Change is Upon Us
It can be a challenge sometimes to identify an appropriate theme for our quarterly newsletter. That is not the case for this quarter, as we find ourselves surrounded by change. While the turn of the calendar each year represents a significant change in itself, unique this year is the change in the presidency, which is already ushering in all manner of geopolitical tide changes. On the economic front, while economists are warming up to increasing U.S. growth and inflation expectations, “animal spirits” (the human emotion that drives consumer confidence), which have been dormant since the 2009 Financial Crisis, appear to have awaken. It seems that sometimes the fear of the unknown which most always results in negative volatility can just as easily be translated into a promising outlook predicated on excitement of the unknown…which appears to be the case since the November election.
This theme of change is also represented on many fronts at our own firm, starting with the introduction of Troy Dunkel as Director of Investment Management and extending to investments in new technologies and enhancements to our investment approach. In this quarterly newsletter, we’d like to describe these changes at Prescott Tax & Wealth Management and the positive impacts you can expect from them.
Investment Model Changes
As a preview to what you will learn more intimately when we meet in person to review your investments, we introduced a philosophical change to our investment approach that resulted in the replacement of investment models consisting primarily of actively-managed mutual funds with models consisting predominantly of passive index exchange-traded funds, or ETFs (see What You Should Know About ETFs below).
Given a long-term economic outlook that portends lower-than-historical investment returns across asset classes, reducing investment costs should prove to be a meaningful contributor to investment returns for years to come. Moreover, beating fund benchmarks by even the most reputable asset managers – including 4 and 5-Star Morningstar managers – has proven elusive in the active management segment (and particularly in active equities) for years, especially when taking their active management fees into account. As such, we’ve introduced an approach that seeks to give you a purer, but still diversified, market exposure and with the added benefit of volatility management. By systematically increasing and decreasing equity exposure as volatility exceeds certain thresholds, our new portfolios stand to achieve a smoother return profile, and in turn can preempt behavioral instincts to buy at market tops and sell at market lows – behavior to which even the savviest of managers can succumb.
By introducing the use of lower cost, more tax-advantageous ETFs (versus mutual funds) combined with volatility management in our models, we believe you can potentially experience enhanced returns in the portfolios we manage for you. And we look forward to helping you understand this approach in greater detail and addressing any questions or concerns you might have about it.
But the investment changes are only the beginning. We have also introduced a host of new systems aimed to help us help you achieve “a better financial future.” Four examples are Riskalyze, Blueleaf, MoneyGuidePro and On-Line Appointment Scheduling.
Riskalyze is a system developed on Nobel Prize-winning research in behavioral finance. This research underpins the argument that average investors underperform the market consistently over time because they invest based on emotional impulses that cause them to sell at market lows when fear has gripped the markets and buy at market highs when they feel like they’re missing out. Therefore, knowing one’s risk tolerance can serve as a powerful tool in developing portfolios that are a good fit, being defined as a portfolio that has downside exposure within an investors tolerance, thereby allowing them preempt the urge to move their investments to cash at what are often the most inopportune times.
By completing a short Riskalyze risk tolerance questionnaire, we can gain an even more precise measure of your willingness to tradeoff between risk and reward. Your “Risk NumberTM” helps us identify a tailor-fit investment option for you. And if interested, we can also use Riskalyze to evaluate whether other investments, or better, your entire investment portfolio (e.g. investments held elsewhere such as in 401Ks or in other brokerage accounts) is appropriately-fitted to your risk tolerance. Reach out to Troy by email to email@example.com or by phone at (949) 248-9815 x4 to get your Risk NumberTM!
We are also in the process of implementing a new reporting system called Blueleaf. We are confident that you will find this system to be an improvement to our current reporting system. It offers easier access, clearer details, more frequency in reporting and via multiple devices. And as with Riskalyze, it offers a significant benefit by allowing you to see your investments in a more holistic perspective. By adding other assets and liabilities, whether entered manually or by entering login credentials to other accounts, your “dashboard” becomes your net worth summary. Testimonials have resoundingly demonstrated that this “net worth perspective” serves to be more meaningful and actionable in gaining control over their finances and financial futures. Here again, we look forward to exploring what Blueleaf can do to help you unlock better financial outcomes.
Late last year we implemented MoneyGuidePro, an industry-leading goals-based financial planning system. MoneyGuidePro allows us to better understand your goals and help you get on a path to achieve them. The advanced nature of this system allows you to easily brainstorm about needs, wants and desires leading up to and through retirement, to prioritize among them, and to help us determine the steps required to achieve them. We have already had very positive experiences using it with clients and we seek to engage with you on this very important step toward bringing your life plans into view and then within reach.
On-Line Appointment Scheduling At Our Website
At Prescott Tax & Wealth Management, we realize that much of the value we provide is by way of meetings with you. In order to make scheduling a meeting with us easier and to save you time, we have implemented on our website at www.prescott500.com, an on-line scheduling system that allows you to request an appointment time at any time of day without having to talk to us directly. By clicking on the “Contact” link at the lower right corner of our webpages, you will be able to access our calendars directly and find days and times that work with your availability. After submitting your choices, we will promptly confirm your request. What’s more, this new system will send you reminders in advance of your meeting, so you can plan accordingly and let us know in advance should you not be able to keep your appointment. I encourage you to schedule your upcoming tax appointment by clicking the “Contact” button at the bottom of our website pages and select “Schedule Now” to make your appointment.
Prescott Tax & Wealth Management Website
Lastly, I’d like to highlight our website, which we enhanced this year. Please have a look at it to get reacquainted with the full complement of services we can provide to you, your family and/or your company. Of course, we are always happy to receive introductions to like-minded people like you who we’d love to see if we can help. An easy way to do so is to pass on our website address, www.prescott500.com.
In closing, I’ll say on behalf of your team at Prescott Tax & Wealth Management that we’re very excited about the changes we have introduced and the promise of better financial outcomes they afford to you, our valued clients. I invite you to schedule a meeting with us to review your investments, discuss our changes in greater detail, and explore what additional changes we can introduce for your financial future.
Traditional ETFs are typically structured as registered unit investment trusts (UITs) or open-end investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index. Some ETFs that invest in commodities, currencies, commodity- or currency-based instruments, or volatility instruments are not registered as investment companies and are generally established as grantor trusts. Unlike traditional UITs or mutual funds, shares typically trade throughout the day on an exchange at prices established by the market.
Like individual stocks, ETFs can be bought and sold throughout the trading day at the current market value, which continuously fluctuates and reflects the value of each share at any particular time. Shares of the ETF are bought and sold on various stock exchanges.
ETFs can track a wide variety of sector-specific, country-specific and broad-market indexes. ETFs may provide diversification to your overall portfolio because one share or one unit may represent multiple underlying stocks, bonds and/or other asset classes. Each ETF seeks to replicate the market performance of the underlying index that makes up its basket of securities. Although ETFs seek to mirror the performance of a particular index, the relationship between performance of the index or sector and the ETF is not exact because of the fees and trading costs associated with the ETF, as well as the difficulties in exactly mimicking an index.
Non-traditional ETFs may be 1everaged” or “inverse,” and function like traditional ETFs, but may offer leverage depending on the product’s investment objective.
These ETFs, which are sometimes referred to as “geared,” “responsive” or “exotic,” generally rebalance daily, although some rebalance monthly. They are complex financial instruments designed to meet a stated investment objective although their performance can change significantly from their stated objective on a daily or monthly basis, depending upon the trading session.
These non-traditional ETFs seek to deliver multiples of the performance of the index or benchmark they track. To accomplish their objectives, non-traditional ETFs involve investment strategies that utilize swaps, futures contracts and other derivative instruments. Both leveraged and inverse non-traditional ETFs are trading vehicles and are not suitable for investors who are interested in a buy-and-hold strategy, particularly in volatile markets.
- Leveraged: Leveraged ETFs attempt to track a multiple of the daily (or monthly) returns of an index usually by using total return swaps. A leveraged ETF may be two times (2x) or three times (3x) leveraged, which means it attempts to provide two or three times the daily index return or loss, respectively. For instance, the double leveraged ETF seeks to provide a 2% gain on that daily return for each 1% increase in the market index return. Conversely, if the index drops 1%, your loss, in theory, would be 2% for that given day, assuming the ETF is rebalanced daily.
- Inverse: Some leveraged ETFs are inverse or “short” funds, meaning that they seek to deliver the opposite of the performance of the index or benchmark they track. An inverse ETF generally engages in trading strategies, such as short selling, or enters into total return swap agreements and futures contracts. An inverse ETF seeks to deliver the inverse (-1x) of the index’s performance, while a two times (-2x) or three times (-3x) leveraged inverse ETF seeks to deliver two or three times the opposite of the index’s performance, respectively.
- Tax Efficiency: Traditional ETFs are generally not actively managed and, as a result, typically generate fewer capital gains due to the low turnover of the securities within their portfolio. Taxes must be paid on all distributions made by the underlying securities and any capital gains associated with transactions made by the fund. However, because ETFs offer in-kind redemptions to qualified entities, they can avoid realizing capital gains for the fund although shareholders must still pay any taxes on realized gains. Non-traditional ETFs may not be tax efficient due to the increased amount of portfolio turnover due to periodic rebalancing as well as the use of leverage.
- Expense Ratios: Non-traditional ETFs will generally have higher fees than traditional ETFs. Associated charges may include management, interest and transaction fees. The management fees are charged by the fund management company, which cover both marketing and fund administration costs. Interest and transaction fees are costs related to holding and transacting in derivatives securities and are generally built into the pricing. Purchases and sales of ETFs are subject to brokerage commissions. All fees and expenses are described in detail in the prospectus.
- Transparency: The securities in the underlying ETF portfolio are made public every day. Since these securities generally trade within an index or sector that
the ETF follows, you may be able to determine the positions within the portfolio at any time. You may find this beneficial because the transparency could allow you to have more control over your overall investment portfolio allocation and weightings.
- Portfolio Diversification (access to wide range of sectors): ETF portfolios can be diversified across many different securities, offering a set of portfolios for almost every asset allocation need. This diversification can help reduce an investor’s risk by potentially offsetting losses from some securities with gains in
others. Individual securities in the ETF portfolios and the net asset value of the portfolios will fluctuate in price. Also, keep in mind that asset allocation and/or diversification cannot eliminate the risk of fluctuating prices and uncertain returns.
- Buying and Selling Flexibility: Unlike traditional mutual funds, which are only priced at the end of each day, ETFs are priced and can be purchased and sold throughout the trading day. Furthermore, you can buy or sell ETF shares on a stock exchange much like the purchase or sale of any other listed stock.
Generally ETF shareholders are subject to income taxes on the interest. dividends and/or capital gains distributed to them from the portfolio. However.in retirement accounts such as individual retirement accounts (IRAs), taxes are deferred until distributions are taken from the account. Also, when an investor sells the ETF position, he or she will generally realize a taxable gain or loss that should be reported on their income tax returns. Nonresident aliens may be subject to special tax withholding and reporting requirements as a result of an ETF sale. Certain ETFs may be subject to the alternative minimum tax (AMT).
The opinions expressed are those of Prescott Tax and Wealth Management as of January 13, 2017 and are subject to change. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Investing in foreign markets involves currency and political risks. Information and opinions are derived from proprietary and non-proprietary sources. Please note that investing in the stock market involves risk and no strategy can mitigate the risk completely. S&P 500 is a registered trademark of The McGraw-Hill Companies, Inc.
Prescott Tax and Wealth Management is a Registered Representative offering Securities and Advisory Services through Independent Financial Group LLC, a Registered Broker-Dealer and Investment Advisor. Member FINRA and SIPC. Prescott Tax and Wealth Management and IFG are not affiliated.