Creating a checklist of ‘to do’ items can be helpful in accomplishing one’s goals, and emotionally satisfying as one knocks items off the list. With that in mind, some years ago I created a financial check list. I have updated it here for you as you tackle your new year’s resolutions.
Each of our financial check lists will vary, but you may be surprised at how many items apply to you.
1) Tax Related Considerations
- Review your long-term capital gains. Are they meaningful? Do you have long-term capital losses available to offset the gains? Should you harvest those long-term losses early in the year, allowing you to take some long-term gains without adverse tax consequences? This could permit you to reposition your portfolio with less tax pain.
- Review your short-term capital gains. Are they meaningful? Do you have short-term capital losses available to offset the gains? Again, should you harvest the losses early in the year?
- Explore whether you (and your spouse) have used up your entire lifetime federal estate and gift tax exemption of $11.4 million for each of you! Many couples have a substantial unused lifetime exemption. Consider making tax-free intra-family gifts, if you can afford to do so. For even greater tax-efficiency, consider making generation-skipping transfers to a trust for the benefit of your grandchildren, or even to a dynasty trust. See my article, What High Impact Tax Planning Can You Do in September? But don’t wait for September.
- If you have exhausted your life time exemption, review, with your team of advisers, the appropriateness of making taxable intra-family gifts. This is not a crazy idea. Learn more about this from my article The Advantages of Making Taxable Lifetime Gifts.
- Have you made your annual exclusion gifts for 2019? Why wait? You and your spouse may each give $15,000 to any one other person federal gift tax-free. If you have a spouse and you have a child with a spouse, that means that $60,000 can be given by a couple to each of their married children/spouse. Better still the exclusion gifts do not count against your lifetime exemption discussed above.
- Think about your 2019 tax liabilities (both state and federal) to avoid being surprised later on by how much you owe – your first estimated payments for may be due soon. Work with your advisers to think about sourcing the required cash, potentially even through a line of credit, where your private banker can be of assistance. See my article Read This If You Still Think You Don’t Need Credit, or see my brief video Innovative Investment Solutions, A New Perspective on Credit.
- If you have an offshore bank account, ask your CPA whether there are any steps that you should take with respect to that account. Offshore accounts are more common than is generally appreciated and can be a red flag for tax authorities in the U.S.
2) Insurance Considerations
- Consider spending some quality time with both your life insurance adviser and your estate planning counsel in the same room. While the prospect of having this meeting may not fill you with joy, it could be important both in terms of tax/liquidity management and estate conservation for your intended beneficiaries.
- Review your property and casualty insurance There are myriad small factors that taken together, can dramatically impact the cost and efficacy of your coverage. You may be spending more than you think, or more than you need to. On the other hand, there may be inappropriate gaps in your coverage.
3) Investment Strategy Opportunities
- Have an offsite meeting of your investment committee and key advisers to evaluate your long-term asset allocation targets. Are the targets still suitable? How does your portfolio conform to your targets? Are you comfortable with the divergences between your targets and your actual exposures?
- Similarly, review your liquidity preference. Can you tolerate more illiquidity in your portfolio than you currently employ? If so, how would you and your advisers like to deploy an increased illiquidity budget?
- If you want to rebalance your asset class exposures you may need to give some managers advance notice of your intentions. This is typically true of hedge funds and other investment partnerships.
- Assess your cash flow needs (e.g., taxes, living expenses, both family and charitable gifts, partnership capital calls, and non-investment asset purchases) and whether you can use your cash flow requirements to reallocate assets back toward your long-term asset allocation targets. E.g., source your cash needs from asset classes where your actual exposures exceed your targets.
4) Investment Tactics
- Review each of your investment managers with your investment committee to see if any managers should be put on a watch list, or are candidates for replacement.
- Has your view of passive asset management (e.g., index-related mutual funds and ETFs) vs. active asset management (e.g., mutual funds and separate account managers who emphasize security selection expertise) changed? Do you want to shift more of your exposures in favor of either active or passive management?
- What opportunistic investments may be worth embracing? Are there asset types that have languished and whose time has come? Your advisers may have perspectives to share with you on this topic.
- Take a close look at your balance sheet, asset allocation and performance reports. Are you getting all of the information that you need? If not, what are you and your team going to do about it?
5) Take a Poll
- Ask each of your advisers what their key issues are for you, and prioritize their ideas. Some advisers are bashful or reticent about pushing their agendas; so, get your advisers to go on record about what they see as priorities for managing your investment/financial affairs, and what they want you to do about those priorities.
I hope that you find my financial check list helpful. If you have a Private Investment Counselor, he/she is a part of your financial life specifically to help you examine all of these matters. If you don’t have such a person in your life, consider whether you need one.
If you would care to, please give me a ring at 617.945.5157, or shoot me an email.
After a wild ride in U.S. equity markets during the week of October 8th, let us remind ourselves that it was not unforeseen, and that it is likely to reoccur. We can’t stop the turbulence, but we can plan for it.
I have written two articles in the last year to provoke my readers’ thinking about how to address the highly valued U.S. equity markets: Volatility – Opportunity or Cause for Concern?, May 15, 2018, and earlier Asset Values Are Stretched – What to Do About it?, November 15, 2018.
It was also instructive to see an article in the Wall Street Journal of Monday October 8, 2018, just before U.S. equity markets hit an air pocket, “U.S. Stock Near a Pressure Point,” by Michael Wursthorn and Sam Goldfarb, whose prescient opening paragraph was:
“Yields on long-term U.S. government debt moved abruptly higher last week, calling into question the durability of the more than nine-year-old bull market for stocks.”[i]
Nonetheless, it will not surprise you that I do not advocate dumping one’s equities and employing a pall mall rush to cash and/or Treasury securities. I am not an adherent of such tactical asset allocation for two reasons:
- The likelihood of making both exit and reentry decisions correctly is low. Missteps in either exit and reentry can be costly.
- The tax consequences of tactical asset allocation for private investors can be significant.
At the risk of reprising my own earlier remarks, here is what I do recommend:
- Be mindful of the degree to which valuations are stretched, to avoid unpleasant surprises.
- Have enough cash, plus assured sources of liquidity (e.g., expiring Treasuries), to cover a year’s spending, including:
a. taxes (income, gift, real estate, etc.),
b. current pledges and anticipated charitable commitments,
c. capital expenditures (e.g., education or acquisition of non-investment assets)
d. life style maintenance, and
e. alternative assets capital calls, without reliance on distributions, which could
be temporarily impaired.
- Review your long-term asset allocation targets. Be sure that they are suitable for your current and likely future circumstances. Consider doing that with a trained and experienced professional.
- Rebalance back to long-term asset allocation targets at least semiannually, reducing exposures that are above target and adding to exposures that are below target. There may be frictional considerations that inhibit your rebalancing, such as tax factors, age and health.
- When feasible (from the point of view of taxation and regulatory supervision of “insiders”) reduce outsized single asset exposure(s).
Managing asset volatility is a part of managing various risks in your overall financial/investment strategy. The steps outlined here, and in my prior articles (see links above), can assist you during market disruptions.
[i] “U.S. Stock Near a Pressure Point,” Wall Street Journal, by Michael Wursthorn and Sam Goldfarb, October 8, 2018, at p. B-1. Or see online Surging Yields Raise Threat of Tipping Point for Stocks Oct. 7, 2018 8:00 a.m. ET
Markets do not just go up. That is not the deal. There are market corrections – every year. We were spoiled for 18 months by a period of ultra-low volatility. I will focus on a few metrics with you to put volatility in context. More importantly, let’s explore the implications of the return of market volatility, including what you could consider doing about it.
Some investors see the return of volatility as scary, leading them to adjust their asset allocations, adopting a more defensive posture. Others argue that volatility is exactly what they have been waiting for, in that it affords long-term investors a new range of wonderful opportunities. There is a third possibility — that fears of volatility could become a self-fulfilling prophecy. We’ll explore that too.
NEPC (New England Pension Consultants) recently put it this way:
“Volatility roared back into US equity markets in the first quarter, snapping an 18-month benign streak. Stoked by fears of rising Treasury yields and a tumultuous unwinding in the short-equity volatility trade, the S&P 500’s run of 15 straight months in the black ended in February.”
Jamie Dimon, the CEO of J.P. Morgan/Chase has a slightly different spin on it, but he too sees volatility ahead:
“With the Fed paring back its balance sheet and the federal government increasing its borrowing, the U.S. will have to finance by the end of the year ‘$400 billion a quarter — that’s a lot, that’s a huge shift from the past,’ Dimon also said. Along with cutbacks in bond purchases by other central banks, it ‘may cause more volatility, higher rates in a way we don’t fully understand’ given the exit from quantitative easing is unprecedented, he said.” (emphasis added)
Volatility is Normal
First, let’s ground ourselves on some metrics about volatility and market corrections:
- Good news: in 28 of the last 37 years, the S&P 500 has provided a positive investment return. That is a 76% hit rate.
- Bad news: on average the S&P 500 has experienced an annual peak-to-trough loss of about 14% each year, even when the S&P 500 provided a positive return for the year.
- In 2017 the intra-year drawdown of the S&P 500 was, amazingly, only -3%. The last time the S&P 500 had an intra-year drawdown of only -3% was in 1995 – 22 years ago. Those are the only two years since 1980 in which the S&P 500 has had such a small peak-to-trough loss.
- Years of high volatility can also be highly profitable for investors who seize the opportunities offered by the markets:
- In 2009 when the S&P 500 was up 23%, it also had a peak-to-trough loss of 28%. That was coming out of the Global Financial Crisis.
- In 2003 when the S&P 500 was up 26%, it had a peak-to-trough loss of 14%.
Markets experience volatility, which is often driven by exogenous factors having little to do with the profitability of enterprises, the value of whose securities can be abruptly repriced. Domestic political and geopolitical events are two obvious factors.
Volatility is part of the function of markets. We all like upside volatility, but we tend to be less comfortable with downside volatility; however, that too provides important opportunities for patient, long-term investors prepared to take advantage of it.
Volatility Provides Opportunities
In listening to first quarter conference calls conducted by equity managers, I was struck by two very different managers making the same point: Volatility gives us an opportunity to acquire positions that we have been watching for months (and in some cases for years), at prices that we finally find to be attractive. We are long-term investors who are delighted by the opportunity to take advantage of short-term price movements. On the sell side, volatility gives us a chance to pare back, if not exit, more fully valued holdings when markets rebound. 
For long-term investors, volatility is far from a curse. It can provide the opportunity that they require to buy low and to sell high. It may, however, create challenges to the patience and commitment required for such a long-term strategy, which should be understood and analyzed explicitly.
A Possible Fly in the Ointment – A Potentially Self-Fulfilling Prophecy
As trading models become more mechanistic, rising levels of volatility can trigger reductions in equity allocations, thus serving to depress prices further. Value at Risk models embrace that concept, which models are often used by banks, insurance companies and pension funds in managing their investment portfolios.
Although some details of post-crisis banking regulations are under review in Washington and Basel, risk-based capital concepts push banks to adjust their portfolios and their lending in the same direction. The same is true of Europe’s Solvency II directive. Further issues will arise as mark-to-market accounting is phased in; despite variations between U.S. GAAP and IFRS, they both tend to go in the same direction.
These quantitative, risk-based, model-driven investment systems and regulatory regimes could lead to synchronous behavior, thus exacerbating a bear market in ways that have not been a part of prior market cycles to the same degree.
What Steps Could Most Private Investors Take?
In the context of the foregoing, here are some steps that you might want to consider:
- Be sure that you have enough highly liquid assets to meet your cash flow needs, including:
- Living / lifestyle expenses,
- Charitable commitments,
- Foreseen/foreseeable commitments, e.g., children’s education, non-investment asset acquisitions,
- Capital calls from non-marketable alternative assets funds to which you have made commitments, and
- A reserve for unforeseen/unforeseeable expenses.
- Review your asset allocation with your council of advisers, thinking about what risk means to you:
- Permanent impairment of your principal,
- Temporary diminution of mark-to-market asset prices,
- What periods of temporary diminution or impairment are acceptable to you? or
- Something else more personal to you.
- How do you define what risks are acceptable or not: what goals make taking which risks worthwhile?
- How do you view your risk profile?
- Is your asset allocation suited to your risk profile?
- If you don’t have a council of advisers, give some thought to assembling such a group
- Keep in mind that asset managers are not necessarily the best advisers for these purposes, in part because they may be more comfortable with the specific risks that they live with every day than you are with those risks.
- Review your asset manager choices with the same council of advisers
- Periods of volatility can offer important opportunities for active managers to add value, so give some thought to your active vs. passive balance.
- Review your financial plan and estate plan (preferably in that order) with a competent (preferably credentialed) financial planner and with your estate planning counsel in light of anticipated changes in overall volatility
- Given the 2017 tax law changes, such a review is timely irrespective of an evolving investment climate.
In addition to the foregoing, please see the last section of my Nov. 2017 article Asset Values Are Stretched – What to Do About it?, which articulates a five-pronged call to action for private investors.
Managing volatility is a part of the process of managing all of the risks in your portfolio and your broad financial/investment strategy. The steps outlined here and in my Nov. article (see link above) are intended to assist you with managing both volatility and other risks, including that of a potentially meaningful market correction, or other episodic event.
 S&P 500 is an index of 500 stocks chosen for market size, liquidity, and industry grouping, among other factors. It is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large capitalization U.S. equity universe. It is not possible to invest directly in the index., although there are securities that strive to approximate its returns.
 Source: Factset, Standard & Poors, J.P Morgan Asset Management, Morningstar Direct and Ballantyne Partners.
 Vulcan Value Partners (VVPLX) Large Cap Fund: 1st quarter 2018 conference call (C.T. Fitzpatrick, CIO, leading the call) – U.S. large cap value equity mutual fund, April 18, 2018.
 Chilton Flagship Fund: 1st quarter 2018 conference call (Richard Chilton, leading the call) – equity oriented long/short hedge fund, April 18, 2018.
 GAAP = Generally Accepted Accounting Principles. In the USA the Financial Accounting Standards Board (FASB) stipulates GAAP overall and the Governmental Accounting Standards Board (GASB) stipulates GAAP for state and local government.
 IFRS = International Financial Reporting Standards, which are a set of accounting standards developed by the International Accounting Standards Board (IASB) that is becoming the global standard for the preparation of public company financial statements.
 James MacKintosh, The Real Risk Is Believing That Volatility Is Risk, Wall Street Journal, April 30, 2018, published in the print edition as “The Real Peril in Believing That Volatility is Risk,” page B-1, May 1, 2018.
Asset Values Are Stretched
As financial asset values become increasingly stretched, it becomes ever-more important for investors to determine clearly their process for managing a potential correction in those values.
Investors and the media have talked about elevated financial asset values (not just U.S. equities, but investment assets broadly speaking) for some time. Rather than being remedied, the issue has been exacerbated.
Tactical asset allocation adherents might have investors reduce (long-term) investment exposures, increasing cash and short-term fixed income.
Philosophically and practically, that is not my inclination:
- As a matter of investment philosophy, I don’t favor that approach, in part because the likelihood of making both exit and reentry decisions correctly in quick succession is low. Missteps in exit and reentry can be costly.
- As a practical matter, the tax consequences of tactical asset allocation for private investors can be significant.
Accordingly, potential missteps in timing and the impact of taxes together present a daunting prospect for private investors who are considering tactical asset allocation as a solution to elevated financial asset values.
What, then, is a private investor to do? I advocate a five-pronged approach:
- Be mindful of the degree to which valuations are stretched, to avoid unpleasant surprises. Three articles may be of interest in setting the table for a further discussion:
- Wall Street Journal, “A Case for the Bulls Is Hard to Warrant,” by James Mackintosh, Oct. 13, 2017, at p. B-1/B-10, or online, “This Market’s Running on Hope, Not Profits.”
- The Economist, “Asset Prices Are High Across the Board, Is It Time to Worry?” Oct. 7, 2017.
- New York Times, Oct. 15, 2017, “Charging Past Chaos,” pp. BU-11/BU-17, or online, “The Stock Market Charges Ahead, Despite the World’s Storms.”
- Have enough cash, plus assured sources of cash (e.g., expiring Treasuries), to cover a year’s spending, including:
- taxes (income, gift, real estate, etc.),
- current pledges and anticipated charitable commitments,
- capital expenditures (college, acquisition of non-investment assets, etc.)
- life style maintenance, and
- alternative assets capital calls, without reliance on distributions, which could be temporarily impaired.
- Rebalance back to long-term asset allocation targets at least semiannually in a disciplined manner, reducing exposures that are above target and adding to exposures that are below target. There may be frictional considerations that inhibit your rebalancing, such as tax factors, cost bases, age and health. It may be wise to review your long-term asset allocation targets to be sure that they are suitable for your current and likely future circumstances. It is wise to conduct that review with a trained and experienced professional of your choice.
- When feasible from the point of view of taxation (and regulatory supervision for “insiders”), reduce legacy, or outsized, single asset exposure(s).
- As discussed in the referenced Economist’s article, heed Benjamin Graham in his The Intelligent Investor from 1949: invest with a “margin of safety.” Each of the measures above is designed to increase your margin of safety. Beyond that, emphasize active asset management over passive index-tracking when assets appear to be overvalued. While active management does not assure a “margin of safety,” it provides an opportunity for the creation of a margin of safety. If one pursues active management, the selection of those managers is hugely important. Vanguard’s research tells us that “. . . after costs: (1) the average actively managed mutual fund underperformed various benchmarks; (2) reported performance statistics can deteriorate markedly once ‘survivorship bias’ is accounted for (that is, once the results of funds that were removed from the public record are included); and (3) persistence of performance among past winners is no more than a flip of a coin.” Accordingly, once again, it may be wise to work with a trained and experienced professional advisor of your choice in selecting investment managers.
If you would care to discuss these, or other, topics with me personally, please drop me an email, or give me a ring at 617.945.5157. And as always, we welcome your comments.
There has been a lot of brewhaha in the investment community about California Public Employees Retirement System’s (CalPERS’) decision to withdraw $4 billion from hedge funds (to learn more see “CalPERS Shows Masters of Hedge-Fund Universe Have No Clothes,” WSJ Online, September 16, 2014). Why does anyone pay attention to the CalPERS action? Partly because CalPERS is the largest U.S. public pension plan, and it has some of some of the finest advisers. So, if CalPERS is withdrawing from hedge funds, should you?
In a previous article of mine, Why Are Hedge Funds So Popular Despite Recent Disappointing Returns?, I provided you with a refresher on hedge funds and critical success factors for investing in them. Is that article still relevant today? Yes. However, in today’s article, I evaluate CalPERS’ move, and provide five key points for private investors who are smaller than CalPERS (which is virtually everyone on planet Earth!).
Five Reasons Why CalPERS’ Hedge Fund Exit May Not be Relevant to Private Investors:
- 1. Hedge funds represented a tiny fraction of CalPERS’ overall portfolio. According to the WSJ article cited above, CalPERS’ decision to exit hedge funds was based less on their returns, and more on the costs associated with managing them. Hedge funds represented less than 2% of CalPERS’ $298 billion portfolio, making their performance – good or bad – insignificant. In my experience, clients who allocate 10% – 30% of their portfolios to hedge funds are able to move the needle with their investments, especially in down equity markets.
- 2. CalPERS’ move is not going to affect the investment market. The hedge funds business is going to be just fine regardless of whether CalPERS is in it or not. The trick for sophisticated investors is to build a portfolio of hedge fund managers and funds that meet their needs: risk tolerance, return expectations, volatility profile, liquidity and tax sensitivity, which is no small matter.
- 3. Withdrawing from an underperforming asset to invest in an outperforming asset may not be wise. One might think that withdrawing from an underperforming asset class (e.g., hedge funds) to invest in an outperforming asset class (e.g., U.S. equities) would be the right thing to do, especially since hedge funds have been underperforming for several years. However, investing in an asset class such as U.S. equities, which has recently outperformed its long-term history, may be a mistake. This is because overall, an asset class’s investment performance tends to revert to its historical, long-term returns (i.e., reversion to the mean). It follows that investors should harvest the proceeds taken from outperforming asset classes (e.g., U.S. equities) and invest the proceeds in underperforming asset classes (e.g., hedge funds, provided that one continues to have confidence in the managers in question). In other words, consider pursuing a strategy that is the opposite of CalPERS’.
- 4. Why not try to replicate hedge fund returns without hiring hedge fund managers? First, hedge fund replication is complex and controversial. Second, replication eliminates your opportunity to select the hedge funds that are best suited to your needs. In my experience thoughtful private investors need to construct a portfolio of hedge funds that meet their particular needs, which are driven by risk tolerance, return expectations, volatility profile, liquidity and tax sensitivity. Hedge fund replication does not always focus on your specific requirements. While a hedge fund replication strategy might be suitable for a large pension fund, I do not often see hedge fund replication used by private investors.
- 5. CalPERS’ decision to withdraw from hedge funds may have been motivated in part by internal management considerations. There may have been staffing issues, since the Chief Investment Officer (CIO) who implemented CalPERS’ hedge fund program is no longer in that post. Perhaps the acting CIO wanted to make his mark and needed to move quickly. Regardless, this ought not to drive a private investor’s fundamental investment strategy.
If you have a comment on this article, please write your comment in the space provided below. Leaving comments allows readers to expand upon the topics I cover in my articles. So please help us all by commenting. If you would care to discuss investing in hedge funds with me personally, please drop me an email, or give me a ring at 617.945.5157.
If this week’s article appears to be a bit off-target from my usual investment topics, then you are right! However, if “learning is the mother of wisdom,” then I am in favor of our learning from my experience as a guest speaker on an internet radio show.
I recently had the pleasure of being on Radio Entrepreneurs, an internet radio show that showcases entrepreneurs and innovative companies, with the goal of creating an online knowledge pool worldwide. Despite the fact that I have produced multiple investment videos and made countless presentations, it was a bit unnerving for me to be on an internet radio show. Why? Because there are no opportunities to edit out the ‘ums’ and other filler phrases. There are also no ‘do-overs,’ allowing me to be more clear and concise. Further, despite much preparation, one doesn’t have control over the questions that the interviewer asks.
If you would like to see a brief (3 minute) video version of my internet radio interview, please click Radio Entrepreneurs Video. If you would like to listen to the 12-minute audiocast, please click Radio Entrepreneurs Audiocast. Links to both the video and audio interviews are featured on www.rgpic.com. Otherwise, please see my candid thoughts about interviews, below.
Six Lessons I Learned from Being on Internet Radio
1. Eye contact is of paramount importance. This might sound strange at first, as radio does not have video. However, my radio interview was videotaped and it was awkward to maintain eye contact with both the interviewer and the camera. Had I taken my marketing manager with me, she would have made sure that I was positioned correctly relative to the camera angle and the interviewer. Instead, you get a great view of my forehead. My apologies to my viewers.
2. Avoid popular filler-phrases and words. I invite you to rate me on how successful I was at avoiding meaningless words and phrases in my interview such as:
- Right (used as a rhetorical question)
- I mean
- You know
3. Don’t rate the interviewer’s questions. For example, saying, “That is a good question,” can appear to be condescending to an expert interviewer. Instead, consider saying, “I’m glad that you asked that question.” It is much more neutral than rating the interviewer’s ability to ask a good question.
4. Do not rate the interviewer’s comments. For example, I would rather not say, “You are exactly right.” The interviewer feels more affirmed (and the interviewee sounds less condescending) if the interviewee says, instead, “I certainly agree with you there.”
5. Help the interviewer by giving her/him a bulleted prompting sheet. Suggest some questions to ask, and for which you have thoughtful answers. However, it is their show and do not expect them to stay with your script. They are likely to go off-script, and when they do you need to follow them.
6. Carefully plan the first 2-3 minutes with the interviewer, before the interview begins. This will help to reduce surprises and avoid either of you being caught off-guard as the interview gains momentum.
I encourage you to share some of your ‘lessons learned’ from being interviewed in the comments section below (regardless of whether you were on radio, a panel, etc.). If you wish, you can also offer me your feedback by calling (617.945.5157) or by shooting me a quick email to jack at rgpic dot com.
A Wall Street Journal article entitled, “Hedge Funds Drive to Another Record,” (WSJ, 04/22/14, page C-1) noted that despite their recent lackluster returns, hedge funds are a popular investment tool and have grown dramatically in assets under management (AUM). In 2013 for example, hedge fund returns averaged 9% after fees, while the S&P 500 was up 32%, 3.5 times the average hedge fund’s return. In Q-1 2014, the total average return for hedge funds was 1.1%, compared to 1.8% for the S&P 500. Ironically, Q-1 2014 was also the seventh consecutive quarter in which hedge funds hit a new record — $2.7 trillion in AUM — by adding $26 billion to AUM in that quarter. Why do hedge funds continue to be such a popular investment despite their disappointing recent returns?
As a result of the Financial Crisis, most investors have learned to not follow the herd. But is the continued popularity of hedge funds driven by a herd mentality? Instead of focusing on AUM, investors should ask, “Are hedge funds a useful tool for my portfolio?” I share with you here six considerations about investing in hedge funds. I have also included three critical success factors for managing your hedge funds.
First, you may want a quick refresher on what a hedge fund is. A hedge fund is an investment vehicle with:
- Constrained access: only sophisticated investors need apply,
- Limited withdrawal capacity: often times, you are only able to withdraw assets quarterly, and lock-ups may be as long as three years,
- Enormous investment flexibility: in that hedge funds may use:
- leverage (borrowing money to make your money work harder),
- shorts (borrowing an asset the hedge fund does not own and selling it, with the hope of buying it back at a later date, at a lower price, and returning it to the firm from which it was borrowed),
- exotic instruments (such as derivatives), and
- other tools not common to most investors’ traditional portfolios.
- Tax reporting consequences: hedge funds typically issue a complicated K-1 vs. a 1099, and they often produce K-1’s after April 15th, meaning that investors must file their taxes on extension.
- Higher than common fees:
- a management fee of 1.5% to 2%,
- a participation in your profits, often 20%, and
- operating expenses (e.g., audit, legal and administrative fees).
Six Considerations to Address with Your Investment Advisers When Investing in Hedge Funds
- How have your hedge funds performed relative to your other investments? Specifically, how have your long-term hedge fund returns been vis-a-vis your other asset classes and capital market benchmarks? Do you have an absolute standard for the return you want to generate? How have your hedge funds performed vs. that goal? The answers to these questions are more important than whether the hedge fund industry’s AUM is up or down.
- Are you fully satisfied with your hedge fund selection process? Manager selection is always important, but the hedge fund environment is particularly complex with limited public information. Additionally, since hedge funds have liquidity constraints, you are not free to terminate an unsatisfactory investment on a moment’s notice. The best information regarding detailed fund-by-fund returns and thorough due diligence about hedge funds is highly proprietary. Most wise investors retain an expert consultant to assist them with manager selection.
- Has your hedge fund program offered protection for your portfolio in periods of crisis? The years 1987, 2001 and 2008 were particularly difficult for investors. Be sure to evaluate the returns of each of your current (or potential) hedge funds to see how well each of them behaved during periods of financial crisis or severe stress.
- Are your hedge funds equity alternatives or fixed income alternatives? If a fund is to be used as fixed income alternative then it should not be compared to the returns of the S&P 500. You need to have a candid dialogue with your advisers and/or each hedge fund manager to develop a fair and appropriate set of expectations about each fund’s investment return and volatility.
- What role do you want hedge funds to play in terms of managing your portfolio’s volatility? Hedge funds can play a favorable role in reducing volatility. You may be well-advised to accept a reduced return compared to the S&P 500, or other capital markets return, if the hedge funds you invest in can reduce the overall volatility of your portfolio and achieve a predictable return.
- How much organizational risk can you accept? In building a hedge fund portfolio, you can put hedge funds roughly into three categories:
- Mega Managers: These are large, multi-billion dollar funds with the capacity to accept significant additional AUM. Their names may appear in the business press with some regularity. They may even be publicly traded companies, or belong to large public financial institutions. These mega funds typically have the least organizational risk. On the other hand, they may not be the most interesting and rewarding funds over the next 10 years – they have already made it big.
- Institutional Main Stream: These funds are somewhat smaller, and may be highly selective in taking additional investor assets – many are open only with a suitable introduction. They may not be willing to engage in fee-sharing with financial institutions that sponsor hedge fund platforms. These funds tend to avoid the press and are hard to find without expert assistance. While they may have more organizational risk than the mega managers, they are well- established businesses (nonetheless professional due diligence is essential).
- Emerging Managers: These funds have $50 million – $1.5 billion in AUM and may have the greatest organization risk. Investors typically engage specialized expertise in the emerging funds arena to help them ‘get it right’ (i.e., stay out of trouble). All that said, there can be very rewarding investment opportunities with emerging funds.
Three Critical Success Factors for Investing in Hedge Funds
- Determine the strategic role for your hedge funds: Wise investors do not embrace hedge funds to follow the herd. Nor do they employ hedge funds to maximize short-term returns. Prudent investors hire hedge fund managers to accomplish an important role in their portfolio in terms of risk/volatility management. Their mission is to achieve favorable long-term returns that are more muted than long-only equities, but attractive nonetheless.
- Evaluate structural considerations: Informed investors understand the liquidity limitations of their hedge fund portfolios, as well as the fee burdens that hedge funds bear. Furthermore, thoughtful taxable investors explore the after-tax returns from their hedge fund portfolios.
- Build an effective management team: Prior to embarking upon hedge fund investments, sensible investors are careful to assemble the right professionals and a deeply experienced investment committee to help them to construct and manage a highly successful program.
If you have a comment on this article, please use the comment box below. Leaving comments allows readers to expand upon the topics covered in my articles. So please help us all by commenting. If you would care to discuss investing in hedge funds with me personally, please drop me an email or give me a ring at 617.945.5157.
When it comes to financial and estate planning, U.S. residents tend to focus more on federal tax planning than on state tax planning, and for good reason. Federal estate taxes (sometimes referred to as a transfer tax) can be burdensome on very large estates. However, some people may have to pay both federal estate taxes and state estate/inheritance taxes (also referred to as death taxes). Paying taxes at both the federal and state level can be quite substantial. With careful planning however, there can be opportunities for significant savings.
State estate and inheritance taxes tend to have a relatively greater impact on moderate-sized estates than on very large estates. For example, if you are a married couple with a $10 million estate, with proper planning you may not have to pay any federal estate tax, but your state estate/or inheritance taxes may be significant. If you live in New York or Massachusetts for example, you are likely to pay a $1.44 million estate tax. If you happen to live in New Jersey, you may have to pay both a $1.5 million estate tax and your beneficiary may have to pay a $1.6 million inheritance tax.
This week’s article, discusses some of the choices you have for gaining attractive death tax relief, regardless of the state in which you live.
What Is a Death Tax?
The term death tax is a colloquialism used by non-professionals to refer to estate, inheritance and gift taxes. They are also referred to as transfer taxes. What are the differences among these three taxes? For the sake of simplicity let’s think of them this way:
- Estate taxes are paid by an estate before the estate’s assets are transferred to its non-charitable beneficiaries. Estate taxes are levied at the federal level and by some states.
- Inheritance taxes are paid by the non-charitable recipient of the assets from an estate-transfer. In the U.S. there is no federal inheritance tax.
- Gift taxes are borne by the living donor of a lifetime gift to a non-charitable beneficiary. Since only two states (Connecticut and Minnesota) have a gift tax, the concept is largely applicable at the federal level.
Why Focus on State Death Taxes?
Federal gift & estate and state estate/inheritance taxes can have a big impact on your estate and/or your beneficiaries. Currently, the federal government offers a relatively generous gift and estate tax exemption of $5.34 million per person, or $10.68 million per couple. However, this exemption is operative to varying degrees (or not at all) in the 19 states and D.C. that have estate and inheritance taxes. New York’s estate tax exemption for example is just $1 million.
- Minimizing federal estate and gift taxes is a topic that applies primarily to the very wealthy.
- Minimizing state estate and inheritance taxes is a topic that applies to a much larger group of persons, both the moderately well-to-do and the very wealthy.
- Hence, a lot more persons need to plan around state death taxes than need to focus on federal estate and gift tax planning.
How to Avoid Death Duties in High Tax States
About one third of the U.S. population resides in the 19 states/D.C. that have estate and/or inheritance taxes. However, two thirds of the U.S. population lives in the 31 states that do not have these tax burdens (sometimes referred to as tax haven states). In order to qualify as a resident of a tax haven state, you must live there at least six months a year (consult your adviser for specifics).
If you reside in a state that has death taxes then you might consider one of the options below:
- Move. Do you like snowy winters? Then consider moving to New Hampshire, Michigan, Wisconsin, the Dakotas, Montana, Idaho or Alaska, which have no state estate or inheritance taxes. On the other hand, if you are a sunbird, then the entire Sun Belt is open to you. From Virginia to Florida and from Florida to California (excluding Tennessee), these states also have no death taxes.
- Have Multiple Residences. If you are a part of a couple and one of you wants to move to a tax haven state while the other does not, this too can be arranged. A client has taken this approach and although it requires careful planning and good recordkeeping, it is not out of the question. Be aware that the estate of the person who continues to reside in the non-tax haven state will still be subject to that state’s death taxes.
- Become a Nomad. You might be wondering, “Hey Jack, instead of moving my residence to a low tax state, why don’t I just travel for six-plus months a year, or perhaps hike the Pacific Crest Trail?” Well you can certainly do that, but most states do not allow you to stop being a resident (and avoid their death taxes) until you become a bona fide resident of another state. The nomad strategy is unlikely to be successful, and each situation is fact- specific, so be sure to consult your advisers.
Lifetime Gifts – A Great Way to Reduce Your State Death Taxes
If you reside in a state with estate and/or inheritance taxes, is there anything that you can do to ameliorate your state death tax burden? Happily, the answer is: yes, by making lifetime gifts to your non-charitable beneficiaries. Unlike estate transfers, gifts made during the lifetime of the asset holder are not taxed at the state level upon transfer to the beneficiary (except in Connecticut and Minnesota). So be generous to your beneficiaries during your lifetime to reduce your death taxes (just be sure to keep enough to live on).
The federal tax system has no such loophole for lifetime gifts, as federal taxes are levied upon non-charitable gifts (above the exemption level) regardless of whether the transfer is made during your lifetime or after your death. If you have exhausted your federal lifetime gift tax exemption, are state tax-free lifetime gifts a ‘no-brainer?’ If you are a regular reader of my articles, then you will know that I have previously made a strong case for lifetime gifts that are taxable at the federal level. In fact, I encourage them. See my earlier article, The Advantages of Making Taxable Lifetime Gifts.
Managing Taxes on Non-Cash Gifts
As you have seen, transferring assets can affect death taxes on both the estate and beneficiary. Transfers can also affect income tax considerations, especially for non-cash gifts. For example, if you transfer a non-cash gift that has appreciated (e.g., securities, business interests or property), then your beneficiary may have to pay a significant capital gains tax if and when they sell it. Fortunately, the capital gains tax problem can be reduced through careful planning and analysis of the tradeoffs between death-related taxes and capital gains tax. Consult your advisers, since as each situation is fact-set-specific.
Recommended Reading to Learn More
You may wish to find out more about the topics I have addressed above and review a table of estate and inheritance taxes, exemptions and top tax rates by state. If so, see States You Shouldn’t Be Caught Dead In by Laura Saunders, in the Wall Street Journal of October 26, 2013, at page B-7. It is most important that you is consult professionals who can assist you with financial and estate planning.
If you have a comment on this article, please use the comment box below. Leaving comments allows readers to expand upon the topics covered in my articles. So please help us all by commenting. If you would care to discuss financial and investment planning with me personally, please drop me an email or give me a ring at 617.945.5157.
The summer is over, the kids are back in school, and just when you think you might have some time to relax, you ask yourself, “How on earth am I going accomplish all of my goals before year-end?” Well, you are not alone. I find that creating a checklist of ‘to do’ items is enormously helpful in accomplishing my goals, and emotionally satisfying as I knock items off my list. With this in mind, I have created a simple, yet pretty comprehensive, financial check list for you to share with your advisers and put your mind at ease as you enter the fourth quarter.
Each of our financial check lists will vary somewhat, but you may be surprised at how many items apply to you. Further, setting your financial priorities and tackling your most relevant items now, will allow you to enjoy a more relaxing and satisfying holiday season come November and December.
If you are unable to meet with each of your advisers, I would be happy to review this financial check list at our earliest convenience without charge. Simply give me a ring at 617.945.5157, or shoot me an email. If you would like to share a few items from your own check list, please be sure to leave a comment at the end of this article. Let’s get started!
A Financial Check List for You and Your Advisers
1) Tax Related Considerations
- Review your long-term capital gains. Are they meaningful? Do you have long-term capital losses available to offset the gains? Are there long-term losses that you should realize before year-end to offset your taxable long-term gains?
- Review your short-term capital gains. Are they meaningful? Do you have short-term capital losses available to offset the gains? Are there short-term losses that you should realize before year-end to offset your taxable short-term gains?
- Explore whether you (and your spouse) have used up your lifetime gift tax exemption of $5+ million each. If not, consider making tax-free intra-family gifts. For even greater tax-efficiency consider making generation-skipping transfers to a trust for the benefit of your grandchildren. See my earlier article, What High Impact Tax Planning Can you do in September?
- Counterintuitive as it may seem, review with your team of advisers the appropriateness of making taxable intra-family gifts. This is not a crazy idea, and you can learn more about this from my earlier article The Advantages of Making Taxable Lifetime Gifts.
- Begin estimating your 2013 tax liabilities (both state and federal) to avoid being surprised later on by how much you owe. Work with your advisers to think about sourcing the required cash, potentially even through a line of credit, where your private banker can be of assistance. See my article Read This If You Still Think You Don’t Need Credit and see my brief video Innovative Investment Solutions, A New Perspective on Credit.
- If you have an offshore bank account, ask your CPA what you can do to minimize draconian forfeitures and fines that could be applicable, depending upon your situation. Offshore accounts are more common than is generally appreciated and are a red flag for tax authorities in the U.S.
2) Insurance Considerations
- Consider spending some quality time with both your life insurance adviser and your estate planning counsel in the same room. While the prospect of having this meeting may not fill you with excitement, it could turn out to be an important conversation both in terms of tax/liquidity management and estate conservation for your intended beneficiaries.
- Review your property and casualty insurance portfolio. There are a myriad of small factors that taken together, can dramatically impact the cost and efficacy of your coverage. You may be spending more than you think, or more than you need to. On the other hand, there may be inappropriate gaps in your coverage.
3) Investment Strategy Opportunities
- Have an offsite meeting of your investment committee and key advisers to evaluate your long-term asset allocation targets. Are the targets still suitable? How does your portfolio conform to your targets? Are you comfortable with the divergences between your targets and your actual exposures? Some investors have a large asset allocation target to bonds, based on a 30-year bull market in bonds. This may be a good time to review those choices.
- Similarly, review your liquidity preference. As a result of the Great Recession, a lot of investors developed an ultra-high liquidity preference. Can you tolerate more illiquidity in your portfolio than you currently employ? If so, how would you and your advisers like to deploy an increased illiquidity budget?
- If you want to rebalance your asset class exposures there may be a need to give some managers advance notice of your intentions. It is not uncommon for hedge funds to allow only annual exits with 60 or 90 day notices, so now is the time to review required notice provisions.
- Assess your cash flow needs (e.g., taxes, living expenses, both family and charitable gifts and capital calls) and whether you can use your cash flow requirements to reallocate assets back toward your long-term asset allocation targets.
4) Investment Tactics
- Review each of your investment managers with your investment committee to see if any managers should be put on a watch list, or are candidates for replacement.
- Has your view of passive asset management (e.g., index-related mutual funds and ETFs) vs. active asset management (e.g., mutual funds and managers who emphasize security selection expertise) changed? Do you want to shift more of your exposures in favor of active or passive management?
- What opportunistic investments may be worth embracing before year-end? Are there asset types that have languished and whose time has come? Your advisers may have perspectives to share with you on this topic.
- Take a close look at your balance sheet, asset allocation and performance reports. Are you getting all of the information that you need? If not, what are you and your team going to do about it and when?
5) Take a Poll
- Ask each of your advisers what their key issues are in your situation, and prioritize their ideas. Odd as it may sound, some advisers are bashful or reticent about pushing their agendas. So get your top advisers to go on record about what they see as priorities in managing your investment/financial affairs, and what they want you to do about those priorities.
I hope that you find my financial check list inspiring, rather than discouraging. If you have a Private Investment Counselor, he/she is in your life specifically to help you examine all of these things. If you don’t have such a person in your life, consider whether you need one. If that isn’t the right answer for you, then divide-and-conquer by carving up the list and getting your existing advisers to help you.
What have I overlooked? Please leave a comment, including items that you would like to add to my financial checklist, just below this article. If you prefer, please give me a ring at 617.945.5157, or shoot me an email.
Happy Dog Days of Summer! In the spirit of warm days, cool breezes and light reading, I want to share with you some thoughts about philanthropy that I acquired from a ‘fire side chat’ with Warren Buffett and his sister Doris.
I had the pleasure of hearing Warren and Doris Buffett speak at a Massive Open Online Course (MOOC) developed by Rebecca Riccio, Program Director, Northeastern (University) Students4Giving. The course is called GivingWithPurpose, and it is sponsored by the Learning by Giving Foundation , established by Doris Buffett to teach younger generations about philanthropy. Part of Rebecca’s course includes interviews with leading American philanthropists, and the first interview (a.k.a., fireside chat) was with Warren and Doris Buffett.
What can the Buffetts teach us about philanthropy? You guessed it, plenty. The beauty of Riccio’s interviews is that they apply to all ages and offers us ‘regular folk’ an opportunity to sit in on intimate interviews with America’s leading philanthropists. Let me share with you six (6) highlights from the Warren and Doris Buffett interview:
1) Giving is a Lifelong Journey
The Buffetts’ father was a strong role model who helped Warren and Doris develop a passion for giving. Warren Buffett has, in turn, been very influential in modeling philanthropy for his children. Warren’s remark, “The chains of habit are too light to be felt, until they are too heavy to be broken,” sends a clear message about forming constructive habits. Build good giving habits early and be a model for others. A related quotation of the Buffetts’ is: “Have the right heroes and march in their footsteps.”
2) When Does a Journey of Giving Begin?
For the Buffetts, their journey of giving began in their 20’s. However, now-a-days I have noticed that children are introduced to philanthropy in their teens, through both their families and schools. If you wish to share your thoughts about when to start teaching children about philanthropy, please comment below.
3) Find a Style of Giving that Works Best for You
Warren Buffett described himself as a ‘wholesale donor.’ Why? Because he prefers donating to foundations, such as the Bill and Melinda Gates Foundation, Learning by Giving, and his own children’s foundations, which select the ultimate beneficiaries. He places his money with direct donors whose causes, values and sense of mission he shares.
Interestingly, Doris is a ‘retail donor.’ Her style is both hugely labor intensive and, as she remarks, “enormously joy intensive.” Doris’ philanthropic style is passionate, businesslike and unsentimental, as she performs intensive due diligence. Despite their different giving styles, both Doris and Warren agree that: 1) the process of giving is intensely personal, 2) you must find your passion and follow it, and 3) you need to do so in a way that works best for you.
4) Narrowcasting is a Fine Thing
Warren Buffett mentioned a conversation that he had with Tom Watson, the founder of IBM, in which Tom Watson said, “I’m no genius, but I’m good in spots. I concentrate on those spots.” In philanthropy, the message is that you cannot solve all of the world’s problems. Find your focus and your passion and don’t get distracted. Doris, for instance, has had great success with prisoner education and higher education for battered women.
5) Have Metrics for Success and be Prepared to Fail
It is wise to measure the results of your philanthropy. That is, establish metrics going in and measure the results of your contributions. Philanthropy is a realm in which intractable challenges can be tackled, so know what constitutes success for you and don’t be afraid of failure. In the words of Warren Buffett, “The rewards of success may outweigh the risk of failure. Don’t be too risk adverse and don’t assume that you will always succeed.” Quoting Walter Lipman, Warren Buffett said, “We sit in the shade of trees planted by others,” and he went on to say that, “we have a responsibility to plant more trees, to provide shade for those less fortunate than we are.”
6) Don’t Define Philanthropy Narrowly
If you do not have money to give, you may have time, talent or expertise to give to causes you feel passionately about. Or, you may be able to contribute a combination of time, talent, expertise and money.
I hope that this ‘summer reading’ has inspired you to share your thoughts and comments about philanthropy with your friends and family. I believe we are a nation of givers and have benefitted greatly from the good will of others.
If you would like to rate this article or leave a comment, please do so below. If you would like to suggest a topic for a future article or talk with me personally, please give me a ring at 617.945.5157 or shoot me an email. In the meantime, happy summer!