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Risk Premiums and What They Mean for Your Portfolio

Executive Summary

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 HighAccurateToo Low
Market InterpretationUnder ValuedFairly ValuedOver Valued
Investment ActionBuyHoldSell

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:

  1. Aaa Corporate Bond Yield vs 10 yr treasury (constant maturity): 1.30% 
  2. 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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Stretch IRA – What Proposed Legislation Could Do to Your Wealth Transfer Plans

Executive Summary

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:

  1. Current Law for stretch-IRA’s
  2. House Bill HR 1994 for stretch-IRA’s
  3. 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

Source:  Centura Wealth Advisory© 2019

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.

Table 1 – Summary Results: Hypothetical Example

Current LawHouse BillSenate Bill
Beginning IRA Balance1,000,0001,000,0001,000,000
Total Tax Paid (10 years cumulative)135,131447,088279,463
Total Distributions (10 years cumulative)2,207,4491,490,295931,544
Remaining IRA Balance (EOY Yr 10)1,535,956–614,382

Source:  Centura Wealth Advisory© 2019

Why It Matters?

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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Baltic Dry Index and Your Investment Outlook: Why You Should Care about the BDI

Executive Summary

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: 

  1. Global demand for raw goods
  2. 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.

References

1 Trading Economics – Baltic Dry Exchange Index: https://tradingeconomics.com/commodity/baltic

2 Centura Wealth Advisory

3 ChartsBin – Cargo Shipping by Country: https://chartsbin.com/view/42162

4 Our World in Data – Economic Growth: https://ourworldindata.org/economic-growth

5 UNCTAD – Review of Maritime Transport:  https://unctad.org/en/PublicationChapters/rmt2018ch2_en.pdf

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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Active Management and Risk Adjusted Returns

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:

  1. If our fixed income portfolio adds statistically significant alpha
  2. 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:

  1. Rising Interest Rates
  2. 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.

Interested in learning more? Read on to learn how Centura supports goals-based investing.

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Charitable Giving: Breaking Down the 60% Deduction

Executive Summary 

The current low interest rate environment affords savvy financial planners certain tax planning strategies that leverage charitable giving. These strategies utilize charitable contribution limits, as a percentage of Adjusted Gross Income (AGI), to plan for and mitigate taxes the current year and up to the next five following years. This article explores the new 60% deduction introduced by Tax Cuts and Job Act (TCJA)5 and highlights the following:

  • Charitable giving in the United States is alive and well
  • Tax Cuts and Jobs Act provides added incentive for taxpayers to give to charity: a 60% deduction
  • Type of gift and recipient organization determine the AGI deductibility percentage
  • Rules for determining deductibility are complex and change over time
  • Only cash gifts to public charities qualify for new 60% deduction
  • 50% limit will still apply on cash gifts to private foundations and gifts including non-cash items

Introduction

Charitable contributions allow taxpayers to deduct gifts of money or property made during the taxable year to nonprofit organizations1. It is generally accepted that these organizations improve society and are afforded the ability to avoid taxation as a result. This avoidance of taxation serves as an incentive mechanism to shift public good to the private sector by encouraging private giving and if done correctly, can help reduce the incentive for politicians to raise taxes in the name of public good.

As such, charitable giving is an integral part of tax and estate planning in the United States. Consider the following statistics from 20172:

  • Americans gave $410.02 billion in 2017 (5.2% increase from 2016)
  • 70% of total giving came from individuals, 16% from foundations, 9% bequests and 5% from corporations
  • Charitable giving accounted for 2.1% of gross domestic product in 2017
  • High net worth donors gave on average $29,269 to charity vs $2,514 for the general population

Based on these numbers, charitable giving is alive and well, with high net worth individuals leading the charge. However, many rules affecting tax incentives have changed with introduction of the TCJA including one notable change to charitable giving thresholds; a 60% AGI limitation.

Charitable Giving Thresholds: Spirit & Letter of the Law

Charitable contribution deductions are outlined under Section 170 of the Internal Revenue Code (IRC) and IRC Section 170 has been through countless changes since being enacted in 19173. The spirit of the law has been to allow “wealthy” taxpayers to receive a deduction for charitable giving, but the letter of the law has evolved into a complex set of rules. These rules are designed to maintain an equitable statutory scheme that encourages charitable giving but prevents tax abuse and are therefore purposefully complex3.

Charitable Giving Thresholds: Tax Cut & Jobs Act 2017

When taxpayers make charitable donations, they may utilize those donations as deductions against AGI, to reduce taxable income6.  The caveat being that the amount of charitable deduction which could be recognized in any one year was limited to a certain percentage of AGI (e.g., 20%, 30%, 50%) based on the type(s) of assets contributed and the type of organization receiving the benefit. The top AGI percentage limitation was 50% until in 2017, the TCJA introduced a new figure, 60%.  But what does it mean and when is it applicable?

Types of Gifts4

To understand when the 60% limit is applicable, it is necessary to understand how the IRC classifies gifts as not all gifts are created equal. Per section 170(b)(1) of the IRC, there are 5 distinct types:

  • Subparagraph G Gifts
  • Subparagraph A Gifts
  • Subparagraph B Gifts
  • Subparagraph C Gifts
  • Subparagraph D Gifts

Subparagraph G Gifts

This is where the calculation now begins, and this is the newest section added by the TCJA. Under a new temporary rule enacted under the TCJA, for tax years after 2018-2025, an individual donor may deduct up to 60% of the donor’s contribution base for gifts of cash (and only cash) to a public charity.  To qualify, these gifts must be “to” the public charity, not “for the use of”.

Subparagraph A Gifts

These include all gifts “to” (not “for the use of”) a public charity and taxpayers may deduct up to 50% of contribution base, reduced by amount of any subparagraph G deduction allowed, for subparagraph A gifts.

Subparagraph B Gifts

Gifts of cash or short-term capital gain property to a private foundation, and for gifts that are “for the use of” rather than “to” a public charity. Taxpayers may deduct up to the lesser of:

  1. 30% of contribution base  – or –
  2. Excess of 50% (not 60%) of the donor’s contribution base for the year reduced by the combined amount of subparagraph G gifts and subparagraph A gifts.

Subparagraph C Gifts

This subparagraph operates as a limitation on deductibility of subparagraph A gifts involving long-term capital gain property and sets forth that except for gifts of conservation easements, an individual may deduct up to 30% of contribution base for gifts of long-term capital gain property to a public charity.

Subparagraph D Gifts

Include gifts of long-term capital gain property to a private foundation of which taxpayers may deduct the lesser of:

  1. 20% of contribution base – and –
  2. Excess of 30% of contribution base for the year over the amount of subparagraph C gifts

For all types of gifts, excess contributions can be carried forward for up to 5 tax years but may only be used within the same category (i.e., AGI % limitation) in those future years.

Exhibit 1 shows the AGI limitations as percentages of contribution base for each category of gift.

Exhibit 1- AGI Limitations4

The primary takeaway is that the new 60% limitation is only applicable on cash contributions to public charities; period. This means that the 60% limit will be reduced to 50% on cash donations when the taxpayer also donates any non-cash property to any type of charity, whether public or private, or when the taxpayer donates cash to a private foundation.

Conclusion

A donor must rely solely on cash gifts to public charities in order to reach the higher 60% limitation afforded by subparagraph G.  While the new 60% limitation may grab headlines, it is limited in its applicability and caution must be paid for donors looking to utilize the 60% limitation in their planning. For example, charitable contribution deductions from prior years, as well as other forms of giving (e.g., household goods, clothing, stocks, bonds, etc.) could void qualification for the 60% limit on cash donations to public charities and reduce it to 50% instead. These rules and limitations are incredibly complex, and ever changing, which means that working with knowledgeable tax professionals is of paramount importance.

At Centura Wealth Advisory, we utilize charitable giving strategies in tax and estate planning, which requires us to be up to date on current tax law and on the cutting edge of tax planning innovation.  As a result, we work with select tax, legal and financial planning professionals who keep us armed with intricate knowledge of strategies, related sections of IRC code and applicable case law. In addition, these professionals allow us to seamlessly implement, manage, and if necessary, defend such strategies. We believe that this coordinated approach to advanced tax planning is what sets us apart.

Finally, today’s low interest rate environment affords many charitable planning opportunities that many advisors and donors have never even considered. If you are interested in utilizing charitable contributions to mitigate income taxes for you or your clients, contact us today for a tax planning evaluation.

References

  1. Internal Revenue Code 170(a)
  2. National Philanthropic Trust – Charitable Giving Statistics 
  3. Marquette University Law School – The Charitable Contribution Deduction: A Historical Review and a Look to the Future
  4. Bedingfield, Brad & Dempze, Nancy – The disappearing 60% deduction: new charitable giving limits are not as generous as they appear
  5. Congress.gov – Tax Cut & Jobs Act
  6. Section 7520 interest rate

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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Capital Market Projections for Asset Allocation and Portfolio Construction – Part 3 in series

Executive Summary

  • Under Modern Portfolio Theory, the goal of portfolio construction is to extract as much return as possible for a given level of risk.
  • Capital Market projections (the forecasting of expected rates of returns on assets, and the variance of those returns) are essential inputs to constructing efficient client portfolios.
  • In addition to expected returns, and variance of those returns, efficient portfolio construction relies on the co-variance or correlation of each asset’s return with that of the others.
  • The combination of a suite of portfolios optimized for efficiency and a sophisticated planning process that matches an individual’s cash flow needs with an optimal investment portfolio for their assets is at the core of true wealth management services.

Introduction

In this post, the third in a series of three on capital market projections, we will cover the importance of capital market projections in the process of asset allocation and portfolio construction.  When constructing a portfolio, a portfolio manager will typically start with a desired level of risk or a target rate of return.  From there the goal would be to maximize the portfolio’s expected return for the particular level of risk, or minimize the portfolio’s risk in pursuit of the targeted rate of return.  In order to do either, we need to use capital market assumptions in the calculations.   The greater the quality of the capital market forecasting, the greater probability that our targets will be met (i.e., efficient portfolios, successful financial plans, etc.)  

The Fundamentals 

Nobel Prize winning economist Harry Markowitz wrote the article “Portfolio Selection” in 1952 where he introduced the notion that combining uncorrelated assets reduced a portfolio’s risk, or variation of returns, to a greater extent than would be assumed by taking the average level of risk of each of the underlying holdings.  This is incredibly important given that volatility can erode returns over time, and more efficient portfolios are preferred. Consider this example: If you lose 20% on an investment ($10 to $8) you need a 25% return to get back to $10 ($2/$8 = 25%), but if you lose 50% on an investment ($10 to $5) you need a 100% return to get back to $10 ($5/$5 = 100%). Since markets tend to move downward quicker and more violently than they go up, this is of key importance when building wealth over time. Thus, limiting downside risk when constructing portfolios is of paramount importance.

Portfolio Standard Deviation

When calculating the expected rate of return of a portfolio, one merely takes the simple weighted average of the expected return for each asset.  But, when calculating the expected risk of a portfolio the calculation is lengthy and far more complex.  It uses the expected variance (standard deviation squared) of each asset’s return along with the correlation of each pair of assets in the portfolio to one another.   Let’s take a simple example to illustrate how this works in a portfolio of two assets that are perfectly uncorrelated (Correlation=0).

The return of the two-asset portfolio is the weighted average of the returns of the two assets.  The risk of the portfolio, as measured by standard deviation, is significantly lower than the weighted average of the risk levels of the two assets.  This is the math behind the benefits of diversification.  Let’s be even more clear.  In this example we will assume the two assets have the same risk and return expectations but are still perfectly uncorrelated.

By combining two uncorrelated assets, the same level of return with a much lower level of risk would be theoretically achievable.  This is referred to as having a better “risk adjusted” return, which is the ultimate goal of modern portfolio theory.  In building a portfolio to target either risk or return, the forecasting of both is critical to the task.  

Portfolio Construction

We can use the math from the previous examples to build a customized portfolio to suit a particular need.  The inputs needed could be found in Table 1 (forecasted returns and risk), and Table 2 (asset class correlation matrix), which shows how correlated each of these asset classes are to each other.

Sources: Callan Institute, JP Morgan, Blackrock, Bank of New York, MFS, RBC 

Source: Silicon Cloud Technologies, LLC 2019.

In practice, we use data like this to build a suite of portfolios.  Each portfolio in the suite is like a tool in the chest.  They can be used independently or in combination with one another to accomplish a variety of tasks across a portfolio/estate.  The array of potential solutions spans from low risk/low return portfolios to high risk/high return portfolios, with a variety of vehicles employed (e.g., stocks, bonds, ETF’s, mutual funds, SMA’s, LP’s, insurance, other).   Regardless of need, the goal is that each portfolio in the suite has the highest expected level of return for its specified level of risk.  

See a sample illustration of three different portfolios below in Exhibit 1, each representing a different risk tolerance (i.e, conservative, moderate, aggressive). By design, the expected returns increase as the risk increases and returns are maximized for each unit of risk taken.  

When done properly, a well-tailored financial plan includes custom portfolio solutions designed to meet specific client needs/goals. Portfolios like those shown in Exhibit 1 are crafted carefully and their constituents are not random. They are chosen based on investment ethos, capital market risk/return forecasts and the unique interplay between assets in the portfolio. At Centura, we believe that multi-asset portfolios are significantly more complex to model than most realize.

For example, illiquid alternatives do not behave the same way as exchange traded alternatives, and neither behaves the same way in all markets. Thus, sophisticated risk modeling must be employed to get a true understanding of how assets could behave in different scenarios. Ultimately assets selected for inclusion are accretive to risk adjusted returns at the portfolio level and can be combined with tactical shifts to over and under-weight different assets at different times to take advantage of opportunities.

Conclusion 

Realizing that capital market projections play a critical role in the Liberated Wealth® management process, we take great care to ensure that we use thoughtful, forward looking capital market projections and that they are updated on a regular basis.  These projections are used in our financial planning, asset allocation, and portfolio construction processes.  The quality of these inputs’ ties directly to the quality of our process outputs and in striving to drive positive outcomes for our clients we ensure no detail is overlooked; this includes the capital market projections that are used.

At Centura, we use forward looking capital market projections to design and construct bespoke portfolios which seek to maximize risk adjusted returns, take advantage of opportunities presented in the market(s) and integrate with Monte Carlo simulation to forecast cashflows and asset growth over time. We don’t just take generic data prepopulated by software vendors, rather we take great care to analyze available data to ensure the quality of the projections used. If you have not had your portfolio analyzed for risk/return optimization or stress tested proactively to understand exactly what risks you are taking, contact Centura Wealth Advisory to learn how we can help.

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.

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.

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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Capital Market Projections & Monte Carlo – Part 2 in series

Executive Summary

  • 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:

  1. Probability of a client running out of money before their “end of plan” (i.e., death)
  2. Most likely “end of plan” value (e.g., wealth transfer, charitable giving purposes)
  3. 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:

  1. Using historical returns may significantly overstate future portfolio values
  2. The portfolio’s safe withdrawal rate(s) may be overstated when using historical #’s
  3. 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.

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Capital Market Projections

Executive Summary

  • 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
EquitiesFixed IncomeAlternatives
Large Cap GrowthGovernmentReal Estate
Large Cap ValueMunicipalHedge Funds
Mid CapCorporatePrivate Equity
Small CapHigh YieldCommodities
International EquitiesInternational 
Emerging MarketsCash

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 ClassIndexAnnualized* Return (10yr)Annualized* Return (25yr)
Large CapS&P 50013.12%9.07%
Mid/Small CapRussell 250013.15%9.62%
International EquitiesMSCI World ex USA6.24%4.76%
Emerging MarketsMSCI Emerging Mkts8.02%7.9%1
US Fixed IncomeBarclays Aggregate3.48%5.09%
Non-US Fixed IncomeBarclays Global Agg ex-USA1.73%4.39%
Cash90-day T-Bill0.37%2.55%
Hedge FundsCallan Hedge FOF5.26%6.06%
CommoditiesBloomberg Commodity-3.78%2.03%
Private EquityCambridge PE11.62%15.46%
Real EstateNFI-ODCE6.01%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:

  1. Callan Institute
  2. JP Morgan
  3. Blackrock
  4. Bank of New York
  5. MFS
  6. RBC
  7. PIMCO
  8. 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.

Table 3 – Forward Looking Estimates
Asset ClassReturnRiskSharpe RatioReal Return
Cash Equivalents2.20% 0.48%0.000.06%
US Fixed              3.49%3.45%0.371.35%
Non-US Fixed1.95%6.57%-0.04-0.19%
Hedge Funds5.25% 6.91%0.443.11%
Emerging Market Debt 5.37% 9.08%0.353.23%
High Yield               5.47%9.35%0.353.33%
Real Estate5.52%11.34%0.293.38%
US Large Cap Equity6.33%15.58%0.274.19%
Commodities           3.04%16.40%0.050.90%
Dev International Equity    7.03%17.55%0.27 4.89%
US Mid/Small Cap Equity    7.03%19.31%0.254.89%
Private Equity    7.41%  21.45%0.24 5.28%
Emerging Market Equity    8.61% 22.75%0.286.47%
Note: inflation estimate is 2.14% annualized.  Sources:  Callan Institute, JP Morgan, Blackrock, Bank of New York, MFS, RBC 

Chart 1

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.

References

  1. https://www.investopedia.com/terms/c/capitalmarkets.asp
  2. https://www.investopedia.com/ask/answers/021615/whats-difference-between-capital-market-and-stock-market.asp
  3. https://economictimes.indiatimes.com/definition/capital-market
  4. Why does portfolio construction matter – PIMCO
  5. Callan Institute
  6. JP Morgan
  7. Blackrock
  8. Bank of New York
  9. MFS
  10. RBC 
  11. PIMCO
  12. GoldmanSachs
  13. RightCapital
  14. XY Planning Network
  15. Invesco
  16. Multipl
  17. Gurufocus
  18. Yale.edu
  19. The balance
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.
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.
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.
,

Your Teen is off to College!

20.4 million kids attended a college, university or trade school in 2017.  Using simple math, that means approximately 40.8 million parents sent their babies off to school last year.  There is so much to do and to remember!  Try googling “college student checklist” and you’ll find countless links to exhaustive lists of things to remember to buy and pack.  These lists include the obvious items like school supplies, but also list medicines, kitchen and bath necessities, cleaning supplies, computer/electronic needs, and items to decorate your room.  All the things needed to prepare your child for college, right?  It might seem so, but there is a glaring omission in this list.

When your child turns 18 years old, that “child” is considered an adult in the eyes of the law. This change comes with all the same rights and protections held by any other adult.  What does this mean for you as the parent?  As a parent, you no longer automatically have the right to speak freely with your child’s doctors and medical care providers.  You no longer have the right to make your child’s medical decisions.  You no longer have the right to manage your child’s finances, or to have access to your child’s financial records.  You do not even have the right to access your child’s grades, class schedule, attendance records, etc.  This is true even if you are paying for your child’s tuition, room and board, and even if your child is still on your medical insurance.  Your rights as a parent are severely diminished on the day your child reaches age 18.

Accidents are the leading cause of death in young adults.  Suicide by young adults is the second leading cause of death.  Beyond that, approximately 250,000 Americans between the ages of 18 and 25 are hospitalized each year.  

Consider what would happen if you were to receive a call that your child, who is attending college miles (maybe even states) away, has been in an accident.  Yet, you as a parent do not have the right to gain information regarding the child’s condition or medical treatment options.  This is a sad reality for many parents.  Without being named in certain legal documents, you may have to petition a court to be appointed legal guardian of your adult child.  This can be a lengthy and costly process.

Here are the critical documents for anyone age 18 and older:

  • Financial Durable Power of Attorney – With this document, your child can name Mom and Dad to have the ability to manage their financial affairs (pay bills, buy/sell assets, file tax returns, etc.).
  • Medical Power of Attorney (also known as a Health Care Surrogate) – This is the document in which your child can name Mom and Dad to have the ability to make medical decisions on his or her behalf (such as consenting to treatment or moving the child to a more specialized facility).  
  • Living Will Directive (also known as an Advance Directive) – This document controls end-of-life decisions with regard to the administration of or the removal of artificial nutrition, hydration and respiration (i.e., life support).
  • HIPAA Authorization – Being named in a HIPAA Authorization will give you the ability to speak freely with your child’s physicians and medical care providers.  This will also allow you the authority to have access to all of your child’s medical and psychiatric records.
  • Family Educational Rights and Privacy Act (“FERPA”) Consent – A FERPA Consent is required before Mom and Dad can have access to all of their child’s school records and information, including class schedules and attendance records.

Be sure to put an estate plan for your 18 year old at the top of your Labor Day break punch list!  Don’t wait until an emergency happens.  Plan for tomorrow today!

–  Written by Charlsey Baumeier, First Financial Resources

Sources:

1 National Center for Educational Statistics

2 National Center for Educational Statistics

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Financial and Estate Planning for Women

Ladies, in today’s world we are exposed to all kinds of sound bites, headlines and political propaganda….. “the war on women,” “wage inequality,” and other such catch phrases designed to incite feelings of helplessness, fear, betrayal and injustice.  

What can you, as an individual woman, do about it?  Instead of trying to figure out this Rubik’s Cube of global and national women’s issues, how about taking a look at your own personal situation first?  

How educated are you on finances and estate planning?  As women, we are most profoundly affected by financial and estate planning, or in most cases, the lack thereof.  This article will identify the leading causes for financial strain and lack of planning among women, and how you can take control of your financial and estate well-being.

Let’s begin by looking at the facts.

  • Women control 75% of the financial wealth in the United States.  
  • Only 35% of women who are offered retirement guidance through their employer take advantage of it.
  • 77% of women are comfortable discussing medical issues with a doctor, but only 47% of women are comfortable discussing money and investing with a financial professional.
  • 84% of custodial parents are women.
  • The average age of widowhood in the US is 55 years old.  
  • Women are three times as likely as men to be widowed.
  • 40% of surviving widows fall below the poverty line within a year of their husbands’ deaths.
  • Less than 1% of a widow’s income come from employment.

So those are the facts, but what do they mean?  Regardless of age, women need to play an active role in their own financial and estate planning, as well as that of their families.  

Understanding your assets, debts and expenditures is step one.  On average, women tend to live 5 to 7 years longer than men. Couple that with the fact that women tend to marry older men, and it’s no wonder that women are the ones left alone and in control of how the family’s assets will ultimately be distributed.  With this control comes great responsibility.  

It is important for women to assume an active role in managing their finances.  There is a common misconception that you must have a certain net-worth before you should start making plans.  This could not be further from the truth.  It’s difficult to implement a plan if you do not understand where you are starting and where you want to finish.  

  • Make a list of your assets (real estate, vehicles, bank accounts, investment accounts, life insurance, 401K accounts, retirement accounts, and any other valuable assets and/or collectibles).
  • Make a list of your debts (mortgages, car loans, student loans, credit card debt, personal loans, tax loans, etc.).
  • Make a list of where your money goes each month – be sure to include all expenditures, including going out to eat, movies, gas, Starbucks, etc.

Going through this exercise is an eye-opener for many people.  When you detail on paper how much money you are spending and where its being spent, it becomes much easier to identify areas in which you can cut spending and add to your overall savings and investible assets.  Finding these “pockets” of money is critical for women, as we tend to have fewer assets in general than men.  There are many reasons for this disparity between men and women, but typically it is due to the fact that women generally earn less money (per hour) than men, spend less time in the work-force (due to caring for children and/or ailing spouses and parents), and are generally more uncomfortable or uncertain about how money works and how to save and invest.

Make sure you understand how your assets are managed today so that you can plan for how they will be managed in the future for your own benefit and for the benefit of your loved ones.

Protecting your assets is step two.  It is vitally important for women to seek the advice of professionals when it comes financial and estate planning.  Learn to overcome your fear of speaking about personal matters with such professional advisors.  The sooner you plan, the better off you will be in your later years.

Make sure your plan includes adequate life insurance coverage for both you and your spouse, to help support your needs after the first death and to support your surviving beneficiaries at the second of your deaths.  Life insurance can be used to pay final debts and expenses, taxes (income taxes as well as estate and inheritance tax), as well as to continue the life styles of your surviving beneficiaries.

If you have recently married, divorced or have been widowed, have you updated your beneficiary designations on your life insurance and retirement accounts?  Remember that the current designations on those accounts control the distribution of those assets – even if you have updated your Will.

If you are a recent widow, have you met with an attorney to discuss electing portability of your deceased husband’s unused federal estate tax exemption?  Currently, (in 2018) every individual can exempt almost $11.2 million in assets from federal estate/gift taxes (during life or at death).  The unused exemption of a deceased spouse can be passed to a surviving spouse, but only by making an election and filing an estate tax return in a timely manner (within 9 months from date of death), regardless of whether any taxes are due.  

Finally, protecting your wealth and your health is step three.  Once you build the wealth, make sure you are taking steps to protect it!  

A Last Will and Testament is a document that directs the distribution of your financial and physical assets to whom you wish and in what manner.  Dying without a Will is known as dying “intestate”.  Without a Will, your assets will be distributed according to your state’s intestate succession laws. This is true even if you are married.  These laws vary from state to state, so be sure you understand the intestate laws of your state.  Another very important reason to have a Will is if you have young children.  Your Will is the document that is legally recognized by courts, in which you name guardianship for your minor children.  If you do not create a Will and name a guardian for your young children, a judge will name one for you.  This can lead to turmoil between families and can potentially land your child in foster care until guardianship can be worked out.

A Revocable Living Trust is a document that can be used to avoid probate upon your death.  This type of Trust is often designed to work with your Will, but unlike Wills, a Revocable Living Trust is a private document, not subject to probate and court jurisdiction.  The terms of the trust, the assets owned by the trust, and to whom and how those assets are distributed all remain private.  By having this Trust in place and retitling your assets into the name of the trust during your lifetime, your estate can avoid the probate process, thereby saving your surviving beneficiaries time and money.  Properly drafted Trusts are also a great way to protect your assets for future generations, keeping those assets in your bloodline to benefit your family.

Many individuals may believe they do not need a Will or a Trust.  Perhaps they are young and are just starting to accumulate assets, or maybe older with modest wealth.  If either is true, there are still reasons to plan today.  What are you doing to protect your rights with regard to controlling your healthcare?  What would happen if you were to have a health-related event that left you incapable of managing your finances or unable to make your own healthcare decisions?  Who would care for you and would that person truly know your wishes?  

A Financial Durable Power of Attorney gives you the ability to name someone as your “attorney-in-fact” or “agent.”  Your agent will have the ability to manage your finances, pay bills, buy and/or sell assets, vote stock, file your tax returns, pay your taxes, etc.  

A Medical Power of Attorney (also referred to as a Healthcare Surrogate Designation), is a document in which you name someone to make your medical decisions for you when you are unable to do so for yourself.  This document would be used in a situation when you cannot speak or otherwise communicate for yourself.  With this power, your agent can make decisions such as consenting to treatment or moving you to a different facility for more specialized care.

A Living Will Declaration (also referred to as an Advance Directive) is the document that controls end-of-life decisions, such as the administration of or the withdrawal of artificial nutrition, hydration and respiration.  In this document you declare your wishes regarding being allowed to die naturally without artificial intervention, or otherwise.

The HIPAA Authorization is the federal document in which you authorize individuals (including the agent under your Medical Power of Attorney) to have access to your private medical information.  Such information may include current and past medical and psychiatric conditions, treatment options, and empowers the individuals named the ability to speak freely with your physicians and medical care providers.

If you have a health event without these documents in place, someone will have to petition the court to be appointed as your legal guardian, giving them the power to handle your finances and healthcare.  I don’t know about you, but personally, I know who I would and who I would not want taking care of me.  Unfortunately, a judge does not know your wishes and it will be a judge that will appoint a guardian for you if you do not have these documents in place.  

Once you have completed your plan, you may want to consider sharing your wishes with your family and loved ones.  Its also a good idea to review your plan with your financial and legal professionals at least every couple of years.

As women, it’s critical that we take an active role in managing our finances, planning for our financial future, protecting our assets during our lifetimes, maintaining control of our healthcare decisions, and having a clear plan for the management and distribution of those assets in the future.  

Plan for tomorrow today!

Sources:

2015 Fidelity Investments Money FIT Women Study

US Census Bureau

https://medicine.jrank.org/pages/1843/Widowhood-Economic-Issues-Economic-effects-widowhood.html”>Widowhood: Economic Issues – Economic Effects Of Widowhood

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