Forget Bitcoin. The red-hot M&A market for RIAs (Registered Investment Advisors) shows no signs of slowing down. Research and investment banking firm Echelon Partners reports deal volumes in 2017 were on track to set a new record breaking 150 transactions. According to industry estimates, there are between 10 to 20 qualified buyers are lined up for every current seller. So much for buying low and selling high.
Private Equity (PE) firms are now investing more than $3 billion a year into the advisory space and PE firms do not suffer fools. Once an RIA accepts PE money, that RIA will be held to very high –and often escalating expectations. In almost every case, the PE ownership is limited to a term of about a half-dozen years before the private equity fund needs to provide its investors with liquidity. This means the RIA will have a “carousel” relationship with new PE firms which will have even higher expectations – not to mention potential changes to management team or philosophy. This is akin to dating a different version of the J.K. Simmons’ character in the movie Whiplash (watch it ASAP) every 6 years – “Do you think you’re out of tune?”
SEC Commissioner Kara Stein, believes ownership concentration affects the willingness of companies to compete. A study by Jose Azar (IESE Business School), stated common ownership by institutional shareholders pushed up air fares by as much as 7% over the 14 years starting in 2001 because the shared holdings put less pressure on the airlines to compete. So, as RIA firms take on more cheap debt or PE ownership investment to purchase growth, ask yourself how will that affect the quality of services and the availability of your advisor, as they will be forced to do more with less.
Keep in mind, PE firms have a fiduciary obligation to the investors in their funds – and not to you. PE firms typically extract fees and “special dividends” from their portfolio companies which will fund them with additional debt. These fees and special dividends are tools with which PE firms use to extract profits up front. Lenders and other creditors carry the risks. Effectively extracting equity and income that can be used to reduce fees or improve services from clients to the passive investors.
“You scream and shout. What’s it all about. I want out. I want out of you,” renowned singer/songwriter Russ Tolman sings in “I Want Out”. I felt like a lot of investors were thinking the same thing about their portfolio after watching the S&P 500 fall 3.9 percent this week, the most since early 2016.
As investors, we shouldn’t think in binary terms. There are significant opportunity costs when pessimistically viewing the stock market at it’s current level and deciding it’s time to get out. In the final twelve months of the last four bull markets, the S&P 500 had an average return of 26%. Something to think about when considering below inflation rate CD’s as the sole alternative. One could make the argument that valuations look risky across all asset classes. But with inflation and interest rates below average and economic growth looking healthy, you could justify the current equity valuations.
There are two things I don’t look forward to in February. The Los Angeles Chargers not playing in the Super Bowl and the following overused market adage, “as goes January, so goes the year.” Though we certainly hope this is the case for 2018, as January was a strong month for stock market returns. The U.S. indices were up about 5%, and international markets also had a good showing.
I can already sense the bull market haters ready to attack. But Chris, “The Dow had its worse week in 2 years.”, “The Dow fell 666 points” …OMG the number the Beast (for the Book of Revelation fans). As investors, we must avoid what is called Naïve Extrapolation. This is the tendency for people to use what recently happened and think it will go on forever. Are there clear risks in the markets now? Absolutely! The U.S. Treasury 10-year rate rose from 2.465 percent to 2.85 percent, the highest level since early 2014. Higher interest rates are normal and expected in this kind of growth environment. But it’s the Fed that yells “Last Call” at 2am and tells the investors to go home. Can the Fed unwind their massive (and experimental) balance sheet while normalizing rates at a pace that doesn’t destabilize the bull market? Let me get back to you -Miss Cleo has me on hold. Another major risk is the pending need to approve federal government spending once again. This is akin to counting on your unemployed roommate to come up with rent on the 1st.
Remember, the Trend is Your friend and the long-term trend is still intact. There hasn’t been a break of the S&P 500 50 day moving averaging since my Dodgers choked away the World Series last October.
Here are five considerations to help you navigate the choppy waters going forward:
- Those that are over the age of 70.5, or have inherited a retirement account, take your required mandatory distribution now. We are in record setting territory with the duration of low volatility.
- Those gifting stocks to charities or churches, and expecting to itemize in 2018, should get those highly appreciated stocks out.
- Meet with your financial advisor and do a stress test with your portfolio. Understand how your portfolio will respond in a bear market. Not just the drop-in percentage but the drop-in dollar amount.
- Review your bonds portfolio. In the short-term, the bond ETF’s price will be volatile because its underlying holdings will fall in value in the short-term while it waits to accrue its interest income. As yields rise, the maturing bonds will be reinvested at higher rates, so you are effectively holding the portfolio’s underlying bonds to maturity. This means there is very little long-term principal risk assuming you are actually holding the instrument across its average effective maturity. Remember the three purposes of your fixed income (bonds):
- Aligning your portfolio to your risk tolerance to prevent adverse investment behaviors during a bear market.
- Liquidity for unexpected life events and living expenses for retirees augmenting income with their portfolio.
- Optionality of rebalancing into higher valuations. This should be done systemically to remove the element of emotion. Few people wanted to put their money to work in 2009 when unemployment was ~10%, but that year the S&P 500 ended up 26.46%.
- Hedging isn’t as easy as it used to be. Until recently, an investor looking to protect against stock declines could simply purchase long-term government bonds or US dollar futures, the logic being that the assets traded inversely to one another. If stocks went up, the other assets would go down, and vice versa. But that relationship has broken down. This means considering other hedging strategies such as tactical investment managers. They tend to underperform bull markets and reward investors during major market turns. Another consideration is looking at attractively priced equity put options.
Isn’t it crazy how every sales guy working at an investment firms claims their products/strategies consistently beats the market? You’ve never heard a salesman say “To be honest, most of our clients lose money with us. However, our client portal is, modestly speaking, quite exquisite.”
However, it’s critical to pay particular attention during these sales meetings and impressive performance with the distinctions between true actual performance, model performance and back-tested performance. Occasionally you will run into a sales rep that claims his performance is GIPS compliant. That means his/her firm uses performance data that only contains actual portfolios managed by their firm. GIPS stand for the Global Investment Performance Standards and are a set of voluntary guidelines for calculating and presenting investment performance. Just because a firm is GIPS compliant doesn’t mean they their performance isn’t misleading. I’ve seen GIPS compliant firms use selective periods in a brochure that only highlight the periods of outperformance, which makes it hard to compare to other options. Instead of getting performance in 1,3,5,7, & 10 year time periods you will get performance in 1 year, 3.67803 years, 5.478 years, and since Breaking Bad Season 2: Episode 6.
Traditionally, an advisory firm will use a model portfolio to show hypothetical or simulated performance. The model is often presented as an ideal combination of securities for a client’s portfolio. Unlike the model portfolios, back-tested performance presents hypothetical results based upon the retroactive application of an adviser’s investment strategy over a select market period. If it did poorly, you and I will never see it. They know it will never sell. But if it looks good, then it might end up in my inbox. The joke in the industry is that you’ve never seen a bad back-test and you will never see one. Investors should always take back-tests with a massive pinch of salt. When dealing with back-tested performance from potential investment managers, ideally, I’d like to see 5+ years of live results and 30+ years of back-tested data. That increases my confidence that there’s really something to this new idea.
In all cases, though, the hypothetical performance data would be misleading unless it is accompanied by full and clear disclosure explaining what it is, how it was derived, why it is being provided, the fact that it is not the performance of any actual account and, of course, that it is not a guarantee of future results. Unfortunately, there is no such thing as a front-test because there is no cure to for those who wish to mislead, or fools who wish to part with their money.
One of the benefits of the newly signed tax-reform law is the temporary reduction in the medical expense deduction floor. The floor, which was scheduled to be 10% of adjusted gross income in 2017, will now be 7.5% for 2017 and 2018 (returns to 10% in 2019). So, each dollar spent on health care beyond the 7.5% threshold is discounted at your personal tax rate and reduces your tax burden. For example, Joe Sixpack’s adjusted gross income (AGI) in 2018 is $60k. As such, he will be able to deduct qualified health expenses over $4,500. This is important as high-price health-care premiums become the norm.
Don’t expect your tax advisor or turbo tax to go through the thorough list of qualified medical & dental expenses. “Mr. Client, how much did you spend on Birth Control Pills?” Take a month to look at the IRS Publication 502 (https://www.irs.gov/publications/p502) if you expect to have significant medical expenses this year or incurred them last year.
I find it helpful to think in terms of monthly thresholds. Let’s go back to Joe Sixpack — the monthly floor he has to exceed in order to deduct is $375 ($4,500/12). So, if his medical & dental expenses are more than $375/month, he should automatically be thinking about this deduction.