November 8, 2016

The Irony of Tax Efficient Funds

The Investment View from Prescott, Arizona

This is capital gains season for mutual funds, and the free ride investors have had for a few years is coming to an end. The stock market rose significantly after 2009, but those gains were largely offset for tax purposes by the huge losses from 2008 that were carried forward, so investors paid no taxes on the following gains. However those losses have now been written off, and for many fund investors it is time to pay the piper.

Many mutual funds do not announce their scheduled capital gains distributions lest investors withdraw from the funds to avoid them. However, InvestmentNews reports that several big funds are poised to report gains referred to as “doozies,” which I take to mean, taxable gains larger than their recent earnings.

Mutual fund taxation is very complex, and investors who have made little money or even lost money sometimes get significant tax bills from their fund. One of the ironies of “tax efficient” funds is that they have the greatest potential for this type of nasty surprise.

As an example, let’s look at what could happen to a hypothetical fund that owned a single stock, Ford (Ticker Symbol: F), and for the sake of this example, making the fund shares and Ford shares the same price.

Let’s say the fund bought Ford in 2009 for $2. Ford went up to $17 in 2013 and 2014, making the fund a rock star and media darling. You read about it and invested in the fund in 2010 when Ford stock was at $16.

Since the fund never sold any Ford stock there were never any taxes to report, but there were large capital gains liabilities building up for unsuspecting investors.

In 2016, as the price slid for Ford stock and the fund entered its third year, your investment was now down 25%, from $16 to $12, and the manager decides to sell the
Ford stock at $12. The entire Ford gain of $10 per share is now reportable as a capital gain to current shareholders, even if you bought in after the price rise.

Although this scenario is an exaggerated one, a number of large funds have these types of gains about to be declared. The funds included in the InvestmentNews article include American Funds, AMG, Ariel, Columbia Acorn, Fidelity, Franklin, JP Morgan, Longleaf, Morgan Stanley, PrimeCap, and T Rowe Price, and many more will not be announcing gains ahead of time, but will join the parade.

I rarely use growth funds in client portfolios, and this is just one reason why.

You can see the full article at:
http://news.morningstar.com/articlenet/article.aspx?id=778475

 What the Markets Are Doing

Trends with Benefits?

The election has the markets on edge, and a tight race may prolong the jitters. One analyst describes the investment environment as “gloomy with a chance of dread.”

The S&P 500** stock index is down 4.79% since its August 15th high, with most of that loss coming in the past few weeks. The markets don’t really care which party is in power, since both the Republicans and Democrats are in bed with Wall Street.

But the weaker the market the more it suggests a non-incumbent party (Trump in this case) wins in today’s election. The reason is that the financial markets don’t like uncertainty. They can adapt to whatever rules there are, but a new administration will make changes that cannot be fully known today, so investors become less certain with the greater potential for change and tend to hold back more on investing. An absence of buyers is all it takes to make the market go down.

Interest rates are beginning to rise, so many of the bond funds that investors have piled blindly into are going to show losses this year.

Gold is finally showing signs of life as a major cycle low is behind us.

Although the first year of a presidential cycle is the worst one to invest in, there are indicators suggesting that this time it may be different. My friend Tom McClellan writes the McClellan Market Report newsletter and is an amazing visual trader. He can see a chart pattern and recall seeing it somewhere else, finding relationships we mere mortals miss.

Tom has discovered that the Dow Jones** Industrial Average chart pattern is very similar to that created by oil prices, with a 10 year lag. We have no idea why 10 years is a magic number, but since it seems to work, we accept it. 2017 is the 10 year anniversary of the beginning of the boom in oil prices that peaked with $150 per barrel of oil in 2008. This strongly suggests a rising stock market through 2018. Tom admits that exogenous events like Saddam Hussein’s invasion of Kuwait can throw things off, so this analog is not perfect, merely very good.

Liquidity appears strong, so hopefully after the election jitters pass, this cash will find its way into the markets and begin bidding prices up.

Stay tuned. 

 A Thanksgiving Gift from Hepburn Capital

I just hate having to stand in lines, and the post office just before Christmas can be especially frustrating as last minute package mailings bog things down. If you share my sentiment, Hepburn Capital can help by giving you the use of our UPS service this holiday season.

Our office maintains a UPS account, complete with the ability to weigh packages, pay for and print UPS labels online. Bring your packages to Hepburn Capital’s Prescott office and in a few minutes our staff can weigh, process and take your payment for your shipping costs. Since we won’t have to wait in line, we will even take them to the UPS store for you.

This is just Hepburn Capital’s way of saying thank you at Thanksgiving and making the holidays a little brighter for those in our circle of clients and friends. Happy Thanksgiving.

And, while you are at the office, please pick up one of our new letter openers that make cutting wrapping paper a breeze. 

 College Classes Coming

     Watch this space for the 2017 class schedule.

  What’s Going on in Your Portfolio?

As of this writing on November 4th, the S&P 500** Index is only up 2.02% for the year. I am happy to say that all of our strategies have outperformed the S&P**, while taking much less risk.

While the S&P** dropped -10.51% at the beginning of the year, the maximum drop in Shock Absorber Growth*, my most aggressive strategy, was only -3.55%, so HCM clients had about 1/3 of the risk of the market and still out performed it. Tell your friends.

We have been heavily hedged for several months as election jitters and normal seasonal weakness in the markets was upon us. Since the market began weakening in early September, this has been the right move and we have enjoyed strong performance.

Currently we hold about a dozen stocks, but over 20% in cash and a large hedge which is our shock absorber. It goes up as the market goes down, so our exposure to stock market risk is about zero at the moment.

I bought gold about two weeks ago, and already have some nice gains in that.

With interest rates rising, the Flexible Income* side of our portfolios that carried us for the past year or two is now weakening a bit, but not enough to warrant large changes.

After the election I will be watching things closely for signs of change. As I often say, I don’t know exactly what will happen, but I am confident I will recognize it and be able to react to the new conditions, quickly.

 Our Spotlight Strategy – Adaptive Balance 

With our Adaptive Balance Strategy we strive to provide an acceptable level of total return from a combination of investments in both the equity and income markets, with an emphasis on the income markets.

Our proprietary indicators are used to determine a stock market exposure that adapts to both strength and weakness in the market, directing exposure to the HCM Shock Absorber Growth strategy from 0% to a maximum of 50% of account value. The balance, 50% to 100% of account value, is invested in the Flexible Income Strategy. The HCM Safety Net suite of indicators is designed to warn of sudden potential declines, in which case, market exposure is quickly reduced.