15%. And as P/E ratios hit record levels, experts share concerns about an imminent correction. Factors include economic and political instability abroad, sluggish growth and shaky fundamentals in the US, and continued uncertainty over policies in Washington.
Many advisors feel that today’s complex market dynamics require a different approach for achieving enhanced diversification. Facing ongoing volatility in a time of rising taxes, advisors need to generate returns, protect principal and maintain liquidity—while providing clients with a smoother ride. To many advisors, this means moving beyond traditional asset classes and adopting alternative strategies.
Our own research indicates that nearly two-thirds of advisors (64%) have increased their use of alternative strategies over the past five years, and 55% see their allocation to alternatives continuing to increase further over the next 5 years. Roughly three-fourths of advisors (73%) indicate “managing volatility” is their primary reason for using alternatives.1
The Rise of Liquid Alternatives
Alternative strategies can help to reduce risk and enhance diversification through low correlation with the general equity and fixed income markets. According to recent research from Lipper, a 30% allocation to alternatives offers less volatility, less downside deviation, and better risk-adjusted returns than the S&P 500.2
Alternative strategies, such as selling short, using leverage or employing derivatives, provide portfolios with added protection against extreme market conditions. By preserving more principal through the worst downturns, alternatives also offer the potential to enhance returns and increase long-term accumulation.
Alternative investment vehicles, such as hedge funds, private equity and venture capital, were once the exclusive domain of the high net worth investor, private banks and large institutions. Now, with the introduction of liquid alternatives in the form of 40-Act mutual funds, advisors and their clients can use many of the same nontraditional investing strategies—with the added advantages of daily liquidity, lower investment minimums and greatly reduced fees, as well as increased transparency and strict regulatory oversight. And, the 40-Act fund structure also relieves investors of managing a multitude of K-1 Tax Schedules.
These liquid alternatives funds have had a strong year. According to Morningstar, more than $28 billion has been allocated into this category as of Q3 2013, the highest growth level of all fund categories tracked by the research firm. Likewise, new research from Boston-based Cerulli Associates, reports 43% of asset managers are either building or considering building products with multi-alternative strategies. Close to 90% of fund managers surveyed plan to develop four or more alternative products over the next 12 months.3
A Tax-Efficient Approach to Alternatives
For many advisors, the challenge with using liquid alternatives is their inherent tax-inefficiencies. Typically these high turnover strategies generate short term capital gains, which are taxed at a higher rate.
Optimizing the after-tax returns of liquid alternatives begins with the strategic use of the tax-deferral. Research has shown that a low-cost tax-deferred vehicle can help alternative strategies, and other tax-inefficient investments, improve performance potential by an average of 100 bps—without increasing risk—to help clients accumulate more.4
This strategy is also known as “asset location”—locating assets in taxable and tax-deferred vehicles based on their tax-efficiency. The first step is to maximize contributions to qualified plans such as an IRA or 401(k). But for the most aggressive savers and high net worth investors who can easily max out the low contribution limits of qualified plans, there has been a shortage of other viable tax-deferred vehicles.
While variable annuities can provide more tax-deferral, they are rarely considered the right fit. The high cost of traditional VA’s, with their layers of asset-based fees, can quickly erode any benefit of tax deferral.
Their limited selection of funds can restrict investment flexibility and reduce upside potential.
Now in recent years, a new generation of VAs has been designed exclusively for tax-advantaged investing—with low fees, greater transparency, and more fund choices—while stripping away commission, complex insurance components and surrender charges that can lock in clients for years. For example, Jefferson National has pioneered a tax-advantaged flat-fee variable annuity that includes the industry’s largest selection of liquid alternative funds.
Managing Volatility and Minimizing Taxes
As concerns in the US and abroad remain catalysts for ongoing volatility, advisors are increasing their use of alternative investments. For many advisors, adopting liquid alternatives is a highly effective and efficient solution to construct portfolios that can take on the outsized risks in today’s environment.
And when using these tax-inefficient strategies to add ballast to portfolios, advisors recognize that tax deferral is more important than ever. In an environment where taxes are rising and every basis point of performance counts, surveys indicates that 76% of advisors would consider increasing their use of alternatives if they could access them in a low-cost tax-deferred account.
If liquid alternatives are the key to optimizing portfolio performance, and the power of tax deferral is the key to optimizing liquid alternatives, then next-generation VAs are the solution to help you and your clients manage volatility and minimize taxes to optimize performance.
Monument Advisor is issued by Jefferson National Life Insurance Company (Dallas, TX) and distributed by Jefferson National Securities Corporation, FINRA member. Policy series JNL-2300-1, JNL-2300-2, JNL-2300-3.
1. Investment Solutions Survey, Jefferson National, October 2013
2. Diversifying and Reducing Risk Using Hedge Funds, Lipper, November, 2013
3. Alternative Products and Strategies 2013: Identifying Enduring Opportunities in Complex Markets, Cerulli Associates, August 2013
4. The Tax-Efficient Frontier: Improving the Efficient Frontier with the Power of Tax Deferral, by David Lau, published by Jefferson National, June 2010