In my book, Buy and Hold is Dead (AGAIN), the Case for Active Management in Dangerous Markets, I devote an entire chapter to portfolio tax planning. The tax chapter is called, The Tax Tail and the Portfolio Dog. The title refers to an old saying about taxes that basically means that investors shouldn’t let tax considerations outweigh value considerations when making asset allocation decisions. The chapter borrows heavily from the work of Michael Kitces, Director of Research at Pinnacle Advisory Group, who points out that unless you die with appreciated securities in a taxable portfolio and get the currently allowed step up in tax basis, the value of most tax strategies is limited to the value of tax deferral. The chapter goes into great detail to show that the value of tax deferral is not as great as most people think it is, and the resulting conclusion for value investors is simple…don’t let tax considerations keep you from selling overvalued assets.
It is possible that this year will put many investors to the test regarding realizing capital gains in actively managed portfolios. The speed and magnitude of the current stock market rally is such that investors will be forced to look at the value proposition of holdings that may have doubled in value since March of this year. If by year-end investors conclude that holdings are overvalued, and if they were purchased within the past 12 months, then they will have to weigh the tax cost of short-term capital gains versus the risk of holding securities for the full 12 month period needed to get the more favorable long-term capital gains tax rate. For savvy investors who bought the market after the severe post-Lehman Brothers market decline in September, they will be “playing chicken” with the markets as they approach their 12 month holding period. Investors with the best market timing will have to hold until next March to get to the favorable long-term rate.
For the record, if you own a security with a 20% gain it only has to retrace 3.06% of its value to completely wipe out the benefits of short-term versus long-term capital gains (assuming 28% short-term gain rates and 15% long-term rates). For 50% gains the breakeven pullback is 7.65% and for 100% gains the breakeven is only 15.29%. Students of market volatility would conclude that the potential for losses from overvalued levels should lead investors who want to protect their profits to go ahead and take them without worrying too much about tax costs in the transaction. Of course, investors may have large amounts of loss carryforwards, or unrealized losses that can be realized in their portfolios in order to offset gains this year. It will be interesting to observe investor tax behavior as we approach the end of the year.
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I have no problem with describing Modern Portfolio Theory as science. After all, Markowitz’s work did win a Nobel Prize for Economics, and for that matter, so did Bill Sharpe’s work on the Capital Asset Pricing Model. I believe that investor’s want to pay for science…and all that it implies. Science implies certainty, exactness, facts versus opinion, expertise, proof, and so on. Since investor’s want to buy science, it should be no surprise that investment advisors want to sell science. For four decades now the financial industry has successfully sold strategic asset allocation as science. But now that the problems with MPT are becoming well known, consumers of investment advice need to reevaluate the value proposition of any investment process that claims to be scientific.
I am still looking for the right word to describe active portfolio management where the decision making process is driven by a subjective, qualitative approach to asset allocation. I have described it as “art,” the antithesis of science. In my book, Buy and Hold is Dead (AGAIN), I contrast art with science as saying that art “lies in the eyes of the beholder.” One investor’s interpretation of the economic facts of the day can and will be different from another investor looking at the exact same data set. The experience, judgment, and wisdom that help an investor reach a conclusion are art, I said. The problem being that art conjures up all of the wrong images. Artists are erratic; art is hard to measure and impossible to repeat. If investing is art than it must be about guessing, hunches, flashes, intuition, and other non-sellable attributes.
So this morning I want to suggest active management as a craft. Yes, craftsmen are still artists, but it seems to me that we value craftsmen. If investing is a craft to be learned, then we imagine that it takes skill and not luck. We expect craftsmen to apprentice for years before they practice on their own because a craft takes judgment and experience, in a context that we value and appreciate. So for now on, I think I’ll describe investing as a craft to be learned. While everyone is not an equally good craftsman, we can all agree that the best of them deserve our respect and are worthy of our patronage.
The mathematics of portfolio declines and recoveries are somewhat counterintuitive. You would think that if your portfolio declines by 50% that you would need the portfolio to rally by 50% to get back to even. But that’s not true at all. The following simple chart shows the relationship between portfolio declines and portfolio recoveries:
When you consider how a 50% decline requires a 100% rally to break even, and a 70% decline requires a 233% rally to break even, you can see why defending against dramatic portfolio declines is important. As it turns out, the actual S&P 500 decline is 57% from the October 9, 2007 high of 1,565 to the March 9, 2009 low of 676 (including dividends the decline is 55%). The recovery as of last Friday’s closing price of 1,004 is 48.5%, or 50% including dividends. Even though the decline was 55% and the recovery has been 50%, the index still needs to rally an additional 56% just to get back to the October 2007 highs!
What would happen if an investor only captured 50% of the market decline and then captured 50% of the latest rally? Once again the numbers might be counterintuitive to some. An investor with a portfolio valued at $1,565 would have seen their portfolio value decline by 27.5% (one half of the 55% decline) to a value of $1,134. Then the portfolio would have rallied by 25% (one half of the S&P rally of 50%) to a value of $1,417. The portfolio would only be 10% below its starting value, as opposed to the current S&P dilemma of needing a 56% rally to get back to even. As it turns out, Pinnacle’s Moderate Growth portfolios have a similar ratio of downside and upside capture. Our Appreciation portfolios have done even better with the downside capture being contained but the upside capture being much higher as a percentage of the market. As we work through the entire cycle, defending against large losses has served our clients well.
One of the unfair facts of life for investment managers is that our clients insist on two different unofficial benchmarks for performance comparisons. In bear markets, when stock market values are plummeting, clients insist on comparing portfolio returns to cash. However, in bull markets, when stock prices are roaring ahead of other asset classes, clients want to change their benchmark and compare their returns to stocks. There is of course, nothing overly unreasonable about this state of affairs, at least in the eyes of our clients. Unfortunately, if you believe in managing risk by constructing diversified portfolios that own stocks, bonds and cash (and many other asset classes), you are virtually guaranteed to underperform cash in a bear market and underperform stocks in a bull market. This somewhat depressing state of affairs of having your portfolio underperform in both bull and bear market environments is the result of switching between two different benchmarks. We are seeing this unofficial “changing of the guard” with our clients’ perceptions occur now that the market rally is entering its 6th month.
Clients used to ask the question “how am I doin?” in the context of a massive bear market that took the S&P 500 Index down by 57% to its intraday low in early March. The market topped in October of 2007, and for the record it is still about 35% below its all-time high price. If you care to view performance in the context of the market top to current price, then our portfolio results of minus single digits are either very good compared to stocks, or very lousy compared to cash, where investors of all levels of experience can park their money without paying Pinnacle a fee. On the other hand, the stock market has rallied by 51% since the lows on March 9th, and the +25% gains in Pinnacle’s Dynamic Moderate Growth (DMG) portfolios look fantastic compared to cash, and pretty lousy compared to stocks, where investors of all levels of experience can park their money in an S&P 500 Index fund without paying Pinnacle a fee.
We continue to counsel our clients to view investment results over a complete market cycle. Once you take a step back and look at performance in a time horizon that includes both bear markets and bull markets, you can get a good perspective for how we are managing portfolio performance. Depending on time horizon, Pinnacle’s DMG portfolios have delivered between 200 basis points (two percent) and 600 basis points (six percent) of performance over and above our benchmarks, net of fees and transaction costs. This year we are having a phenomenal year relative to cash and a very good year relative to our blended benchmarks. In fact, at the moment most of our portfolios are beating the performance of the S&P 500 Index for the year to date period, which is entirely unexpected in a year where the S&P is delivering positive returns. However, we are trailing from the market bottom, which is entirely expected. So, “how are we doin?” It depends on your investment time horizon and what benchmark you care to use.
My long-time client, Diane, politely interrupted my possibly overly detailed summary of her portfolio returns with the question, “Just tell me when we will get rid of the parentheses?” Parentheses are used in our portfolio reports to separate negative portfolio results, and Diane was hoping we might be getting rid of them soon. She was referring to our trailing 1 year portfolio results, since for the year-to-date period (January 1 to the present) Pinnacle accounts are in robustly positive territory. However, the trailing 12 month returns for Pinnacle Moderate Portfolios remain about 5% in the red? (Note: See your wealth manager for performance numbers for other portfolio policies.) The good news is it appears that history is on our side.
The key to evaluating trailing 12 month returns is to realize that the starting number (12 months ago) changes every day. Unlike year-to-date returns where the January 1 price is always the same, the rolling 12 month return is just as much about what happened last year as it is about current market prices. If the stock market was declining one year ago then, all things remaining equal, 12 month performance is likely to improve as we measure from the lower prices after the decline. And guess what? We are rapidly approaching one of the biggest price declines in history, the stock market panic sell-off that followed the Lehman Brothers bankruptcy on September 17, 2008. So while the current trailing 12 month return for the S&P 500 Index is -20%, if prices were to stay the same the index would break even in terms of 12 month returns on October 7, 2009. Diane, if you own the S&P Index and the price doesn’t change between now and then; the parentheses go away on exactly that date.
The story for Pinnacle Moderate portfolios looks even better. Assuming that current prices don’t change, and considering all of the usual caveats about cash flows, fees, and different portfolio securities due to tax considerations, and considering that this is a completely unofficial, Sunday morning view of the matter, I’m guessing that Pinnacle accounts could break even as early as September 18th, the anniversary of Lehman collapse. Mark your calendars! Of course, there is the not so small matter of current prices, which most assuredly will not stay the same between now and then. Market rallies will take us to positive territory sooner, and sell-offs will postpone the date. Heck, if the stock market rallies 10% on Monday and portfolios gain 5%, we will break even by the time you read this post! All of which is my way of saying that hanging on to short-term performance numbers is best left to Chief Investment Officers with nothing better to do on a Sunday morning.
Financial Planning | Ken | 
August 27, 2009 2:54 pm | 
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