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When one considers Dennis Rodman, what typically comes to mind are his off-court exploits – most notably his trips to the communist state of North Korea[1]. It’s hard to tell what Rodman is bringing to the table during these meetings other than something akin to being a court jester. But in this update, we’ll focus on Rodman’s on-court exploits and what he did for basketball teams he played for during the late 1980s and early 1990s.

What relevance does Dennis Rodman have to an investment portfolio? According to teammates and opponents, Dennis Rodman brought a valuable combination of defense and second-chance opportunities. In our mind, defense and second-chance opportunities in the NBA translate into investment portfolio benefits such as diversification, staying power, and optionality. We’ll discuss each of these concepts below, but the overarching concept is that all portfolios could use more Dennis Rodman.

Diversification

We’ve written about the concept of diversification in recent publications as the S&P 500 has been one of the best-performing equity indices over the last eight years. There was a confluence of factors, to include stable currency, political stability, and savvy corporate management, that contributed to this positive outcome for US equities. Yet, as we sit here at the midyear point in 2017, the winds of change are blowing in favor of companies domiciled outside the United States. Consequently, in many alternative strategies we have implemented in portfolios, the correlation/diversification benefits are starting to become more apparent.

The crux of the argument relating to diversification benefits is seen clearly in the mathematics of a portfolio drawdown. We illustrate this concept below, displaying the return required to get back to even based on various levels of portfolio drawdown.

Essentially, if you can construct a portfolio in a way that reduces the drawdown by owning non-correlated assets, you allow the math to work in your favor.  We believe alternative assets/strategies are an effective way to mitigate portfolio risk.

Staying Power

This concept may be new to many clients but it is one that we’ve been thinking a lot about recently.  Staying power is a behavioral concept that has application to every long-term investment portfolio and refers to the idea that portfolios will either succeed or fail due to investor behavior during stressful market periods.  As we’ve all witnessed over the years, we know people who can’t handle watching their portfolio losing money.  How many people do you know that sold out of all their equity exposure during the financial crisis and haven’t repurchased yet, or they have only recently added it back while equity markets are at all-time highs?

All this being said, if a portfolio contains assets/strategies that are zigging when the market is zagging, an investor’s ability to remain invested in the “riskier” portion of their portfolio goes up dramatically.  This staying power could be seen in the win/loss record of almost every team Dennis Rodman was on over his career, due to the fact that Rodman was a master at keeping his teams in the game with both tenacious defense and rebounding.  These two traits took the pressure off the superstars that surrounded Rodman.  We believe that a properly diversified allocation to alternative assets/strategies has the potential to reduce pressure on the more volatile segments of a portfolio (typically equities) over a full market cycle.

Optionality

Finally, we believe that all portfolios should be constructed with a degree of optionality.  Optionality is the flexibility a portfolio has to make changes or adjustments during significant stress periods in the financial markets.  The way in which most portfolios possess optionality is via a cash position.  Cash is said to have a high degree of optionality because the “price” of cash does not fluctuate and is readily accessible to redeploy in the event opportunities arise on very short notice.

Optionality is an important characteristic to have in a portfolio primarily because it allows investment decisions to be made without external influences.  For example, we believe investors like Warren Buffett and Seth Klarman have enjoyed success partly due to the fact that their portfolios carry a significant amount of cash (optionality) at almost every point in time.  In the case of Seth Klarman (via his investment vehicle Baupost LLC) the average level of cash over the last 30yrs has been 20%.  In the case of Buffett (via his investment vehicle Berkshire Hathaway) that cash level has been even higher!  The point in mentioning these levels is that both Klarman and Buffett have been able to succeed because they are almost always investing in opportunities based on merit.  Further, when they are making investments, they do not need to sell something to free up capital.  In this way, they are making only one difficult decision (what to buy) and not two (what to buy and what to sell).  Optionality is something investors should consider, as we currently find many equity and fixed income markets at extended valuation levels.

In summary, every team needs a Dennis Rodman, just as every portfolio could benefit from alternative holdings that generate a return that is different from traditional stocks and bonds.  While the benefits described (diversification, staying power, optionality) above may not be intuitive in the midst of an eight-year bull market, these benefits are invaluable during periods of significant market distress.  To that end, even though we have no way of knowing when the next significant downturn will come in the financial markets, that doesn’t mean we shouldn’t begin preparing for the next occurrence.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

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[1] In fairness, I cannot claim credit for the idea of correlating Dennis Rodman with alternative strategies.  That idea came from Chris Cole of Artemis Capital.  On the Artemis Capital website under “Market Views,” you’ll find a very interesting publication entitled “Dennis Rodman and the Art of Portfolio Optimization.”

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Most financial advisors advocate maximizing employer-sponsored 401(k) accounts or municipal 403(b)s. Generally, we agree. However, you could be missing out on tax savings if you aren’t careful.

Before going any further, let’s be clear on what we mean by tax efficient. According to Wikipedia, a financial process is said to be tax efficient[1] if it is taxed at a lower rate than an alternative financial process that achieves the same end.

The collaborative encyclopedia offers two tax efficient examples:

#1 – Passing one’s assets on to one’s heirs using a Grantor Retained Annuity Trust, for example, is potentially more tax efficient than simply letting the heirs inherit the assets.

#2 – An exchange-traded fund (ETF) that follows the S&P 500 Index generates fewer “taxable events” than a mutual fund that follows the same index.

Another Viewpoint

Financial educational portal The Balance[2] uses the term tax diversification and offers the following definition: Tax diversification is a financial term that refers to the allocation of investment dollars to more than one account type.

The Balance clarifies the term further by adding, “Tax diversification is similar to asset location (not to be confused with asset allocation), which refers to spreading investment dollars among various account types (the location of the investment assets) and choosing the best investment types that work best in those accounts.”

Tax Efficient or Tax Diversification

For the purposes of this post, we’ll use the two terms interchangeably, since they both seek the same end result. To help you more effectively evaluate tax efficient strategies, we asked Gratus Capital Director of Financial Planning Kevin Woods, CFP® for some advice.

Lack of Tax Diversification Negatively Impacts Retirement

“One of the reasons tax diversification is important for investment portfolios is due to the need to minimize paying taxes during retirement,” says Woods. “Keep in mind that if you place all of your money in tax-deferred investment vehicles, such as a 401(k) or Individual Retirement Account (IRA), you could end up paying more in taxes as compared to if you’d placed some money in taxable accounts today.”

Avoidable Yet Common Mistake

According to Woods, there are many people who only save for retirement using a traditional tax-deferred retirement account, such as an IRA, and never accumulate savings through an additional investment brokerage account.

“Placing all your money in tax-deferred retirement accounts imposes a built-in liability,” says Woods. “Essentially, a percentage of your retirement savings must go towards paying taxes.”

On the flip side is someone who invests in both traditional tax-deferred retirement accounts as well as other investments through a brokerage account. The investor who only saved using an IRA has to pay ordinary income tax on all of their withdrawals during retirement. Not true for an individual who saved using both an IRA and an investment brokerage account. This investor has a more tax efficient retirement portfolio, since he or she has saved their money in different types of investment accounts that have varying tax implications.

For example, the investor now has the ability to withdraw 50 percent from their IRA and the balance of what they need from a brokerage account and only pay taxes on what they withdrew from their IRA.

Detailed Scenario:

The White Coat Investor[3] provides a detailed example of two retired physicians who each draw $100,000 for the year from their financial savings vehicles. One physician placed all his money in a tax-deferred IRA account, and the other used a mix of tax-deferred and taxed accounts. Ultimately, the physician who used both tax-deferred and taxed accounts ends up paying less in taxes. The end result of the example is: One doctor pays an overall tax rate of 12.5 percent, while the tax-diversified doctor pays 1.9 percent.  

4 Different Tax Planning Investment Accounts

To build a tax-efficient investment portfolio, it’s important to distinguish among the four different types of investment accounts used for tax diversification, says Woods.

These include:

Taxed-Deferred (Pre-Taxed) – such as a 401(k) or 403(b). These vehicles are considered qualified investment accounts and have several benefits. Investopedia provides a simple explanation to help differentiate between qualified and non-qualified[4] investment accounts.

Why are tax-deferred accounts so popular? Woods isolates three key benefits:

“First, tax-deferred accounts enable you to lower the amount of income you pay taxes on now, increasing your take-home pay,” says Woods. “Second, since you’re deferring taxes until you withdraw funds during retirement, your investments grow tax-free during the years you’re making contributions. Finally, most retired investors are in a lower tax bracket as compared to when they were working, lowering their tax obligations when they begin withdrawing.”

After-Tax – such as a Roth IRA, Roth 401(k) or Variable Annuity. There are no upfront tax deductions when you contribute to these retirement accounts; however, you pay no taxes on withdrawals during retirement, and investment growth is tax-free.

“As a rule-of-thumb, if you’re age 55 or younger, a Roth 401(k) or Roth IRA makes sense to the extent that you’re not in the highest tax bracket,” says Woods. “Roths generally make more sense when you have more time to invest before retiring and you’re in a lower tax bracket.”

Taxable – such as stocks, mutual funds, bonds, CDs and money markets. Contributing to these taxable accounts means that you pay taxes each year on the dividends, interest and realized capital gains, rather than when you withdraw these funds during retirement.

Tax-Advantaged – such as municipal bonds or life insurance. These financial vehicles typically include a mix of tax-deductible, tax-deferred, and tax-free as well as other tax benefits.

Possible Diversification Strategies

“There are a number of strategies you can use with your portfolio management to strive for tax efficiency,” says Woods. “One approach is to have all your income-producing investments in your retirement account, thereby not requiring you to pay taxes on your interest each year. What’s more, you can also put all your stocks in taxable accounts, helping to provide a preferred lower tax rate on your dividends and long-term capital gains.”

In Closing

While saving for retirement may seem like a straightforward process, complexities arise when it comes to tax liabilities. “There are a myriad of variables to consider when trying to lower your tax liability both for today and during retirement,” says Woods. “I encourage all individual investors to seek the help of both a CPA and a financial advisor.”

Why both?

Because a CPA is an expert in tax laws and the tax preparation process, whereas a financial advisor is an expert at looking at an individual’s overall financial life. The latter includes financial and estate planning, as well as risk and investment management. Investors need both advocates to help ensure a tax efficient financial portfolio, says Woods.

Woods’ number one recommendation for investors, “Have more than just an employer-sponsored retirement account,” says Woods. “If that’s all you have, then it’s likely your portfolio is not tax efficient.”

At Gratus Capital, our team is made up of CPAs, MBAs and Certified Financial Planners. We believe that it takes a well-diversified skill set and team approach to ultimately guide individuals to financial freedom while lowering their tax burden. If you have questions regarding tax diversification or any other financial concerns, please contact us.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

[1] https://en.wikipedia.org/wiki/Tax_efficiency

[2] https://www.thebalance.com/tax-diversification-with-investing-2466705

[3] https://www.whitecoatinvestor.com/taxes/tax-diversification-2/

[4] http://www.investopedia.com/ask/answers/206.asp

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If you’re seeking to change a life or make a positive impact in your community, preparing a charitable giving plan is an essential first step in helping you to achieve your goals.

This guide outlines seven steps to take in order to maximize the positive impact of your hard-earned money.

Discover:

  • Key elements to consider when compiling or updating your list of organizations that receive your donations.
  • Specific tax-advantaged financial vehicles that help maximize tax deductions related to charitable giving.
  • The one giving strategy that needs to occur in order to achieve and sustain the greatest positive impact of your charitable efforts.

Learn how to make a real impact within your community.

Click here to download the guide.

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Do you dream of owning a ski, beach or lake house? Well, you’re not alone. In fact, according to leading statistics company Statista, roughly 2.1 million people last year said they plan to buy a second home within the next 12 months1.

If a special hideaway is on your wish list, then planning ahead is highly recommended in order to remain financially sound. To help you make an informed purchasing decision, we asked Gratus Capital Director of Financial Planning Kevin Woods, CFP® for some advice. [This is really strong, considering our disclosures.  How about – To help you get started, we asked Gratus Capital Director of Financial Planning Kevin Woods, CFP® for his thoughts on making a detailed plan, first.]

What follows are six key considerations Woods encourages you to ponder before signing on the dotted line for a second home.

#1 – Estimate Real & Unexpected Costs

The very first consideration for buying a second home is to ask yourself if you can actually afford it, says Woods.

There are many people that think they’ll buy their second home, rent it and make money, or make enough from rental income to substantially subsidize their bills,” says Woods. “Unfortunately, a great deal of the time this doesn’t turn out to be true. Generally, it’s because many home buyers underestimate the actual carrying costs of owning a second home, above and beyond a second mortgage, property taxes and insurance.”

These Additional Second Home Expenses May Include:

  • Utilities
  • General maintenance & repairs
  • Security system
  • Mowing & lawn services
  • House cleaning services
  • Internet & cable
  • Water & sewer
  • Trash & recycling removal
  • Seasonal maintenance for heating, cooling, hot tub/spa, fireplace, gutters, septic pumping, pesticide spraying, etc.
  • Opening and closing of pool, spa and irrigation system
  • Long-term maintenance for exterior painting, driveway sealing, roof and appliance replacements
  • Travel expenses to reach second home
  • Insurance riders, e.g., snowmobiles, pool, speedboat, etc.
  • Flood insurance
  • Property manager

Hidden Expenses

Remember to account for association fees, such as condo fees, says Woods. Additionally, watch out for an association’s periodic assessments.

Examples Could Include: A one-time $1,500 fee assigned to each condo owner for a new roof, a $5,000 fee for a town-mandated water system upgrade, or a $7,500 assessment post-hurricane damage, and so forth.

Woods also reminds us to look out for individual state property taxes, since some can be significantly higher than what you’re currently used to with your primary home.

Woods recommends that once you’ve isolated all of your variable expenses, double them for the first 10 years of ownership. If you can afford your second home after doubling all monthly variable expenses, then more than likely you can actually afford it. “Keep in mind that at any moment you could lose your job,” says Woods. “If this were to happen to you, do you have enough buffer to continue affording your second home?”

Bankrate® provides a simple home loan calculator that you can use to generate a quick snapshot in qualifying for your second home.

#2 – Identify Usage:  Renting, Personal Use or Both

It’s important to decide if you’ll use your second home for personal leisure, as a rental or both. The key reason to make this determination before purchasing a second home is due to tax ramifications.

For Example:

According to Investopedia, as long as you use the property as a second home and not a rental, you can deduct mortgage interest and property taxes the same way you would for your primary home. You can rent your property for 14 days or less each year without needing to report this as income to the IRS.

However, the financial education portal adds that when you rent out your second home for 15 days or more and either use it for less than 14 days or 10 percent of the number of days the home was rented, it’s now considered a rental property, and you must report all rental income to the IRS. Of course, you’ll be able to deduct a portion or all of your rental expenses, including mortgage interest, property taxes, insurance premiums, fees paid to property managers, etc.

TurboTax provides some detailed scenarios of renting versus personal use and the respective tax ramifications here.

Also, keep in mind that the market fluctuates. A property that is easily rented today may take weeks or maybe even months to rent a few years from now. “We simply don’t know what the real estate market will demand from year to year,” says Woods.

#3 – Titling Your Second Home

If you’re renting your second home, Woods suggests forming a Limited Liability Company (LLC) for the property, helping to protect your personal assets if your rental business is sued. For investors owning a property outside of their resident state, Woods suggests that you title your second home within a revocable trust, helping your loved ones avoid probate should anything happen to you.

#4 – Manage Borrowing Requests & Minimize Resentment

According to Woods, often when you purchase a second home, you’ll start hearing from long-lost relatives and friends asking to stay over or even borrow your second home outright.

Therefore, it’s important to plan ahead and set limits. The first question to ask yourself is, will I allow others to use my property? If so, who and for how long and how often? If you do allow others to use your second home, it’s important to establish rules, such as no smoking or pets, or no one under the age of 21 without an older adult.

“The most important thing to keep in mind is that your vacation home is yours,” says Woods. “You’ve worked hard and have been financially responsible, enabling you to purchase a second home in the first place. And while it’s nice to have guests or to do a favor for someone who needs an affordable vacation alternative, you do not owe anyone a place to stay. Nor do you need to provide an excuse as to why they’re not allowed to use your second home. You’ll enjoy your hideaway more when you manage your expectations, not others’.”

Real Simple provides some great examples of guilt-free strategies for saying no to various types of requests from friends and family members. All of us at Gratus Capital especially enjoyed the first strategy, “Saying no for the sake of your wallet.”

#5 – Estimate Time & Pressures

The concept of buying a second home is exciting, says Woods. Yet many buyers forget to take a step back and realistically consider exactly how much time they actually have to use their second home.

“I’ve seen second homes work out well for families that have very young children,” says Woods. “However, when kids enter middle school their activities become more of a commitment, to the point that they may be penalized if they miss a game or practice. Your 9-year-old may love skiing or camping now, but as he ages, he may lose interest and resist the idea of driving to the mountains. Ask yourself if you’re prepared to manage such situations.”

Also, it’s important to ask yourself if you’ll feel pressured to use your second home every time you vacation versus taking a different vacation, given that you’re paying a substantial amount of money to maintain your second home. Woods says that vacation home owners often feel a pressure to vacation at their second home. This travel limitation can ultimately lead to resentment.

#6 – Maintain Formal Co-Ownership Agreements with Friends & Family

If you’re considering co-owning a second home with a close friend or family member, Woods suggests that you have a clear agreement before signing on the dotted line. “Keep in mind that people’s lives change, and not everyone is successful at projecting their future goals,” says Woods.

“For example, someone may decide they want out of the house because they need the money to help pay for their child’s college education.

It’s important to discuss the nitty-gritty when creating your co-ownership agreement. In fact, if any member of the two parties starts to get agitated with developing an agreement, this could be a sign that you may not want to get into business with this individual. If you’re unable to have ongoing, open and difficult conversations with your co-owners, then the partnership will likely fail.”

At a minimum, Woods suggests that you include the following in your agreement:

  • A list of shared expenses and distribution of expenses.
  • Facilitation of repairs.
  • Usage scheduling, who can use the house and when, including key vacation periods?
  • Guests, who, how many and how frequently?
  • House restrictions, e.g., no smoking, no pets, no adult children without parent present, etc.
  • Buy-sell agreement. The latter would allow you to take out life insurance on the co-owner, enabling you to buy his or her share of the property in the event of their death. Otherwise, you could end up sharing your second home with your best friend’s adult children who may not like your established rules.

In Closing

“I’m all for individuals and families purchasing a second home,” says Woods. “I, too, value quality time and relaxation with my family. Still, it’s imperative that you consider both the financial and emotional factors associated with owning a second home. If you can afford it, that’s terrific. However, do you have the patience to manage it, including enforcing boundaries regarding friends wanting to use your special hideaway? Owning a second home, even if you have the money, isn’t for everyone.”

At Gratus Capital, we take our clients’ lifetime goals very seriously. This includes their desire to secure a second home, whether it be for a personal escape or as another form of income. However, the purchase of a second home has both short and long-term ramifications on your financial well-being. It’s important to weigh the purchase of a second home within your overall financial plan, particularly tax and estate implications.

If you have questions regarding the purchasing of a second home or any other question pertaining to your overall financial health, including taxes and estate planning, as well as investment and wealth management, please contact us. In delivering financial advisory services, we aim to be your collaborative partner and dedicated advocate.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.
[1]  https://www.statista.com/statistics/228870/people-living-in-households-that-plan-to-buy-a-second-home-usa/
[2] http://www.bankrate.com/calculators/home-equity/loan-pre-qualification-calculator.aspx
[3] http://www.investopedia.com/articles/personal-finance/013014/tax-breaks-secondhome-owners.asp
[4] https://turbotax.intuit.com/tax-tools/tax-tips/Home-Ownership/Buying-a-Second-Home/INF12015.html
[5] https://howtostartanllc.com/what-is-an-llc
[6] https://www.realsimple.com/work-life/10-guilt-free-strategies-for-saying-no

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This quarter we asked Gratus Capital Director of Investments Todd Jones to weigh in on the current financial environment to learn more about critical market trends.

Here’s what Todd is talking about this summer:

With equity markets at new all-time highs, where is Gratus now looking for different equity allocations?

Certainly, we’re being a little more cautious with our equity investments, while remaining at our targets. The reason we’ve been giving more caution to this side of the portfolio is due to elevated valuations. Specifically, equity markets are experiencing valuation levels that haven’t been seen in a number of years.

Furthermore, the number of bargains available to equity investors is among the lowest we’ve witnessed at any point in this recovery cycle. It’s important to recognize this, since as value investors, we consider price an important factor in all of our positions when determining what investments to add to or remove from a portfolio.

For the past 12 months, we’ve been focusing on developed international markets, such as Continental Europe, because we continue to see select opportunities available in these markets. However, this is not the case for other developed areas of the world, including Australia and Japan. In our view, these areas are more risky than Europe because of their proximity to China.

Emerging market stocks and bonds have been performing well. Is this an area Gratus is considering for portfolios?

We’re still considering these allocations both on the equity and fixed income sides. However, Gratus has yet to make any investments in emerging markets. This is primarily because of the substantial liquidity risks that are evident in most of these markets. As an example, on May 17, 2017, the Brazilian stock market was down approximately 18 percent. This one-day price plunge highlights the hidden risks in emerging market equities. Unfortunately, many investors aren’t paying attention to this rapid movement.

On the emerging market bond side, this asset class looks unattractive. Yields on emerging market bonds relative to U.S. Treasury bonds are nearing all-time lows since the 2008 global financial crisis. We believe this represents a negatively skewed risk-return tradeoff.

Technology stocks have been drawing a lot of news attention and seem to be up almost every day. Is this something we should be concerned with?

There certainly have been a number of publications correlating where technology stocks are today versus a similar high valuation situation in 2000, when there was a tech bubble. However, this time around in 2017, technology segments within the equity markets appear far less risky than in 1999 and 2000.

There are two reasons why:

#1 – The tech-knowledge economy is becoming larger, certainly larger than in 1999.

#2 – Technology companies are generating substantial earnings. Therefore, given that these companies are generating far-superior earnings as compared to 1999, the valuations are much more believable and reasonable.

Are there any portfolio changes Gratus is making now?

There are a number of things that we’re doing and have been doing throughout 2017. I’d like to highlight three:

#1 – Similar to the first quarter in 2016, we rebalanced all of our accounts this year, but for different reasons. Last year, equity markets had sold off dramatically. Therefore, we rebalanced in order to add to our equity positions. This year, we rebalanced all of our accounts in order to reduce equity positions, because prices have moved up substantially as compared to last year.

#2 – We are increasing cash positions where available. Overall, we haven’t held much cash in our accounts through this recovery. Still, we believe cash will create potential opportunities within portfolios in the near future.

#3 – We are continuing to transition some of our equity and alternative positions from passive indexes to active strategies. Given the deluge of money being invested in passive strategies, we believe active strategies will have better potential to outperform than they have at any point in the last 10 years. We discussed this active management approach in our June Market Insights, Investing In An Era Where Price Is Irrelevant.

Authored By:

Gratus Capital is an SEC registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request.  The opinions expressed are as of July 2017, and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  As with any investments, past performance is not a guarantee of future results. In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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We are pleased to announce that Wayne Holbrook has joined the Gratus team as our Chief Operating Officer.  Wayne is responsible for collaborating with the Executive team to develop and measure team structures, create operational efficiencies, and innovate policies and procedures to align with the firm’s vision.

Prior to joining Gratus, Wayne was the Chief Operating Officer / Chief Compliance Officer for Cornerstone Investment Partners and was responsible for operations, trading, finance, human resources, compliance and technology. Before that, he was a Global Partner with Invesco, where he was responsible for operations, trading and technology for the North American Institutional Group. Wayne earned his Masters of Business Administration from the J. Mack Robinson College of Business at Georgia State University, and he earned his Bachelor of Arts degree in Economics from the University of Illinois at Chicago.

Please join me in welcoming Wayne to the Gratus family.

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Dedicated to helping others in our community, the Gratus Team recently volunteered at Camp Twin Lakes. The nonprofit organization provides week-long summer camps and year-round weekend retreats for Georgian children with serious illnesses, disabilities, and other life challenges.

Camp Twin Lakes collaborates with nearly 60 different nonprofit organizations to create customized programs that teach campers to overcome obstacles and grow in their confidence and capabilities.

The Gratus Team Charge

The Gratus Team was tasked with harvesting more than 548 pounds of potatoes, all grown on site at the camp’s sustainable teaching farm. Every potato will be converted into farm-fresh french fries, mashed potatoes, and other wholesome dishes. In fact, almost every meal served at the camp has some component that originated on the farm. All in all, our harvesting will feed approximately 800 campers this summer and saved the camp staff a full day of working in the potato fields.

Tangible Impact

After farming, we received an in-depth tour of the camp’s grounds. Along the way, all of us gained a deeper understanding of just how Camp Twin Lakes creates impactful and life-changing experiences for children facing serious challenges. After much reflection, we also hold a new perspective on how farming education can help to instill strength and confidence in those facing adversity.

For More Information

As strong advocates of volunteerism and charitable giving, we encourage you to explore volunteer opportunities with Camp Twin Lakes. Or, if you’re pressed for time, then please consider supporting their Wish List requests or planned giving efforts.

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No one likes to think about the idea that there may be no tomorrow, whether it be for themselves or a family member. But life happens, and it’s for this very reason that life insurance plays such an important role in protecting your family and financial interests.

The key question is, how much life insurance does one person or family need?

While the answer varies greatly depending on your personal situation, there are important considerations to evaluate in order to obtain a well-rounded answer. To help you start preparing a life insurance strategy, we asked Gratus Capital Wealth Advisor Al Meadows, MBA, CFP® for some first steps.

Initial Life Insurance Planning Steps

“When determining whether or not you even need life insurance, the first step is to ask yourself if anyone is financially dependent upon you,” says Meadows. “If so, then you need life insurance. The next step is to identify your current financial needs as well as your future goals.

Start by asking yourself what current and ongoing financial obligations need to be paid. Then consider your long-term goals. Do you want to pay for your children’s or grandchildren’s college education or a wedding or perhaps provide enough income so your spouse will no longer need to work? No matter what your long-term goals are, you want to purchase enough life insurance to supplement existing assets to cover what you need for today and also for your future goals.”

Common Oversight

Many people wait until they have children to purchase life insurance. Meadows says this is often a mistake.

“Keep in mind that you may have a mortgage and credit card debt, as well as vehicle and college loans,” says Meadows. “Many people can’t afford to pay these debts off without their significant other’s income. If this resonates with you, then you more than likely need life insurance right now whether you have children or not.”

Estimating Life Insurance Costs

Research firm ValuePenguin recently took an in-depth look at the average cost of life insurance across a number of different policy durations. The firm determined that the largest influencing factor on life insurance prices is the health of the individual being insured. In fact, individuals that smoke can expect to pay up to 200 percent more for their life insurance policies than nonsmokers.

As an example, for a 20-year term policy worth $250,000, a nonsmoking 30-year-old can
expect to pay $334.54 annually. However, for smokers, the same policy is $721.99. Insurance premiums increase as you age. For the same plan, a 40-year-old can expect to pay $432.36 and $1,175.35 respectively.

To find your age group, ValuePenguin has put together a detailed Average Cost of Term Life Insurance by Age[1] chart. As an added life insurance price benchmarking resource, the nonprofit organization Life Happens® offers a detailed life insurance calculator[2]. 

Term Life versus Permanent Life Insurance

There are two different types of life insurance:  term life and permanent life. The latter is also known as whole life. Term life insurance is good for a specific time period. It could be two, 10 or 30 years, or any amount in between. Permanent life insurance is a policy that you own your entire life.

According to Meadows, 90+ percent of individuals only need term life insurance. The idea is to determine the period of time that you or your life partner would need additional income if something were to happen to either of you.

Rarely does someone need to purchase permanent life insurance. However, Meadows identifies two legitimate reasons for needing a permanent life insurance policy:

#1 – If you have a special needs dependent since he or she will need to be taken care of indefinitely.

#2 – If you have a large estate, necessitating the need for added income to cover the cost of your estate taxes.

Employer-Provided Life Insurance

According to Meadows, large employers will frequently pay the premium for the first $50,000 of the employee’s group-term life insurance coverage as part of a full-time employee benefits package.


Downside Potential

While there generally is no downside to receiving the first $50,000 of term life insurance paid by your employer, there are downsides in taking out more coverage through your employer, says Meadows. Specifically, if you terminate your employment, you’re now without life insurance and are that much older, unnecessarily increasing the cost of acquiring another life insurance policy.

Meadows adds that there is often a misconception when it comes to employer-sponsored term life insurance. “Most people think it’s cheaper to go through your employer,” says Meadows. “But this isn’t always the case. In fact, if you’re a nonsmoking healthy individual, you’re potentially paying higher premiums due to the unhealthiness of some of your coworkers.” Meadows encourages everyone to explore the idea of an independent policy, above and beyond an employer-sponsored plan.

Key Man & Buy-Sell Life Insurance for Business Owners

Business owners face two unique challenges when it comes to life insurance, says Meadows.

#1 – If you’re a business owner and would suffer financially due to a “key” employee dying, then this insurable interest[4] enables you to take a life insurance policy out on the employee, referred to as Key Man Insurance. You can retain the policy, even if this vital employee quits.
#2 – Suppose you have business partners and one passes away suddenly. If you do not have enough money set aside, you could end up being business partners with your deceased partner’s spouse or adult children.

To avoid this, business owners will establish a buy-sell agreement whereby all business partners agree to a purchase price for their business. They then take out life insurance policies on each other in the amount needed to buy out the deceased partner’s share of the business.

More Life Insurance Planning Considerations

  • Be Mindful of Hidden Expenses: When estimating current and future expenses, be aware of the money that is not spent. A common example is a spouse who remains home to care for your children. If he or she dies, you would need to ensure that you have enough life insurance to pay for childcare and home upkeep.
  • Update Beneficiaries: An important step within your overall life insurance strategy is to ensure that you regularly update your policy beneficiaries, says Meadows. He suggests that you revisit all financial and estate planning accounts with assigned beneficiaries, no less than once a year, and most certainly when you have significant life changes, e.g., divorce.

In Summary

At Gratus Capital, we help our clients build comprehensive financial plans. Our plans encompass every financial facet of life, including life insurance, estate, retirement and tax planning. Furthermore, we’re actively involved in the structure of our clients’ life insurance policies, including helping them to determine how much they really need in relation to their current financial situation and future goals.

To minimize conflicts of interests, we do not sell life insurance nor do we receive a commission when we refer our clients to an experienced life insurance specialist.  If you have questions regarding life insurance or any other financial matter, please contact us. We welcome the opportunity to get to know you better.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

[1] https://www.valuepenguin.com/average-cost-life-insurance

[2] http://www.lifehappens.org/insurance-overview/life-insurance/calculate-your-needs/

[3] https://www.irs.gov/government-entities/federal-state-local-governments/group-term-life-insurance

[4] https://en.wikipedia.org/wiki/Insurable_interest

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Most investors think quality, as opposed to price, is the determinant of whether something is risky.  But high-quality assets can be risky, and low-quality assets can be safe.  It’s just a matter of the price paid for them.

– Howard Marks (Sept 2015)

It seems not a day goes by where a media outlet or publication doesn’t run a story on the death of active management. Whether these stories note the current tidal wave of money being dumped into low-cost index mutual funds and exchange traded funds (ETFs) or the idea that some large percentage of active managers fail to beat their benchmark, it’s all the same story.  Even notable investing legend Warren Buffett in his annual letter to shareholders[1] recommended that individuals allocate almost all their investable assets to an S&P 500 index.  Everywhere you turn, the drumbeat of passive investing is audible.  But is it a siren’s song?

Doesn’t it strike you as odd that humans spend countless hours getting the “best deal” on items to include toothpaste, cable bills, gasoline, and groceries, and yet do not put in equal amounts of effort to a far more critical commodity: their financial assets?  Put another way, the word “deal” as described in the prior sentence is meant to imply a recognition of price consciousness.  The passive approach to investing mandates that you ignore your inner drive for price consciousness.  To me, this behavior seems a little strange, but recent flow of funds data[2] would suggest that many investors are, in fact, eschewing price consciousness in favor of simple “market exposure”….just as the equity markets touch new all-time highs.

As with other manias in financial markets history, we think what is really going on here is momentum investing.  In financial markets, the phenomenon of momentum refers to the positive feedback loop that is created by prices that go up over a short/intermediate-term time frame.  This upward bias in prices draws in additional investors near the mid-to-latter stages of the cycle as FOMO (Fear Of Missing Out) creates a buying frenzy.  Investor memories can be myopic, and you don’t have to look hard for examples of this activity.  Some would include: technology stocks in the late 1990s, single family homes in the mid-2000s, master limited partnerships (MLPs) in the 2010s, and the soup du jour is exchange traded funds (ETFs) based on indices.

So why is it a problem that so many investors are now price insensitive, and how are we (Gratus) accounting for this new potential risk?  We touched on this topic in an update last year, but I believe it’s time to revisit the issue as the answer may not seem obvious.

Low Cost ≠ Low Risk

We’ve put this idea first, as we think it is the most important concept to consider when thinking about an ETF or index mutual fund.  Just because the vehicle is low cost (ETF/index mutual fund) does not mean that the assets underlying the vehicle do not carry risk of over-valuation.  Many in the financial media will eschew this point by saying something nebulous like “in the long run” or “over a full market cycle” to indicate why your entry point is irrelevant.  To us, these phrases are meaningless, because every investor’s time horizon is different and considerations around their financial assets are unique to some degree.  So to reinforce the point, just because you can buy an index that has a low management fee does not mean you aren’t paying too much for the underlying assets.

Someone Needs To Do The Hard Work

To us (as we’ve mentioned in prior publications) successful investing all comes down to basic probability analysis and, by extension, risk/reward.  The only way we know how to pass judgment on risk versus reward is to relate an investment to its valuation (i.e. is this investment a good deal relative to how good a deal the investment was at various points in the past or to its future prospects?).  There are many ways to gauge value, but for simplicity’s sake, we will use the price-to-earnings (P/E) ratio.  Simply stated, the P/E ratio relates the share price of a company to the earnings it generates.  The higher the P/E ratio, the worse of a value it becomes and the lower the probability becomes that the subject company shares can perform in line with historical norms.  This is a gross simplification of all the variables that go into the P/E and a rigorous company valuation, but the concept helps underscore a point.  The only investors that undertake company valuation analysis are active investors….not passive index or smart beta investors.  Therefore, if fewer and fewer investors are willing to undertake valuation assessments, then who is judging whether a company is overpriced or not?  Clearly, it’s not the index/ETF contingent.  

Ease of Trading ≠ Better Investment Outcomes

Just because you can trade an ETF (buy or sell) intraday, whenever you feel like it, doesn’t mean that this liquidity is a good attribute.  In fact, Gratus (and others like Credit Suisse Global Strategist Michael Mauboussin) would argue that the more liquid an investment, the more likely it is that an investor will trade that investment.  This is partly due to loss aversion, whereby losses that an investor experiences (whether realized or unrealized) feel three times worse than gains of an equal amount.  Behavioral psychologists Daniel Kahneman and Amos Tversky documented this concept (known as prospect theory) in their academic paper.[3]

Leaving loss aversion aside, buying a low cost index ETF does not guarantee a good investment outcome because the purchase of an ETF implicitly involves investment decisions to include what size companies to purchase (small v. large), where those companies should be domiciled (US v. international), type of company to be purchased (growth v. value), currency exposure, % weighting in the portfolio (overweight v .underweight), among others.

Next, there are instances of equity index /ETFs that actually trade at premiums to the companies within the index they are replicating.  In this way, investing in these select ETFs means you are paying more than you would if you were to buy the underlying constituents.  This is not supposed to happen in an ETF.  Admittedly, this doesn’t happen very often, but when it does (as was the case with the Van Eck Junior Gold Miners) it makes news as the ETF marketing machines have placed considerable emphasis on minimal premiums and low cost.

Contrast the high-frequency trading of ETFs with some of the most successful investment programs, and we believe that the intra-day liquidity of ETFs is more of a marketing tool than an actual benefit to investors.  In the case of Gratus, we prefer to hold our equity/ETF positions multiple years (if not decades). 

Market Structure Degradation

I’ve left this section for last as it may be a little less intuitive than the sections above.  I won’t go into too much detail here but wanted to show a chart that may shed some light on this section.  Put simply, we now have a dynamic where an increasing number of ETFs are being created while the number of underlying stocks are declining.  What new risks does this dynamic present?

Next, obtaining diversification within a portfolio of indices/ETFs is now harder to obtain.  Take the case of ExxonMobil.  It’s a mega-cap energy stock with ample amounts of trading liquidity in its shares and an above-market dividend yield (3.8%).  Due to these qualities and the way these attributes are weighted in both market capitalization as well as factor-based indices, ExxonMobil finds its shares a top 10 holding in a surprising number of ETFs, to include iShares Core Dividend Growth ETF, iShares Russell 1000 Value ETF, PowerShares BuyWrite ETF, SPDR MSCI USA Quality Mix ETF, Goldman Sachs Active Beta US Large Cap Equity ETF, John Hancock Multifactor Large Cap ETF, SPDR S&P 1500 Momentum Tilt ETF.[4]  Does ExxonMobil really fit the requirements of all these types of investment vehicles?  You can see the issue in trying to reduce overlap in an ETF portfolio where a single stock is held in many different indices.  True diversification is harder to attain, which is why at Gratus we are migrating our portfolios to more active approaches.

Finally, within the context of market structure degradation, we will spend a little time on factor-based approaches to ETF/index construction.  In the media, factor-based approaches are commonly referred to as “smart beta”.  While the concept of smart beta is a valid approach to index construction (whereby stocks are selected not just by size but also other factors to include dividend yield, volatility, valuation, momentum) the problem lies with the mass adoption of the concept.  I would note that most major investment firms, to include behemoths like Dimensional Fund Advisors (DFA), now have smart beta index ETFs as a product offering.  Observing this build-up in enthusiasm, our thoughts turn to the risks: if we all agree that equities are trading at elevated valuation levels generally, then what good does weighing by slightly lower P/E or slightly higher dividend yield provide…… if everything is overvalued?  This is where an active manager’s decision on what constitutes absolute value from the smart beta relative value becomes important.  This distinction can be seen very clearly in periods approaching major turning points in the equity markets (e.g. 1929, 1970, 2001).

Conclusion

In summary, as we have outlined above, there are many reasons to be wary of the passive investment revolution.  So how are we addressing this potential issue in our portfolios?  First, by recognizing that index mutual funds and ETFs have advantages and disadvantages.  This is a big first step because the financial media and marketing machines like Vanguard and Blackrock have powerful platforms to spread their message which usually revolves around the ideas that (1) there is nothing to fear with index investments and (2) cost is the only area where an investor should focus.  This, of course, is way too short-sighted.  As even Vanguard founder Jack Bogle would admit, there are limits as to how many market participants could engage in indexing.

The simple fact is, no one knows the exact percentage amount where passive ownership in equity indices becomes problematic.  We would argue that the math of index investing indicates we are closer to this problem area than many realize.  As an investment firm, and not a marketing firm, Gratus has no preference in favor of any investment vehicle.  Our concern is to provide high quality investment counsel and identify the appropriate strategies to achieve specified goals and objectives with the least amount of risk.  For many of the reasons listed above, Gratus has been migrating toward select active investments as we believe better opportunity lies ahead for active strategies with a discernable value proposition.  In an era where price is seemingly becoming increasingly irrelevant, we at Gratus Capital remain committed to the concepts of a value-oriented approach, as we believe that value (or price consciousness) is one of the few time-tested investment strategies leading to long-term success.

[1] http://www.berkshirehathaway.com/reports.html

[2] Investment Company Institute 2017 Factbook

[3] Prospect Theory:  An Analysis of Decision Under Risk (1979).

[4] Horizon Kinetics, “Indexation: Capitalist Tool”, October 4, 2016

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

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Each quarter we ask Gratus Capital’s investment experts Todd Jones or Marc Heilweil to weigh in on the current financial environment—addressing key issues you’ll want to have on your radar. This spring we reached out to Todd Jones, Director of Investments, to learn more about critical market trends.

Here’s what Todd is talking about this spring:

Are you concerned about current market levels being so high? If not, what are the reasons you are comfortable with staying invested in stocks?

We are eight years into the current bull market in equities, and all indications point to a continued upward bias. Yes, there are indicators that are flashing caution signs that occurred around previous equity market highs (e.g., elevated Schiller P/E, record margin debt, record profit margins, high levels of insider selling, etc).

Yet these are all known issues which are currently being discounted by the market. On the positive side of the equation, there is no denying that while the U.S. economy may be slowing down a little, other parts of the globe are counterbalancing this slowdown, particularly Europe.

This brings us to why we are comfortable with our global equity holdings at this point in the market cycle.  The primary reason we remain fully invested is due to the fact that we’ve been transitioning a portion of our equity holdings away from U.S. based companies to (primarily) European-based companies given their significant valuation and yield difference.

According to data from JP Morgan, the price-to-earnings ratio for the next 12 months on the S&P 500 sits at 17.49x while the MSCI EAFE is a more reasonable 14.86x.  On a yield basis, the S&P 500 current dividend yield is 2.01% while the MSCI EAFE yield is 3.03%.

In all, we recognize that financial markets are cyclical.  We just believe that there are a number of positive factors at work right now that lead us to believe that there is still a decent way to go until we reach the end of the current market cycle.

What are the biggest risks you see with the global stock markets right now?

It’s important to recognize that predicting what will be the catalyst for the next downturn with any degree of accuracy is next to impossible. Market turns are usually a confluence of events conspiring to sap investor confidence to a point that leads to a mass “sell” in the markets.

That being the case, the biggest risks to global stocks within this mosaic approach appear to be two-fold: (1) a rapid change in inflation expectations (which causes bond yields to rise quickly) and, (2) a rapid rise in the U.S. dollar.

The impact of either of these events would be a reduction in global liquidity. A reduction in global liquidity is a difficult environment for risk-seeking assets like stocks, as leveraged holders of equities can be forced to liquidate their holdings to meet capital calls in other parts of their portfolios. Post-2008, global central banks have broadly filled the liquidity gap with assets purchases (e.g., quantitative easing) but the efficacy of such policies is starting to be called into question now that the U.S. Federal Reserve has embarked on an interest rate-hiking paradigm.

Are you concerned with inflation or interest rates rising soon?

This is the million-dollar question as all financial assets derive their value from a risk-free rate. Our base case is that long-term U.S. interest rates remain contained and will trade within a range for the foreseeable future.

Shorter term U.S. interest rates will likely rise at a measured rate in lock step with the increases of the Federal Funds rate over time. The reason we believe longer term rates will remain contained is because economic growth in the U.S. is slowing and U.S. demographics continue to gray (leading to incremental demand for bonds).

As we’ve pointed out in the past, this “flattening” of the yield curve starts to turn problematic typically when short-term rates move higher than long-term rates. We are still a long way from this occurrence.  What would be highly problematic, however, is if intermediate/long-term rates were to rise in a rapid manner over a short period of time.

Look for the next edition of our quarterly newsletter this summer, when it’s Marc Heilweil’s turn to share his expert insight on the key financial issues of the day — and points you’ll want to consider.

Authored By:

Gratus Capital is an SEC registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request.  The opinions expressed are as of February 2017, and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  As with any investments, past performance is not a guarantee of future results. In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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