Sometimes the emotions of investing can cause quick reactions, following the trends—which isn’t always the most successful.
The Liberated Wealth® Process helps us uncover and solve big and small challenges. Sometimes these are common issues and opportunities for wealthy families, and sometimes they are unique.
Unique opportunities can include emotional investing that can happen with trends and quick reactions. But there are ways to implement room for risk and create a diverse portfolio that can sustain for generations.
Understand The Motivation
The psychology behind quick judgments reveals a lot about human nature.
Just like there are stages of grief, there are emotional stages of trading and wealth. Committing to a snap decision with a high-risk can bring a roller coaster of emotions: excitement, hope, anxiety, fear, panic, and relief (if all goes well). This is true for financial planning in general.
Investor behavior has been the target of many studies because investment (even when unwanted), is powered by emotions. Ask yourself some of the following questions about your potential investment:
Why am I investing?
Does this align with my long-term goals?
Can I pivot my wealth if this fails?
What do I want in life and does this decision support this?
Setting Goals Instead
Implementing long-term goals is always a good idea, especially when you might have a history of pulling the trigger on quick investments that failed. Dollar-cost averaging and diversification are two approaches that investors can implement to make consistent decisions that are not driven by emotion.
Life is About Balance!
At the end of the day, finding a balance of overconfidence and underconfidence might find you not in the sweet spot of the exhilaration of investing, but the confidence of having sustainable wealth.
And better yet, there is a tangible way to measure balance—a diversified portfolio!
Talk to one of our trusted wealth advisors today at Centura Wealth Advisory to learn more about liberating your wealth!
Centura Wealth does not make any representations as to the accuracy, timeliness, suitability or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes and all users thereof should be guided accordingly.
We are neither your attorneys nor your accountants and no portion of this material should be interpreted by you as legal, accounting, or tax advice. We recommend that you seek the advice of a qualified attorney and accountant.
For additional information about Centura, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). Please read the disclosure statement carefully before you engage our firm for advisory services.
https://centurawealth.com/wp-content/uploads/2024/08/iStock-1225117361.jpg14142121Magdi Cookhttps://centurawealth.com/wp-content/uploads/2024/07/Centura-Logo-Grey.pngMagdi Cook2021-09-25 17:54:002024-08-27 17:55:42How to Sustain Wealth in an Ever-Changing Market
Did you know about 70% of wealthy families lose their wealth by the second generation, and 90% lose it by the third generation?
This is a troubling statistic—which is why, at Centura Wealth Advisory, our goal is to help families explore and implement purposeful strategies and solutions for successful wealth outcomes.
With vast experience working with high-net-worth individuals and families, our team is fully prepared to embrace your family’s complex financial life, circumstances, and strategies. We will help develop the best strategies for you.
Read on to understand why families are losing their wealth so quickly and to learn how to transform your strategy to make your generational wealth last.
Why is Generational Wealth Difficult to Preserve?
As the Chinese proverb says, “The first generation makes the money, the second spends it, and the third sees none of the wealth.”
Typically, in the process of earning wealth, the first generation learns how to:
Acquire assets
Optimize investments
And spend wisely
The second generation, being born into wealth, may forgo the opportunities to learn these skills. Therefore, a common mistake of the second generation is not acquiring assets and investments that:
Support lifestyle they’re accustomed to
Can be passed onto the next generation
Consequently, the third generation is left with little remains of the original wealth along with limited financial education and experience.
How Can You Make Your Generational Wealth Last Beyond the Next Generation?
Creating long-term goals, prioritizing financial education, having clear expectations, and communicating clearly are all essential practices in making your generational wealth last.
Identify Your Family’s Purpose
To implement successful strategies, we focus on generational wealth through purpose. This method includes:
Unpacking your family’s values and dreams
Helping you define, implement and track your family’s purpose
Making your family’s purpose the impetus of your wealth
Avoid responding to daily market conditions, buying the next hot investment product, chasing the latest wealth strategy, or only attempting to preserve your wealth.
At Centura, we instead suggest developing long-term goals that align with your family’s purpose and focus on the growth of existing assets. These goals might include:
Investing in the stock market
Investing in real estate
Building a business to pass down
Creating a strong retirement plan
We recommend working with one of our trusted advisors to ensure your unique financial situation is progressing towards these goals.
Invest in Financial Education
Financial education is crucial for family members to understand wealth sustainability. Without the proper knowledge and skills, the next generation is likely to deplete the wealth through poor spending habits and a lack of guided investments.
By providing the next generation with financial education, you provide the skills, knowledge, and habits they need to preserve and build their wealth.
This education can range from enrolling family members in relevant courses, teaching them about assets and investments at the office, or even just including them in day-to-day conversations about smart spending.
Provide Clear Expectations and Goals for Your Family
Consider possible goals you may have for your family to ensure their financial stability. Some examples may include:
Should you require members of your family to commit to their own success?
Should you ask the next generation to acquire assets and investments to contribute to the wealth of your family?
Would you like members of your family to build a business to pass down to the next generation?
Should you insist every member of your family earns a college degree?
These goals can encourage your kin to build their own financial success. Whatever these goals may be, we suggest introducing your expectations early on and in a clear manner.
Prioritize Transparency and Communication
Tell stories of how your family’s wealth was built; include the next generation in current financial conversations. This communication will allow your family to see the difficulties you have overcome to build your wealth as well as the current challenges you still face.
Additionally, your family can learn from your past and current decisions when it becomes their turn to make similar choices.
Healthy family communication is integral to wealth longevity. Consider hiring a family mediator, coach, or therapist to help your family navigate more difficult discussions about money.
Take Advantage of Life Insurance
Life insurance allows you to protect your family in the event of an untimely death. Without your income and resources, the next generation may not be able to maintain generational wealth. By taking advantage of life insurance, you can secure your family’s financial future.
Invest In and Save for Your Children’s Education
Education can give your children the tools and opportunities they need to have successful, independent careers to navigate their own finances.
According to U.S. News and World Report, the average student loan debt has hit a new record high for recent college graduates—exceeding $30,000. If your child graduates college without this debt, they are more likely to begin accumulating their own wealth, become a homeowner, and pass wealth on to the next generation.
Ready to Take These Steps to Ensure Generational Wealth?
With diligent stewardship, care, and attention, a family’s wealth can last for generations. This is what we provide at Centura Wealth Advisory.
At Centura, our main focus is to liberate your wealth, going above and beyond traditional money management. We aspire to bring only the best value-added solutions to our clients.
Centura Wealth does not make any representations as to the accuracy, timeliness, suitability or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes and all users thereof should be guided accordingly.
We are neither your attorneys nor your accountants and no portion of this material should be interpreted by you as legal, accounting, or tax advice. We recommend that you seek the advice of a qualified attorney and accountant.
For additional information about Centura, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). Please read the disclosure statement carefully before you engage our firm for advisory services.
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Professionals have compared structured notes to the innovative mindset behind mutual funds—with the main draw being zero interest rates. In the past, structured notes were a high-risk, high-return investment that only very wealthy investors could get involved in. Recently, however, the transition to using more technology for investing has opened the door for more individuals and families to invest using structured notes.
Centura Wealth Advisory works with clients to build a diversified portfolio when financial planning, and considering structured notes is a step toward having a more diverse portfolio.
Listen to the recent Live Life Liberated podcast, “Structured Notes Simplified with Robert Sowinski,” for a professional perspective.
What Are Structured Notes?
There are different types of structured notes that can be helpful to understand before investing.
There are a few categories to know for understanding structural notes:
Maturity
Underlying Asset
Protection Amount
Return/Payoff
Structured notes can be compared to a “hybrid security.” They combine the features of various financial products into one. Structured notes combine bonds and additional investments to offer the features of both debt assets and investment assets.
Structured notes aren’t direct investments, but derivatives. They track the value of another product. The amount on a structured note will depend on the issuer repaying the premium and underlying bond.
How do they work?
The basic ways structured notes can be ‘structured’ are the following:
Provide downside market protection
Provide upside (or enhanced) participation
Provide regular payments/income in the form of coupons if certain market conditions are met
Provide a payout/return at maturity if certain market conditions are met
The U.S. Securities and Exchange Commission (SEC) provides more detailed information on structured notes: “Structured notes have a fixed majority and include two components—a bond component and an embedded derivative.”
Financial institutions, as a result, are generally responsible for designing and issuing structured notes, so then the Broker/Dealer can sell them to individual investors.
Potential Risks
It’s important to understand that structured investments will not be a perfect match for all investors based on their risk profile and current portfolio. They are risky as your investments can sit idly without growth
The SEC lists the risks that come with investing in structured notes:
Market Risk
Insurance Price and Note Value
Liquidity
Payoff Structure (which is affected by participation rates, capped maximum returns, and knock-in feature)
Credit Risk
Call Risk
Tax Considerations
Talk to us!
If you’re interested in structured notes and diversifying your portfolio, speak to one of our trusted financial advisors today.
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Opportunity Zones (O-Zones) are a unique product of the 2017 Tax Cuts and Jobs Act (TCJA). Since being introduced, opportunity zone investments (OZs) have been a hot topic for potential tax planning. So much so, it’s been reported that Qualified Opportunity Funds have raised over $6.7 billion thru December 2019, a number that grew at a rapid pace at the end of 2019 as taxpayers looked for ways to defer capital gains.
When it comes to O-Zone, tax breaks are the headliner, but the actual underlying investment within the Opportunity Zone shouldn’t be overlooked. Questions investors should ask include:
Where am I investing my money?
Are there enough good investment opportunities in this space?
Will the tax benefits be significant enough to outweigh an under-performing investment?
Would the investor be better off just paying the tax and re-investing in an investment of their choosing?
In this blog post, we’re going to dive into Opportunity Zones, which can be a hybrid tax planning and investment solution for those that have recognized a large capital gain. We’ll define the basics of the Opportunity Zones, discuss the tax benefits, compare O-Zones to other types of investments, and explore the characteristics of an investor that might consider an investment in a Qualified Opportunity Zone.
What is an Opportunity Zone?
The Tax Cuts and Jobs Act of 2017 brought about a new type of investment offering, Opportunity Zones, which provide a unique way of mitigating capital gains tax. The Opportunity Zones were created to incentivize investment of capital gains into low income or economically distressed communities. By investing in these communities, taxpayers may be allowed to defer capital gains when investing funds into a Qualified Opportunity Fund (QOF) and meeting other requirements.
Check out the California Opportunity Zone map here.
What is a Qualified Opportunity Fund (QOF)?
A Qualified Opportunity Fund is an investment vehicle that files either a partnership (Form 1065) or corporation (Form 1120/1120S) federal income tax return and is organized for the purpose of investing in Qualified Opportunity Zone property.
What are the tax benefits of investing in a QOF?
There are three main categories for the tax benefits:
Deferral of a Capital Gain
Step-up in Basis of the deferred gain amount
Tax free gain on new Qualified Opportunity Fund growth
Deferral of Capital Gain
When a capital gain is recognized on the sale of an asset, you have the option to take any part of the capital gain and re-invest the proceeds into a Qualified Opportunity Fund (QOF). If the capital gain proceeds are re-invested into a QOF within 180 days of the gain being recognized, the dollar amount invested will be eligible for deferring the capital gain until the earlier of:
The tax year when the QOF interest is sold
Or December 31, 2026
At that time, the capital gain amount that was initially deferred when proceeds were invested into the QOF, would be recognized (less any step up in basis, see below) and taxes will be paid. The capital gain tax rate will be based on the tax rate applicable during the year the gain is eventually recognized.
Step-Up in Basis
If the investment in the QOF is held for at least 5 years, there is a 10% step-up in the basis of the deferred capital gain. If the QOF investment is held for 7 years, there is an additional 5% step-up in basis of the deferred capital gain (for a total of 15%). For those investing in 2020 and beyond, there will not be a 5% step up since it will be impossible to reach the 7-year holding period by 2026.
Tax free growth
If the interest in a QOF is held for 10 years or more, the post-acquisition gains in the QOF will be excluded on the sale of the QOF interest, thereby completely avoiding capital gains tax on this portion of the gain. There are several tax incentives that could be a big win for the long-term investor. However, taxes alone should never drive an investment decision, so let’s review a few of the primary risks associated with investing in a Qualified Opportunity Fund.
Risks Abound
The TCJA just put Opportunity Zones on the map in 2017, and as recent as December of 2019, the IRS published its final regulations on Opportunity Zones. The Qualified Opportunity Funds are new vehicles and due diligence is paramount. Investors will be facing questions of operator risk, investment risk, and illiquidity risk to name a few.
Operator risk– There won’t be an extended track record for any of the funds or operators. Are they putting the money to work in good opportunities that will net investors a positive return? Are they operating in compliance to meet the requirements of a Qualified Opportunity Fund?
Investment risk– While the Opportunity Zone rules do encourage more than just real estate development, it is likely that a lot of early projects will be in real estate development. Any real estate development project carries its own risks, not to mention that the developments will be located in Opportunity Zones, which by design are designated as an economically distressed area. As such, investing in these areas could carry additional risk(s) and expectation of returns should be scrutinized closely. Depending on the QOF, there could be single property risk if the fund has only invested in one project versus others that plan to invest in multiple projects.
Illiquidity – depending on the fund, the investment could be illiquid. To capture the tax benefits and defer the gain the maximum number of years, you would need liquidity elsewhere. This will be a 10-year investment if you want to hit the tax trifecta (deferred gains, step-up in basis, and future tax-free growth). If holding the QOF investment for ten years, the investor would also need to set aside cash to pay the initial capital gain tax that was deferred and recognized in 2026, so plan accordingly.
Is an Opportunity Zone Investment Worth Consideration?
For comparison, we ran a hypothetical scenario to help evaluate the break-even return required by an investor that has captured a tax benefit from the Opportunity Zone (OZ) investment:
Option 1: Recognize capital gains on an investment, pay tax on those gains for Federal and California (assuming a California tax payer), and reinvest all the net proceeds (gain and basis) into a new investment
Option 2: Recognize capital gains on an investment, pay tax on those gains for California only, and reinvest the net gains in a Qualified Opportunity Fund while putting the basis in a new investment
It’s clear the Opportunity Zone investor has the beginning advantage with more capital to invest in year 1 (Option 2). A larger starting investment can compound at lower rates of return and still arrive at the same future dollar amount over 10 years. But, how much lower can the return be for the tax advantaged investor before the lackluster investment performance wipes out the tax advantages?
The goal here was to find the break-even return required from an Opportunity Zone fund to put the investor on par with just paying the tax and re-investing.
For the first scenario (Table 1), we assumed the investor paid the tax and re-invested the remaining proceeds into an equity portfolio with an expected return of 6.33% (see Capital Market Assumptions Blog). The Opportunity Zone investor invested the gain portion into a QOF and the basis in an equity portfolio. Assumptions are that all investments are liquidated at the end of ten years. The numbers are as follows:
For the second scenario (Table 2), we assumed the investor paid the tax and re-invested the net proceeds into syndicated real estate that is expected to return 8%. The real estate investment has additional tax deferral options at the end of the ten-year holding period. It is still assumed that both options are liquidated at the end of ten years. The breakdown comparison of the options are shown below:
The QOF has merit when compared to paying the taxes and investing in an all equity portfolio. The break-even return required in the QOF of 2.75% (see Table 1) gives the investor a nice cushion provided by the tax savings. However, for accredited investors with the options to place funds within more sophisticated investment vehicles, the results become more convoluted. The QOF investor would require a break-even rate of return at 6.64% which is a much higher hurdle for an Opportunity Zone investment that carries many additional risks outlined earlier.
Conclusion
Let’s summarize where the Opportunity Zone seems to be an optimal solution.
At minimum, it’s an investor that has recognized or will be recognizing a significant capital gain. If the investor:
Has liquidity elsewhere to allow for a 10-year investment horizon in a QOF and liquid assets to pay the deferred tax due in year 2026
Would like to diversify a portion of their portfolio to real estate
Desires to invest money within economically disadvantaged areas for community/social benefits
Based on the comparison we modeled, if the motivation is strictly financial, an accredited investor in California (zero state tax benefits) with access to private syndicated real estate investment opportunities might just consider paying the tax and investing in a lower risk real estate investment. Instead of investing money in projects requiring development, existing properties with current cash flows may be a lower risk option.
Of the tax incentives, the ‘tax free’ growth on a new investment in an Opportunity Zone sounds appealing. However, real estate investments already allow for significant tax efficiency. Real estate investors can defer unrealized gains in future 1031 (IRC Section 1031) exchanges and heirs of real estate property receive a step up in cost basis at death.
In addition, certain types of real estate investments also allow investors to utilize depreciation to shield income from taxation; until exhausted or exchanged into a new property via 1031 exchange.
Given the existing tax efficiency and opportunity to invest outside of economically disadvantaged areas, private syndicated real estate has the potential to outperform a higher risk Opportunity Zone investment in the long run.
If you’ve incurred or will be incurring a significant capital gain and need help evaluating your options, contact Centura Wealth Advisory for a consultation.
Centura Wealth Advisory (“Centura”) is an SEC registered investment adviser located in San Diego, California. This brochure is limited to the dissemination of general information pertaining to Centura’s investment advisory services. Investing involves risk, including risk of loss.
Centura Wealth does not make any representations as to the accuracy, timeliness, suitability or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes and all users thereof should be guided accordingly.
We are neither your attorneys nor your accountants and no portion of this material should be interpreted by you as legal, accounting or tax advice. We recommend that you seek the advice of a qualified attorney and accountant.
For additional information about Centura, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). Please read the disclosure statement carefully before you engage our firm for advisory services.
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Given an ever-shifting market, it’s important to stay abreast of asset class expectations and how changes in market levels over time can help drive asset allocation decisions in an investment portfolio. In our first blog series on capital markets, we presented our forward-looking risk and return estimates. In this blog we will check current markets relative to our projections and illustrate how we use risk premiums to garner insights necessary for optimal portfolio recommendations. Keep reading to learn more about risk premiums, what they might mean for your portfolio and why now is a prudent time to take inventory of your asset allocation across your entire balance sheet.
Introduction
Both stock and bond markets are at or near all-time highs but historically these markets have not been correlated like they are today. In fact, the S&P 500 Beta for the Barclays US Aggregate Bond Index is -0.03 which indicates virtually no relationship between the change in price between stocks and bonds and suggests that price correlations will likely diverge at some point in the future. Thus, the question is not whether stocks or bonds will go up or down but whether stocks are cheap relative to bonds; and other assets like real estate. In order to solve this riddle, we can utilize risk premiums in different markets to evaluate which may be over/under valued. This blog post will examine current risk premiums in the stock and bond market(s) to assess relative valuations between the two and garner investment insights.
Risk Premiums – What are they?
Risk premiums represent the price of risk in different markets and investors can use them as a gauge of relative risk. They also reflect fundamental judgement about how much risk we see in an economy/market and what price we attach to that risk. The price of risk influences our asset allocation decisions as well as security selection within each asset class. The following are some (not all) factors that influence risk premiums:
Risk Aversion
Consumption Preferences
Economic Risk
Information
Liquidity and Fund Flows
Catastrophic Risk
Government Policy
Monetary Policy
Behavior
As seen in the list above, risk premiums are complex, and embedded in them is a significant amount of information. Fortunately, risk premiums can be extracted from market data which infers that the considerations above are baked in to prices. Utilizing market data allows investor’s to assess risk premiums relative to their own forward looking views and relative to other markets.
Investment implications
Before diving into the different risk premiums, it is important to lay the foundation for why looking at risk premiums matters. By comparing risk premiums, investors and practitioners can evaluate risk and returns on a relative basis and make investment decisions accordingly. The table below provides an overview of the relationship between different assessments of risk and the related market interpretation and investment action.
Table 1 – Risk Premium Assessments
Too High
Accurate
Too Low
Market Interpretation
Under Valued
Fairly Valued
Over Valued
Investment Action
Buy
Hold
Sell
Equity Risk Premium
The equity risk premium (ERP) represents the price of risk in equity markets and can be inferred as the expected excess return over the risk-free rate. For example, if the risk-free rate is 2% and equity markets are expected to earn 7% then the ERP is 5%. This risk premium is interpreted as the opportunity cost for investing in a market as well as the expectation of what that market will return, on average. Both considerations can be adjusted by volatility (standard deviation) to provide a risk adjusted comparison as well.
In our blog series on capital market projections, we forecasted US Large Cap Equity market returns of 6.33% over 10 years with volatility of 15.58%. If we utilize our current 10-year treasury yield of 1.64% we would derive an estimated ERP of 4.69%. However, in practice there are a variety of methods for utilizing market prices and other data to model and estimate the ERP. At Centura, we calculate the current ERP to be 5.65% which would imply that relative to our 10-year outlook, stocks are currently undervalued at today’s low interest rates and may represent an attractive long-term investment. With the ERP explained, we turn to the RP of debt (bond) markets, also known as Credit Risk Premium.
Credit Risk Premium
When it comes to evaluating the bond market, we typically look to the default spread between a bond and the risk-free alternative (e.g., Corporate bonds vs US treasuries) to estimate the credit risk premium (CRP). Default spreads are the market’s interpretation of credit risk premiums at different maturities, and the tighter spreads get the more overvalued the market becomes (see Table 1). Fortunately, the US Federal Reserve provides default spreads, and for Aaa and Baa corporate bonds relative to 10-year constant maturity treasuries (i.e., risk free rate) the current (as of September 2019) spreads are:
Aaa Corporate Bond Yield vs 10 yr treasury (constant maturity): 1.30%
Baa Corporate Bond Yield vs 10 yr treasury (constant maturity): 2.20%
At Centura, our capital markets projection for US Fixed Income is 3.49%, which versus the current 10-yr treasury yield of 1.64% represents a 10-year projected CRP of 1.85%. This implies that fixed income is priced efficiently with our long-term credit market forecasts.
Stocks vs Bonds
On a relative basis, at a blended CRP of 1.85% vs an ERP of 5.65%, bonds look expensive versus stocks. That said, at Centura we prefer to look at risk adjusted returns when comparing what it takes to earn that extra risk premium. For example, fixed income standard deviation is estimated to be 3.45% which when paired with a blended CRP of 1.85% begets a Sharpe Ratio of 0.54. Equity Market standard deviation is estimated to be 15.58% which when paired with an ERP of 5.65% equals a Sharpe Ratio of 0.36. Thus, on a risk adjusted basis bonds are more attractive than equities. So, what does all this mean?
Conclusion
In summary, at current market levels the equity risk premium (ERP) implies that equities are cheap relative to bonds. The ERP also implies that equities are cheap relative to our forward-looking capital market projections; whereas bonds look more efficiently priced based on our forward estimates. Thus, we are bullish on equities for the long term (i.e., 10+ years). While we are neutral on bonds, we recognize that they provide enhanced risk adjusted returns and can serve a vital role in portfolio management as they help steady returns. Additionally, they allow us to target specific risk/reward mandates.
At Centura, we construct portfolios of stocks, bonds and other alternative assets utilizing risk premiums to assess relative value between asset classes and intra asset class as well. Given the long bull run in risk assets over the past 10+ years, we at Centura feel that this is a prudent time to take inventory of holdings across your entire balance sheet to ensure your asset allocation is in line with your risk tolerance and portfolio objectives. If you self-direct your own portfolio, or are interested in a second opinion on your managed portfolio, contact Centura Wealth Advisory for a complimentary portfolio review.
Disclosures
Centura Wealth Advisory (“Centura”) is an SEC registered investment adviser located in San Diego, California. This brochure is limited to the dissemination of general information pertaining to Centura’s investment advisory services. Investing involves risk, including risk of loss.
Centura Wealth does not make any representations as to the accuracy, timeliness, suitability or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes and all users thereof should be guided accordingly.
We are neither your attorneys nor your accountants and no portion of this material should be interpreted by you as legal, accounting or tax advice. We recommend that you seek the advice of a qualified attorney and accountant.
For additional information about Centura, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). Please read the disclosure statement carefully before you engage our firm for advisory services.
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Two retirement reform bills (the SECURE Act and RESA) have been circling around Washington, and if passed, may make significant changes to many retirement and estate plans. Notably, the proposed changes outlined in the bill(s) have meaningful implications as the rules on inherited IRA’s are up for debate. Both the House and Senate have different views on the technical aspects of how tax shelters for inherited wealth could be reduced. Read our blog to learn about the differences in proposed changes for “Stretch IRA’s” and what they could mean for tax planning, wealth accumulation and wealth transfer.
Introduction
Retirement savings and tax laws are inextricably linked. For example, IRA’s, 401(k)’s and other tax deferred retirement vehicles have been designed to assist savers in meeting their future income needs so that Social Security is not the sole source of retirement income. While lawmakers have created different ways to save (e.g., traditional IRA vs Roth IRA), the RMD (required minimum distribution) types of accounts that have currently garnered attention from lawmakers are “stretch” IRA’s. This post will examine new bill(s) from both the US House of Representatives and US Senate, as they pertain to stretch IRA’s, evaluating the potential implications from a financial planning perspective (especially taxes).
What is a Stretch IRA?
A stretch IRA is an estate planning strategy that extends the tax-deferred status of an inherited IRA when it is passed to a non-spouse beneficiary. This approach allows for continued tax-deferred growth of an individual retirement account (IRA) and sets limits to the amount that must be withdrawn each year. The goal of this type of strategy is to limit the required distributions on an inherited IRA, stretching them over time, in order to avoid a large tax bill.
The IRS blesses this approach through Required Minimum Distribution (RMD) factors (based on age), which guide how much of an IRA must be withdrawn each year (at a minimum). The RMD amount withdrawn is taxable and therefore represents revenue to the United States government. Thus, while investors seek to extend the period of withdrawal to be as long as possible, lawmakers looking to accelerate tax revenues have honed in on stretch IRA’s.
Proposed Legislation
On March 29, 2019 the House Ways and Means Committee presented HR 1994, also known as the SECURE Act, which eventually passed on May 23, 2019 and is currently awaiting senate approval. SECURE is an acronym for Setting Every Community Up for Retirement Enhancement and represents a bipartisan bill. In the House bill, inherited IRA’s would need to be withdrawn within a 10-year period. Depending upon taxpayer preference, this could be periodically, at regular intervals, or even ballooned on the back end. Taxes will be paid on the distribution(s) when taken and after 10 years the entire IRA balance must be depleted.
Following suit, on April 1, 2019 the Senate introduced a bipartisan bill known as RESA; Retirement Enhancement and Savings Act. The Senate version allows a “stretch” on the first $400,000 of aggregated IRA’s and the exceeding balance must be distributed within 5 years. Taxes would be paid on the distribution(s) when taken.
Both proposed bills cover a wide range of retirement issues, and allow exceptions for distributions to minor children, disabled or chronically ill beneficiaries, or beneficiaries who are not more than 10 years younger than the deceased IRA owner. Both versions would apply to inherited IRA’s for deaths occurring after December 31, 2019 and are applicable to Roth IRA’s as well as traditional IRA’s and Qualified Plans.
Potential Impact
To illustrate the potential impact of this legislation, we will model three scenarios to garner insight into how they compare and what they might mean for a beneficiary. The three scenarios we will model include:
Current Law for stretch-IRA’s
House Bill HR 1994 for stretch-IRA’s
Senate Bill RESA for stretch-IRA’s
The assumptions we use for all three scenarios include a 50-year-old beneficiary with a 30% effective tax rate (federal & state), inheriting a $1,000,000 traditional IRA. For simplicity, we use a flat effective tax rate of 30% to illustrate the effects of legislation on taxation and assume a linear withdrawal rate on non-stretch assets; however, we note that in reality “bracket creep” is likely to occur, absent tax planning.
Bracket creep means that incremental income (e.g., RMD’s) moves you into higher tax brackets and increases the overall taxes that you pay. This would mean that effective tax rates are likely to be higher than 30% when RMD’s are accelerated (ceteris paribus), exacerbating the punitive effect of taxes and increasing the value of tax planning.
Thus, for individuals at or near retirement (and/or in high tax brackets) accelerated RMD’s as proposed by the House and Senate could have detrimental effects on wealth retention, and tax planning strategies should be considered.
Ignoring the supplemental effects of “bracket creep,” we find that a $1,000,000 portfolio that earns an annualized 8% pays the following taxes over 10 years:
Chart 1 – Estimated Total Tax Paid: Hypothetical Example
Evaluating the results shown above, we find that under the current law a 50-year-old, at a 30% effective tax rate, would pay $135,131 in total taxes over a 10-year period. This compares to $447,088 in total taxes paid over 10 years under the House Bill (HR 1994) and $279,463 under the Senate Bill (RESA). Intuitively these results make sense as the House Bill is asking beneficiaries to deplete entire account balances over 10 years, whereas the Senate Bill only asks that a portion (in this example 60%) is accelerated over 5 years. See summary results in Table 1.
These proposed legislative changes have huge financial planning implications as increased tax burdens are never welcome. At Centura, we specialize in tax and estate planning, designing plans for 10, 20, 30+ year periods so these changes create new opportunities and strategies for us to discuss (and potentially use) with clients.
For example, under these proposals Roth conversions become increasingly valuable as does charitable giving; pairing the two together in the right way can liberate wealth transfer, decrease taxes and fulfill philanthropic goals for your estate. Additionally, permanent life insurance will be more valuable as it can be used to pass death benefits tax free to heirs, mitigating the negative impact of taxation on their inherited assets.
Challenges beget opportunities and we believe this legislation has the potential to make sweeping changes to many estate plans. As such, we are closely following this legislation and diligently working to be ahead of the curve with strategies and solutions to deploy. We encourage clients (and advisors) to follow this proposed legislation, and if passed, contact us to discuss the ramifications and appropriate solutions.
Disclosures
Centura Wealth Advisory (“Centura”) is an SEC registered investment adviser located in San Diego, California. This brochure is limited to the dissemination of general information pertaining to Centura’s investment advisory services. Investing involves risk, including risk of loss.
Centura Wealth does not make any representations as to the accuracy, timeliness, suitability or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes and all users thereof should be guided accordingly.
We are neither your attorneys nor your accountants and no portion of this material should be interpreted by you as legal, accounting or tax advice. We recommend that you seek the advice of a qualified attorney and accountant.
For additional information about Centura, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). Please read the disclosure statement carefully before you engage our firm for advisory services.
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The Baltic Dry Index (BDI) is a meaningful economic indicator that may return to its heyday as a predictor of future changes in market prices. At Centura, we believe the BDI is a great barometer for global economic health and is likely to be a useful data point as trade wars continue to escalate. Understanding how changes in global trade and key macro-economic factors may impact your portfolio is a key consideration related to portfolio planning and investment strategy.
For example, what does a trade war mean for your portfolio?
Our models show that a repeat of 1930’s mistakes between the US and China could result in:
US markets under-performing global markets
Gold becoming an outperforming asset class
BDI could be down 30%
Alternately, successful resolution of the trade conflict with China could result in:
US markets outperforming their global counterparts
Gold becoming an underperforming asset class
BDI could be up 5% or more
At Centura Wealth Advisory we specialize in constructing globally diverse portfolios and the Baltic Dry Index (BDI) is one tool we use to measure the current health of the global economy. We model the BDI in combination with other factors to learn how changes may impact markets & portfolios. When designing and managing our clients’ portfolios, we are careful to evaluate emerging trends (e.g., recent changes in BDI rates) to assess where there may or may not be opportunity and/or risk. Read our blog post on Trade Wars and the Baltic Dry Index to understand why we like this indicator and how it may be used by investors and advisors alike.
Introduction
In looking back on historical markets, one might find reference to an oft used leading economic indicator known as the Baltic Dry Index (BDI). For a long period of time prior to the Great Recession, BDI rates correlated with market moves and changes in the BDI rates came before moves in market prices. This made the BDI a valuable leading economic indicator. However, in 2009 structural shifts entered the shipping industry and a key global economy (China) softened demand. This combination of changes in both supply and demand caused changes in BDI rates to diverge with changes in the prices of other key global markets that were expanding (e.g., the US Equity Market). Since 2009, BDI shipping rates have been less useful for predicting price changes in most major markets although we believe they could become more meaningful again. This post will discuss why.
The Baltic Dry Index1
The Baltic Dry Index is reported daily by the Baltic Exchange in London. The index provides a benchmark for the price of moving the major raw materials by sea. The Baltic Dry Index is not restricted to Baltic Sea countries or to a few commodities like crude oil. Instead, the Baltic Dry Index accounts for 23 different shipping routes carrying coal, iron ore, grains and many other commodities.
The Baltic Dry Index measures charter rates for dry bulk ships, which haul raw goods like iron ore, coal, and grains. Typically developed (and/or growing) nations provide healthy demand for raw goods when economic conditions are steady and/or improving. Additionally, the cost to fill a dry bulk carrier with raw goods is significant and nations typically do not order goods they do not expect to consume/refine. Chart 1 shows how the BDI has changed over time.
Chart 1 – Baltic Dry Index Shipping Rates2
What does BDI measure?
BDI rates measure the interplay between two unique aspects of the shipping market:
Global demand for raw goods
Size of the shipping fleet (supply)
These two dynamics interact to determine BDI rates on raw goods. For example, rising demand on a fixed supply of ships (ceteris paribus) means that BDI rates go higher; and vice versa. However, when shipping supply is no longer fixed (ceteris paribus) prices are subject to 2 changing factors and the rates themselves no longer reflect changes in demand alone. In our opinion, this is a key reason why BDI rates have diverged from market prices since 2009 and why some practitioners no longer use this tool.
Chart 2 – Baltic Dry Index Correlations to other asset classes since December 2008
Our quantitative findings indicating low to no correlation amongst the BDI and various indices since 2009, are presented in Chart 2. These figures are in strong contrast to the higher correlations seen in prior periods, for example 2006 – 2009; see below.
Chart 3 – Baltic Dry Index Correlations to other asset classes 2006 to December 2008
It is clear from these numbers that something is markedly different between these 2 periods of time in these markets. To support our quantitative findings, we will decompose both demand and supply as they relate to the Baltic dry index and evaluate what market conditions look like on a go forward basis.
BDI Market Decomposition: Demand
Dry bulk commodities are raw materials that are to be utilized in the global manufacturing and production process. When countries are building, growing and expanding they tend to provide strong demand for bulk dry goods. Demand for raw goods comes from growing countries and regions which are depicted in the chart below using average GDP per capita as a measure of economic prosperity over time.
Chart 4 – Average GDP per Capita3
BDI Market Decomposition: Supply
In turning to supply, we find that countries all over the world are engaged in cargo shipping with certain regions being more engaged than others; including many emerging markets (Chart 4). These countries/regions are typically commodity rich and benefit when exporting their primary good(s). However, they can also be economically volatile as their health is reliant upon that of developed nations and the global economy.
Chart 5 – Cargo Shipping by Country4
Another consideration as related to supply is not just the countries which supply raw goods, but also the vessels used to carry them. The sophistication, length of time and construction costs for bringing new dry bulk carrier ships to market provides high barriers to entry and tend to make vessel supply numbers easy to estimate. This means that during times of stable vessel supply, changes in historical BDI rates are more reflective of changes in demand as compared to changes in supply.
This was largely the case prior to 2002. However, beginning in 2003 and accelerating dramatically from 2007 to 2009 that changed, and a large new supply of dry bulk carrier ships began coming online, increasing competition and decreasing rates.
Chart 6 – World Tonnage on Order, 2000-2018 (thousands of dead-weight tons)5
This dramatic threefold increase in the supply of dry bulk carrier ships meant that BDI rates were no longer reflective of demand alone, and when contextualized against historical rates, became meaningless. That said, orders for new ships has come down dramatically since peaking in 2009 and that has led to more stable vessel supply. Stable supply should return market dynamics to how they were prior to the 2007-2009 period and that means that on a go forward basis the BDI may be a more useful indicator for measuring changes in global demand for raw goods. If so, this will be helpful in many ways.
Relationships to Markets and Why It Matters Going Forward
Global markets are currently very tense, asset prices are at all-time highs and every headline has the potential to rattle markets. At Centura, we recommend keeping an eye on the Baltic Dry Index as a measure of global economic health. A healthy global economy is likely a boon for many markets around the world and any weakness may be forecasted in this leading economic indicator. We design portfolios to strategically take advantage of emerging themes like this one and use sophisticated technology to model and stress test potential changes in factors such as the BDI.
For investors who are uncertain how their portfolio will handle global market shifts, and to understand how changes in the BDI may impact your portfolio, contact Centura for a complimentary portfolio review and related stress test. We will help you evaluate your country/regional exposure as well as measure your portfolios sensitivity to changes in key variables across a wide variety of scenarios.
You will learn how your portfolio behaves and what it responds to; both positively and negatively. Many of our clients benefit from this type of information as it provides clarity, understanding and the framework to make sound investment decisions.
Centura Wealth Advisory (“Centura”) is an SEC registered investment adviser located in San Diego, California. This brochure is limited to the dissemination of general information pertaining to Centura’s investment advisory services. Investing involves risk, including risk of loss.
Centura Wealth does not make any representations as to the accuracy, timeliness, suitability or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes and all users thereof should be guided accordingly.
We are neither your attorneys nor your accountants and no portion of this material should be interpreted by you as legal, accounting or tax advice. We recommend that you seek the advice of a qualified attorney and accountant.
For additional information about Centura, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). Please read the disclosure statement carefully before you engage our firm for advisory services.
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Active versus passive management is a long-standing debate that tends to divide rooms of investment professionals. At Centura Wealth Advisory, we believe in both – but not universally.
We propose investors opt for a blended approach of active and passive management to benefit from the advantages of each. This strategy can deliver the best risk-adjusted after-tax returns.
Let’s review the advantages of a blended management approach, our philosophy, and the research that supports it.
What are the Advantages of a Blended Active and Passive Management Approach?
Active management offers the potential to outperform passive indexing but has become increasingly difficult to do on a consistent basis. Recent research has called into question the merits of active management, but not all markets (i.e., stocks, bonds) are created equal.
Let’s break down our philosophy at Centura.
Our Philosophy: Why a Blended Approach?
At Centura Wealth Advisory, we utilize a blend of both active and passive portfolio management. However, we believe it is the skill of knowing which tactic to employ on which asset classes that contributes to an improved risk-adjusted return.
For example: When constructing diversified portfolios, we usually take a passive approach to equities unless we are actively managing taxes via index replication and tax harvesting.
However, regarding fixed income, we typically utilize a diversified active and passive approach due to the favorable economic backdrop that fixed income markets provide as related to active management.
But, are these philosophies rooted in sound economics and, perhaps more importantly, does research support them?
Does Current Quantitative Research Support Our Thesis?
Fund Selection Criteria
We believe that actively managed funds (equity or fixed income) must meet the following mandate(s) in order to be selected over an index:
Funds held in a portfolio must add statistically significant alpha versus their respective index*
Funds held in a portfolio must be accretive to risk-adjusted returns (i.e., Sharpe Ratio)
*To determine whether funds outperform their respective index, net of fees, we employ Fama-French Regression Analysis using a variety of factor returns for both equity and fixed income markets.
Then, we analyze the portfolio of funds over varying periods of time. In these analyses, we assess their return/volatility profile as compared to the appropriate index (or blended index).
Economic Backdrop: Equities vs. Fixed Income
Equity and fixed income markets are very different in their structure, policies, and participants. Therefore, a complete understanding of the subtle nuances is paramount to understanding why the opportunity for outperformance may or may not exist.
Equity Markets
Equity markets are fiercely competitive and well-covered by highly skilled analysts, traders, and various media outlets. This level of competition and sophistication creates an environment that has democratized information, access to markets, and technology.
For these reasons, we believe actively managed equity funds underperform their respective indices on a risk-adjusted, net-of-fees basis most of the time.
Given our belief, we typically look to access market beta for equities as cheaply and efficiently as possible through the use of large, liquid, low-cost index ETFs. This passive, low-cost approach to indexing equities ensures that we will participate in market returns but reduces the risk of underperforming on a net basis due to fee drag.
Equities are not typically an area of the market where we look to source alpha; unless we do so through tax management.
Fixed Income Markets
We believe actively managed fixed-income funds offer more opportunities to outperform based on the following considerations (including, but not limited to):
Fixed-income investors have different objectives and may have mandates and/or other incentives when making investment selections
The bond market(s) are dynamic in that thousands of issuers constantly issue new bonds, which provides ample supply of both primary and secondary issues of
Various yields and maturities
Bonds are generally held to maturity and therefore trade infrequently
Trading occurs via over-the-counter (OTC) transactions and not on exchanges
Infrequent, over-the-counter trading, across thousands of different issues can lead to mispriced assets, negotiated trade prices, and opportunities for outperformance (alpha)
Return profiles of individual bonds are far more skewed
For these reasons, we utilize actively managed fixed-income funds in our fixed-income portfolio whereas with equities we generally rely on passive strategies alone.
Additionally, we retain a portion of our fixed-income portfolio in the respective index as we recognize there are periods where indexing will still outperform. This allows us to create a blended portfolio.
Let’s Test It: Qualitative and Quantitative Testing
Now that we have outlined our general philosophy and economic rationale supporting it, we will test whether a sample fixed income portfolio that we utilize at Centura Wealth Advisory meets our specified mandate(s).
Test: Part 1 – SPIVA Results
We will use the 2018 year-end Risk-Adjusted SPIVA scorecard provided by S&P Dow Jones Indices to begin our test.
The Risk-Adjusted SPIVA Scorecard measures the performance of actively managed funds against their benchmarks on a risk-adjusted basis, using net-of-fees and gross-of-fees returns.
Risk-adjusted performance in SPIVA is measured by the Sharpe Ratio (i.e., higher = better) and evaluates results over three distinct time periods: five years, 10 years, and 15 years. For purposes of our study, we will utilize these SPIVA findings to evaluate our philosophy on active vs. passive fund selection.
For detailed results, please reference the SPIVA research report for year-end 2018. Key highlights relevant to our analysis include:
Benchmarks outperformed U.S. Equity Funds 81% to 95% of the time, depending on whether looking at five, ten, or 15-year periods
Unlike their equity counterparts, most fixed-income funds outperformed their respective benchmarks’ gross of fees
However, when using net of fees returns, most actively managed fixed-income funds underperformed across all three investment horizons on a risk-adjusted basis
This gross vs. net performance divergence highlights how the role of fees in fixed income fund performance was especially critical
Do the Results Support our Thesis?
These findings confirm our thesis. This research supports our rationale for taking a passive approach to equities and a diversified active/passive approach to fixed income.
Test: Part 2 – Quantitative Analysis
Next, we will evaluate the actively managed funds (held in the portfolio) that we utilize in our fixed income model(s) at Centura. Our goal is to determine:
If our fixed income portfolio adds statistically significant alpha
To see if our fixed income portfolio has outperformed the bond index on a risk-adjusted, net of fees basis over the recent one, three, and five-year periods
To assess whether our fixed income portfolio produces statistically significant alpha, we run a Fama-French multi-factor regression which includes term and credit.
We run this regression over the longest common period – four years. The result is a statistically significant (p-value = 0.000) model with an adjusted R2 of 73.2% and annualized alpha of 1.22%.
Do the Results Support our Thesis?
These results confirm our first mandate that our fixed income portfolio must add statistically significant alpha.
Table 1 – Regression Results
Turning to risk-adjusted returns in a portfolio backtest, we find diverging results between the actively managed funds we have selected and the index itself.
For example, in the tables below we see that the index has outperformed on a risk-adjusted, net of fees, basis over the one-year period. However, over the three and five-year periods, the actively managed funds are preferred.
These outcomes help support the notion of holding both active and passive funds together in a portfolio.
Table 2 – Risk-Adjusted Returns
Note: Returns are net of expense ratios. However, AUM fees are not included.
Test: Part 3 – Stress Testing
Lastly, we will evaluate our portfolio (versus the index) under simulated stress test scenarios including rising interest rates and inflation; risks paramount to fixed income markets.
We seek to understand how different types of portfolios behave under different types of “stress” conditions. The stress tests conducted include:
Rising Interest Rates
Inflation
Table 3 – Stress Test Results: Potential Downside
The table above displays a marked difference between the potential downside risk of unconstrained actively managed bond funds versus the index alone. Thus, we believe active management decreases portfolio risk in ways that may not be captured through returns and volatility data alone.
Consider Centura
At Centura Wealth Advisory, we believe in active fund management for specific markets at specific periods of time. We acknowledge that there are periods of relative outperformance between one strategy and the other—and we caution readers not to try and time these swings.
Rather, skillful portfolio construction and prudent risk modeling can help build a diversified, actively managed fixed-income portfolio that leverages a strong economic backdrop that favors such an approach.
Our team specializes in portfolio risk management; designing our fixed income portfolios to optimize risk-adjusted returns against the index and to mitigate key fixed income risks over time (e.g., rising interest rates and inflation). We leverage industry and academic research paired with rigorous quantitative analysis to do so.
If you have been indexing your fixed-income investments, chances are you can do better. Contact us for a portfolio evaluation and stress test to see if our fixed income solutions could improve your portfolio’s risk-adjusted returns.
Capital Market projections (mean & variance) serve as parameters for Monte Carlo simulation
The Monte Carlo Method is used by Centura for Liberated Wealth planning in order to solve complex problems when other methods fail
Relying on historical data for Monte Carlo simulation may produce misleading results with potentially harmful ramifications (e.g., spending too much, retiring too soon, etc.)
Forward looking capital market projections incorporate structural market changes that are present today and/or are expected to continue in the future
Careful consideration of inputs and related assumptions is paramount when crafting long term financial plans and forecasting portfolio returns & risk; garbage in, garbage out
Introduction
Sophisticated projections are critical to crafting a well-designed financial plan and capital market projections are one of many key inputs that play a vital role in doing that. At Centura Wealth Advisory, we pair forward looking capital market projections with the Monte Carlo Method to estimate:
Probability of a client running out of money before their “end of plan” (i.e., death)
Most likely “end of plan” value (e.g., wealth transfer, charitable giving purposes)
Optimal asset allocation strategy for a given plan
Part 1 of this series introduced capital markets, historical returns and forward-looking return/risk projections. In Part 2, we explore the Monte Carlo Method and evaluate the potential pitfalls of using historical results vs. forward looking projections when conducting experiments/simulations. Part 3 of the series will focus on portfolio construction and strategic asset allocation using mean variance analysis. Readers can take our quick assessment survey provided at the end of this blog or found here.
Monte Carlo Method
The Monte Carlo Method is a risk management tool that allows financial professionals to model and predict the future with varying levels of confidence. This tool is particularly valuable when it comes to retirement planning, which tasks advisors with forecasting a wide range of variables including, but not limited to:
Asset returns
Future income from all sources
Asset distributions (withdrawal rate) to support future income shortfalls
Taxes (based on current law and potential for sunset provision)
Varying inflation rates for different types of expenses (e.g., general vs healthcare)
Other volatile, subjective and potentially unknown factors as well
Problems of this nature are too complicated to solve with one formula, so we must employ an alternate approach.
Enter, the Monte Carlo Method. This method uses scenario modeling to predict a range of future possibilities, all with varying levels of probability (or likeliness to occur). At the upper end of the range are the very best scenarios (90th percentile), and at the lower end of the range lie the worst (10th percentile). At the midpoint of this range (50th percentile) lies the median which represents the most likely end of plan value (best estimate). If all scenarios end in assets at the end of plan above $1, the simulation is considered a success. If assets are exhausted prior to end of plan, it is a failure. The percentage of successful simulations represents the plan’s overall probability of success.
Monte Carlo Experiment: Hypothetical example
To illustrate how the Monte Carlo Method works, we will run a simple Monte Carlo simulation on a $1,000,000 portfolio invested as follows:
We will first conduct this simulation using historical returns & risk (Chart/Table 1) and then we will re-run the simulation using forward looking return & risk estimates (Chart/Table 2). Last, we will compare the results (Table 3) and highlight any key insights garnered.
Monte Carlo Experiment: Historical Returns
In Chart 1– Simulated Portfolio Using Historic Returns, we show a $1,000,000 portfolio simulation run 10,000 times based on historical asset class returns & risk. The different color lines indicate different percentiles of returns and summary statistics for each percentile can be found in Table 1.
In Chart 2– Simulated Returns Using Capital Markets Projections, we show a $1,000,000 portfolio simulation run 10,000 times based on forward looking asset class returns & risk. The different color lines indicate different percentiles of returns and summary statistics for each percentile can be found in Table 2.
Monte Carlo Experiment: Comparing Results
To analyze simulations using historical vs forward looking projections we will select the 10th percentile (worst) returns and 90th percentile (best) returns to compare the nominal and inflation adjusted ending portfolio values as well as maximum drawdown and the safe withdrawal rate; see Table 3 – Comparative Results of Simulated Historic versus Projected.
Comparing statistics in Table 3 reveals some key insights:
Using historical returns may significantly overstate future portfolio values
The portfolio’s safe withdrawal rate(s) may be overstated when using historical #’s
Tail risk (max drawdown) is approximately equal, confirming that forward looking risk is commensurate with historical levels if not slightly higher (i.e., lower expected risk adjusted returns; see Part 1 of Capital Markets Blog)
These insights highlight some of the primary reasons why forward-looking capital market projections are preferred to historical numbers when modeling the risk that someone may run out of money before their “end of plan” (i.e., death). But why do they diverge? One of the primary reasons forward looking estimates diverge from historical results are due to what are known as “structural changes” or shifts.
Structural shifts are changes in the overall landscape of a market/economy, and if not handled properly, skew data. For example, a future riddled with tariffs and global tension is much different than the coordinated global easing (QE) that took place in the wake of the Great Recession. Similarly, the high interest rate environment of the 1980’s is materially different than the low interest rate environment of today, and not accounting for such structural components can produce misleading results; as evidenced above. Thus, investors and advisors must be careful when crafting plans and modeling long term risk.
Conclusion
Monte Carlo simulation is a complex, but effective risk management tool used by Centura that pairs asset forecasting with cash-flow modeling, over a long period of time and allows investors to evaluate the impact of different decisions on their long-term financial wellness.
Monte Carlo simulation usefulness is predicated upon the accuracy of input data whereby capital market return and risk forecasts represent the input parameters. You can determine the status of your current Retirement Plan analysis by taking our quick survey here.
In Part 3 of this series, we explore how these same capital market projections are used to construct portfolios and form strategic long-term asset allocation plans using mean variance analysis and optimization.
Disclosures
Centura Wealth Advisory (“Centura”) is an SEC registered investment adviser located in San Diego, California. This brochure is limited to the dissemination of general information pertaining to Centura’s investment advisory services. The statistical projections contained herein are provided only as an example to illustrate how the choice of methodology impacts those projections. Historical performance is no guarantee of future results and may have been impacted by market events and economic conditions that will not prevail in the future. Investing involves risk, including risk of loss.
Centura Wealth does not make any representations as to the accuracy, timeliness, suitability or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes and all users thereof should be guided accordingly.
For additional information about Centura, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). Please read the disclosure statement carefully before you engage our firm for advisory services.
https://centurawealth.com/wp-content/uploads/2024/08/simulation-small.png32364821Christian Duranhttps://centurawealth.com/wp-content/uploads/2024/07/Centura-Logo-Grey.pngChristian Duran2019-05-31 16:35:002024-08-20 16:45:11Capital Market Projections & Monte Carlo – Part 2 in series
Capital market projections (risk & return) allow Centura Wealth Advisory (CWA) to help clients with long-term strategic financial planning
Estimates are applicable to financial planning, portfolio construction and risk management
Represent the best thinking regarding forward looking markets and a longer-term outlook
Issued by many sources and different methodologies are employed
Financial planning risk models (e.g., Monte Carlo simulation) require such assumptions as inputs
Portfolio construction utilizes these projections to evaluate markets and make informed decisions around asset allocation and investments
Careful planning is recommended given current views on forward looking markets and the uncertainty represented therein
Introduction
Capital market return (and risk) projections are at the heart of wealth management. These projections are a critical input to financial planning and portfolio management applications where the opportunity cost of mis-estimation is material: project too high and one may get a false sense of security out of their retirement plan and/or portfolio estimates; project too low and one may not provide a realistic estimate of the future, thereby making naïve decisions with potentially harmful results (e.g., working too long, saving too much, taking too much portfolio risk, etc.).
In part 1 of a 3-part series, we discuss capital market projections, provide a framework for creating current estimates and compare those estimates to historical results. In parts 2 and 3 of this series, we discuss how capital market projections are used in financial planning and portfolio construction (i.e., Monte Carlo simulation and mean/variance optimization) applications.
Capital Markets
Capital markets are venues where buyers and sellers engage in trade of financial securities. Examples include stock and bond markets where savings and investments are exchanged between the suppliers of capital and those who demand it. Suppliers of capital include retail and institutional investors whereas those in need of capital are businesses, governments and people. 1,2,3
Capital markets consist of various types and sub-types. For example, stock markets can be broken down into large, mid and small company stocks as well as growth, value or blend.4 While there are many ways to slice and dice capital markets, below is a list of asset classes that are common among many of the providers and are also utilized in both financial planning and portfolio management applications at Centura:
Table 1 – Capital Market Asset Classes
Equities
Fixed Income
Alternatives
Large Cap Growth
Government
Real Estate
Large Cap Value
Municipal
Hedge Funds
Mid Cap
Corporate
Private Equity
Small Cap
High Yield
Commodities
International Equities
International
Emerging Markets
Cash
Each asset class has its own drivers of both risk and returns and must be evaluated differently when measuring and predicting both risk and returns. In addition, different firms and analysts within those firms may have different methods of evaluating each asset class and that means a wide variety of methodologies are employed.
To illustrate how firms may vary, here is an example of how Invesco estimates asset class returns which differs slightly from the approach used at the Callan Institute. We won’t dive into the specifics of different methods employed, but one should understand that differences exist between firms and careful consideration should be paid as to which estimates are utilized, when and why.
Capital Market Returns: Historical Results
Now that we understand different capital markets and their related asset classes, we can evaluate historical data to see how various asset classes have performed over time:
Table 2- Asset Class Historical Results
Asset Class
Index
Annualized* Return (10yr)
Annualized* Return (25yr)
Large Cap
S&P 500
13.12%
9.07%
Mid/Small Cap
Russell 2500
13.15%
9.62%
International Equities
MSCI World ex USA
6.24%
4.76%
Emerging Markets
MSCI Emerging Mkts
8.02%
7.9%1
US Fixed Income
Barclays Aggregate
3.48%
5.09%
Non-US Fixed Income
Barclays Global Agg ex-USA
1.73%
4.39%
Cash
90-day T-Bill
0.37%
2.55%
Hedge Funds
Callan Hedge FOF
5.26%
6.06%
Commodities
Bloomberg Commodity
-3.78%
2.03%
Private Equity
Cambridge PE
11.62%
15.46%
Real Estate
NFI-ODCE
6.01%
8.05%
Annualized returns for periods ended 12/31/2018. 1 Denotes 15 yr annualized return as 25 yr data is not availableSource: Callan Institute
Historical returns are the baseline for which forward looking projections can be evaluated against and contextualized upon. While historical returns are insightful and provide context for both planning and portfolio management applications, they may have little or nothing to do with what is expected to take place in the near, intermediate and/or long term. To highlight this point, we note the well-known industry disclaimer which states, “past performance is not indicative of future results”. So, to cover our bases and provide a more robust view, we will now look at forward looking return projections followed by a comparison between the past and present.
Capital Market Return & Risk: Forward looking projections
To predict the future, however futile that may be, many institutions provide capital market projections that provide practitioners (and interested readers) with their firms best thinking regarding forward looking markets and long-term outlooks. These estimates serve as inputs for a variety of applications including Monte Carlo simulation and portfolio construction using mean variance optimization, both of which are key considerations to a healthy and sustainable long-term financial plan.
A partial but influential list of firms that provide capital market forecasts include:
Callan Institute
JP Morgan
Blackrock
Bank of New York
MFS
RBC
PIMCO
Goldman Sachs
While any single provider can be utilized, each brings a different methodology to the table and an average of several providers can be a good way to obtain exposure to many firms’ best ideas and to reduce risk associated with any one firms’ method being off in any given year.
The Table 3 below shows different asset classes and the 10 year forward looking estimates, averaged amongst several providers included in the list above. Table 3 also shows the estimated Sharpe ratio (i.e., risk adjusted return) which allows for an apples-to-apples comparison of asset classes, controlling for risk. Furthermore, we also include the real return, which is gross return less inflation (estimated to be 2.14% over the same period). In Chart 1 we represent these same results visually.
What is notable about the returns in Table 3, is that while asset class trends may be the same (e.g., stocks > bonds > cash) domestic equity returns are significantly lower than the returns in Table 2 as are private equity and real estate (over both time periods). This means that firms expect future returns in these asset classes to be less than historical results, which is in line with the big picture takeaways garnered from analysis of the current Shiller P/E ratio (as well as the current Buffett Indicator), both of which seek to estimate forward returns by incorporating capital market and economic data such as stock prices, GDP and earnings cyclicality. However, volatility in these asset classes is expected to stay in line with historical levels (if not slightly higher) which implies that investors should expect lower returns for the same level of risk on a go forward basis.
These lower forward-looking return projections are due to the cyclical aspect of business, credit and the economy. In the United States, we are late in the economic expansion cycle(s) and most expect some negative years (i.e., economic slowdown) in the coming decade which would materially impact return figures as compared to a decade prior when economic expansion was predominate.
This does not necessarily mean doom and gloom ahead but does imply that caution should be heeded in terms of where risk assets are allocated. Perhaps a greater allocation to cash and other stable investments is warranted given the relatively low level of anticipated inflation. However, if real returns on cash go markedly below zero, investors will be incentivized to purchase risk assets (e.g., stocks & bonds) at even more elevated prices than today, meaning the opportunity cost of sitting in cash is high. With such a dichotomy, careful planning is certainly required.
Conclusion
Individuals looking to retire (i.e., access investment assets for income) in the next 15 years would be well served to review their investment allocations and future income/cash-flow plans in the wake of a decade worth of gains in most risk assets. For these investors, locking in gains and preserving capital is of paramount importance, but in markets such as these professional guidance will certainly help navigate choppy waters.
Additionally, for investors already in retirement drawing down investment assets, extreme caution must be paid to asset distribution plans and how those assets are invested. Sequence risk can exacerbate financial plan failures and in order to protect against running out of money in adverse scenarios, sophisticated planning software and risk models must be employed to develop a robust cash-flow and integrated portfolio plan that is well suited to defend wealth in any and all markets.
In part 2 of this 3-part series, we will explore risk modeling in financial planning (e.g., Monte Carlo simulation). Last, part 3 will explore how capital market projections are used to construct portfolios and develop strategic asset allocations.
About the Author
Sean Clark holds a Master of Science in Risk Management from New York University and a Bachelor of Arts in Economics from Clemson University. Areas of practice include financial planning and portfolio management, specializing in applied mathematics and risk.
Centura Wealth Advisory (“Centura”) is an SEC registered investment adviser located in San Diego, California. This brochure is limited to the dissemination of general information pertaining to Centura’s investment advisory services. Investing involves risk, including risk of loss.
Centura Wealth does not make any representations as to the accuracy, timeliness, suitability or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes and all users thereof should be guided accordingly.
Past performance is no guarantee of future results and may have been impacted by market events and economic conditions that will not prevail in the future. This newsletter contains certain forward‐looking statements (which may be signaled by words such as “believe,” “expect” or “anticipate”) which indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward‐looking statements. As such, there is no guarantee that the views and opinions expressed in this letter will come to pass.
Indices are unmanaged. Any reference to a market index is included for illustrative purposes only as it is not possible to directly invest in an index. The figures for each index reflect the reinvestment of dividends, as applicable, but do not reflect the deduction of any fees or expenses, or the deduction of an investment management fee, the incurrence of which would reduce returns. It should not be assumed that your account performance or the volatility of any securities held in your account will correspond directly to any comparative benchmark index. Bonds and fixed income investing involves interest rate risk. When interest rates rise, bond prices generally fall.
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