Tax Efficient Portfolio Turnover

December 9, 2010

In making the decision between passive index funds and active strategies, investors have several considerations. First, they must do their homework to find out if there is reason to believe that a given active strategy is likely to outperform a passive index over time. In the case of relative strength strategies, we addressed that question in one of our white papers (click here). Investors will also want to know about the volatility characteristics of the strategy and understand how a given strategy may complement their overall asset allocation. That is also a topic that we address frequently (click here). Furthermore, because short-term gains are given different tax treatment by the IRS, investors will want to know about the tax efficiency of a given active strategy.

Depending on the investor’s income-tax bracket, the tax treatment of capital gains is as follows:

Source: The Investment FAQ

As a brief primer on relative strength strategies, the process goes like this: Take a universe of securities; rank them by their relative strength; construct a portfolio of high relative strength securities; hold on to strong securities, sell any holdings which weaken beyond an acceptable relative strength rank and replace with another high relative strength security. Such a process obviously involves some portfolio turnover in order to keep the portfolio fresh with high relative strength securities. If, for example, a given active strategy has annual portfolio turnover of 125%, does that mean that it is tax inefficient? Not necessarily. Remember, a relative strength strategy is designed to hold on to the winners and to cut the losers. This often results in the majority of the gains coming in the form of long-term capital gains.

In fact, the table below shows the percentage of gains that are long-term vs. short-term from 1996-2010 of our Systematic Relative Strength Aggressive strategy.

(Click to Enlarge)

As noted in the table above, this has been a very tax-efficient strategy over this time. In fact, the percentage of gains that were short-term capital gains (and therefore taxed at the higher rates) was never above 31%. I suspect that the tax efficiency is much better than many investors would have expected.

To receive the brochure for our Systematic Relative Strength portfolio, click here.

Click here for disclosures. Past performance is no guarantee of future results.

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Posted by Andy Hyer

The Economy is Just Waiting for an Excuse to Boom

December 9, 2010

Gallup had an interesting post discussing small business hiring and the bottom line is this: small businesses are understaffed.

A Wells Fargo/Gallup Small Business Index poll found earlier this year that 34% of small business owners are hiring fewer people than they need because they are worried about revenues, cash flows, healthcare costs, and finding qualified employees.

Once again, the cost of behavioral uncertainty is apparent. All markets, not just financial markets, are affected a lot more by the psychology of participants than is generally understood. In this case, the market just happens to be the labor market.

This workplace understaffing implies that many American businesses remain in “survival” mode. If policy-makers can ignite any kind of economic spark that gives businesses a reason to grow, then new hiring could become an urgent competitive need. Pent-up job growth could literally explode.

In the stock market, we call that a melt-up. The stock market trades on expectations, not reality, so if you see a sudden strong move for no apparent reason, maybe the market is anticipating the end of policy-maker gridlock idiocy. Relative strength has a good record of sorting out the winners and the losers in that kind of situation.

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Posted by Mike Moody

From the Archives: Static vs. Dynamic

December 9, 2010

Neal Templin’s column in today’s WSJ, “Honey, I Shrunk the Nest Egg,” is an excellent illustration of the need for Tactical Asset Allocation—even though, on the surface, his column had nothing to do with Tactical Asset Allocation.

“For years, my wife and I have had an understanding. Clarissa would spend the money, and I would save it.

Well, Clarissa is still holding up her end of the bargain, but I’m an abject failure. My company retirement accounts, despite what I thought was a relatively conservative mix, were down close to 35% in early March from the fall of 2007. That, in turn, forced me to do some painful thinking about how much risk I can stomach on my family’s behalf, and how much money we can expect to have in retirement…

My conclusion: My longtime portfolio allocation of 50% stocks and 50% bonds wasn’t safe enough. I’ve already begun gradually trimming back my stock position each time the market rises. When I’m done with this transition — and it could take a couple of years — I will have a portfolio that can better ride out storms. But it will also be a portfolio less likely to produce a big nest egg.” —Neal Templin

I suspect that millions of investors have come to the same conclusion as Mr. Templin—they intend to move to an allocation that is dominated by fixed income so that they never again have to face devastating losses in their retirement savings. Mr. Templin, and many others, make asset allocation decisions in order to create the “ideal” allocation, given their risk tolerance. Up until this bear market, Mr. Templin’s asset allocation consisted of 50% stocks, 50% bonds. Now, he will dramatically overweight bonds.

A Tactical Asset Allocation approach address the issue of managing risk from a totally different perspective. Instead of creating a static asset allocation, a tactical approach shifts exposure to asset classes based on the relative strength of each of the asset classes. Tactical Asset Allocation will certainly experience losses along the way, but it is a much more dynamic approach. Instead of deciding to be either aggressive, moderate, or conservative, a tactical asset allocation simply says that we’ll let the markets determine the allocation.

—-this article originally ran 5/22/2009. Over the past year and a half, we’ve seen millions of investors pour into bonds like Mr. Templin, making the assumption that they were reducing their risk exposure. Now that premise is not so clear. As Andy points out, tactical asset allocation is dynamic and adjusts to the market situation.

Leave a Comment » | From the Archives, Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

Hello, Goodbye

December 9, 2010

I say high, you say low
You say why, and I say I don’t know
Oh, no
You say goodbye and I say hello
Hello, hello
I don’t know why you say goodbye
I say hello
Hello, hello
I don’t know why you say goodbye
I say hello
—-John Lennon/Paul McCartney

This is a good reminder not to get locked into a position-when one door closes, another door opens. I have long suspected these lyrics referred to sector rotation in the stock market, but I guess you can never be sure, since John Lennon is no longer around to ask. He was killed thirty years ago yesterday, news that was broken to the American public by Howard Cosell during a Monday Night Football game. Moment of silence, please.

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Posted by Mike Moody

Fund Flows

December 9, 2010

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders. Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

Foreign equity funds brought in the most new money last week, while domestic equity funds had the biggest outflows. For the moment at least, the demand for taxable bond funds seems to have cooled down after attracting the lion’s share of new money for the year.

 

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Posted by Andy Hyer