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Tax-Loss Harvest Swap – A Prudent Move For Energy Investors

Summary In this article, we will discuss a popular tax strategy called a “loss-harvest swap”. This is effectively a legal version of the SEC-outlawed “wash-sale”. This is particularly relevant for investors with current unrealized losses in energy companies. A tax-loss harvest swap works well in times of indiscriminate selling within a sector, such as the recent selloff in oil. Whenever there are substantially alike securities to “swap” one position for another, this strategy can work well. The strategy also works well (better in fact) with ETFs. Loss-Harvest Swap Example Take this example portfolio. You’ll see we have some unrealized losses in Ultra Petroleum, a small-cap E&P company. Since the broad selloff in energy, many small-cap E&Ps have gone on sale. There are several which have fallen more than UPL and which we wouldn’t mind owning instead of it now. Say our swap of choice is SWN , a larger E&P trading at a similar valuation of 3.5x trailing cash flow, and more stable long-term Marcellus acreage. The stock has fallen 39% over the past year, compared to UPL’s 35%. A loss-harvest swap calls for a sale of UPL and a buy of SWN. From a portfolio standpoint, my risk / reward would be basically unchanged – I am still long a small-cap E&P company that is substanitally correlated to the sector. I might eventually end up with more gains from SWN than UPL, or less – that is a risk. But, I also generate some immediate & guarranteed tax benefits. Tax Savings The exact amount of the tax savings depends on your tax bracket: The savings vary, but the point is that these tax savings were obtained without much risk, and are essentially free money. If you have some short term capital gains, this is pure gold. Also, if your realized losses exceed your realized gains for the year, one can use $3000 of the losses to reduce one’s taxable income, and carry over the rest to next year. How Often to Harvest Losses Tax-loss harvesting is a strategy that can be used fairly often. Taking trading commissions into account as a cost, and leaving some margin for error for divergence between your swapped securities’ returns (don’t want inadvertently destroy alpha by buying an inferior name), you could easily make the case for an automatic swap at set thresholds (for example- harvest at every 5% loss). As such, you could benefit from even minor market volatility after you buy– and lock in a lower cost basis. However, swapping more often will generate trading costs, so I recommend using a discounted broker such as Interactive Brokers or Optionshouse (these are two I have used in the past). Also, keep in mind tax strategy is not a substitute for a good investment strategy – make sure you have the latter in place first. For a stock or sector that keeps falling, using 2 substantially-alike securites, one can swap one for the other once every 31 days and still remain in the clear with respect to the SEC’s wash sale rules. Using 3 alike securities, such as 3 ETFs which track the same index (yes, that is still allowable under SEC wash sale rules), one could swap more often than that, one just cannot swap the same security in 31 days.

How To Build A ‘Lifetime’ Portfolio (Step 1)

Why obsess about what will happen this coming week? That’s the job of people who get paid by the word. Why not take the road less traveled and ignore 90% of the hullabaloo?!! This is the time of year when most investment writers predict what will happen in 2015. What I’d rather offer, however, is what is “most” likely to happen this year, next year, or the next 10, 20 or 50 years. The short and glib answer is the one proffered by J.P. Morgan when asked what the market would do next. “It will fluctuate,” he replied. That may sound offhandedly dismissive of the question, but in fact there is much truth, and the beginnings of what we now call Modern Portfolio Theory (MPT) in his pithy response! Modern Portfolio has much to recommend it and much to eschew. The basic idea is solid: MPT is a way to optimize your returns based on your acceptable level of market risk. You accomplish this by diversification among various asset classes. If you can remember as far back as January 2014, almost every pundit was predicting a disastrous year for bonds, a so-so year for US stocks to digest the gains of 2013, and sector bets all over the place. I don’t know of a single analyst who predicted that the best-performing sector in the USA would be utilities, yet there they are, proudly atop all markets. The matrix below shows what asset class performed best over the past few years. (These are asset classes, not business sectors, so you won’t see utilities there, but you will see “REITs” and both “High Grade” and “High Yield” bonds, both of which are equally-interest-rate-sensitive.) If you look carefully at every year, you will note the results vary considerably. The same holds true over all other, even more extended, periods. Diversification works! Yes, you will sometimes fail to beat the market, “market” being shorthand to most investors for the “Large Caps” represented by the S&P 500, but over most periods other than an out-and-out bull romp in US stocks that means you are likely to do much better. (click to enlarge) You’ll note, for instance, that in 2000, the large caps, as measured by the S&P 500, were the 3rd- worst performing asset class. In 2002, they were “dead last.” In fact, if you look closely, you’ll note that not once was the S&P 500 the top-performing asset class – including the past 6 remarkable years! Being open to other asset classes is the heart of Modern portfolio Theory, but also the heart of Asset Allocation theory, and the heart and soul of our approach to building a Lifetime Portfolio. In a period of low and declining or stable interest rates, the aforementioned utilities, bonds and REITs often outperform stocks, and with considerably less volatility and heartburn. MPT has also become associated with the notion that, since no one can predict what will happen on any given market day (or week, month, year, etc.) why bother? Why not instead select the asset classes that give you a level of risk you are comfortable with and then get reasonable returns year in and year out? Rigorous academic research shows that you will typically come out ahead after even a few years of doing this than you will if you try to “beat the market.” To oversimplify: if your risk tolerance is low, you might create a portfolio of 40% high grade bonds, 20% REITs, 20% high yield bonds and 20% large cap stocks. If you are comfortable seeking greater returns with greater risk, you might select 10% each of high grade and high yield bonds and REITs, with the other 70% of your portfolio split among US Large and Small Caps, International Large and Small Caps, and Emerging Markets. In any scenario you construct, you want to let your profits grow while feeding the areas you have selected that aren’t doing as well. The usual way this is done is to rebalance at some defined period every year (or less). A variation of this is to pick a certain percentage, say 20%, and if one asset class gets “out of whack” by that amount you add to it if it is down, or sell off some of it if it exceeds the 20% higher than your chosen percentage allocation. If you wanted to hold 20% of your portfolio in large caps, for instance, if that asset class appreciates 20% and is now therefore 24% of your total portfolio (20% of 20 is 4), you would “re-balance” to bring that part of the portfolio back to your risk comfort level, using the proceeds to buy, at lower cost, some of the other asset classes that are “currently” lagging. Does this sound boring? It may be, but which sounds better: a 7.4% annual return over 14 years or a 4.3% return? The bottom line on the above chart is that the simplest asset allocation plan imaginable, 40% high grade bonds, 15% each U.S. large caps and international stocks, and 10% each of small caps, emerging markets and REITs, rebalanced annually, still beat the currently-in-vogue “just buy an S&P 500 index fund; active management doesn’t work” mantra. This “just buy an S&P 500 index fund; active management doesn’t work” fable becomes popular once we are well ensconced in a bull market – and dies just as quickly when the market plummets. As the data above shows, the drawdown for the S&P 500 was -37% in 2008. The biggest drawdown for the asset allocation model (AA) was -22.4%. For comparison, our Growth and Value portfolio, in which we used our own variations on asset allocation described below, was down 18.7% that year. On a million dollar portfolio, the S&P would have declined in value to $670,000; our G&V to $813,000, with less position risk and less volatility. How We Diverge From the Standard Model There are scores of ways you might select an asset allocation model that works for you, from changing the percentage allocations to increasing the asset classes to adding a little sentiment, fundamental, historic or technical analysis. We try not to sway too far from the basic principles of asset allocation. We like to think we are merely adding a dollop of common sense and placing history on our side. We believe: Rebalancing based on the calendar is folly. In the chart above, the results tabulated are for a rebalance once a year at the beginning of each year. Macro-trends evidence themselves any time of the year; both black and white swans swoop and dive based upon events, not calendars. We take action when our asset allocation percentages diverge from our intended allocation. Underlying the concept of asset class investing is the assumption that markets are efficient and that investors act rationally. We might give some credence to the first assumption, but the second is patently false! We believe we can benefit from investor emotions. An example today might be early nibbling at the huge integrated oil companies that can slash CapEx and make a profit on their current properties if the price of oil falls even another 50%. Buy them when they’re cheap; don’t obsess if something you buy for 10 times forward earnings and a 5.9% yield falls so that you “might have” bought it at 8 times forward earnings and a 6.4% yield. At times when interest rates are rising, we might be as little as 0-20% in bonds and REITs combined. When falling, we might be at 60-70%. We are dynamic, not static. [This is a very big divergence from the academics’ idea of asset allocation. That’s their way; this is our way.] “To every thing there is a season.” We augment our asset class investing to take advantage of the fact that small caps tend to enjoy the bulk of their outperformance in the first two quarters of the year, that pre-presidential election years are often excellent market years as both parties crank up the PR machines, etc. We don’t chase any single asset class like S&P 500 large caps, REITs, small caps or any other. Nor do we obsess if we fall behind in comparison to any one asset class for an extended period. We maintain our discipline and do our best to grow our portfolios steadily. Sometimes we have setbacks, sometimes we are out of sync, but we’ve always bounced back. In Part II, I will discuss the asset classes that are historically most and least correlated with the S&P 500 (U.S. large caps) and with each other, so you can begin to consider how you might construct a Lifetime Portfolio that works for you. I’ll also discuss the types of mutual funds and ETFs our research and analysis leads us to, including examples and some of our specific current holdings. As Registered Investment Advisors, we believe it is our responsibility to advise that we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice. Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund one year only to watch it plummet the following year. We encourage you to do your own due diligence on issues we discuss to see if they might be of value in your own investing. We take our responsibility to offer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

The Consequences Of Overvaluation: A Word Of Caution To Funeral Owners And Fund Managers

The Socratic Equity Rate is one tool investors can use to identify areas of value and over-value. Compared to past levels, a high yield might indicate areas of value. Compared to past rates, a low rate indicates investors might want to be cautious. If you ever owned a diversified mutual fund or ETF, chances are, at one time you were a part owner of a funeral services business. For those running the fund, and especially for owners of shares in a funeral services business such as Service Corporation International (NYSE: SCI ), it is essential to be familiar with the Socratic Equity Rate . Developed by The Socratic Investor, the Socratic Equity Rate was designed to assist in identifying opportunity and risk in investment securities. Intended for board of directors, company management, securities lawyers, fund managers and individual investors, this proprietary equity rate is a number to understand. The Trial of Socrates | The Death of Socrates movie trailer, by educationalmovies For an investment fund manager, the higher the current Socratic Equity Rate is compared to past readings, the more attractive an investment might be. The lower the reading, the more cautious an investor should be. For another professional, the readings will be the same but the takeaway will be different. The key is to know the historical range, be able to identify anomalies, and know what to do when those areas of value or overvalue appear again. Although the last part will be different depending on what role you play in the investment world, the concept is the same . Examine the performance of Service Corporation International after SCI’s Socratic Equity Rate reached 25% in 2000. From $1.75 to $13.81, SCI’s return was one of the best in the market. At a Socratic Equity Rate near the highest recordings ever seen in SCI’s history, Service Corporation International was a buy. For a board member, a lower number might indicate a time to incentivize management to issue equity . If private companies are cheap, management would be smart to pay using overvalued equity. A deal that won’t rest in peace, by TheDealVideo Take a look at the performance of investing in SCI when the Socratic Equity Rate was near its lowest levels ever. From $10.00 to $5.08, SCI investors experienced devastating returns. At a Socratic Equity Rate near the lowest readings ever, 1%, SCI’s overvalued equity presented management an opportunity to acquire another funeral company’s crown jewels without spending cash . On the other hand, if you are a private funeral home business owner looking to sell, and the acquiring company wants to pay in stock, you better know how overvalued the stock they want to pay with is. Knowing the Socratic Equity Rate can help protect your crown jewels from theft, as what happened to Time Warner when AOL paid using tech-bubble inflated AOL shares to merge. Ted Turner’s biggest regret, by CNNMoney From a securities law standpoint, an upstanding securities lawyer might consider using this rate as a tool to defend the innocent teacher’s pension fund or university endowment fund that lost money. By exhibiting a Socratic Equity Rate near the lowest levels ever, the lawyer could argue the fund manager breached their fiduciary duty by paying a premium substantially above historical norms. Examine what could happen to a fire-fighter pension’s investment when a supposed fiduciary buys SCI at a Socratic Equity Rate of 1%, a reading that is one of the lowest on record. If the supposed,”fiduciary” keeps ignoring the Socratic Equity Rate, one day there may not be a pension for retired fire-fighters. At a level near 2.1% today, SCI’s Socratic Equity Rate is approaching the lower end of its historical readings. Fund managers and individual investors should remain defensive. Be advised, this is not investment advice. The Socratic Equity Rate is one tool out of an entire tool box of equity valuation methods. Your decision to buy, sell or sue will depend on your profession and further research is always recommended. Thanks be to YCharts, who provides The Socratic Investor with Service Corporation International financial data.