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The struggle continues!
On July 1, 2007, the S&P 500 Index (1) opened at 1,525.40 (2). On June 30, 2010, the S&P 500 Index closed at 1,030.24 (3). That's a price decline of 33% over the past three years. The reasons for the decline are well documented so no need to repeat here. Over the three years, the Index slid to 666 on March 10, 2009 (4) and recovered to a peak over 1,200 (5) in April of this year, so it's been quite a ride for investors with equity exposure.
Late last year, we became concerned that equity markets were over-valued and likely to correct at some point during 2010. The run-up from the late March bottom had been substantial and earnings growth forecasts for 2010 were inconsistent with U.S. GDP growth forecasts for 2010. Either investment analysts were overly optimistic or economists were overly pessimistic heading into 2010 and it was clear that someone was right and someone was wrong. We sided with economists. As we were unsure of timing, we didn't want to eliminate equity exposure from client portfolios but we did believe we needed to provide some sort of mitigation of risk against a market correction. We allocated roughly 20% of client portfolios to strategies that hedged market exposure against potential declines. We used a combination of three strategies to provide the type of risk mitigation that I like to think of as a form of "insurance".
First, we used a fund that shorted stocks managers believed were likely to decline in price. This approach was long-biased but maintained consistent short exposure. That exposure provided some positive returns in declining markets. Second, we used a fund that employed an equity market neutral strategy. This approach invests the same dollar amount long (buys stocks) as short (sells stocks). It maintains very modest exposures to securities managers expect will either do well (long exposure) or do poorly (short exposure). The fund objective is to seek capital appreciation independent of stock market direction. (6) Finally, we used a strategy that employed two primary hedges. First, the manager uses cash as an asset rather than as a residual of his process. Thus, if he doesn't like market dynamics, he'll raise cash by selling equities. The objective of this reduction in equity exposure hedges against declines in equity markets. Second, he uses a "cashless" collar derivative strategy. This is best described by using an example. Bill owns IBM stock currently worth $50.00 per share. Bill doesn't expect the price to appreciate much and is worried about losing money. He sells calls with a strike price of $60.00. He takes the premium he received and buys puts with a strike price of $45.00. Bill hedges his downside as he can exercise the puts at $45 if the stock price declines below $45. He gives up some upside as he can be called out if the price exceeds $60 but he isn't worried about that now. Giving up some upside is like an "insurance premium" for protecting the downside.
These strategies were added to portfolios in November of 2009 when the S&P 500 Index was at roughly 1,100. Fast forward to mid April and the index was around 1,200 and these funds weren't looking so good! But, the second quarter was not kind to stocks and the S&P 500 ended up down over 11%. So, how did the hedge do? All three strategies were UP for the quarter and two of the three are UP year-to-date (the S&P is down 6.6%) (7). The average return for the three funds for the quarter was 2.96%(8). The result for BFP clients is that median returns of roughly 0.51% for June, (2.52%) for the quarter and 0.31% year-to-date. All portfolios out-performed the S&P 500 for the quarter and for the year-to-date and most out-performed a 60% equity/40% fixed income balanced benchmark.
We work hard to preserve and increase our clients wealth over time. This is the kind of economic and financial market that demands skepticism and a willingness to "give up" some upside performance in an effort to minimize downside risks. We were able to accomplish that objective this quarter. While we can't guarantee we'll be as successful in future quarters, we can guarantee we'll continue to focus on managing risk and striving for an absolute positive return over longer investment periods. As always, we will continue to work hard for our clients.
(1)To (5) Click on the following link - http://finance.yahoo.com/echarts?s=^GSPC+Interactive#symbol=^GSPC;range=1d - and change the date range to 7/1/2007 to 6/3/2010. The chart is interactive enabling the reader to scroll across the chart to see closing values.
(7) Morningstar Office
(8) Morningstar Office and BFP calculations.
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Estate Planning Opportunities in a Down Market
A down market can mean tough times, but it can also present unique opportunities to minimize property transfer (gift and estate) taxes. While owning assets that are losing value might seem like a bad thing, it may actually be a great time to reduce your taxable estate by giving those assets away. That's because current low asset values and interest rates enable you to make gifts at a lower gift tax cost. And, if and when the market rebounds, those assets will be growing in your child's (or other heir's) estate and not in yours. Here are a few gift-giving techniques that take advantage of today's depressing economic climate:
· Basic gifting: You can give away up to $13,000 to anyone you want, to as many people as you want, each year gift-tax free. This is know as the annual gift tax exclusion. You can give away twice that amount if both you and your spouse make the gifts together. And, you can give away even more if you pay tuition or medical bills on behalf of another person (you must make these payments directly to the school or health-care provider.)
· Family loans: You can lend money to your children at the current IRS minimum interest rate, and then forgive an amount equal to the gift tax exclusion each year (the gift tax exclusion amount is adjusted annually for inflation: $13,000 is the figure for 2009).
· Grantor retained annuity trust(GRAT): A GRAT is a trust into which you put assets that you expect will increase in value over time. The value of the gift is determined using the IRS's current interest rate. The trust must terminate at a specified time (e.g., 10 years). You receive annuity payments during the term of the trust, and at the end, your children receive the property. Hopefully, the assets will appreciate beyond the IRS's interest rate, allowing the excess to pass tax free. | |
Copyright 2006-2010 Forefield Inc. All rights reserved |
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As always, if there is anything we can do for you please feel free to contact us.
If you find the bulletin of value- please pass it on. We welcome all referrals!
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Have a safe and happy summer!
Sincerely,
John P. Middleton, CFA, CAIA
Brighton Financial Planning |
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 | | Portfolio Volatility
Figures that show an average return on an investment are only part of the story. They don't tell how that return was achieved. Is the investment a volatile one, with a lot of ups and downs in price or returns that varied dramatically? Or was its performance relatively steady, with prices and returns that were very similar month to month or year after year? Understanding volatility measures can help you evaluate whether a particular investment is suited to your own investing style. Volatility measurements can be used to evaluate the performance of mutual funds and investment portfolios as well as individual securities.
Standard Deviation measures how much an investment's return varies from its mean return. The higher an investment's standard deviation is, the more dramatic its ups and downs. For example, let's say two stocks each return an average of 6 percent a year. Superficially, they appear the same, but here's the return pattern for stock A - (-10%),8%, 20%,(-5%), 18% and here's the return pattern of stock B - 6%, 1%, 8%, 5%, 10%. Now, it becomes clear that Stock B is more attractive than Stock A!
Another way to evaluate an investment's volatility is to look at its beta, which compares an individual investment's volatility to that of the market. A stock or mutual fund with a beta of 1.0 would have exactly as much market risk as its benchmark--for example, the S&P 500 stock index. A stock or mutual fund with a beta of 1.5 would involve 50 percent more market risk than the benchmark; if the benchmark went up, the individual security would be expected to go 50 percent higher. If the benchmark's return dropped, the security's return should be 50 percent lower. Conversely, a stock or fund with a beta of less than 1.0 would involve less market-related volatility than the overall market. If the S&P rose by 50 percent, an investment with a beta of .5 should benefit by only 25 percent. If the benchmark fell by 50 percent, the individual security with a .5 beta should experience only a 25 percent drop.
We incorporate standard deviation and beta into our portfolio construction process by analyzing hypothetical performance of our portfolios relative to an appropriate benchmark for the asset allocation and relative to a pure equity benchmark (S&P 500). We want the long-term beta relative to the S&P 500 to be consistent with our intended equity exposure. For example, if we are constructing a portfolio with a 40% weight in equities, we want the beta to be approximately .4 over a 10 year period. The objective of this analysis is to ensure we're comfortable with our individual positions, when aggregated into a portfolio, and not adding unintended equity exposure. This is important to us because equities tend to be more volatile, as measured by standard deviation, than fixed income. This volatility can lead to better than expected performance, which is great, but it can also lead to worse than expected performance, which is decidedly not great!
Source: Forefield, Inc. |
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Disclosures
The views expressed herein represent the opinion(s) of Brighton Financial Professionals as of the date of this posting, and may change at any time without prior notification. |
The links to other websites provides a path to other entities' websites that are not affiliate with BFP. BFP is not responsible for the content or information practices by websites linked to Brighton. Often we provide links to other sites solely as pointers to information or topics that may be of interest to users of our website. Such links do not imply BFP's endorsement of any information or material on any other site and BFP disclaims all liability with regard to your access to and use of such linked websites.
Brighton Financial Planning utilizes information from third party sources. Brighton Financial Planning is not responsible for verifying the accuracy of any information sourced by such third-party information providers.
Any mention of products or securities does not constitute a recommendation, investment, legal or tax advice, as BFP is not holding itself out as providing such advice.
Any mention of securities does not represent an offer or a solicitation of an offer to buy or sell such securities, particularly in those jurisdictions where such solicitation or offer is prohibited by law.
As with all investments, there are inherent risks to investing that may not be able to be mitigate through responsible investing. You should consult with a qualified investment adviser prior to investing. |
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