November 20, 2012
A Shifting Status Quo
The Investment View from Prescott, Arizona
If you think the election in America is bringing changes, take a look at other areas of the world and the secessionist movements that will have Rand McNally scrambling to rewrite maps for years.
In his Things that Make You Go Hmmm… economic newsletter, my friend John Mauldin comments on movements to secede in the Catalonia area of Spain whose capital is Barcelona, Venice, northeast Italy, and Scotland.
Recent elections in Greece, Finland and France had secessionist candidates coming much closer to winning than many expected.
The European Union looks like it will be facing the toughest test of its 19 year existence as economic tensions there continue to escalate. The differences in language, customs and culture among the EU countries are vast compared to different areas in the U.S. and the EU will have its work cut out just to survive, especially with another recession underway there.
This is just another face of worldwide slowing growth and the protectionism that develops as regions struggle to keep as much of their wealth to themselves as possible.
Sir John Templeton was a role model for me when I entered the investment industry. When he retired in 1991, his Templeton Funds had the best 40 year track record in the business. The photo in my office captures one of the highlights of my career when I was invited to visit privately with Sir John at his place in the Bahamas. Sir John was a very spiritual man and had this to say about Thanksgiving.
“Thanksgiving is a creative force that, if lived on a continuous basis and not just for one day each year, can create more good in your life. Perhaps we could call this way of living thanksliving. Thanksliving is based on the premise that living a life of appreciation and gratefulness leads to having more to be thankful for. We have the ability to create blessing in our life through the power of mind action and the choices we make.”
Have a happy and bountiful Thanksgiving celebration.
Bake cupcakes directly in ice-cream cones, so
much more fun and easier for kids to eat.
Tax-Managed Funds in The Spotlight
The tax law changes slated to go into effect on January 1st don’t leave a lot of room for tax payers to do tax planning. Some of the advice I have read even says “make less money to avoid paying taxes.” Well, Duh!
A recent article in InvestmentNews, an industry newspaper read by almost all investment representatives, sported a headline that read “Tax-Managed Funds Back in the Spotlight.” On the surface it would seem good to have the taxable events of a mutual fund “managed,” implying that taxes would be reduced.
Reduced for a while, perhaps, but I think I should warn you that tax-managed funds are tax bombs just waiting to blow up on investors.
A key component to managing taxes within a fund is by not “realizing” gains within the fund. That is the tax term for taking gains and paying taxes on them. Tax-managed funds go to great lengths to avoid selling stocks that would realize gains and result in a tax liability. But in the process “unrealized” gains continue to build up as stocks are held for longer and longer periods, creating a tax liability within such funds.
Let’s look at an example of two investors who each invest $100,000 in the mythical XYZ Tax-Managed Mutual Fund on the same day in 2011. They pay $10 per share.
And let’s assume that XYZ fund held only one stock, Monster Energy (formerly Hansen Natural), which it bought January 3, 1996 at 5 cents per share. Current share prices are $45.47 as of this writing on November 17th, 2012. Clearly that stock has been a good investment allowing that fund to post impressive gains.
But those $10 mutual fund shares include $9.99 in unrealized gains that have never been taxed in almost 17 years because the XYZ has never sold any of its Monster Energy stock.
Of concern is that over the past 5 months Monster stock shares have declined from a high of $78 dollars to today’s $45 level.
Investor A decides that with Monster declining, the XYZ fund is no longer what he wants to own, and today (November 20th, 2012) he sells to get exactly his original $100,000 investment back. Despite Monster’s recent plunge, he broke even. Whew.
At the same time the XYZ fund manager decided it was time to get out of Monster and sold all the shares of Monster the fund owned. The sale realizes all 17 years worth of gains and on November 21st, the day after A sold his shares, the fund formally declares the capital gain making it taxable to shareholders.
A few days later, Investor B hears that A sold his shares and decides to sell his shares too, so he sells and he also breaks even, getting exactly $100,000 from the sale. Whew.
However in January, Investor A gets his 1099 for taxes reporting zero gain, meaning zero tax due, but Investor B gets his 1099 showing a $99,900 taxable gain, despite his investment just breaking even. Investor B just found out what I mean by the term ‘tax bomb.’
Although this example is extreme, it shows the problem inherent in tax-managed funds. Those tax liabilities do not go away, but are merely passed along to later shareholders, like bombs quietly ticking away until they go BOOM!
Mutual fund taxation is very complex and forecasting when and how much gains will be is often hard to do. Holding one of these funds is a bit like playing Russian Roulette with your investments.
So, although tax-managed funds sound good, I think investors should steer clear of them to avoid nasty surprises down the road.
Scottsdale Office Date
Please call the office at (928) 778-4000 if you would like to meet with Will in the Scottsdale office.
A Slice of Life
Hepburn Addresses National Conference
I returned last week from a conference in Chicago hosted by the National Association of Active Investment Managers where I was invited to address the topic of “Adapting to Changing Markets.” Since that is my forte the presentation was fun to do, but it is always humbling to think that a roomful of really bright people who manage upwards of $30 billion want to hear what I have to say.
Since I grew up in Chicago and have family and friends in the area, Chicago is one of my favorite places to go.
How’s The Market Doing
My last few newsletters have talked about how the stock market seemed to be running on fumes. Two weeks ago I mentioned that rising volatility signaled a change and since the market had gone up earlier in the summer, a change suggests it would begin going down. That is exactly what happened.
Beginning the day after the election, the market began selling off and has been in a fairly steady decline since then.
I believe this is caused by investors wishing to sell investments that have gains to pay taxes on those gains at today’s rates. With the tax laws slated to change on January 1st, some of those investors will see taxes on investment gains go from 15% to 23.8%, a 58% tax hike.
At this point, waiting to take gains is a waste of money, so extra sellers are coming forth. And the health of the stock markets is nothing more than the balance between buyers and sellers. Right now sellers are outnumbering buyers. Unless Congress changes things, I expect this trend to continue creating a serious headwind for the stock market over the next couple of months.
What’s Going On In Your Portfolio?
Since making portfolio changes in August, our growth portfolios have gone up while the S&P 500 Index** has gone down. We have outperformed the markets by about 5% during this period. Tell your friends.
Currently our growth model* is hedged and is slightly “net short” which means we have one stock and a couple of growth mutual funds that are paired up with some inverse funds. This goes up when the markets go down – a good kind of investment to own the past few weeks. Net short means we have slightly more inverse funds than traditional (long) investments. When the market goes down a buck we should go up 30-40 cents.
Of course when the market goes up, we go down, which is why we monitor the inverse funds daily to decide when to take our gains to the bank.
Flexible Income* model is fully invested in municipal funds, as well as floating rate funds, corporate and government bond funds. It has been making small gains most days lately, which is a good way to invest.
New Balances Page for Online Accounts in MyStreetscape!
This newly re-designed page makes it easier to obtain the balances you need and allow you to quickly identify changes to those balances in real-time.
The new Balances features include:
• Real-time Balances – Know the account value based on current market values and activity in the account. Obtain the most current balances by selecting the ‘Refresh’ icon on the upper right hand corner of the page.
• Recent, Prior Day and $ and % Change all on the same page – This change helps you get the information you need faster by combining the Intraday and Prior-day screens into one page.
• $ and % Change Fields – When a change occurs in an account, the dollar amounts responsible for the change are readily apparent–no more manual calculations to determine the change in a particular value. Percentage figures allow users to quickly see and communicate account changes in percentage.
Our Spotlight Strategy
With our Flexible Income strategy we strive to provide high total return consistent with Capital Preservation.
Your money will be invested in bond or currency funds, including precious metals that may be used as currencies and equity-income investments whose price trend is up. If the price cycles down, holdings are replaced with new investments that are going up. Repeat as needed. Growth stocks are not used.
If you would like a current copy of our SEC Form ADV, Part 2, it is on our website at hepburncapital.com/form-adv.html
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable; however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.