Isn’t It Time to Make a Change?

Tom Brady Image

Imagine this: the year is 2041. Tom Brady has just won his 19th conference title. He is also the first player in Superbowl history to have a grandchild in the stands. Lululemon is the largest fashion retailer as the “athleisure” trend continues to dominate closet shelves everywhere. The next sequel in the Fast & Furious franchise (Not Quite as Fast, but Still Quite Furious) starring 73-year-old Vin Diesel has just been released. The Knicks, meanwhile, are still terrible.

Sound ridiculous (aside from the Knicks)? We’ve watched investors make money over the last 20 years applying old paradigms like the ‘60/40 portfolio,’ using ‘100 Minus Your Age’ to determine stock allocations, and the ‘4% withdrawal’ rule. But think about how much our world has changed just in the last eighteen months. As I write this, my six-year-old is sitting in the next room attending kindergarten class on Zoom, something unimaginable at the beginning of 2020.

And that got me thinking, has the investment industry, which has sometimes struggled with change, changed? And, perhaps more importantly, have investors changed with it?

The latter question is crucial, as applying old thinking to current markets can be dangerous. Take bonds, for example. Bonds finished 2020 up a respectable 7.5%. Longer-dated treasury bonds even outperformed most stock mutual funds. But what was different about bonds in 2020 was that most of their return came not from interest paid, but the price adjustment that occurred as interest rates dropped – essentially amounting to a paper gain (a bond’s price moves inversely with interest rates). As interest rates hit record lows, bonds have become extremely expensive. One way of measuring this is to compare a bond’s price relative to its yield or “earnings.” In 2020, treasury bonds were trading at 50x earnings, but finished the year with a price-to-earnings ratio of nearly 100x. Compare that with U.S. equities that trade at just 22x their expected earnings.1 Another way to think about this is from an income perspective. Consider that in 1987, to generate $100,000 of income, you needed a $1,000,000 portfolio of treasury bonds. At the end of 2020, however, you would need a $10,000,000 portfolio to get the same amount of income. Despite these materially lower yields, many investors still cling to old paradigms. According to the American Association of Individual Investors, the average allocation to bonds in 2020 was roughly the same as it was in 1987, even though yields are 90% lower.2

Federal Reserve Graph
Figure 1. 10-Year Treasury Constant Maturity Rate, 1987-2020. Source: Federal Reserve

Has the investment industry changed to address this issue? In short, yes. Attractive yields on secure, private debt have long been available for large pools of money such as pension and sovereign wealth funds.  What’s changed recently is that high net worth investors can now access private debt in the same way institutions have.  With a broader investable universe, higher payouts, and access to real assets with inflation linked cash flows, private debt is becoming increasingly important as investors continue to shift away from publicly traded bonds.  Monroe Capital, a middle market focused asset manager, expects this asset class to double in size to $1.5 trillion by 2025.

We believe investors should be tilting their portfolios away from publicly traded debt with low yields. If an investor can tolerate the illiquidity, private debt is one alternative to consider, where yields are 4 – 5x greater without the commensurate increase in risk.

Bringing institutional-level asset management to the individual investor is happening in other parts of the market as well. Direct indexing has been a welcome change in our industry over the recent decade. This strategy refers to buying an index like the S&P 500 one stock at a time versus simply buying a fund, such as the SPY ETF. High commissions and expensive software have long kept direct indexing out of the tool box for the individual investor; however, zero commissions have enabled firms to design custom index funds of individual stocks for clients in separately managed accounts.

Parametric Figure
Figure 2. Custom index exposure. Source: Parametric

The benefit of direct indexing for the client is threefold. First, it counteracts the risk of concentrating in a single stock. For example, let’s say you’re an executive at Google. A significant portion of your compensation is paid in Google shares, which you can’t sell immediately. Your livelihood, in many respects, is dependent on how well Google performs. From a risk perspective, the last thing you would want from a wealth manager is more Google stock. Thanks to new tools, you could exclude Google, and other highly correlated stocks from your portfolio. Second, direct indexing enables clients to tilt their portfolios towards some companies and away from others according to environmental, social and/or governance considerations. As an example, we could build a fully customized fund that allocates more to companies that have committed to minimizing their carbon footprint. Third, direct indexing can be useful for tax-sensitive investors. Let’s say you’re selling a business in 2021. You don’t want more gains, in fact, you are probably looking for losses this year. In this case, we could ”program” your fund to only sell stocks with a loss. A mutual fund, by contrast, where assets are commingled with other investors is not set up to cater to an individual’s tax situation.

And no conversation about change would be complete without a discussion of politics. To steal a quote from Heraclitus of Ephesus, “The only constant in [Washington], is change.” Being aware of these changes and working with an advisor to adapt to them will be crucial over the next several years. With President Biden’s victory and Democrats controlling the House and Senate, research firm Strategas’ view is that tax increases of $1 trillion are likely in 2021 (although some may not be effective until 2022), which include:

  • An increase in the top marginal rate from 37 to 39.6%
  • Lowering the Value of Income Tax Deductions to 28% for Top Earners
  • Increasing the Capital Gains and Dividend Tax Rate to a range of between 25 to 28% (but could be as high as 43.4% for Top Earners)
  • Increasing the Corporate Tax Rate from 21 to 25%

The implication for business owners and top earners is that it may no longer make sense to defer taxes to future years when rates could be higher. Here are a few examples of conversations we are having with clients right now:

  • If you are selling a business in the next two years, you may want to sit down with your advisors to discuss the pros and cons of selling now versus a future year. There are many factors to weigh when doing a deal, but the prospect of higher tax rates in the future could be a driving one for you.
  • If you are charitably inclined, have you discussed accelerating future charitable contributions to a donor-advised fund or charitable trust with a CPA while potentially taking the standard deduction in future years? This approach could make sense for those with higher tax burdens this year relative to future years.
  • If you are getting paid an earnout or will receive deferred compensation over several years, have you consulted a tax advisor to review whether this agreement is still the most prudent for your situation? After reviewing, you may decide that you wish to renegotiate your agreement.

For investors, here are a few considerations:

  • For those with highly-appreciated securities, does it make sense to sell some of these now at a potentially lower rate while redeploying the proceeds to other areas of the market that may be more tax-efficient and possess better fundamentals?
  • Have you discussed doing a Roth IRA conversion this year with your CPA? It could make sense for some investors especially if markets become more volatile.
  • Required Minimum Distributions (RMDs) return this year for those 72 and older, or are the beneficiary of an inherited IRA. If you are subject to one, and charitably inclined, does it make sense for you to make a qualified charitable donation to take income off of your 2021 return?

There is also talk of adjusting estate tax rates and reducing the exemption amount. While the current exemption is $11.7 million per individual, Biden’s tax plan calls for reducing that back to 2009 levels ($3.5 million per individual). Larry Moye, a partner at Womble Bond Dickinson, points out that clients may face a “use it or lose it” scenario in 2021, and they may desire to transfer assets using their available exemption now, while they still have it.

Of course, all these changes are still in proposed form, and we don’t know when or if they might take effect. But, with the burgeoning deficit, it is unlikely that rates are going down for top earners. Given that, it might be wise to sit down with your advisors and start doing some contingency planning now.

Intelligence is the ability to adapt to change. Stephen Hawking

It is possible to achieve success without change. Just ask Tampa Bay, who will be starting a quarterback whose career began 20 years ago. But is Tom Brady likely to be a franchise quarterback even three years from now? Don’t fashions change…and sequels of “B” movies get old? In the same way, can investments that were put in place years ago continue to win in a world that has changed so much?

Stephen Hawking once said “Intelligence is the ability to adapt to change.” Has your portfolio adapted to the change around it? Should it? At Balentine, we believe in continual innovation. Whether it’s navigating the market and providing access to improve expected returns, leveraging technology to be more tax-efficient, or helping entrepreneurs through business planning and succession, we strive to do things better on behalf of our clients. And we would welcome the opportunity to discuss serving you too.

1 Morningstar.

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