Author: Jesse Mackey

This article represents part 2 of 3 in this series. Please see yesterday’s post as well as tomorrow’s for the full article.

In the event that assets cannot be invested in an account/plan that allows for tax deductions, tax deferral, or tax elimination, the following seven techniques are excellent ways to reduce the tax burdens associated with investing in currently taxable accounts, such as jointly titled, trust-owned or individual accounts, which may come in the form of brokerage accounts, fee-based managed advisory accounts, or direct subscription investment vehicles.

Municipal Fixed Income – Possibly the most traditional method of tax minimization for high income tax bracket investors is the use of bonds issued by government municipalities, which are typically free of income taxation if purchased by an investor that resides in the state in which the security is issued, even if purchased within a currently taxable account. Muni’s are useful both for tax minimization purposes and for portfolio diversification purposes, but may not be beneficial in large quantities for all investors.

Low Turnover Managers – When purchasing mutual funds or hiring individual security Separately Managed Account (SMA) managers, it is useful to consider the amount of active trading that will occur in the fund/account during the course of the year, as this will often be indicative of the amount of capital gains taxes (short term and long term) that will be realized in an up-market scenario. Lower portfolio turnover often indicates lower realized (as opposed to unrealized) capital gains, whereas higher turnover managers may indicate a higher propensity to generate tax liabilities for the investor.

Separately Managed Accounts (SMA) and Individual Stocks – It is often cited that the use of individual securities (stocks and bonds) in a brokerage account or SMA will, all things being equal, generate lower current tax liabilities for investors than the use of mutual funds. This is because mutual funds, as pooled investment company vehicles, may distribute capital gains and dividends to all investors regardless of whether the individual investor was able to participate in the full benefit of the appreciation in value of the underlying holdings of the portfolio (because the fund may have been purchased after the majority of the price appreciation, but before distribution of the full capital gain liability by the fund). SMAs are not pooled investment vehicles, and therefore holdings purchases/sales are specific to the individual investor, allowing managers to actively customize the transactions in the portfolio to the tax situation of the individual, thus reducing unwarranted tax liabilities.

Fund Dividend and Capital Gains Distribution Awareness- The flipside of the above argument regarding the tax-efficiency of individual securities is that a portfolio composed of mutual funds, if managed properly, may be just as tax efficient as an individual-securities-only portfolio while also providing the investor with the full investment diversification necessary to reduce long term portfolio volatility. If this is to be accomplished, the mutual fund portfolio manager must make purchases and sales of the component mutual funds with an awareness of any upcoming fund dividend or capital gains distributions in order to avoid these if unwarranted for the investor, and to avoid “selling dividends” which is a prohibited practice. The mutual funds may also be selected based on the manager’s professed tax-efficient style of investment, or based on a history of asset type tax efficiency.

The series concludes tomorrow…to be continued…

Jesse Mackey is a partner and Investment Officer of 4Thought Financial Group Inc. 4Thought was created with the base vision of advancing individual freedoms and the human quality of life through economic means. This vision is pursued by applying the firm’s four specialties – Economic Theory and Research; Multi-Contingency Investment Management; Financial Planning for Business Owners and Individuals; and Support for Partner Firms and Advisors.

Contact:

Jesse Mackey

4Thought Financial Group Inc.

www.4TFG.com

jmackey@4TFG.com

Structured security products (SSPs) encompass a range of financial instruments, such as securities that derive their value from, and provide exposure to, various asset classes, including, among other things, a single security, baskets of securities, indices, options, commodities, debt issuances and/or foreign currencies.

SSPs are a subset of such securities products and are generally registered under the Securities Act of 1933 (“Securities Act”) in order to facilitate their offerings to retail investors.

These registered securities are generally offered to retail investors in the form of medium-term or short-term corporate debt with exposure to a variety of asset classes issued by an affiliate of a broker-dealer, and then distributed by that broker-dealer.    The issuer of the obligation is typically the parent public company of the affiliated broker-dealer underwriter.

SSPs intended for retail distribution, which are sometimes listed on an exchange, typically have some form of option or other embedded financial derivative exposure.   They may be described as offering, among other things, partial or full “principal protection,” higher interest payments, or leveraged and/or asymmetrical exposure to the underlying asset class. SSPs are often quite complex and can present wide-ranging risks and regulatory issues, including suitability and disclosure concerns, limited liquidity, comparatively opaque and often expensive fee structures, paucity of secondary market activity, and difficulty in pricing. They also pose supervisory, compliance and sales training challenges.

Total U.S. sales of SSPs (to both retail and institutional investors) had risen from approximately $32 billion in 2004 to in excess of $100 billion in 2007.  The demise of Lehman Brothers Holding Co. and its associated default on many SSPs it had issued and distributed, as well as its default on other of its structured products had a sobering effect across the SSP market in 2008.  Nonetheless, SSPs seem to have resumed an overall upward sales trend in 2009 and 2010, and SSP sales to retail investors have, on an estimated basis, risen from $34 billion in 2009 to $45 billion in 2010.

SSPs can generally be classified into five basic categories with varying payouts and risks:

The most basic category has been referred to as partial or full “principal protected” notes. Such notes typically have returns linked to broad-based equity indices, such as the S&P 500, Nikkei 225, and Nasdaq.  The basic “principal protected” SSPs might have maturities of five years or more, but they usually have a duration of 6 months to 2 years.

The next category – enhanced-income notes – typically pays a higher coupon base and has capped returns tied to the value/performance of the underlying asset and may include at least some level of “principal protection.”  The underlying assets for enhanced income notes typically include single stocks, baskets of stocks, and indices.  Enhanced-income notes with indices as the underlying reference are typically coupled with increased principal protection and have longer maturities and lower yields than others. Enhanced income notes typically have maturities of 5 years or less with the majority having maturities of 1.5-2 years.

Another category, performance/market participation notes are linked to underlying assets such as gold, or investment strategies, such as long-short strategies, that are not  otherwise easily accessed by small investors.

The fourth category is leveraged/enhanced participation notes that offer  a leveraged upside (with a leveraged risk of loss). (For example, the notes may  pay a return two to three times the return on the underlying,  usually with a cap on the return and no principal protection.

In the fifth category, these basic forms are often adjusted and/or combined with each other to form numerous other types of SSPs, most notably reverse convertible notes (“Reverse Convertibles” or “RCNs”).  With Reverse Convertibles investors are, in essence, purchasing a security with the sale of a put option embedded in it (some call option-SSPs are also offered).  The payout for a typical equity-linked reverse convertible note is a high-level interest rate plus a return of principal at maturity if the equity increases in value (or stays the same) over the term of the note.

Tomorrow’s blogticle will contain a discussion relating to life insurance.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

In a low interest rate world, high-yield investments offering principal protection are enticing to investors. But the complexity of some high-end investment products has the Financial Industry Regulatory Authority (FINRA) and Securities and Exchange Commission’s (SEC) warning investors to look before they leap.

In an alert titled Structured Notes with Principal Protection: Note the Terms of Your Investment, the regulators warn investors that these structured products may not be what they seem. Although they are marketed under a variety of names with a “principal protection” component—e.g. “absolute return” and “minimum return”—the true extent of their safety is never obvious at first glance. Investors need to read the fine print to determine whether they are suitable for their investing needs and risk tolerance.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

Why is this Topic Important to Wealth Managers? In this edition we present a discussion of the 60 day rollover provisions for retirement accounts. Sometimes the transaction does not always go as planned. Thus wealth managers should be aware of unique situations that apply to traditional planning circumstances.

Can a widow rollover, past the 60 day statutory window, distributions from an employee trust to an IRA on behalf of a husband who passed away mid-transaction? The IRS has recently said no. [1]

In a private letter ruling issued last week the Service determined that since the widow had funds in a joint account with her husband who later passed away that she was precluded from rolling over that amount to a tax advantaged arrangement in her name.

Widow’s husband received a distribution from an Employee Retirement Plan totaling Amount X. The Widow asserts that the failure to accomplish a rollover within the 60-day period prescribed by section 402(c)(3) was due to the fact that her husband entered the hospital and passed away during the 60-day period.

The husband had ended his employment earlier in the year. Unbeknownst to him, the plan had a “cash out” provision that mandated complete distribution of plan assets upon the participant’s attainment of 65 years of age. The husband then received a check, and initiated arrangements to move the funds to an individual retirement account in order to maintain the funds in a tax free vehicle. In the meantime, the husband had deposited the funds into a joint account with his wife. Between the time of the distribution from the plan and his scheduled rollover, the husband became ill and passed away. The widow sought to complete the rollover intended by her husband.

Generally, if any portion of the balance to the credit of an employee in a qualified trust is paid to the employee in an eligible rollover distribution, and the distributee transfers any portion of the property received in such distribution to an eligible retirement plan, then such distribution (to the extent transferred) shall not be includible in gross income for the taxable year in which paid. [2]

The Code states that such rollover must be accomplished within 60 days following the day on which the distributee received the property. An individual retirement account (IRA) constitutes one form of eligible retirement plan. [3]

The Code however allows a waiver by the Secretary where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement.[4]

Moreover, the Code provides that if any distribution attributable to an employee is paid to the spouse of the employee after the employee’s death, the preceding provisions of this subsection will apply as if the spouse was the employee. [5]

In addition, when determining whether to grant a waiver of the 60-day rollover requirement pursuant to section 402(c)(3) of the Code, the Service will consider all relevant facts and circumstances, including: (1) errors committed by a financial institution; (2) inability to complete a rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error, (3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed); and (4) the time elapsed since the distribution occurred.[6]

The Service held in summary that because the husband is now deceased, it is impossible for him to complete the proposed transaction. Since the amount was received by the husband from the retirement plan prior to his death, his wife (widow) was precluded from rolling the funds over into a tax-deferred account in her name under section 402(c)(9) of the Code.

Tomorrow’s blogticle will discuss tax and market issues relating to wealth management.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Private Letter Ruling 201123048.

[2] IRC Section 402(c).

[3] IRC Section 402(c)(3)(A).

[4] IRC Section 402(c)(3)(B).

[5] IRC Section 402(c)(9).

[6] See Rev. Proc. 2003-16, 2003-4 I.R.B. 359, (January 27, 2003).

Why is this Topic Important to Wealth Managers? This week we continue our series on “Wealth Management in Today’s Economic Environment”. The series is designed to address the specific question many wealth managers are currently asking: “what are the best investment, retirement and financial planning tools given the current global financial position?” We explore alternatives from “safe” to “risky” from “traditional” to “emerging” to discover and discuss the most relevant wealth management tools and techniques available today. We look forward to presenting this discussion and think you will find the information quite valuable. Please note that this series is presented in continuation starting with last week’s entries. That being said each blogticle resumes discussion from the previous day.

The total market size, or notional principal value, of derivative contracts worldwide is estimated at over 700 trillion U.S. dollars, based on recently available data.  To put this figure in comparison the total market capitalization, i.e., the sum of all listed companies market capitalization, of the New York Stock Exchange/Euronex is around USD $27.3 trillion, which is “larger than the next four largest exchanges combined.” In other words, the worldwide derivative market is over 25 times larger than the largest stock exchange in the world.

The easiest to understand and probably most common products  for clients are futures and options.  A futures contract is an agreement to buy or sell an asset at some point in the future for an agreed upon price.  A simple example is a farmer who produces wheat.  He may harvest in September, and since the market price is subject to change throughout the year, he may want to lock in a price, say during the previous January. The farmer then agrees in January with a local baker that in September he will sell all his wheat to the baker for X dollars a bushel.   Another example is airlines that contract to purchase fuel for a specified price well into the future.  By negotiating long-term contracts the airline is less subject to the movement of the price of fuel in relation to its primary operations, i.e., providing air travel.  The airline is better able to price its products if its costs are less subject to change.  This is generally what is known as hedging.

A futures contract does not involve any exchange of assets or currency up front.  Rather it is simply a contract to perform at some point in time.  One area of that should be noted when discussing futures contracts is margin.  Margin is an amount the investor must keep with the clearing firm to ensure the investor makes good on his promise in the futures contract.

Options contracts are an agreement that gives the holder the right, but not the obligation, to purchase the underlying asset at, or before the expiration of the contract.  For this right, the holder of the option pays a premium to the grantor, or writer, of the option.  There are two types of options, a call and a put.  A call option is purchasing the right to buy, and a put is purchasing the right to sell.  Also, American style options can be exercised anytime at or before exercise date, whereas European style options can only be exercised on the expiration date.

Example: Assume an investor expects that the price of Intel stock is going to rise from $10.00 to $20.00.  If the investor had $100 to invest he could purchase 10 shares.  Assuming the stock price rose to $20.00 he would double his money with a $100 in profit.  But if that investor has the same $100 to invest, he may consider call option contracts as an alternative.  The price of the option premium is determined by market participants’ willingness to both buy and sell options on Intel at any given price.  A call option (right to buy) Intel at $20.00 may be trading for around $2.00 per share.  This means that the investor can purchase options on 50 shares of Intel with his $100.  And if the market price of Intel actually does go to $20.00 and the investor exercises his options, he will have set to make a $900 gain (50 shares x $20=$1000-$100 investment), or 9x that of his purchase of the stock alone.  This strategy is generally known as leveraging.

The use of options and futures contracts can diversify a client’s portfolio while at the same time providing for an investment tool for future expectations of markets.

Our series continues tomorrow to continue to explore financial planning in today’s economy.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

Series Author: Benjamin Terner

Why is this Topic Important to Wealth Managers? This week we continue our series on “Wealth Management in Today’s Economic Environment”. The series is designed to address the specific question many wealth managers are currently asking: “what are the best investment, retirement and financial planning tools given the current global financial position?” We explore alternatives from “safe” to “risky” from “traditional” to “emerging” to discover and discuss the most relevant wealth management tools and techniques available today. We look forward to presenting this discussion and think you will find the information quite valuable. Please note that this series is presented in continuation starting with last week’s entries. That being said each blogticle resumes discussion from the previous day.

Interest received from bonds is generally taxed at ordinary income rates, this includes both government and corporate bonds unless otherwise excluded by the tax code. [1] Dividends though (as discussed earlier in this series) are taxed at capital gains rates, which for the meanwhile, can provide a significant tax advantage.

However, some state and local municipal bonds often called “muni” bonds, are tax—exempt under Internal Revenue Code § 103. The general obligation interest on state or local bonds fall into this category, [2] as distinguished from private activity bonds. [3]

A comparison between tax-exempt and taxable income bonds is illustrated with rates of return below:

“A 4% yield on a muni is the equivalent of a 5.6% payout on a taxable bond if you’re in the 28% tax bracket and 6% if you’re in the 33% bracket. And these yields are relatively safe. Muni defaults have been rare over the years.” [4] However, some state and local municipalities are currently facing financial difficulties. This may affect the traditional ability of the issuers to pay. See generally though Advisorfyi.com, Change in Muni Bond Market Could Help Producers.

The advantage of municipal bonds over corporate bonds is that income from the latter is not specifically excluded from gross income.  Another example adapted from Advanced Markets Advisor FX: [5]

Individual A can chose to purchase, a $1,000 Corporate Bond with an annual interest rate 7.5%, or a $1,000 State/Local Bond at 5.5%.  The first option will yield Interest Income of $750 with a tax of $210 (28% bracket), therefore a net return of $540. The State/Local bond will yield $550 and the income is specifically excluded from gross income.  Even though the corporate bond has a higher stated return the muni bond is most likely a better overall investment.  But why are the muni rates lower?

The “exclusion is intended to benefit state and local governmental units” because the cost of borrowing to these institutions becomes less and in turn “enabling them to market bond issues to investors at lower rates of interest than ordinary private sector bonds.”  Additionally, because “the interest on these bonds is tax-free, investors are generally willing to purchase them at prices that provide a lower rate of return than regular bonds.” [6]

Our series continues tomorrow to continue to explore financial planning in today’s economy.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

Series Author: Benjamin Terner

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[1] 26 U.S.C. § 61(a)(4).

[2] 26 U.S.C. § 103 (a).

[3] Municipal Securities Rulemaking Board.  http://www.msrb.org/msrb1/glossary/view_def.asp?param=PRIVATEACTIVITYBOND.  2010.  Last Accessed 10/9/10; A detailed discussion of private activity bonds in comparison to general obligation bonds can be found at Tax Facts: Q 1123. Is interest on obligations issued by state and local governments taxable?

[4] “Tax-Free Bonds”.  Kiplinger’s Personal Finance Magazine.  March 2008.  Jeffrey R. Kosnett and David Landis.  http://www.kiplinger.com/magazine/archives/2008/03/maximize-returns-with-bonds.html#ixzz11tDv5mBV.  Last Accessed 10/9/10.

[5] AUS Main Libraries.  Section 19. Income Taxes.  Subheading 3-“Interest On State And Local (“Muni”) Bonds—I.R.C. §103.”  http://www.advisorfx.com/articles/f19_1_8_3240.aspx?action=13.  Last Accessed 10/9/10.

[6] Id.

Why is this Topic Important to Wealth Managers? Today we continue our series on “Wealth Management in Today’s Economic Environment”. The series is designed to address the specific question many wealth managers are currently asking: “what are the best investment, retirement and financial planning tools given the current global financial position?” We explore alternatives from “safe” to “risky” from “traditional” to “emerging” to discover and discuss the most relevant wealth management tools and techniques available today. We look forward to presenting this discussion and think you will find the information quite valuable. Please note that this series is presented in continuation. That being said each blogticle resumes discussion from the previous day.

As was briefly mentioned yesterday with regards to stock equity positions, one analyst recently compared the returns of the S&P 500 against hard assets such as gold and silver (discussed later in this series). His research strategy was to model an investment starting in 1981 where the client would invest $1,000 each year in either the S&P 500, silver or gold at the average price for that year. The returns from the stock portfolio would be reinvested each year in the model. Additionally, the model showed a $1,000 contribution was made each year. [1]

The analysis provided the conclusions that investing in “stocks had been much more profitable in the first 20 years.” For example in the year 2000 the equity index holdings illustrated in the model provided for a 879% greater asset worth as compared to the price of gold and a 774%  increase over the price of silver.

However, since 2004, “precious metals have begun to quickly make up ground and, helped by S&P 500′s 57% crash during the last recession, silver managed to slightly surpass stocks in 2010”.  Interestingly, on “April 28, 2011, when the price of silver was near its peak, silver was a clear winner with a value of $233,917 and a compounded annual return of 11.8% compared to S&P 500′s $173,400 and 10.3%, and gold’s $115,889 and 8.12%.” [2]

The race is tight however, the silver market in particular is known for its volatility which was is still an ever present consideration. The conclusions drawn by the study include, in part, that “the magnitude of compounded rates of return depends a lot on the window of time” that the investor selects.[3] This conclusion is similar to those presented by other investment strategy such as those presented by Sethi (see previous section).

As the S&P 500 strategy may very well reflect, some investment commentators are questioning old models that may no longer be the right path for many investors.

Moreover, as one commentator notes, the traditional approach of selling stocks as retirement age approaches may not necessarily provide the best wealth management solutions. The traditional approach is to “typically tell those near retirement to move to safer asset classes. But stocks are not risky so long as they are selling at reasonable prices, according to [some] research.” [4] The commentator notes what wealth managers should be advising clients to look to valuations and timing to dictate asset class allocations.  In addition, the commentator suggests that “young investors can afford the risk of stocks because they have time to recover from price crashes.” [5] However, it may also be contended that a loss in value of assets caused by price devaluations in the market have a significant negative affect on long-term earnings given time value of money calculations. In other words, “this loss is greater for young investors than it is for any others (because young investors have more time ahead of them in which the compounding returns).” [6]

Nevertheless, as Warren Buffett notes, his investment strategy has never changed, it has always consisted of the motto—investment in companies that are undervalued is a large consideration to successful financial growth.[7]

Finally, there may be tax advantages to using the equity index model over the purchase of precious metals. Generally dividends are subject to special tax treatment and thus provide additional benefit. For detailed tax treatment of dividends see TaxFacts: Dividends.

Tomorrow we continue our series with Corporate Debt and U.S. government investment.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

Series Author: Benjamin Terner

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[1] See Sergei Barna. The Best Long-Term Investment: Gold vs. Silver vs. S&P 500. Seeking Alpha. May 20, 2011. http://seekingalpha.com/article/271054-the-best-long-term-investment-gold-vs-silver-vs-s-p-500. Last Accessed 5/29/2011.

[2] Id.

[3] Id.

[4] Rob Bennett. “The Bull Market Caused the Economic Crisis.” http://knol.google.com/k/the-bull-market-caused-the-economic-crisis#. Version: 26, Last edited: Apr 22, 2010. Last Accessed 5/29/2011/

[5] Id.

[6] Id.

[7] See generally, “Understanding Financial Statements with Warren Buffett”. Advisorfyi.com. Posted December 1st, 2010. http://www.advisorfyi.com/2010/12/understanding-financial-statements-with-warren-buffett/. Last Accessed 5/30/2011.

Why is this Topic Important to Wealth Managers? Today we present the first part in a series on “Wealth Management in Today’s Economic Environment”. The series is designed to address the specific question many wealth managers are currently asking: “what are the best investment, retirement and financial planning tools given the current global financial position?” We explore alternatives from “safe” to “risky” from “traditional” to “emerging” to discover and discuss the most relevant wealth management tools and techniques available today. We look forward to presenting this discussion and think you will find the information quite valuable. Please note that this series is presented in continuation. That being said each blogticle resumes discussion from the previous day.

Read most investment strategies published in recent time and nearly all will reflect both a constant (but variable) fundamental element, risk. Take for example Harry Markowitz and his ground breaking, Nobel prize winning work regarding risk in investment strategy with the Modern Portfolio Theory. As the great Yale Professor John Langbien states, “the most fundamental thing that has happened to the investment process [includes] the development of the Modern Portfolio Theory…the scientific understanding of risk/return relationships and the importance of diversification of portfolios.” [1]

Wealth management and investing in tough economic conditions is thus based on the same or similar methods and principles as those used in bullish times. The pillars that Langbein refers to, risk/return relationships and risk diversification, can be applied to client situations to help better ensure their financial success. This series is intended to present wealth management techniques and products as applied to today’s economic environment.

The current financial outlook is not great. High levels of unemployment continue to burden the financial system, and the national debt and deficit are a major concern. Changing demographics, Social Security and Medicare, Madoff and the increased cost of living… the list goes on and on. As one commentator notes, “in today’s economic environment, it’s more difficult than ever to implement an accurate long-term financial blueprint.” [2]

Now more than ever, wealth managers are being sought to review and update financial plans as many investors and individuals are less certain about their financial choices and decisions. Clients are seeking wealth managers’ expertise regarding asset level protection and growth.  What advice can you provide to your clients regarding wealth management in today’s economic environment?  Presented below is a discussion of investment approaches and how they may relate to current financial market conditions.

Corporate Stock/ Equity

The traditional view of the equity stock markets has since changed since the financial collapse in 2008. Many investors that sought a “buy and hold method” were negatively affected when markets took a dive. Now, some commentators are strongly advocating a more actively managed model based on indicators. Timing is the key to their models.

Rajiv Sethi, an economics professor at Columbia University, has noted that “market timing based on aggregate P/E ratios can be a far more effective strategy than passive investing over long horizons (ten years or more).” [3]

On the other hand, some advocate the long-term strength of the financial markets. Tomorrow we will present, in example, the S&P 500 returns as compared to other investments. Additionally, we will continue our series on “Wealth Management in Today’s Economic Environment”.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

Series Author: Benjamin Terner

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[1] See Tim Hatton. “The 27 Prudent Investment Practices for Financial Advisers, Trustees and Plan Sponsors”. Bloomberg. At 25. 2005.

[2] Ken Morris. “Consider Holistic Approach to Financial Planning and Investing”. The Oakland Press. 1/31/2010. http://www.theoaklandpress.com/articles/2010/01/31/life/doc4b6100694a71c496761710.txt. Last Accessed 5/29/2011.

[3] Rajiv Sethi. “The Invincible Markets Hypothesis”.  February 14, 2010. http://rajivsethi.blogspot.com/2010/02/invincible-markets-hypothesis.html. Last Accessed 5/29/2011.

Author: Jesse Mackey [1]

Why is this Topic Important to Wealth Managers? This blogticle represents part two a special series regarding advanced investing with ETFs. Recently there has been much discussion in the marketplace on the use of these tools and thus we present this topic for wealth managers who may consider these investment vehicles for their clients.

The existence of numerous disparate portfolio management methodologies in the institutional investment management world has not slowed the growth in popularity of Exchange Traded Funds (ETFs) and other Exchange Traded Products (ETPs) in the last several years. In fact, possibly the most convincing reason for the enormous popularity and success of ETFs is that they are so versatile. They are not designed for any one philosophy of investment, but can play a role in many different investment methodologies. Presented below are a few examples:

Passive Management Strategic Asset Allocation- For wealth managers and clients that use strategic asset allocation and adhere to a strict “Efficient Markets” view of the financial world, an entire diversified portfolio allocation may be built using ETFs, thereby minimizing costs/expenses to the investor, optimizing the transparency of the investment, and reducing risks associated with specific managers.

Active Management Strategic Asset Allocation- For wealth managers and clients that prefer to use actively managed components for the majority of the strategically allocated portfolio, they may also use ETFs to gain exposures to specific sectors that are not otherwise present in order to “round out” the allocation. They may also choose to use an ETF for the part of the portfolio devoted to the “efficient” markets, while the “inefficient” markets would be covered by an actively managed fund or separately managed account.

Tactical Asset Allocation and Absolute Return- ETFs have gained a great deal of popularity amongst wealth managers and clients that prefer to tactically shift the portfolio in anticipation or reaction to market events or other factors in an attempt to outperform the market. These investors are seeking to outperform (to the downside or the upside) not by selecting individual stocks or bonds, but by having an awareness and specialization in the qualitative/quantitative relationships between different areas of the market. ETFs allow them to have this specialization because they do not need to spend their time in finding stocks/bonds to fill out their allocation and can instead focus on inter-market relationship analysis.

Liability Driven Investing- The highly specific mandates/indexes associated with many ETFs mean that they are an excellent tool for Liability-Driven Investing (LDI). Passive Bond ETFs, industry-specific funds, leveraged ETFs, short ETFs, and the ability to buy/sell options on some ETFs make particularly attractive tools for this philosophy of investment, which focuses on hedging and insuring against risks as opposed to seeking risk-adjusted market returns.

Next week’s blogticles will present a discussion on wealth management and investing in tough economic conditions.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Jesse Mackey is the Chief Investment Officer of 4Thought Financial Group Inc. 4Thought is a boutique think tank created with the base vision of advancing individual freedoms and the human quality of life through economic means. This vision is pursued by applying the firm’s four specialties – Economic Theory and Research; Multi-Contingency Investment Management; Financial Planning for Business Owners and Individuals; and Support for Partner Firms and Advisors. You may contact Mr. Mackey at jmackey@4TFG.com or visit www.4TFG.com.