Active Management & Taxes

I have mentioned in the past that I like active management, assuming the proper due diligence is performed.  However, one thing I didn’t mention is the impact of taxes.

Passive management tends to have a lower tax burden than active management.  This is because passive managers follow an index and thus have little turnover (e.g. buying the 500 stocks in the S&P 500 and holding until the index changes).  Active management on the other hand tries to beat the index and may therefore have higher turnover.  Higher turnover = higher capital gains distributions = higher taxes at the end of the year.

Higher taxes mean a lower net return.  When looking at client portfolios, we always manage for after-tax return because that is what the client brings home.  Returns can look great on the surface, only to get dinged by taxes.

Is higher turnover a negative aspect of active management?  Absolutely, but it isn’t a death knell.  First, having the proper manager is still paramount to tax savings.  Keeping your taxes lower is part of the manager discussion, but certainly not the end all be all.     Second, you can still manage for after-tax rate of return and have active managers:

• Keep high turnover funds in tax-deferred accounts
• Tax loss selling to offset your gains
• Utilize active managers that have lower turnover
• Blend in passive managers to go along side your active managers 

Important -

Capital Advisors LTD and Capital Analysts does not provide Tax advice. Contact your tax advisor for review, implications, and applicability of any tax strategy to your situation.  This tax information is provided for educational purposes only and is not a recommendation. Pursuant to recently-enacted U.S. Treasury Department Regulations, we are now required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Chinese Real Estate Bubble?

“Falling home values. Debt-strapped borrowers. Real estate woes dogging the economy.”  Sounds like the US circa 2007, but it is also going on in China right now. 

The LA Times recently wrote an article about China’s property market, highlighting many of the issues it faces.  While it seems certain prices will fall, will it be orderly?  Or will it be more chaotic like the US?  Here are some points on both:

Orderly:

• China’s government has intentionally slowed development
• Lending and purchasing restrictions could be lifted if need be
• Leverage is not nearly as bad as it was in the US ( first-time buyers have a 30% down payment required)
• Hundreds of millions of Chinese are moving into cities
• The drop is not surprising as I can recall this forecast by China bulls and bears alike for some time
• Equity prices in China are down pretty far over the last 12 months (greater than 20% on the Shanghai Composite Index­) indicating some of the pain may be priced in

Chaotic:

• Home prices have fallen for 3 straight months
• Average home prices are down about 40% from their 2009 peak
• Beijing has nearly 2 years worth of inventory
• Sales are plummeting
• Property sector is one-fifth of GDP and a huge employer
• Local governments are highly dependent on sales/appreciation
• Banks have issued a record number of home mortgages
• Home buyers have staged numerous demonstrations (see the personal side in the linked article)
• China has built empty cities

The answer to this question will have broad ramifications for China and the rest of the world, which is hoping that China becomes more of a consumer and/or feeds its demand for commodities. 

I myself can’t say I know how it will ultimately shake out.  On the one hand there are things that certainly don’t pass the smell test (see the Ordos video), on the other hand there seem to be some tangible differences between our housing market and theirs.  

Lowering Your Tax Burden – Tax Loss Selling

At the end of every year it makes sense to take a look at your taxable investment accounts and see if you have any big losses.  If you find some, then it probably makes sense to sell that position (depending on how big the loss is, among other factors) to lock in the loss.  Why?

By selling some securities at a loss, you can offset the gains you have on other items for the year.  Do your losses exceed your gains?  In that case you can deduct up to $3,000 against ordinary income.  Still have more losses?  You can hold on those and do the same thing next year or the year after until you offset the taxable gains in future years.  In short, you can lower your taxable income now and in the future.  Here is an example:

1. I bought XYZ at $100,000.  The position is now worth $80,000 and I sell XYZ for a $20,000 loss.
2. If I have $10,000 in gains, I can use part of the $20,000 to offset that.  I can then deduct $3,000 from ordinary income and save another $7,000 in losses for next year.
3. To make it easy, let’s just say all income is taxed at 15%.  Thus, while you lost $20,000 on the investment, you saved $3,000 in taxes, lowering your net loss to $17,000. 

If you still like the investment, you can still buy it back later after the “Wash Sale Rule” is satisfied (i.e. you can’t purchase the same investment within 30 days or you can’t claim the loss).  During that 30 day window you can purchase something similar to keep your allocation reasonable unchanged. 

The counter argument is that if you buy the same investment back you will now have to pay gains on the appreciation so why tax loss sell in the first place.  Still, I think the benefit goes to selling now:

• A dollar today is worth more than a dollar tomorrow. 
• There is no guarantee the investment will go up.

Important -

Capital Advisors LTD and Capital Analysts does not provide Tax advice. Contact your tax advisor for review, implications, and applicability of any tax strategy to your situation.  This tax information is provided for educational purposes only and is not a recommendation. Pursuant to recently-enacted U.S. Treasury Department Regulations, we are now required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Macro Domination

Here is a graph from EconompicData, which shows ETF performance in September, October, and most of November:

The above graph paints a picture of what most market followers already knew – there has been a “risk on, risk off” trade over the past few months.  Further, the moves each month were pretty sizable.  Take a look for instance at Emerging Market equities – down 18%, up 17%, and then down 11% each in a separate month!

My big takeaways from the graph are these:

• Given how riskier assets are moving in lockstep, it’s pretty evident that macro data is driving the market and however the macro issues (namely Europe) shake out will ultimately determine the fate of the markets. 
• The size of moves and how quickly they change indicate the markets are very uncertain.

Ultimately, even if my conclusions above are off base you can’t argue that markets aren’t very volatile right now.  If you are struggling with the daily moves, reducing your portfolio’s beta might be a viable solution.  

Hedge Funds Look like the Market. So What?

The Wall Street Journal’s MarketBeat just ran an article noting that hedge funds as a whole now exhibit a high correlation to equities and actually have a negative alpha - risk adjusted return relative to the S&P 500.

I don’t think either higher correlation or negative alpha matter, and here’s why:

• The graphs in the article go back to 1995.  Since 1995 I would be willing to wager the total number of hedge funds and the assets hedge funds hold have risen by a large amount. 
• The greater the assets the closer hedge funds will resemble the market.
• More hedge funds means the greater likelihood there will be more underperforming mangers, resulting in lower alpha.
•  I am sure the numbers are similar for the mutual fund universe, but that doesn’t mean quality mutual fund managers don’t exist.
• Hedge funds have various disciplines (e.g. Macro, Convertible Arbitrage, Long/Short, Long Only, etc.) and each discipline probably has different correlation and alpha numbers.

Ultimately at the end of the day picking the right hedge fund manager or any manager that compliments your portfolio is the decision that needs to be made. 

Maybe after doing your due diligence you discover the manger mirrors the market, or the fees are too high, or you don’t like the illiquidity; however, deciding against using a single manager because the universe as a whole isn’t performing up to standards shouldn’t be a large part of this decision.  

Margins are High, Really High. Can they last?

Per Bloomberg, “U.S. companies are the most profitable in more than 40 years”.  In Q3 this year margins of non-financial companies reached 15%, which was the highest level since 1969.  Right now this is a great thing; however, the question the article proposes is whether or not this is sustainable.

To answer that, I think we need to look at why margins are high.  I have ranked the answers below by what I feel is most likely to continue:

1. High unemployment keeps labor costs down
2. Low cost of money
3. Business are investing in technology, increasing productivity
4. Sales to emerging markets help stabilize revenue
5. A surge in government spending 

I think 1, 2, and 3 are in a tie for longevity.  It is hard to see unemployment dropping dramatically, interest rates raising much, and/or improvement in technology not being implemented.  Number 4, I think is trick:  in the short-term there could be some danger here, but in the long-run emerging markets should consume more and more.  Number 5, I think, will evaporate soon given the focus on cutting the deficit.

This leaves me with the following conclusions:

• Margins probably won’t be expanding as costs can’t be cut further, but could stay higher in the near-term given structural issues.
• Longer-term margins are likely to contract given mean reversion and structural issues correcting.
• This could be offset by top-line growth, which will be the most important part of keeping margins elevated.