For the past decade, the Federal Reserve has maintained interest rates at unprecedented lows during the financial crisis, the Great Recession and the ongoing recovery. In recent years, nearly one-third of all government bonds worldwide have been posting negative yields.
This has radically changed the way that bonds will perform and the ways they should be used. Now that the Fed has signaled a slow return to more normal interest rates starting with a quarter percentage point increase in December 2016, we expect further complications for advisors and their clients in the foreseeable future.
Fixed income was once the fulcrum with which advisors helped many clients to manage risk as they transitioned from maximizing growth during the accumulation period to generating a stable income stream during retirement. But as my recent research demonstrates, fixed income’s potential for managing risk and mitigating losses during the accumulation stage has been severely diminished — and will continue to erode — while forcing clients to endure near-zero returns. This will be exacerbated as rates rise, as outlined here.
Accumulation Challenge for EHNW Clients
The challenge is extremely acute for clients who are in the accumulation stage of their financial life cycle, in particular those with emerging high net worth (EHNW). With investable assets between $500,000 and $1 million, these EHNW clients are often in their mid-40s to late 50s. They are at a pivotal point where they are trying to maximize their retirement assets while balancing several competing priorities.
» They are in their peak earning years and peak income tax bracket.
» They are actively building wealth and don’t currently need income.
» They must maximize returns but are working toward an unknown retirement target.
» They need more tax deferral. They can max out qualified plans and can easily give up liquidity.
» They must slowly dial back downside risk as they approach retirement, but 2 to 3 percent returns on bonds are not enough to reach their retirement goals.
Given the current challenges of using fixed income for those with emerging high net worth and other clients in the accumulation stage, liquid alternatives can provide a highly effective solution to manage risk with greater upside potential. In addition, using asset location to enhance the performance of liquid alternatives can help these clients maximize accumulation at the same time that it helps minimize year-end tax bills.
Choosing the Right Liquid Alternatives
Alternatives can provide a controlled range of exposure to the market in different scenarios. In addition, they can provide a unique source of returns and risk to your clients’ portfolios that can significantly enhance diversification. Historically, these types of alternatives strategies have been the exclusive domain of institutional investors and those with high net worth. But liquid alternatives, including ’40 act mutual funds, exchange traded funds (ETFs) and variable insurance trusts (VITs), offer many of the same characteristics of hedge funds. They use the same nontraditional investing strategies while also providing daily liquidity, lower fees and greater transparency.
Alternatives are not a magic asset class. But they can be very effective as a specific strategy to address a specific risk in the portfolio. Advisors should take a targeted approach to identify alternative strategies that will meet their clients’ specific needs. My recent research examines three types of alternative strategies that can serve clients’ need for risk protection while also meeting their need for higher returns. They are managed futures, hedged equity and merger arbitrage.
» Managed futures can help hedge equity tail risk by providing outsized return potential in periods of extreme equity market declines. Tail risk events are rare, but during times of crisis or financial market distress, the magnitude of losses suffered by all asset classes at the same time can decimate a portfolio. Managed futures have historically provided a powerful level of portfolio protection in “crisis” markets, without significant negative impact on returns in normal markets.
» Hedged equity can help reduce risk near retirement by providing a defined “floor” to limit downside risk from stocks. Most clients cannot endure the near-zero returns of fixed income. They need greater growth potential to meet their goals. A long-short equity strategy with a defined downside hedge in place, typically called a hedged equity strategy, can provide more dependable downside protection than bonds. This eliminates the risk of sharp losses from stocks while also capturing most upside in normal markets.
» Merger arbitrage can help manage interest rate risk. The worst-case scenario for fixed-income investors is that interest rates rise quickly. This may not be likely, but the worst case rarely is. It is common for advisors to add floating rate loans to traditional bond portfolios to ease this duration risk. While loans can limit interest rate sensitivity, they do not diversify the liquidity and credit risk common in most diversified bond portfolios. Merger arbitrage is an alternative strategy that can offer a return similar to loans, with much lower volatility and substantially lower drawdowns.
The Power of Asset Location
Many advisors do not adopt alternatives because of their high tax costs. Liquid alternatives tend to be highly tax-inefficient, but proper asset location with a tax-deferred vehicle can minimize the impact of taxes and potentially increase returns between 100 and 200 basis points per year, without increasing risk.
Asset location is the proven strategy of holistically evaluating a client’s holdings across all of their accounts and locating tax-inefficient assets in tax-deferred vehicles. By using asset location, advisors can expand the universe of potential investments and leverage more high-quality alternative strategies that may not have been considered due to their tax implications.
To maximize the benefits of asset location, begin with the optimal investment mix to meet a client’s objectives and risk profile. To size a client’s tax-deferred accounts to the optimal level, based on the tax efficiency of assets in their portfolio and their liquidity needs, first max out qualified plans, then use vehicles such as low-cost investment-only variable annuities (IOVAs). IOVAs are designed to maximize the power of tax deferral on advisor-managed portfolios. Several factors must be considered to fit the fee-based or fee-only model.
» Low fees and no commissions: Just as taxes erode performance, so do fees and commissions.
» No surrender charge: Flexibility is imperative. Back-end surrenders can lock up assets for extended periods.
» Broad set of underlying investment options and unlimited trading: Use these to execute the optimal investment strategies.
Add Value and Increase AUM
Fixed income has been an effective tool for advisors, allowing them to solve for both accumulation and income over a client’s life cycle. While bonds will remain a critical component for generating retirement income, the current low-rate/low-yield environment is forcing advisors and their clients to reconsider their use of fixed income during the accumulation stage.
Alternative strategies are effective substitutes during the accumulation period, to manage risk while generating greater returns. Today many liquid alternatives, such as ‘40 Act funds, are available to help mitigate specific risks while capturing more upside potential than fixed income can.
One of the biggest impediments to using liquid alternatives is their tax implications. Just as using liquid alternatives to replace fixed income can boost the performance of a client’s portfolio, using asset location can further enhance the performance of these liquid alternatives and is fundamental to maximizing returns.
This challenging environment of low rates and low yields is likely to produce investment outcomes not seen in the past 35 years. Both the greatest challenge and the greatest opportunity are in the accumulation stage. Liquid alternatives combined with asset location can help you add greater value for your clients and increase assets under management for your firm.
Thomas J. Quinn, CFA, is chief investment and research officer with Jefferson National. He may be contacted at email@example.com.