Using Average Cost Or FIFO?
Sunday, September 14, 2014 23:23

Tags: average cost | cost basis | FIFO | high cost | tax lots | Tax-efficient investing

I am amazed when I run across advisors who are still using average cost or FIFO for tax lot accounting. Do they not realize that their clients are paying more taxes than necessary each year? In these days of automation and "check the box" custodian options, it borders on malpractice to not minimize clients' tax bills. 

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I'm sure some of the "guilty" justify their actions (or non-action) because selling higher cost lots merely postpones tax. I don't buy it. Clients would rather pay tax later than sooner. Also, unless the client is going to sell everything prior to death, some of the temporary tax savings will become permanent. 
The cost basis rules allow changing methods - going forward. Even though basis methods can't be changed for old shares, advisors can ensure that their clients don't pay extra tax on sales of new shares. 
If the advisor is willing to do some work to specifically identify lots or use a program like Total Rebalance Expert, the optimal method is as follows (in order):
1) Sell highest cost loss positions. 
2) Sell break-even lots. 
3) Sell highest cost long term gains
4) Sell highest cost short term gains. 
(Since net short-term and long-term losses offset net short-term and long-term gains, I believe that it is better to recognize a larger long-term loss than a smaller short-term loss.)
Advisors wanting to take advantage of a custodian's preset option should use either "high cost" or "best tax." High cost will differ from the above recommendation by recognizing the highest cost gains, whether short or long term. Thus, the recommended method would recognize a $1,000 long-term gain before a $500 short-term gain. Under high cost, the $500 short-term gain would be recognized first. 
The "best tax" method is similar to the recommended method except it will recognize short-term losses before long-term losses. Thus, the recommended method would recognize a $1,000 long-term loss before a $500 short-term loss. Under "best tax", the $500 short-term loss would be recognized first. 
Although I believe that the recommended method is best, advisors who want to give their clients better tax consequences without extra work should choose the custodian's "high cost" or "best tax" options. 
Despite Misguided Comments About The Title, Dr. Craig Israelsen Gets 4.6 Stars For Presentation On How Advisors Can Encourage Good Behavior In Investors
Sunday, August 31, 2014 17:20

Tags: diversification | Diversified portfolio design | investing | portfolio management

A few advisors attending a webinar by Dr. Craig Israelsen about encouraging good behavior by investors were sharply critical of the title of the presentation but they’re objections are misguided, and attendees overall awarded Israelsen a 4.6 star rating.

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“I enjoyed the webinar and learned a lot, but feel the title was misleading, said one advisor after the session.
“This was good,” said another attendees. “However, I expected it to be more about motivating behavior. Forewarning that it would be another presentation of the 7Twelve model would have better set my expectations.”
After reviewing comments from attendees, Dr. Israelsen, responded with a point that is so important. “Very simply, creating better client behavior starts with a shared investing philosophy,” said Israelsen. “7Twelve is an example of an investing philosophy:  broad diversification with systematic rebalancing.”
Israelsen is exactly right. To remember how to behave properly, people need structure — what Israelsen in this case calls “investment philosophy.” Without a set of guiding principles that are clearly articulated and reinforced constantly, people won’t behave well.  
And regarding A4A members who felt this session plugged Israelsen’s 7Twelve Portfolio program, I can understand why you may look at it that way agree but you're off base Here’s why.
Israelsen has spent the last 23 years academia teaching thousands of college students about family financial management, specializing in researching low-cost, tax-sensitive investment strategy that promoting good behavior in investors. He's expert in applying modern portfolio theory and using broad diversification to optimize a household’s financial resources, and he has codified his research in a program called 7Twelve Portfolio. Branding and packaging his ideas does not diminish the validity of his research and investment philosophy. It makes it more valuable to advisors!
Expect A4A to continue to give you uncommonly authoritative ideas from thought leaders in the wealth management profession in a 24/7 video lesson, and please don't hold it against these very generous professionals for capitalizing on their ideas and making them accessible. I believe in these wealth management thought leaders and have culled them carefully. These webinars are just another new kind of journalism in financial planning and investment management for CFPs, CPAs. CIMAs, CFAs, CIMAs, EAs, CLUs, ChFCs, insurance agents and other professionals -- with unlimited professional continuing education 24/7.
“Investors with no investment philosophy are more susceptible to emotionally-based buying and selling (i.e., greed/panic) because they are not grounded in a game plan,” says Dr. Israelsen, who presents quarterly at A4A webinars. “If an advisor does not have a fundamental investing philosophy, he or she certainly cannot share it with a client.  And if an advisor and client are not synchronized around a common philosophy, they will likely part ways sooner rather than later.
“Broad diversification is a philosophy that guides the investor through good markets as well as rough markets,” he added, in responding to comments from attendees. “Clients that understand the nature of diversification are less likely to get greedy when the S&P 500 soars.  They understand that a diversified model isn't designed to crank out that type of return and that a diversified portfolio will have fewer down years and less drama.”
Here are answers to some question from attendees:
You began the presentation using the last 44 years of data and then switched to the last 15 years (1999-2013).  Why?  Does this have a more favorable effect in comparing the 7Twelve results?
The reason for a 15-year analysis period for the 7Twelve model is that it can't be back-tested prior to 1998, when TIPS were introduced in the U.S.  I'd love to test it back to 1970, but can't.  The 44-year history for seven asset classes is the longest period I can test. 
On slide 25, does the client contribute but only buy in years when the sum of investments in below the target?
Yes, that's correct.
Okay, what does the client buy each year?
The client would invest the needed amount of money into the portfolio as a whole.  Pragmatically, the investor would add the needed money into the funds that were lagging at that time. 
Why do I feel this is an infomercial for 7Twelve? There is a lot of math here that most of us already know but what about the psychology of changing behavior, for example getting people to put more money into a bad market?  Long-term results are great, but clients live in a short-term world and we all know they feel the pain of loss more than the joy of gains.  
7Twelve is what I know best, so I use the model in my presentations.  We change behavior by implementing protocols:  such as saving a higher percentage of our income as we get older, which we covered in the presentation.  We change behavior by introducing a protocol for supplementing our portfolio with additional investments when the portfolio is "on sale," which we covered as well.  We change behavior when we benchmark the performance of our portfolio more correctly by using a blended index, rather than an all equity index, which was covered.  Changing investor behavior starts with rules and guidelines for building and managing portfolios.  If not, emotions will rule the day.
What about the opportunity cost of having all of that cash sitting on the sidelines awaiting a ""buy sign” moment?
Most older investors were glad to have "all that cash" on the sidelines during 2008.  If a person has saved correctly, they don't need a portfolio that cranks out a 10% return--they need to keep their savings safe.  Cash does that.  For investors that have not saved enough, they likely will not be able to enjoy the luxury of having 40-60% of their portfolio in cash.
Can you share any details on the Partners program? Cost, annual renewals, time commitment, etc.?
7Twelve Partners is an annual commitment that costs the advisor 1 bp of AUM.  There are several deliverables to the advisor: 
    1)  in-depth monthly performance reporting of the 7Twelve model and the various sub-components (the 12 asset classes),
    2)  access to monthly deep-dive webinars that cover a particular asset class in depth
    3)  access to all the 7Twelve research reports and white papers produced by Dr. Israelsen
    4)  ability to use the 7Twelve trademark
    5)  free registration at the annual 7Twelve Conference in Salt Lake City, Utah each October
    6)  consulting from me and Lunt Capital Management
Can you comment on the non-US bond fund? Is this a non-US dollar fund that reflects currency risk or a US-dollar denominated fund with non-US names?
Excellent question.  Funds handle this differently.  For example, Vanguard hedges currency risk its international bond funds, whereas T. Rowe Price does not.  One option is to use two funds in the non-US bond allocation.  One fund is hedged, the other is in local currency.

Learn more about 7Twelve's $350 a year research report and service for advisors, and its Partners Program, which costs one basis point per year.


Craig Israelsen Reveals a 3-Pronged Approach To Encourage Clients To Adopt Good Investment Behaviors
Monday, August 25, 2014 10:15

Tags: 7Twelve | benchmarking | client education | investment strategies | investor behavior

Investors naturally focus on the latest gains or losses in their portfolio, and on benchmarks that show up in the media every day like the S&P 500 and the Dow Jones Industrial Average. As their financial advisor, consider guiding your clients to a more effective outlook for long-term investment success.

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In a new Advisors4Advisors webinar, Prof. Craig L. Israelsen, an expert in the field of indexes and passive investing, offers a structured method of encouraging good investor behavior among your clients. Israelsen teaches financial planning at Utah Valley University and offers the 7Twelve Portfolio system to advisors. He divides the client education task into three area: responsibilities, mechanics, and expectations.
Teaching Investors Their Responsibilities
Investment portfolios have two basic features, contribution rate and portfolio return. Investors focus on returns, which are the source of happiness in some years and angst in other years, Israelsen says.
Investors try to control returns by investing in assets that have produced higher returns in the recent past, or by adjusting the percentages invested in different asset classes.
But the factor they have the most control over is their contribution rate. Advisors may illustrate this fact with the following graphic:
Younger clients may contribute less and still build up retirement funds because they have more time to benefit from compounding. As clients age they have less time before reaching the age 65 target, so their savings rate becomes more important.
Showing Investors The Power Of Buying Low
Israelsen recommends a simple and systematic way to ensure investors “buy low” by setting a benchmark based on the assumption of a desired annual return rate.
He provides the example of an investor who invests $5,000 annually and compares each year’s returns with an 8% annual return benchmark. Years in which the investor’s actual returns fall below the benchmark trigger “buy low” moments – the investor adds a dollar amount to the annual $5,000 investment base equal to the dollar amount the portfolio fell short of the return expected by the benchmark.
In this example, actual returns fell below the “8% growth” level six times. In each of those years the investor made an additional investment equal to the discrepancy (limited to $5,000 maximum). The result was $12,501 in added value above the total additional investment amount.
“The main message is to get away from the S&P 500 as your comparison,” Israelsen says. “Set up a benchmark, an ideal growth rate, and check your actual balance against that. When it’s below, add some money. That is the easiest source of alpha I can imagine, supplementing the portfolio at opportune moments.”
Setting Realistic Expectations
For clients who insist on setting an index-level benchmark, Israelsen recommends using an equally weighted, seven-asset portfolio based on his 7Twelve Portfolio system.
Comparing the seven-asset portfolio against popular benchmarks such as the Russell 2000 reveals a solid rate of return paired with lower volatility.
Israelsen notes, however, that clients will still tend to “do an end-around” and compare the seven-asset benchmark against the S&P 500, which is featured on news shows around the clock.
“Many years the S&P 500 beats the seven-asset portfolio, but after a 44-year period they end up at basically the same place. The difference is that the multi-asset portfolio did it with a lot less drama.”
Between 1970 and 2013, large-cap U.S. equities returned an average 10.41% a year with standard deviation of 17.6. By contrast, the seven-asset portfolio returned 10.29% with a 10.2 standard deviation, making for fewer sleepless nights.
“A portfolio’s job is to produce a modest return without a lot of drama,” Israelsen sums up. “Associate that with a client who is saving 10% to 15% of their income and they’re going to win. That is the ideal approach, not to be swinging for the fences, enduring lots of volatility, hoping to make up for an inadequate contribution rate.”
To view the entire webinar, click here.
Rating and Comments
Webinar viewers gave Israelsen a high average rating of 4.6. Comments were:
“Good to see multiple time periods, 44 years, 15 years, 10 years, to support the conclusions.”
“Excellent. Provocative and logically presented.”
“I think his program, 7Twelve, is good. I use it for some clients. However, I do not think the question on how to handle client’s behavior was well addressed.”
“I agree with Andy that this was a new twist on Craig’s prior presentations, and it was a good one. If the viewer listens to Craig carefully on a regular basis, the concept of 7Twelve sinks in pretty clearly. And it makes consummate sense. This is great stuff, and is good for the investment junkies who like to crunch numbers, but also appeals to the fundamentalists who just plain enjoy hearing great new ideas.”
“The webinar was very good, however it was a very long commercial for the 7Twelve Portfolio.”
“Excellent presentation. Interesting concept.”
“Very clear explanation of his concepts. He takes his time to help you fully understand his slides and thoughts.”
“Great. Thanks.”
“This was good. However, I expected it to be more about motivating behavior. Forewarning that it would be another presentation of the 7Twelve model would have better set my expectations.”
“Very much enjoyed the content...good pacing good explanation.”
“I enjoyed the webinar and learned a lot, but feel the title was misleading.”
“One of the best ever. Thanks Andrew!”
“Great stuff! Challenges me to think about how to communicate with clients in simpler, more motivating terms that resonate with them.”
“Definitely provided some food for thought and further investigation.”
“Some of the best research in retirement planning.”


Obstacles To Location Optimization
Monday, August 11, 2014 01:31

Tags: behavioral finance | client communication | client education | investment management | investment strategies | Tax Management | Tax-efficient investing

Location optimization can be a great tool in portfolio management. Location optimization, in basic terms, is locating specific types of investments in specific types of accounts to minimize taxes. The tax reduction "prize" is huge. IRAs can be used to postpone ordinary tax on current income. Taxable accounts can achieve tax deferral (until a sale) at capital gain rates or tax avoidance (basis step-up at death). Roth IRAs can maximize tax-free compounding on high return investments. 

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To apply location optimization, you and the client must want to reduce taxes. This is a no-brainer, right? It should be, but it's not. There are three obstacles:
  • Client perception
  • Advisor-client communication 
  • Advisor workload
Clients can have difficulty with location optimization. This is because the client's individual accounts will not each hold the same investments. Therefore, each account will perform differently than the others. Will your client be ok with her IRA showing a lower performance number than her taxable account? This can be a very real concern for many clients. 
Because of the performance disparity between accounts, the advisor must report returns at the portfolio level and train clients to only look at portfolio returns and not individual account level returns. This takes time and patience to change client perspectives and can only be achieved by communicating the significant benefits from location optimization.  
Finally, advisors must be willing to do the work (and invest in the software necessary) to implement location optimization.  
Is the reward knowing that the clients will be better served? Can providing this service actually increase your business? The answer is both. Location optimization can save your clients taxes and differentiate you from the competition. You just need to overcome the obstacles. 
UHNWIs' Growing Need For Help With Self-Directed IRAs Spawns A Niche; Our Expert Gets A 4.7-Star Rating On A Webinar About This Esoteric, Fun, And Lucrative Niche
Tuesday, July 22, 2014 10:46

Tags: alternative investments | high net worth | IRA | retirement income

The popularity of alternative investments has sparked an increase in the use of self-directed IRAs by high-net-worth individuals who want to diversify beyond securities and invest in private deals. And, since most HNWIs and UHWNWIs have a big chunk of their wealth tied up in IRAs, it makes sense that sophisticated investors are disciovering the possibility trapping higher tax-deferred returns in self-directed IRAs invested in private offerings and need help from an advisor with expertise in this arcane field.

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Private deals are and will always be a great haven to sleazy operators, and RIAs must consciously steer clients clear of any notion that a self-directed IRA is a way to get rich quick. However, self-directed IRAs can be invested in real estate, start-ups, and precious metals, as well as oddball deals like livestock and third-world currencies. So HNWIs and UHWNIs are seeking help in increasing numbers with investing their IRAs in a friend's string of car washes, laundromat, or a venture manufacturing drill bits designed for use in The Rockies. 
I invested some of my IRA money in a private investment at the suggestion of an advisor and I'm very glad I did. So I have some personal experience in this somewhat estoric area and attiorney Mat Sorensen's presentation made me realize this is a fun and, possibly, lucrative niche for advisors.


Mathew Sorensen, a partner with the law firm of Kyler Kohler Ostermiller & Sorensen, LLP in Phoenix, spells out the legal ins-and-outs of self-directed IRAs that advisors must know about at an A4A webinar.
“There is a lot of pent-up demand for self-directed IRAs, and there is a lot of bad information out there. Custodians that handle these accounts are dying for advisors who understand the rules (governing self-directed IRAs),” Sorensen says.
Working With Trustees
Under Internal Revenue Service rules, investors must place the assets of a self-directed IRA with a qualified trustee, or custodian. Among firms that take custody of alternative IRA assets, the big names are Millennium Trust Co. and Pensco Trust. Trust Company of American does some of this as well and there are many others. The role of the custodian is to keep records, file IRS reports, issue client statements. Organzing as a trust company is a simpler, less expensive form of business in the U.S. So all of the IRA custodians do business as trust companies and not broiker dealers. I am sure Mat will chime in with details as to why. 
The custodian may offer a range of investment choices to the account owner, but does not provide financial guidance. As a result, Sorensen says some custodians maintain lists of financial advisors to recommend to their retail clients, many of whom are high-net-worth investors. If you already custody assets at one of these firms, make sure you're on the company's advisor listing.
Understanding the IRS Restrictions
Some advisors may shy away from alternatives because of a perception that IRS rules are complex and difficult to comply with.  Sorensen says the rules get complex but not hard to follow.
The basic principal is that retirement funds are granted tax-free status to encourage people to save for their retirement years, and they should not be used for personal benefit otherwise. So the IRS spells out four restrictions:
·      Collectibles (except for certain coins that meet precious metals criteria)
·      Life Insurance
·      S Corp Stock
·      Prohibited Transactions (restricts who your IRA account can transact with)
In its simplest form, the Prohibited Transactions rule prevents account owners from engaging in transactions such as purchases, sales, leases, or exchanges with their own companies, employees, spouse, children, or parents, or with any company in which these persons have an ownership stake of 50% or more. Account owners may, however, engage in transactions with siblings, aunts, uncles, and cousins.
Account owners may leverage transactions with loans, but only if the owner does not guarantee the loan.
The bottom line is that any investment or transaction must be strictly intended as an investment. For instance, if you buy raw land, you cannot then go hunt on that land. Or allow your father to do so. If you invest in a vacation rental property, you cannot stay there, and neither can your children.
These areas can get pretty tricky. For instance, if you use funds in a self-directed IRA to buy stock in a company and you are a member of the board, you may need to prove that the purchase did not grant you more power to dictate your own compensation. What if your spouse is an employee of a start-up company that you want to invest in?
You can’t sidestep these rules by simply having an asset transferred from your spouse, parent, or other prohibited person to a friend, then purchase it from them. That’s called a “step transaction” and the IRS will disregard the middleman.
Penalties Can Be Steep
If a prohibited transaction occurs, the IRS will “distribute” the entire IRA account as of the date of the violation. That means the entire account becomes subject to taxes and distribution rules, which include a 10% penalty for those under 59½ years of age.
Your other retirement accounts will not be affected.
Other Tax Considerations
Transactions conducted through a self-directed IRA are subject to additional taxes under certain circumstances, primarily UBIT (Unrelated Business Income Tax) and UDFIT (Unrelated Debt Financing Income Tax).
UBIT is triggered by investments in private companies such as LLCs or Limited Partnerships that don’t pay corporate taxes, such as restaurants, tech start-ups, and businesses that sell goods and services. This can also apply to real estate development, construction, or active investment (i.e. “flipping” property). Exceptions to the UBIT include interest income, dividend income, royalty income, rental income, and most capital gains.
UDFIT is triggered by leveraging IRA transactions with debt, because borrowed funds did not originate as retirement account money. For a simplified example, if you buy property with 50% retirement funds and 50% loaned funds and sell it later at a profit, half of the gain will be taxable.
For more details and strategies, view the entire webinar at Advisors4Advisors.

Mat Sorensen’s average rating by webinar participants was 4.7.


These were the comments left by attendees at this sparse summer session:

“Great presenter. He could have used more time for specifics.”
“This was an excellent webinar. Thank you.”
“This is such a great topic and important in our five-tier tax system.”
“Very interesting subject.”
“Very well done. He was knowledgeable and he tailored his presentation to what we needed to learn (benefits and pitfalls) about self-directed IRAs.”
“Great job!”

“Very interesting and timely as this is a popular topic today. Many pitfalls were discussed that can render the idea of real estate and other investments in an IRA useless if not set up properly.”


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