MARKET INSIGHTS

Not so long ago, only the ultra-wealthy and large institutions such as banks and public pensions had access to alternative investment opportunities. Today, almost any individual investor has access to these versatile investment tools. However, the key question is, are alternative investments right for you?

Before deciding, let’s take a look at what an alternative investment really is and its potential impact on an individual investor’s financial portfolio.

According to the Huffington Post[i], alternative investments are investments in assets other than stocks, bonds and cash, essentially investments using strategies that go beyond traditional ways of investing. Gratus Capital Chartered Alternative Investment Analyst and Director of Investments Todd Jones, MBA, CAIA agrees.

However, Jones takes the definition a step further.

“At Gratus Capital, to be considered an alternative investment, the investment vehicle must not exhibit a correlation of greater than 0.60 to either the stock or bond markets in any rolling three-year period,” said Jones. “Otherwise, we exclude the investment from our universe of alternative investments when making selections for client portfolios. Alternative investments are meant to provide diversification and a unique income stream return. In fact, we don’t expect alternative investments to outperform the equities or fixed income markets. Instead, our approach is to identify alternative investments that, on average, have returns that are no greater than the equities markets and no lower than the fixed income markets.”

Jones also believes that almost every portfolio should include at least a small amount of alternative investments because of the diversification value typically generated by this asset type.

Legitimacy of Alternative Investments

“There has been a multitude of alternative investments entering the financial marketplace compared to just three years ago,” said Jones. “Individual investors should be very cautious. Roughly 95 percent of alternative investments available today engage in strategies that provide minimal benefit to a portfolio. Far too often the investment doesn’t perform as described, the return is too low, or the fees are too high.”

Types of Alternative Investments

There are many different types of alternative investments. Sang H. Lee of The Street offers the following examples:

  • Venture Capital
  • Private Equity
  • Hedge Funds
  • Real Estate Investment Trust (REITs)
  • Commodities
  • Real Assets: precious metals, rare coins, wine and art

Jones cautions investors who are contemplating alternative investments such as art, rare stamps, or wine, because the values of these assets are mostly driven by personal taste and sentiment. Instead, Jones recommends that investors focus on alternative assets that can be deeply analyzed: specifically, assets that have ample data to forecast valuations and output key metrics and trends.

Today, we’ll discuss three alternative investment strategies:

#1 – Interval Mutual Funds

InvestmentNews offers the following definition: Interval Mutual Funds[ii] are mutual funds that offer daily purchase for investment but liquidity for limited redemptions at specific intervals (usually quarterly). This change to the mutual fund structure creates large advantages: the fund can simultaneously invest in both private and public assets in a structure that has a liquidity feature and a daily net asset value. This allows the sponsor to create a portfolio of investments that may provide higher levels of yield and noncorrelation to equities, but without the illiquidity and lack of price transparency.

#2 – Private Equity

Financial news giant Investopedia provides the following definition: Private Equity[iii] is capital that is not noted on a public exchange. Private Equity is composed of funds and investors that directly invest in private companies or that engage in buyouts of public companies, resulting in the delisting of public equity.

Typically, private equity investments have been limited to large institutional investors or a person or organization that can allocate at least five million dollars to one single idea or asset. However, access to private equity investments is becoming more of a necessity for mass affluent investors, said Jones.

Why?

Recent news coverage of disappointing IPO offerings for private companies such as Blue Apron[iv] and Snapchat[v] is spurring other profitable private companies to remain private, limiting investment opportunities for investors.

“Now, quality companies that would typically go public early in their business lifecycle are remaining private much longer,” said Jones. “This is problematic for investors, since it limits investment opportunities, especially ones that substantially help an investor to diversify their portfolio.”

For Example:

Amazon went public in 1997. The company’s valuation at the time was approximately $300 million.  Today, it’s roughly a $300 billion dollar company. However, all the growth that has happened since Amazon’s public offering has led to massive investment opportunity and growth for individual investors, according to Jones.

With many large private companies retaining their private status, financial advisory firms are creating new opportunities for their clients.

“Back in 2013, Gratus Capital began formulating ways to gain access to private investment returns,” said Jones. “We began forming limited partnerships for our accredited investors, in order to gain access to existing private investments. This past June, we raised capital and closed our first fund that focuses on private debt and credit as well as private real estate. Our subsequent funds will more likely have a capital appreciation focus. We see these limited partnerships as a necessary evolution of our services if we’re to help our clients achieve targeted rates of return. Specifically, we’re seeking to access illiquid markets that are private and that generate above-average market returns.”

#3 – Hedge Funds

Hedge funds use pooled funds of underlying securities to earn returns for investors. According to Investopedia[vi], the most cited reason to include them in any portfolio is their ability to reduce risk and add diversification. Also, a hedge fund that provides consistent returns increases the level of portfolio stability when traditional investments are underperforming or, at most, are highly unpredictable.

BarclayHedge[vii] reminds investors that hedge funds are not currently regulated by the U.S. Securities and Exchange Commission (SEC). The financial research firm adds that hedge funds can invest in a wider range of securities than mutual funds can. While many hedge funds do invest in traditional securities, such as stocks and bonds,  they are best known for using more sophisticated (and risky) investments and techniques.

Choose Alternative Investments that Align with Individual Goals

BlackRock[viii] recommends investors choose alternatives that align with their distinctive goals. The investment giant gives four common objectives:

  1. To mitigate the effects of stock market volatility
  2. To lower correlation to traditional stock and bond markets
  3. To invest capital for a longer time frame in exchange for higher return potential
  4. To hedge a portfolio against inflation or rising interest rates

In Closing

At Gratus Capital, we believe that almost every financial portfolio should include some level of alternative investments specifically to sustain diversification and separation from the stock and bond markets.

Alternative investment strategies are not to be taken lightly, particularly when deciding between liquid and illiquid assets. Overall, it’s important to focus on what you’re seeking to achieve within your financial plan and how much risk you’re willing to take.

Alternative investments tend to come with higher risk; however, they can also come with greater than average returns. If you have questions about alternative investments or your overall lifetime financial plan, 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.

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[i] http://www.huffingtonpost.com/madelaine-dangelo/5-common-alternative-inve_b_14366582.html

[ii] http://www.investmentnews.com/article/20140506/BLOG09/140509948/the-rise-of-interval-funds-mutual-funds-for-alternative-investing

[iii] http://www.investopedia.com/terms/p/privateequity.asp

[iv] http://money.cnn.com/2017/06/28/investing/blue-apron-ipo-price-range-cut/index.html

[v] http://www.cnbc.com/2017/06/26/snap-shares-may-be-unable-able-to-stay-above-ipo-price.html

[vi] http://www.investopedia.com/university/hedge-fund/place-in-portfolio.asp?lgl=rira-baseline-vertical

[vii] https://www.barclayhedge.com/research/educational-articles/hedge-fund-strategy-definition/what-is-a-hedge-fund.html

[viii] https://www.blackrock.com/investing/resources/education/alternative-investments-education-center/how-can-i-use-alternative-investments

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It’s expected that in 2017 more than 62 million Americans will receive roughly $955 billion in Social Security benefits.[i] The vast majority of these individuals need this income in order to afford retirement.

In this post, we’re seeking to help individual investors who don’t need Social Security income. Specifically, we want you to better understand how to value Social Security within your overall financial plan.

Medium to High-Net-Worth Individuals

You’ve been contributing to Social Security for many years, and even though you may not need the added income, it’s your right to collect it. Therefore, we’d like to outline some concepts for you to consider when contemplating the overall value and benefits of Social Security and how they factor into your life.

Even though you don’t need the money, there are some legitimate reasons to collect your Social Security benefits early, just as there are key reasons to hold off collecting until you’re age 70. Furthermore, some creative strategies for this excess income could make a tremendous positive impact on another life.

Here are 4 Concepts to Consider:

#1 – Supplement Income During Retirement

“When working with many of our clients, we tend to view Social Security as supplemental income to be used during retirement years,” said Kevin Woods, CFP® and Director of Financial Planning at Gratus Capital. “Even though you may not need Social Security given your sizable retirement savings, it’s important to value the benefits derived from Social Security income.”

For example, Social Security can be used to supplement health care and Medicare costs, provide investment income, pay for unexpected lifestyle needs, and to help with future expenses overall. “Social Security adds value to almost any financial plan, and it’s important to identify how this income will be allocated during your retirement years,” said Woods.

#2 – Redistribute Social Security Income

Let’s say you’ve grown your financial assets to the point that you have no real need to spend your Social Security income, yet you’re still receiving $2,000 a month in benefits. There are many beneficial ways to redistribute this income while helping others and enriching lives at the same time, according to Woods.

He cites the following examples:

  • Grandchild’s college education
  • Adult child’s first home or business
  • Alma mater
  • Irrevocable trust for special needs dependent
  • Loved one’s long-term care
  • Humanitarian and other Charitable Giving Efforts
  • Travel expenses for outreach volunteers

#3 – Reasons to Collect Social Security Early

“While your robust investment portfolio will likely cover your retirement expenses, there are generally three reasons to consider taking Social Security early,” said Woods.

These Include:

  1. Health
  2. Change in investment income
  3. Higher expenses early in retirement

However, there may also be a fourth reason to consider collecting Social Security early.

In a recent Kiplinger article[ii], Financial Advisor and CERTIFIED FINANCIAL PLANNER™ Professional Scott Hanson discusses the concept of “means testing” and suggests that high-income retirees may ultimately receive reduced Social Security benefits.  He writes, “One thing we know is that Social Security, in its current form, cannot continue forever. There simply aren’t going to be enough workers to pay for the benefits of all the projected retirees. Payroll taxes will either have to increase, or benefits will have to be reduced…or a combination of both.”

Hanson reminds us that for roughly its first 45 years, Social Security income was tax-free. However, as the years passed, laws were passed and wealthier individuals’ benefits were taxed.  The tax situation has also been compounded, given federal income tax increases.

Along the same lines, many of Woods’ clients believe that the Social Security system won’t sustain itself and, therefore, choose to collect their benefits as early as possible. Woods agrees that decreasing Social Security benefits for wealthier individuals is a valid concern and that collecting benefits early is a reasonable response relative to your individual goals.

For more information regarding Social Security means testing, read the AARP Public Policy Institute’s Reforming Social Security[iii] special report.

#4 – Reasons to Delay Taking Social Security

According to AARP[iv], the longer you wait to start collecting your Social Security benefits, the higher the amount you’ll receive.  The popular social welfare organization cites the following examples:

If you postpone collecting Social Security until your full retirement age of 66*, your benefit will be 25 percent higher than if you started as early as possible.  However, if you delay collecting beyond your full retirement age, then your benefit will go up eight percent a year until age 70, essentially equating to a 32 percent bonus.

In general, Woods recommends delaying your Social Security benefits until you reach age 70. A key reason is due to a frequent income earning disparity among couples, whereby one spouse has earned significantly more income over the years as compared to the other spouse.  By waiting, you’ll likely leave your surviving spouse in a stronger financial position.

For example, one spouse may be eligible to receive $2,500 per month in Social Security benefits at age 70, while the other spouse may only receive $1,500 per month.  If the greater-earning spouse passes away, the surviving spouse would receive the greater of the two Social Security benefits payouts, i.e., $2,500 rather than $1,500 a month.

Special attention should be given to the status of your health and that of your spouse when determining the best time to start collecting your Social Security benefits, said Woods.

*Your full retirement year is based on the year you were born.  To determine your full retirement year, consult Social Security’s Retirement Planner: Benefits by year of birth[v].

In Closing

Gratus Capital’s financial planning approach addresses complex wealth management issues faced by our clients.  And while many of our clients do not rely on their Social Security benefits to experience a financially fulfilling retirement, we believe that the value of this income should be included within every financial plan.  If you have questions regarding your Social Security benefits or any other financial, estate or trust planning concerns, please do not hesitate to contact us[vi].

Helpful Resources

Obtaining Your Social Security Online Statement[vii]

Social Security Estimator[viii]

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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[i] https://www.ssa.gov/news/press/factsheets/basicfact-alt.pdf

[ii] http://www.kiplinger.com/article/retirement/T051-C032-S014-worried-about-future-social-security-benefit-cuts.html

[iii] http://www.aarp.org/content/dam/aarp/research/public_policy_institute/econ_sec/2012/option-means-test-social-security-benefits-AARP-ppi-econ-sec.pdf

[iv] http://www.aarp.org/work/social-security/info-08-2010/10-things-you-need-to-know-about-social-security.html

[v] https://www.ssa.gov/planners/retire/agereduction.html

[vi] https://www.gratuscapital.com/contact-us/

[vii] https://faq.ssa.gov/link/portal/34011/34019/article/3709/how-can-i-get-a-social-security-statement-that-shows-a-record-of-my-earnings-and-an-estimate-of-my-future-benefits

[viii] https://www.ssa.gov/retire/estimator.html

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Over the years, we’ve received many questions regarding Individual Retirement Accounts (IRAs). Typically, most investors want to know if they should choose a Traditional IRA or a Roth IRA.  However in reality, while there are differences as well as pros and cons for each, the key focus should be on avoiding the most common mistakes pertaining to IRAs in general.

Today, we’ll discuss five of the most common mistakes that we’ve seen.

#1 – Neglecting to Update Beneficiaries

Believe it or not, this is one of the most common mistakes individual investors make when it comes to managing their IRA, said Al Meadows, MBA, CFP® and Wealth Advisor with Gratus Capital.

“If you haven’t assigned a beneficiary for your IRA and do not have a will or trust established when you die, then the distribution of your IRA proceeds will be determined by the probate court,” said Meadows. “Also, many people are surprised to find out that beneficiary designations will override provisions in a will or trust agreement.  Unfortunately, I’ve heard of situations where someone’s hard-earned money went to someone they didn’t want it to go to, such as an ex-spouse still listed as the beneficiary.”

Meadows recommends revisiting your beneficiary designations for all of your investment accounts no less than once a year.  He adds that it’s particularly important to update your beneficiaries when there is a significant change in your life, e.g., divorce, death of a loved one, purchase or sale of a business, etc.

#2 – Roll-Over Mishaps

One of the key reasons an investor transfers their IRA savings is due to a change in employers.  In general, as long as you’re transferring your IRA retirement savings as a “directed distribution,” meaning from one trustee to another, you don’t need to worry about unplanned taxes or early withdrawal penalties.

However, if you request a withdrawal in the form of a check or direct deposit, you have only 60 days to roll this money into an IRA in order to avoid an early withdrawal penalty and additional ordinary income taxes.

Furthermore, if you receive a direct withdrawal of your IRA funds, keep in mind that the trustee is required to withhold 20 percent of your total IRA balance.  Why?  Because the IRS assumes that you’re keeping the other 80 percent (not rolling it over into another IRA account) and, therefore, requires the trustee to facilitate the withholding of your savings in order to pay the income taxes on the 80 percent that you retained.

If you do decide to roll over your direct withdrawal of 80 percent into an IRA, you must then come up with the other 20 percent in order to avoid the above penalties.  The trustee can’t distribute this money to you.  Rather, it will be reflected as a credit on your next income tax return, said Meadows.

#3 – Forgetting about Required Minimum Distributions (RMDs)

According to the IRS[i], you can’t keep retirement funds in your account indefinitely. Generally, you have to start taking withdrawals from your IRA, SIMPLE IRA, SEP IRA or retirement plan account when you reach age 70-1/2.  Roth IRAs do not require withdrawals until after the death of the owner.

To determine your required minimum distribution, the IRS provides several different worksheets[ii].  The IRS adds that you can withdraw more than the minimum required amount.  Your withdrawals will be included in your taxable income, except for any part that was taxed previously or that can be received tax-free, such as qualified distributions from Roth accounts[iii].

“Sometimes investors forget that they have a small IRA tucked away somewhere,” said Meadows. “One time, when a new client came to me with 4+ million in assets, we discovered that he had a $100,000 IRA sitting in a self-directed account that he hadn’t touched in more than 20 years.  Since he was retired, we quickly accounted for his minimum distribution so that he could avoid any further unnecessary penalties.”

#4 – Over-Contributing to an IRA

According to Meadows, there are limitations as to how much you can contribute to a Traditional or Roth IRA each tax year.  Investors under age 50 may contribute up to $5,500 per year. Investors age 50 and older may contribute up to $6,500 each year.  However, how much you can actually contribute is determined by your income.  Also, tax deductions related to these contributions depend on whether or not you or your spouse are covered by an employer-sponsored retirement plan.

If you or your spouse are not covered by an employer-sponsored retirement plan, then refer to this chart to determine your tax deductions and income requirements.  However, if you or your spouse do have an employer-sponsored retirement plan, then refer to this chart instead.[iv]

#5 – Mindset & Emotional Mistakes

There are a handful of other IRA mistakes that Meadows has seen over the years, including mindset or emotional mistakes.

For Example:

  • Not starting soon enough – It’s never too soon to start saving for retirement. The key is to open an account now and set up an automatic deposit.
  • Not taking advantage of the “catch up” contribution – The IRS enables investors to contribute more to their IRAs when they reach age 50, up to $6,500. The extra $1,000 a year can truly make a difference for those reaching retirement said, Meadows.
  • Stopping contributions – Some investors think they have enough money already, so they stop contributing to their IRA. With increasing longevity and inflation, there really isn’t much downside to continuing your contributions, said Meadows.

In Closing

At Gratus Capital, we consider IRAs, 401(k)s and many other retirement savings vehicles to be key tools in building, diversifying and sustaining long-term wealth.  We encourage all individual investors to contribute no less than the amount your employer matches, and ideally more.  If you have questions about your retirement vehicles or other financial questions pertaining to financial, estate, insurance, tax and philanthropic planning or asset management, 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.

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[i] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds

[ii] https://www.irs.gov/retirement-plans/plan-participant-employee/required-minimum-distribution-worksheets

[iii] https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions

[iv] https://www.irs.gov/retirement-plans/2017-ira-deduction-limits-effect-of-modified-agi-on-deduction-if-you-are-not-covered-by-a-retirement-plan-at-work

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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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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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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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You worry about them and work hard every day to provide for them, hoping they’ll grow up to be happy, healthy and independent adults. Yet as parents, we often scratch our heads trying to figure out how to teach our kids about money. In fact, some of us don’t talk with our children about money at all.

According to a recent T. Rowe Price® survey, 13 percent of parents surveyed said they never have financial conversations with their kids, while 59 percent said they only talk to their kids about money when their kids ask them about it.

Intuitively, we know it’s important to educate our children about the financial side of life, but what’s the best way to go about it? To answer this question, we looked to Gratus Capital’s Director of Financial Planning Kevin Woods, CFP® for some answers. To qualify his answers even further, we focused on children aged 11 to 25.

Before delving into the different age groups and their respective strategies, Woods believes it’s important that parents come to terms with the following two concepts. Once you do, you’ll have greater success helping your children become money-wise adults.

#1 – Understand Your Own Thoughts about Money

To help your children understand money, Woods says that you must first understand your own thoughts about money. “Every day as adults we make decisions that determine what we need and want,” said Woods. “This drives our lifestyle choices, including the cars we drive, the jewelry and clothes we wear, the house we own and all the extras that make us feel good

“However, living within your means and knowing what you can afford often starts with how we grew up and how our own parents helped us learn about discipline, sensibility, sacrifice, reward and goals when it comes to money. To educate your children, you have to come to terms with your own thoughts and expectations regarding money. Only then can you teach your children how to lead financially fulfilling and responsible lives.”

#2 – Understand the Impact of a Digitally-Charged Generation

According to Woods, today’s children are part of a generation that rarely struggles to get what it wants. In fact, most have never had to make a major sacrifice. Instead, many of today’s children primarily understand what makes them happy and how to get immediate gratification.

But why?

Because now more than ever, today’s generation of children are being highly influenced by products and services that promise to make them happy. Search engines are tracking your children’s behaviors and creating advertisements that match their individual search history. This bombardment of highly-targeted and customized advertising enables today’s children to see the very things they want to buy repeatedly. Whether it’s Facebook, Instagram, Snapchat or another digital channel, most kids can’t escape digital advertising.

Digital influence aside, what can you as a parent do to help your children establish good habits about spending, giving and saving for the future?

Since your children’s needs, wants, and goals will change depending on their age, Woods suggests these money-wise parenting strategies for the following ages:

The Formative Years: Children Aged 11 to 18

Most children receive money for allowances, birthdays, holidays and odd jobs such as babysitting and mowing lawns. At this time of your child’s life, you should explain three financial concepts to them:

  1. How much to save.
  2. How much to give back.
  3. How much they’re allowed to spend.

Woods suggests that children save no less than 20 percent for future needs, such as college, buying a car or attending a concert. He’s also a strong charitable giving advocate and recommends teaching children now about setting aside money for the sole purpose of giving back. He recommends five to ten percent be set aside for giving. The rest of the money should go toward what your child wants today – Starbucks, trips to the mall, etc.

Talk More to Bring Goals to Life

It’s very important to talk with your children throughout the year about their saving, spending, overall needs and wants, as well as their long-term goals. Woods suggests that parents have no fewer than four comprehensive financial conversations per year with their kids, and ideally 12. The more conversations you have, the more you help by reminding your children about their goals and checking in to see if they’re on target to accomplish them.

Spend More Time Together by Opening a Joint Account

Starting at age 11 and up is a perfect time to start buying some shares of stock or open a mutual fund. The key is for you and your child to establish what your child’s ongoing contribution goal will be. Over time, as your child sees his or her savings grow, this will instill the encouragement to save even more. This account also becomes one of the key financial conversations you’ll have throughout the year.

The Budgeting Years: Children Aged 19-25

Financial conversations between you and your children will vary greatly at age 19, perhaps even starting a bit younger. The focus now turns to budgeting, says Woods. For children who go off to college, Woods recommends that you and your child establish a budget for both their everyday and monthly needs. They’ll have fixed expenses, such as food and housing; however, they’ll also have variable expenses including entertainment, weekend traveling with friends, etc.

A monthly amount of money allotted to your child strengthens their decision-making ability surrounding how to make money last.

Many savings apps can be quite useful in helping your son or daughter to budget more responsibly. PCWorld has provided a nice roundup of budgeting apps for tracking savings and spending.

What’s more, Woods recommends that your child have a summer job and be solely responsible for saving no less than the money needed for the extra spending they may want throughout the school year and summer.

By allotting a monthly college budget and instilling upon your student that he or she is responsible for the extra spending they desire, when your child graduates college, they will have built a foundation for knowing how to live within an established budget.

Watch Out for Credit Card Magnetism

According to a recent Experian College Graduate Survey Report, one in five of the college students surveyed gives their college an F grade on preparing them to understand how credit works. What’s more, of those surveyed, 58 percent have a credit card and had the following personal experiences: 33 percent made a late payment, 31 percent maxed out a card, 23 percent had a card declined, and 15 percent missed a payment.

Given these statistics, it’s imperative that parents and their college-age children maintain open and ongoing communication about their child’s credit card usage. Like most financial vehicles, credit cards have their pros and cons. However, as with any effective financial tool, it needs to be managed, says Woods.

Beware the Taxman

When your adult child starts their first professional job, it’s very important that they understand taxes and how to manage what is left over. Too often, young adults forget to take taxes into consideration within their saving and budgeting planning.

Woods recommends that parents encourage their adult children to pursue four positive financial habits:

  1. Contribute 10 to 15 percent of their newly-found income to their company’s 401(k) or a similar retirement plan. If their company doesn’t have a retirement plan, which can be true for many small businesses, then contribute to an Individual Retirement Account (IRA).
  2. Make a list of monthly expenses to determine how much is available to afford rent, such as mobile phone, gas, car payments, food, etc. Additionally, there are new expenses, such as auto and renter’s insurance, that need to be accounted for.
  3. Establish a second savings or investment account, in addition to a 401(k) or IRA, and contribute to it each month.
  4. Set all savings and investment contributions so that the funds are deposited automatically, alleviating monthly decision-making around surplus income and increasing the likelihood the money is saved.

In Closing

It’s been our experience at Gratus Capital that parents who start educating their children about money during their formative years, such as talking about the costs of operating their home, including the mortgage, property taxes, electricity, heating and so on, help their children go on to be far more money-wise and successful simply due to the open dialogue between parent and child about life’s financial responsibilities and expectations.

At Gratus, we’re financial life counselors who advocate not just for your strong financial future, but that of your child’s. If you have any questions about your financial future, or that of your child’s, please contact us. Finance, budgeting, and investment management are just the beginning of our expertise.

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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In the first quarter of 2017, the bull market seemed unstoppable. The Dow Jones Industrial Average soared past 20,000 and closed at all-time highs on 12 consecutive trading days. The Nasdaq Composite gained almost 10% in three months.1

An eight-year-old bull market is rare. This current bull is the second longest since the end of World War II; only the 1990-2000 bull run surpasses it. Since 1945, the average bull market has lasted 57 months.2

Everyone knows this bull market will someday end – but who wants to acknowledge that fact when equities have performed so well?

Overly exuberant investors might want to pay attention to the words of Sam Stovall, a longtime, bullish investment strategist, and market analyst. Stovall, who used to work for Standard & Poor’s and now works for CFRA, has seen bull and bear markets come and go. As he recently noted to Fortune, epic bull markets usually end “with a bang and not a whimper. Like an incandescent light bulb, they tend to glow brightest just before they go out.”2

History is riddled with examples. Think of the dot-com bust of 2000, the credit crisis of 2008, and the skyrocketing inflation of 1974. These developments wiped out bull markets; this bull market could potentially end as dramatically as those three did.3

A 20% correction would take the Dow down into the 16,000s. Emotionally, that would feel like a much more significant market drop – after all, the last time the blue chips fell 4,000 points was during the 2007-09 bear market.4

Investors must prepare for the worst, even as they celebrate the best. A stock portfolio is not a retirement plan. A diversified investment mix of equity and fixed-income vehicles, augmented by a strong cash position, is wise in any market climate. Those entering retirement should have realistic assessments of the annual income they can withdraw from their savings and the potential returns from their invested assets.

Now is not the time to be greedy. With the markets near historic peaks, diversification still matters, and it can potentially provide a degree of financial insulation when stocks fall. Many investors are tempted to chase the return right now, but their real mission should be chasing their retirement objectives in line with the strategy defined in their retirement plans. In a sense, this record-setting bull market amounts to a distraction – a distraction worth celebrating, but a distraction, nonetheless.

At Gratus, we provide sound asset allocation advice, from determining each client’s initial allocation (“getting it right”) to ongoing strategic asset allocation (“keeping it right”).  We offer our clients balanced and comprehensive investment advice, complete objectivity and a personalized investment strategy. We apply a value-orientation (absolute not relative) to all facets of the investment decision-making process. This approach informs both the asset class and underlying strategy decisions in asset allocation construction.

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 April 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. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.  All indices are unmanaged and are not illustrative of any particular investment.  This article was prepared by MarketingPro, Inc. This information has been derived from sources believed to be accurate. This 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.

Citations.

1 – money.cnn.com/2017/03/31/investing/trump-rally-first-quarter-wall-street/index.html [3/31/17]

2 – fortune.com/2017/03/09/stock-market-bull-market-longest/ [3/9/17]

3 – kiplinger.com/article/investing/T052-C008-S002-5-reasons-bull-markets-end.html [4/3/14]

4 – thebalance.com/stock-market-crash-of-2008-3305535 [4/3/17]

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Gratus Capital, LLC
3350 Riverwood Pkwy, Suite 1550
Atlanta, GA 30339
Phone: (404) 961-6000
Toll Free: 1 (888) 707-0773
Fax: (404) 961-6020