Investor, Protect Thyself: The InvestSense Investor Self-Defense Strategy

During his term as Chairman of the Securities and Exchange Commission (SEC).(1993-2001), Arthur Levitt focused more on investor protection than perhaps any other recent SEC Chairman. His advice from a1999 speech, “Financial Self-Defense: Tips From and SEC Insider,” is still relevant and valuable to investors today.

There are more ways to invest than ever before. But there also seem to be more ways to be confused – or to be misled.

America’s marketplace is generally honest – but there are some crooks out there. And, there’s only so much that law enforcement and regulatory watchdog agencies, like the SEC, can do.

You’ve got to do your part, too….You also need to be on guard when dealing with investment professionals. The vast majority of people selling securities are honest. But we do have people who walk a fine line between good sales practices and poor sales practice….

An informed investor looks beyond the packaging of a product and also sees what’s inside.1

Sadly, recently the SEC has seemingly focused more on protecting the interests of Wall Street rather than on the protection of investors, one of the stated purposes and goals of the commission. As a result, Chairman Levitt’s admonition to assume greater responsibility for self-protection when dealing with the investment and/or the pension/retirement industries is equally applicable today.

Active versus Passive-Costs Matter
The late John Bogle, founder of the Vanguard Group, was fond of reminding investors that “costs matter.” In the ongoing debate over actively managed funds compared to passively managed index funds, one issue that is undeniable is that actively managed mutual funds, by their very nature, will have higher costs than index funds, specifically trading and management costs.

Advocates of actively managed funds argue that that the higher costs are justified by the fact that actively managed funds produce higher returns for investors. Evidence would suggest otherwise. So the questions are (1) how much higher costs does an actively managed fund have compared to a comparable benchmark index fund, and (2) what impact do the higher costs have on a fund’s performance?

As for a fund’s management fees, those are reflected in a fund’s annual expense ratio/fee. Whether those fees are justified or not are reflected in the fund’s performance relative to a comparable benchmark index fund, as well as the actual amount of active management actually provided by a fund.

As for trading costs, mutual funds are not currently required to provide their actual trading costs to investors. Instead, funds are allowed to group actual trading costs into a generic category of “operating costs,” which are then deducted from a fund’s gross return in reporting a fund’s performance.

Allowing an actively managed fund to “hide” such important information as trading costs prevents investors from being able to compare such costs to make a meaningful evaluation of a fund’s efficiency in managing the fund. As the SEC and other government agencies have noted, such costs do have a significant impact on an investor’s return. Each additional 1 percent in fees and costs reduces an investor’s end return by approximately 17-18 percent over a twenty year period.

Fortunately, Bogle recognized the importance of trading costs. He created a simple metric that allows investors to create a proxy for such cost and compare such costs between funds. Bogle’s metric simply doubles a fund’s reported annual turnover ratio and multiples that number by 0.60. So, if a fund has an annual turnover ratio of 50 percent, Bogle’s metric would result in an estimated trading cost of .0.60 for comparison purposes.

Bogle himself acknowledged that his metric probably understates a fund’s actual trading costs. However, the metric is still valuable in that it provides investors, fiduciaries and attorneys with a means of comparing such costs. As studies and simple mathematics show, the potential impact of such costs is simply too important to ignore.

Investor Self-Defense and the Active Management Value Ratio™
Unfortunately, the sheer number of investment options and the complexity of same make it extremely difficult for investors to independently evaluate the available investment options. Inexplicably, despite the acknowledged importance of pension/retirement plans, such as 401(k) and 403(b) plans, and “retirement readiness,” there is no express requirement that employers provide employees with any type of investment education.

Fortunately, there are simple and extremely effective tools and strategies that investors and pension plan participants can use to independently evaluate investment options. One such tool is a metric I created, the Active Management Value Ratio™ (AMVR). The AMVR allows investors and others to follow Chairman Levitt’s advice and look “beyond the packaging of a product and also sees what’s inside.” The AMVR allows investors, plan participants, fiduciaries and attorneys to evaluate the cost-efficiency of an actively managed mutual fund.

The Supreme Court has stated that the Restatement of Trusts (Restatement) is a key resource in interpreting fiduciary law and resolving questions regarding prudent investing. Fiduciary law requires that a fiduciary always act in the best interests of the beneficiaries and/or other parties whose interests they represent. Even when a fiduciary is not actually involved, the investment standards established by the Restatement ensure that an investor’s best interests are being served.

The AMVR incorporates the Restatement’s prudent investment standards and is simply the basic cost-benefit equation that every economics student learns in their Econ 101 class. The only difference is that the AMVR compares the incremental costs and incremental returns between an actively managed mutual fund and a comparable index fund. Applying simple common sense, actively managed funds whose incremental costs exceed the fund’s incremental returns are deemed to be cost-inefficient, and thus an imprudent investment.

A simple worksheet would be as follows:

In the worksheet above, assume that we are comparing an actively managed mutual fund and a comparable index fund with the following cost and return data:

Active Fund: Annual Expense Ratio 1.00%/5-Year Annualized Return 10.50%

Index Fund: Annual Expense Ratio .0.10%/5-Year Annualized Return 10.00%

As a result, the actively managed fund would have incremental costs of 90 basis points and incremental returns of only 50 basis points. (A basis point is equal to .01 percent.) A fund’s AMVR score is simply its incremental costs divided by the fund’s incremental returns.

Here, the actively managed fund’s AMVR score would be 1.80 (.90/.50). An AMVR score greater than 1.00 indicates that a fund’s incremental costs are greater than its incremental returns, indicating that the fund is not cost-efficient. An AMVR less than zero indicates that the actively managed fund underperformed its benchmark, providing no positive return for an investor.

In interpreting the AMVR, an investor or other user only needs to answer two questions:

  1. Did the fund being evaluated provide a positive incremental return?
  2. If so, did the fund’s incremental return exceed the fund’s incremental costs?

If the answer to either of these questions is “no,” the fund does not qualify as a prudent investment under the prudent investment standards established by the Restatement.

The AMVR calculation process provides another important piece of information regarding the cost-efficiency of an actively managed fund. In the example above, the numbers show that 90 percent of the actively managed fund’s total fee is only producing approximately 5 percent of the fund’s return. This is yet another example of the fund’s cost-inefficiency and further proof that it would not be a prudent investment choice.

Investor Protection Plus
While the AMVR example provided demonstrates the importance of evaluating the cost-efficiency of actively managed mutual funds, the nominal, or reported, numbers may not properly factor in the actual contribution of active management  in the fund’s performance, and thus may understate the implicit efficiencyof the fund’s fees and costs..Investors can avoid this oversight by simply considering an actively managed fund’s R-squared correlation number.

Morningstar states that

R-squared measures the relationship between a portfolio and its benchmark. It can be thought of as a percentage from 1 to 10.

If you want a portfolio that moves like the benchmark, you’d want a portfolio with a high R-squared. If you want a portfolio that doesn’t move at all like the benchmark, you’d want a low R-squared.

An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark. Conversely, a low R-squared indicates that very few of the portfolio’s movements can be explained by movements in its benchmark index. An R-squared measure of 35, for example, means that only 35% of the portfolio’s movements can be explained by movements in the benchmark index.

So, by reviewing an actively managed fund’s R-squared number, an investor can get an estimate of exactly how much of an actively managed fund’s performance can be attributable to the fund’s management team, as opposed to the performance of an underlying market index. In our example, the actively managed fund’s R-squared number of 95 would indicate that 95 percent of the fund’s performance can actually be attributable to the performance of the benchmark, with only 5 percent of the fund’s return being attributable to the fund’s management team. In short, a fund’s R-squared score gives investors a totally new perspective on an actively managed fund’s fees and costs, specifically the fund’s annual expense ratio/fee.

Ross Miller created a metric, the Active Expense Ratio (AER). Miller has stated that the AER measures the implicit cost of an actively managed fund’s annual expense ratio/fee by factoring in the fund’s R-squared number. The higher an actively managed fund’s R-squared correlation number, the lower the actual contribution of active management to the fund’s performance and the higher the fund’s AER score.

Using our earlier example and assuming an R-squared correlation number of 95 percent for the actively managed fund, the cost-inefficiency of the actively managed fund becomes even more apparent.

The combination of high incremental costs (90) and a high R-squared correlation number (95) result in an AER of 5.35, over 400 percent higher than the fund’s stated annual expense ratio. This further supports the argument that investors, fiduciaries and attorneys should always factor in an actively managed fund’s R-squared number.

Morningstar provides an R-squared correlation number for each of the funds it analyzes under the “Risks” tab. The only issue with Morningstar’s R-squared number is that they often use the S&P 500 index as the benchmark for all equity funds. Since Morningstar classifies S&P 500 Index funds as large-cap blend funds, the use of the index for other categories of funds is subject to questioning. At InvestSense, we calculate our own R-squared correlation numbers using comparable Vanguard index funds from the same Morningstar style box as the actively managed fund being analyzed.

While advocates of actively managed funds would argue that the results can be manipulated by assigning a high R-squared number to a fund, a simple review of data from the Morningstar Data Research Center will show that a significant percentage  of U.S. domestic equity funds currently have a R-squared number of 90 or above. And yet, inexplicably, the majority of investment holdings in personal investment accounts and pension plans are still in actively managed mutual funds.

Lessons Learned

When people ask me what I do for a living, I tell them that I am a wealth preservation attorney. When they follow-up by asking me what that means, I tell them that I combine my 20+ years legal experience as a securities/RIA compliance director and estate planner with my 30+ years experience as a financial planner to help clients develop a REAL wealth management/preservation program that focuses on the accumulation, protection, and distribution of wealth.

“Get what you can, and keep what you have. That’s the way to get rich.” That Scottish adage essentially sums up my philosophy about wealth management and preservation. I have written various articles on the three aspects of REAL wealth management and preservation, all of which are available on this blog. However, as Chairman Levitt pointed out, investors need to have a better understanding of investing in order to protect their financial security.

In my practices, we provide various comprehensive forensic analyses that calculate the efficiency of an actively managed fund, in terms of both risk management and cost efficiency, as well as a fund’s consistency of performance. However, the AMVR itself provides public investors, fiduciaries and others with a simple, yet effective, means of avoiding unnecessary investment losses due to cost-inefficient actively managed mutual funds.

The issue of cost-efficient investing is gaining increased attention in both the legal and wealth management communities. Studies have consistently concluded that the overwhelming majority of actively managed mutual funds are not cost-efficient, resulting in statements such as

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.2
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.3
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.4
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.5

Financial plans often recommend that a customer spend less money than they earn. The AMVR just stands for the proposition of avoiding actively managed funds that are not cost-efficient, funds whose incremental costs exceed their incremental returns.

Advocates of active management will often claim that active management allows mutual funds to cover the higher costs associated with actively managed mutual funds, namely higher annual expense ratios/fees and higher trading costs. The above-referenced studies prove otherwise. Furthermore, given the high R-squared correlation numbers of many U.S. domestic equity-based funds, it can be argued that such funds are “closet index,” or “mirror” funds, further reducing any chance that the fund’s active management can cover their extra costs

Very few investors and investment fiduciaries even consider a fund’s R-squared correlation numbers. Stockbrokers and other investment professionals try to avoid the issue due to the overwhelmingly negative evidence on the performance on the commission-based actively managed funds they sell,

Nevertheless, in addition to the two AMVR questions we previously mentioned, we suggest that all investors and investment fiduciaries doing business with stockbrokers and/or other financial salesmen always include the following two questions as part of their self-defense strategy:

  1. Will you be acting as a fiduciary in advising me/managing my account, with full disclosure of material facts and putting my best interests first?
  2. Will all of the investments you recommend be cost-efficient, with incremental returns exceeding the investment’s incremental cost relative to an appropriate benchmark?

And finally, if the stockbroker or financial adviser answers “yes“ to both questions, ask them if they are willing to put those assurances in writing. One of the first things every law student learns in their first-year contracts class is that a verbal promise is only as good as the paper it is written on.

Notes
1. https://www.sec.gov/news/speech/speecharchive/1999/spch305.htm
2. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
3. Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e. 
4. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
5. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).

© Copyright 2019 The Watkins Law Firm/InvestSense. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in Absolute Returns, Active Management Value Ratio, AMVR, Closet Index Funds, Consumer Protection, Consumer Rights, ERISA, Estate Planning, Fiduciary, Fiduciary Standard, Integrated Estate Planning, Investment Advice, Investment Advisors, Investment Fraud, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Retirement, Retirement Distribution Planning, Retirement Plan Participants, Retirement Planning, Uncategorized, Wealth Accumulation, Wealth Distribution, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , ,

Investopedia Top 100 Most Influential Financial Advisor Honor

Honored to be named by Investopedia as one of the Top 100 Financial Advisors for 2019. Unlike a lot of other “top” lists, Investopedia bases its selection largely on criteria such as contributions to online media to educate investors on timely topics such as wealth preservation, wealth preservation and investor self-protection strategies.

Additional information on the Investopedia Top 100 is available at https://bit.ly/31GZrzi.

Posted in Active Management Value Ratio, AMVR, Consumer Protection, Consumer Rights, Fiduciary, Investor Protection, Life Advice, Portfolio Construction, portfolio planning, Retirement Distribution Planning, Retirement Planning, Wealth Accumulation, Wealth Distribution, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , ,

One Step to Building More Effective, and Safer, Investment Portfolios

What is the first factor an investor or investment fiduciary, such as a pension plan sponsor, should consider in evaluating an actively managed mutual? Most people’s answer would probably be a fund’s returns or the number of Morningstar “stars” given to a fund, despite the fact that Morningstar has warned investors that their “star” system was never intended to be used for predicting future returns.

Most investors and attorneys are surprised when they learn that the first piece of data I look at in evaluating an actively managed mutual fund is the fund’s R-squared correlation number. My reasoning is that a fund’ R-squared number provides meaningful context to the rest of a fund’s numbers.

The R-squared number I look at is the correlation of returns between an actively managed fund and a comparable index fund. I use a comparable index fund so that I can factor in incremental returns and incremental costs to calculate the actively managed fund’s cost-efficiency, or lack thereof.

[R-squared] is simply a measure of the correlation of the [investment’s] returns to the benchmark’s returns. An R-squared of 100 indicates that all movements of a [investment] can be explained by movements in the benchmark. An R-squared measure of 35, for example, means that only 35% of the [investment’s] movements can be explained by movements in the benchmark index.

The benchmarks I use most often are Vanguard index funds (VIGRX/VIGAX, VIVAX/VVIAX and VFINX/VFIAX). However, other low-cost index funds may also be appropriate.

Morningstar provides an R-squared number for the funds it covers. However, Morningstar tends to use the S&P 500 index in calculating the R-squared number for U.S. equity funds, even when the fund is question is not a large cap blend stock, which is how the S&P 500 Index is categorized. As an attorney, I would obviously object to any cost-efficiency comparisons using a different asset category other than the one for the fund in question.

R-squared gives me a quick signal of a potential “closet index” situation. Closet indexing is a world-wide problem that is receiving greater attention due to its impact on investors. Closet indexing is generally defined as a fund holding itself out as an actively managed fund, and charging higher fees based on such active management, but whose performance closely tracks the performance of a comparable, less expensive, index or index fund.

A recent check on the Morningstar Investment Research Center indicated that the average annual expense ratio on domestic equity-based funds was 1.06 percent (106 basis points). The average turnover ratio on such funds was 61 percent, which equates to 73 basis points for trading costs using Bogle’s turnover/trading costs metric.

Using such data, the average U.S, domestic equity mutual fund starts out almost 180 basis points in the hole. The only way to cover such a deficit is by producing annual returns higher than comparable index funds. However, when actively managed mutual funds typically report R-squared correlation numbers of 90 and above, the chances of an actively managed fund covering its costs are unlikely.

Result – the investor is stuck with a cost-inefficient investment that actually costs them money and returns. Examples of the findings of some studies include

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.

John Bogle was known for his famous “humble arithmetic” speech in which he announced his Cost Matter Hypothesis, stating that

Gross return in the financial markets, minus the costs of financial intermediation, equals the net return actually delivered to investors….Whether markets are efficient or inefficient, investors as a group must fall short of the market return by precisely the amount of the aggregate costs they incur.  It is the central fact of investing.

Costs and the impact of such costs on performance, and therefore investors’ end returns, are at the heart of the ongoing debate over the merits of actively managed funds versus passive/index funds.

There are some, myself included, that have argued that “humble arithmetic” is equally valuable in evaluating actively managed mutual funds in terms of their cost-efficiency relatively to comparable index funds. Bogle was fond of saying that investors “get to keep what they don’t pay for.” Financial advisers and investment managers often try to minimize the cost of their services or their investment with the “it’s only 1 percent” argument.

However costs, like returns, compound over time, greatly increasing both. Each additional 1percent in fees/costs reduces an investor’s end-return by approximately 8 percent over a 10 year period and 17 percent over a twenty year period.

The impact of a fund’s fees and expenses can increase dramatically once a fund’s R-squared number is considered. Professor Ross Miller created a metric called the Active Expense Ratio (AER). Miller has said that the value of the AER is that it “enables one to compute the implicit cost of active management.”

The driving force behind the AER is the actively managed fund’s correlation of returns to a comparable index fund. Miller’s research has shown that actively managed funds often have a high R-squared, or correlation, number and charge significantly higher fees than comparable index funds. As a result, the AER often indicates that many actively managed have implicit annual expense ratios that are significantly higher than their stated rates, in many cases 500-600 percent higher, without an equally commensurate return to cover such fees.

Actively managed mutual funds routinely attempt to justify their higher fees based on the alleged benefits that their actively managed funds provide relative to comparable index funds. However, with many actively managed funds showing high R-squared correlation numbers of 90 and above, the contribution, if any, of active management to a fund’s overall performance is greatly reduced, especially from a cost-efficiency perspective.

There are those who argue that funds holding themselves out as providing active management and the purported benefits of same, whose high-R-squared correlation numbers indicate otherwise, are in violation of federal securities laws. Whether or not that is true, the fact remains that in evaluating an actively managed fund, the fund’s fees should be adjusted to reflect the fund’s reduced active management component and the resulting change in the implicit costs of such high R-squared actively managed mutual funds.

Whether you want to frame the question in terms of “best interest,” “prudence,” “suitability, or “fair dealing,” actively managed mutual funds with high R-squared correlation numbers and significant incremental costs compared to equivalent index funds are never in an investor’s best interest. How many of your current 401(k) and personal investments have a five-year R-squared number of 90 or above? A quick check on morningstar.com (under the “Risk” tab) might prove insightful.

As my colleague, Fred Reish, one of America’s leading ERISA attorneys, likes to say, forewarned is forearmed.

© Copyright 2019 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in Closet Index Funds, ERISA, Fiduciary, pension plans, portfolio planning, Portfolio Planning, Retirement, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , ,

CommonSense InvestSense About…Returns

As an attorney that specializes in wealth management/preservation and asset protection, I often see investors who have suffered unnecessary financial losses due to poorly designed and/or poorly managed investment portfolios. This is especially troubling, for as legendary investment expert Benjamin Graham once noted in his classic, “The Intelligent Investor,”

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

Three key concepts can help investors avoid unnecessary financial losses and help maximize an investor’s returns:

  1. Front-end loads dramatically reduce an investor’s end returns.
    Most stockbrokers and financial advisers recommend actively managed mutual funds for the commissions such products pay them. Commissions on actively managed mutual funds are commonly known as “front-end loads.” Under current law, the maximum front-end load that funds can charge is 5.75 percent of the total purchase price of the mutual fund.

Front-end load charges are automatically deducted at the time of the purchase of the fund, reducing the actual amount of a customer’s actual investment. So, on a $100,000 purchase of a mutual fund that charges a 5.75 percent front-end load, only $94,250 would actually go into a customer’s account.

Many investors are unaware of the cumulative impact of a front-end load. In our example, if we assume an annual return of 10 percent over ten years, the reduced initial investment due to the front-end load reduces an investor’s annualized return to 9.35 percent and a reduced actual dollar amount of almost $15,000 due to the impact of compounding.

Mutual funds are required by law to provide their return information net of fees, including any the impact of a front-end load. That information must appear in any ads published by a fund, as well as in a fund’s prospectus. The problem is that evidence shows that few investors actually look at a fund’s prospectus, and the load-adjusted return information is often buried in an ad’s small print.

2. Expense ratios and so-called “invisible” costs further reduce an investor’s returns. The impact of front-end loads is not the only factor that investors need to consider when selecting mutual funds. Studies have shown that most actively managed mutual funds are not cost-efficient, consistently underperforming comparable no-load index mutual funds due to the impact of the extra costs associated with active management, e.g, higher annual expense ratios and trading costs. Samples of the findings of such studies include the following:

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.

As a result, index funds are usually the better choice for investors. Since mutual funds are not legally required to disclose their actual trading costs, these added costs are often referred to as “invisible” costs that investors forget to factor into their investment decision.

3. The actual contribution of an actively managed mutual fund’s management team is often negligible and, in some cases, actually cost investors. While many investors select mutual funds based on Morningstar’s famous “star” system, the most valuable information provided by Morningstar may actually be an actively managed fund’s R-squared correlation number.

Morningstar defines R-squared as

the relationship between a portfolio and its benchmark…. R-squared is not a measure of the performance of a portfolio….It is simply a measure of the correlation of the portfolio’s returns to the benchmark’s returns…. An R-squared measure of 35, for example, means that only 35% of the portfolio’s movements can be explained by movements in the benchmark index.

While actively managed funds like to tout the presumed advantages of the active management their fund allegedly provides, the evidence suggests that many funds’ returns are due more to the movement of the stock market than an actively managed fund’s management team. Evidence of this fact is supported by the percentage of actively managed funds with R-squared correlation numbers of 90 or above.

As index funds have consistently outperformed their more expensive actively managed counterparts, many actively managed funds have seemingly adopted a “if you cannot beat them, join them” approach to investing in hopes of minimizing both the extent of any potential underperformance relative to index funds and the potential loss of customers from such differences in performance.

© Copyright 2019 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in Closet Index Funds, Consumer Protection, Investment Advice, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , ,

Sound Investment Advice from Jack Bogle…Again

Why write anything? Mr. Bogle says it all.

https://www.yahoo.com/finance/news/vanguard-founder-jack-bogle-apos-194408395.html

Posted in Investment Advice, Investment Portfolios, Portfolio Construction, portfolio planning, Wealth Management | Tagged , , , ,

REAL Wealth Management 2019 – Wealth Distributions and Transfers

Today, we address what I consider to be the third aspect of a genuine wealth management program – distributions and transfers of one’s assets.  Distribution encompasses both transfers made while one is living, inter vivos transfers, and transfers made after one’s death, testamentary or postmortem transfers.

Distribution planning generally focuses on deciding how to allocate one’s assets to achieve one’s personal goals while minimizing the impact of taxes (i.e., income tax, gift tax, estate tax, alternative minimum tax, etc.) and other financial issues, both during one’s lifetime and after one’s death.  I have already written several posts and white papers that cover some of these issues, so I will simply use this post to provide a general overview of some common issues.

As always, the information provided here is general in nature and is not intended to provide advice for any specific individual.  If you need specific advice or assistance, you should contact an attorney or other professional who is experienced and knowledgeable in such matters.

One of most common distribution mistakes people make is failing to properly complete the beneficiary forms associated with their retirement plans so as to maximize the benefits such assets by avoiding the impact of taxes. By carefully considering who to designate as their beneficiaries and properly completing the beneficiary form to ensure the most effective distribution of the assets in their plan, the plan owner can effectively “stretch” the lifetime of the assets to benefit more than just the beneficiaries they designate.  For those who have a large balance in their pension account, it may be better to have a custom beneficiary form drafted to ensure the maximum benefit and protection for the assets within their personal account.

Another consideration regarding beneficiary forms has to do with the consolidation that has taken place within the banking and investment industries.  It is not uncommon for people to contact a bank or broker-dealer after the death of a loved one and request a distribution of a loved one’s IRA account, only to be told that the bank or broker-dealer cannot find the beneficiary form for the account.  In such instances the bank or broker-dealer will enforce the default distribution provision on the account, which are generally not in the best interests of the deceased’s heirs, as the usually result in a heavier tax impact and thus, a significant reduction in the amount of assets going to the heirs. Loss of beneficiary forms can also occur in connection with 401(k), 403(b) and 457(b).

Bottom line, owners of retirement plans should review their beneficiary forms regularly in order to verify that the custodian of a plan has the owner’s beneficiary form on file and that the forms still accurately reflects the account owner’s wishes.  There are numerous cases where the retirement account owner has divorced and remarried, but failed to change the beneficiary forms on his retirement account(s). The Supreme Court has ruled that even though it would make sense that the deceased would want to leave at least a portion of his retirement account assets to his current wife, the terms set out in a retirement account beneficiary form control distributions from said retirement account, regardless of what is stated in the deceased’s will.

Inter Vivos Distribution Planning
A common misconception about wealth distribution planning is that it has to be complicated. A common, yet simple, inter vivos wealth transfer strategy is the use of the annual gift tax exclusion amount.  This exclusion allows an individual to give a certain amount each yer to as many recipients as they wish without triggering any federal gift tax. The annual gift tax exclusion amount for 2019 is $15,000.

Married couples can maximize the benefits of the annual gift tax exclusion by each making a qualifying gift. That means for 2019, a couple with three children could give each child $30.000 annually, effectively reducing the size of a taxable estate if that is a goal.

Anyone contemplating lifetime transfers of their assets need to carefully review their personal financial situation to make sure that they can truly afford to make such transfer.  People should be careful not to “let the tax tail wag the wealth management dog.”

Another common inter vivos strategy is the use of trusts.  Some of the common inter vivos trusts include family trusts, intentionally defective grantor trust (IDGT), income-only trusts and special needs trusts.

– Family trust are typically drafted in such a way as to remove the trust’s assets from the grantor’s estates (usually a husband and a wife), but provide for ongoing management of the trust’s assets.
– IDGT trusts are drafted so that the trust’s assets are removed from the grantor’s estate, but drafted in such a way that the grantor, not the trust, is liable for any annual income tax owed by the trust, allowing the grantor to pay such taxes, providing a further reduction of the grantor taxable estate and to allow the trust’s asset to benefit from compound growth.
– Income-only trust are drafted in such as way as to remove the trust’s assets from the grantor’s estate, but to provide income to the grantor on an ongoing basis. These trusts are often used in attempting to qualify for benefit programs such as Medicaid.
– Special needs trusts (SNTs) are established to provide financial aid to injured or otherwise challenged individuals.  SNTs must be carefully drafted in order to preserve the beneficiary’s potential right to important government benefits.

As we mentioned in our previous post, the effectiveness of a trust in providing wealth management advantages is based largely on the amount of control retained by the person establishing the trust, the grantor..  The more control the grantor retains over the assets while in the trust, the less protection provided.

Testamentary or Postmortem Distribution Planning
Testamentary planning basically refers to estate planning and specific distributions instructions provided in one’s will.  A common tax strategy is to add testamentary trust provisions within a will that will allow one’s heirs’ to possibly have access to such assets in certain circumstances if the trustee assents to such access, yet still provide tax benefits for the deceased’s estate.

The rules in this area have changed dramatically in the past few years, most changes providing potentially significant tax savings for an estate, thereby allowing taxpayers to pass more of their assets to their heirs. For that reason, if you have had any estate planning done in the past, you should definitely have your planning reviewed to see if such plans are still effective and/or whether changes might be advisable that make them even more effective.

A full explanation of all the changes is beyond the scope of this blog and not advisable, since the appropriate estate planning strategy for anyone depends any number or interrelated variables. Overall, the recent changes in the tax code relative to estate taxes have resulted in most people not owing any federal estate taxes upon their death. Again, less taxes means more assets to pass on to one’s heirs.

One such change that has benefited many taxpayers has been the so-called “portability” rules. The portability rules generally allow a surviving spouse to take advantage of the unused portion of her deceased spouse’s unused federal estate tax exemption.

In the past, estate planners would often recommend that a couple equalize their estates to make sure that they maximized the benefits of the federal estate tax exemption. With the new portability rules, estate equalization is no longer necessary.

A common trust strategy used with married couples is the so-called “A-B Trust” plan. In this strategy, the will directs that the executor fund one trust, the so-called “bypass trust,” with the applicable estate tax exclusion amount and place any remaining assets in a trust that qualifies for the unlimited marital deduction. The applicable estate tax exclusion amount for 2019 is $11.4 million dollars. That amount is subject to an annual adjustment based on inflation. Another reason to review your estate plan annually.

Assuming the marital trust is set-up properly, the use of the marital trust defers any potential taxation of the marital trust’s assets until the death of the surviving spouse, with any tax being based on any asset remaining in the trust that is not otherwise exempted from taxation. The terms of the “bypass trust” usually provide for distribution of the trust’s assets upon the death of the surviving spouse in accordance with whatever terms are provided, with the distribution of the trust’s principal being tax-free.

The “A-B Trust” strategy is just one testamentary distribution strategy that can be used to both achieve one’s goals while minimizing the impact of taxes. The appropriate strategy for an individual will depend on their specific situation, goals and concerns. That is why anyone considering distribution planning should only do so after consulting with an attorney or other appropriate professional who is both experienced and knowledgeable in such matters.

When large estates are involved, postmortem distribution planning may help resolve issues that were not contemplated when the decedent originally drafted their will. Beneficiaries of large estates may find that distributions to them under a will may not be needed or may produce unwanted tax implications.

In such cases, a beneficiary may choose to disclaim a distribution. The disclaimed distribution is treated as if it were never made and is distributed in accordance with instructions in the will. Effectively disclaiming a distribution should only be done with the assistance of an experienced estate planning attorney in order to avoid potentially serious tax issues.

Disclaimers are often used when the distribution will result in other family members, who are also beneficiaries under the will, receiving the disclaimed assets.  Disclaimers, when done properly, can be a very effective tax planning and wealth management strategy. However, it is important for anyone considering a disclaimer to understand that if a beneficiary disclaims a distribution under a will, the beneficiary does not get to designate someone to receive the disclaimed distribution.

© 2013-2019 InvestSense, LLC. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

The strategies discussed herein are only a general overview of some common wealth management strategies for wealth distribution and transfers.  Anyone considering engaging in wealth distribution and transfer strategies should only do after consulting with an attorney or other professional experienced and knowledgeable in such matters. This is definitely not an area for do-it-yourselfers!

Notice: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.

Posted in Estate Planning, Integrated Estate Planning, Uncategorized, Wealth Distribution, Wealth Management | Tagged , , , ,

REAL Wealth Management 2019 – Preservation

“Make as much money as you can and keep what you get. That’s the way to become rich.” – Scottish adage

When I tell people that I am a wealth preservation attorney, I often get the obligatory inquisitive look, followed by “what’s that” question. In my law practice, wealth preservation law covers several areas of the law, primarily wealth management, tax planning, estate planning, and asset protection. The primary focus is to address each of these areas, analyze a client’s current situation, and reduce or eliminate any unnecessary exposure to actual or potential losses

Many people mistakenly believe that wealth preservation is only for high net worth individuals who needs trusts and other expensive asset protection tools and strategies. In truth, the most effective and easiest wealth preservation strategy is to effectively diversify all investment accounts, including 401(k) accounts and IRAs, and avoid unnecessary costs by only selecting cost-efficient investments.

With regard to wealth management, I analyze a clients’ current investment portfolio in overall suitability and efficiency, in terms of both cost and risk management.  I draw heavily on over thirty years of experience in the area of quality of financial advice, including various stints as a compliance director. both for general securities and investment adviser operations.

I use four proprietary metrics, three of which are proprietary – the Active Management Value Ratio™ 3.0, the Cost-Efficiency Quotient, the Fiduciary Prudence Score, and a proprietary stress test.  Relying on these metrics, we often find situations where clients are paying fees that are often 300-400 higher than necessary to get similar, or better, performance from less expensive investment options

I also analyze a client’s investment and financial situation in terms of the client’s overall financial needs and plans.  As an example, variable annuities can basically destroy a client’s estate plan is the client annuitizes the annuity prior to his/her death by removing the asset from the estate plan.  A variable annuity can also have serious implications for those who need Medicaid later in life.  These are all issues which should really be considered prior to investing, but definitely analyzed at some point in case steps should be considered to minimize any potential damage.

Tax planning is an obvious part of wealth management.  As legendary jurist Judge Learned Hand stated, there is nothing wrong or illegal with arranging one’s affairs so as to minimize taxes.  Losses due to taxes obviously reduce wealth and can significantly reduce one’s estate. Tax laws can impact investment choices, e.g., Traditional IRAs vs Roth IRAs, tax deferred investments options vs. non-tax deferred investment options.  Tax laws can impact estate plans e.g., estate equalization strategies, marital property considerations, disclaimer strategies. With the constant change in tax laws, it is critical that clients utilize all possible resources,  including tax attorneys and CPAs, in order to keep their comprehensive wealth management up-to-date with regard to tax planning.

Estate planning focuses on the efficient distribution of one’s estate.  Efficient distribution focuses on both ensuring that the deceased’s last wishes are honored, but also that the estate is not greatly reduced due to the impact of taxes. We will discuss estate planning more in next week’s post on distribution. For now, let’s just say that there are a number of strategies, including estate equalization, trusts and qualified disclaimers that can be used as part of an effective wealth management process.

Finally, studies consistently show that the public wants to know about asset protection strategies, particularly the use of asset protection trusts.  There are basically two types of asset protection trust – domestic asset protection trust (DAPTs) and foreign asset protection trusts (FAPTs).  The most popular domestic jurisdictions are currently Nevada, Delaware, Alaska and South Dakota.  Popular foreign jurisdictions include the Cook Islands, Nevis, Isle of Man and the Cayman Islands.

In choosing a jurisdiction for an asset protection trust, there are several things to consider. First and foremost, the asset protection laws differ from jurisdiction to jurisdiction.  Two of the most important legal issues to consider are the statute of limitations (SLs)/contestability provisions and the exceptions from protection.  The optimum situation is a jurisdiction with short SL/contestability period and as few exceptions as possible.  With DAPTs, there is also the issue of whether the DAPT state will honor and enforce a judgement from another state under the “full faith and credit” provision of the U.S. Constitution.

I have a lot of people contact me and say they are going to be sued, so they need an asset protection trust…now!  Then I explain a couple of things of things about asset protection trusts, such as (1) asset protection trusts cannot be used to perpetuate fraud; (2) the earlier an asset protection trust is created, the greater the protection; and (3) the effectiveness of an asset protection trust is inversely related to the amount of rights and powers retained by the trust’s grantor. In many cases, it is too late to create an effective asset protection trust, as the event creating the liability has already occurred.

The key to effective wealth preservation is not to view wealth preservation in isolation, but rather as part of a comprehensive wealth management plan.  Wealth preservation involves various aspects of the law, including wealth management, tax planning, estate planning, retirement distribution planning and asset protection. The key is to also create a strong team of professionals experienced in these areas and work towards the client’ goals and needs.

© 2013-2019 InvestSense, LLC. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in Active Management Value Ratio, AMVR, Asset Protection, Estate Planning, Investment Advice, Portfolio Construction, portfolio planning, Retirement, Retirement Distribution Planning, Uncategorized, Wealth Management, Wealth Preservation, Wealth Recovery | Tagged , , , , , , , ,