Volatility, Efficiency and the Persistent Low
by PE KelleyMr. Kelley is the managing editor of this magazine. Connect with him by e-mail: email@example.com
The dogged tenacity of our low-interest climate has advisors looking under every stone to find returns for their clients. But as the 2015 investment statements come in, reflecting a continued flat performance, investors are beginning to ask some very tough questions.
Tom Quinn is Chief Investment & Research officer for Jefferson National. His company has embraced a pro-active approach to innovating solutions for what is an historic bear market. He spoke with Advisor Magazine about the severity of these issues, and how advisors might take a fresh look at some key areas: asset location strategy, the after-tax implications of an investment plan, as returns hover near zero, and some new alternative products and ideas.
Advisor Magazine: When do you introduce the concept of tax-efficiency into a client’s overall income plan?
TQ: Broadly speaking, advisors tend to focus on it a lot once their clients get to the distribution phase, when they actually start taking income, while it tends to be overlooked during accumulation. But in our more recent history, we’ve seen either raging bull markets or complete disaster, and when performance is that volatile, any discussion about after-tax returns can kind of get swept under the rug. When clients realize a 25% return, they won’t bat an eyelash at the tax bill, whereas today they’re looking at 2015 returns that are flat, and the conversation is suddenly making a lot of sense.
AMag: Like waking a sleeping bear…
TQ: Well, the trends that you cannot ignore today are transparency and access to information. I believe you could see the theme of tax efficiency emerging almost as fast as the conversation about minimizing product fees with respect to allocation decisions. After-tax implications are more and more becoming an everyday discourse with their advisors. If returns are low, the last thing advisors want to do is cut their own fees, so they need a way to differentiate themselves. To me, the after-tax story during accumulation does just that.
AMag: What about allocation strategy. Is that changing as well?
TQ: Asset location definitely should come into play. Advisors need to use the qualified structure as a tool to maximize performance. Many advisors use the same allocation in the taxable account as in the IRA. They may swap in Muni Bonds in the taxable account and taxable bonds in the IRA. Other than that, it’s a consistent allocation, and it’s easy to demonstrate that you can add return to your clients by doing nothing else than putting the tax-inefficient assets in the IRA and the more tax-efficient assets in the taxable account.
AMag: So, would you consider this an aggressive strategy?
TQ: Asset location is straight forward and conservative. However, by taking advantage of tax deferral, you can invest in more unique strategies. Calling these strategies aggressive might be a fair assessment… opportunistic is probably the term I would use. It’s all about after-tax returns. A common strategy that we see is combining Municipal Bonds and Equity ETFs. That is a very tax-efficient strategy because it generates little to no taxable gains or income. The issue is that it is a very low return environment for munis, and there are risks in owning just equities. Being able to offer more interesting asset classes, but doing so in a tax-efficient way, presents a real opportunity to your clients, not just minimizing the tax bill but offering the best portfolio.
AMag: What are the new strategies that advisors can employ to find gains for their clients in a low-interest environment?
TQ: Let’s say they own a portfolio of municipal bonds that is generating, probably, barely enough to cover their fees. What do they want to accomplish with those assets? If you are willing to move to the tax-deferred account, you can use some liquid alternative strategies, whether it be a market-neutral, an event driven strategy, long-short equity or managed futures. They can provide some similar downside protection that the fixed-income portfolio was doing, but still, you want to enhance the return of the overall portfolio.
One of the concepts I am excited about is the defined outcome solution, something you really only see in high-net-worth and institutional portfolios… kind of a managed option portfolio, where you take an equity portfolio and say ‘OK, I’m going to take 2% of this and buy some put-options to hedge against anything more than a 10% loss’.
In the past, the only way a retail client could access something like this was through very expensive, very illiquid products. Ironically, these are like some of the bread and butter insurance products that we had worked so hard to differentiate ourselves from, with all those expensive guarantees and being very tax inefficient. Now we’re seeing them emerge on the liquid side, providing that structured return and, more importantly, the managed, absolute downside hedge.
AMag: Can you give me an example? And how does it work?
TQ: One that we really like is the Exceed Defined Shield Index Fund. It is an option strategy that provides a defined exposure to the S&P, capped at 15% with a floor of 12.5%, providing investors with market exposure but with a defined floor. That can be very useful in today’s environment, where in order to keep your losses below 15% in an equity and bond portfolio you’d need to hold 40 to 50 percent in bonds, which are now only generating 1 to 2 percent. Here is an alternative way to cap the downside.
AMag: So, with a market defined by an extreme and persistent low interest climate as well as abnormal volatility as, what are advisors doing to help their clients?
TQ: Low Rates and volatility are absolutely the most critical variables right now. And what is really interesting to me is that the low rate environment encourages risk-taking which works to heighten your sensitivity to that volatility. When you try to balance long term return targets and downside risk concerns, this environment is directly impacting the decisions that it forces advisors to make.
No one at work in the market today has managed in an environment like this. It’s been over fifty years since we had these kinds of interest rates, and that was a time when the equity markets were about to go on a historic run, and you didn’t have to ever worry about volatility. Today, there’s no avoiding it… and it’s global. It’s everywhere.
AMag: What has to happen for change?
TQ: I think there’s some potential in the non-US market, like Europe, the markets are fairly priced and where there is some operational leverage, companies have been under-utilizing capacity. There may be a little bit of upside there. Still, these are not what we know as traditional growth opportunities’ and the best case scenario, it seems, is to just inch along with extreme low-growth and wait for it to just add up. It’s scary.
AMag: And is this why you’re looking more careful at the after-tax implications of a client’s portfolio, toward the inherent efficiency, or inefficiency, of the investment strategies in play?
TQ: It’s always important. You can be costing your clients money by not making the optimal asset location decisions, and this becomes clearer the more educated clients get and the more transparent information becomes. There is a lot of money being managed in this low-return environment and advisors need to figure out other things to do. Buying a portfolio of municipal bonds 20 years ago may not have been the optimal strategy, when rates were six percent clients didn’t really mmd. Today that portfolios in generating less than one percent and clients are beginning to ask more difficult questions.
AMag: What about alternatives, like REITs and Business Development Corporations, BDCs? Are they truly alternative and do they hold some promise for returns?
TQ: BDCs are products that have come to market over the past couple of years or so in direct response to low interest rates and opportunities to lend to smaller companies who did not have access to credit markets. They sell well, but that may have more to do with their high-commission than their investment merits. When you dig into some of them, there are layers upon layers of hidden fees. They promise to generate a 6% return with no volatility, but this profile cannot always last, and there may be weird redemption policies when clients decide they want their money back.
AMag: What are the safe hedges?
TQ: Liquid alternatives, in the format of mutual funds or variable insurance trusts, are emerging. The issue you run into with these is product selection. As a whole, if there are 500 choices on the mutual funds side, I think there may be 100 that are worthwhile and maybe 50 that are really good. But that means that 80 percent of the choices are not worthwhile. You have to look hard for the good ones.
Also the defined outcome is a strategy that can be effective with less required expertise to evaluate, either in fund form or if you have the expertise to run an option portfolio in-house. ◊