The current bull market is a boon for investors, but advisors are understandably wary. Up almost 280 percent since hitting its March 2009 low, record high after record high too often signals a downturn to come. It could be debated that valuations are stretched, and hence they rightly wonder, what will it mean for portfolio allocations?
Getting compositions back in line with original mandates and risk tolerances after drifting in the market mania is a delicate rebalancing dance for advisors and clients who want to avoid capital-gain triggers and their associated tax liabilities.
Yet because of the possible tax liability from selling and repositioning assets, advisors—and their clients—are often reluctant to do much about it, resulting in the potential for far more damage and loss in the long run. Experiencing a significant hit to the portfolio early in retirement, widely known as sequence-of-return risk, is especially troubling, and something from which many investors struggle to (or never) recover.
Luckily, a number of rebalancing strategies exist that, if executed correctly, avoid the tax hit, and range from relatively basic to a bit more complex.
Tax-loss harvesting is one of the better known, and involves the reporting of investment losses as a way to offset the tax liability attached to capital gains. The losses can be taken, or “harvested,” now or in the future, as anything unreported can be brought forward into subsequent years, and a tax reduction of up to $3,000 annually can be applied until the losses are expended.
A second strategy is the donation of appreciated shares to a (qualified) charitable organization. A win-win for both the client and the charity, the donation is deductible for the former, while the latter receives a break on the capital gains when it chooses to sell.
A third technique is to incorporate a type of portfolio insurance “overlay.” Time-tested and in play for decades, it’s a strategy that’s especially relevant given current conditions, and incorporates the use of an options strategy that sells calls and/or buys puts.
It’s a bit more sophisticated, and therefore requires more explanation, yet it’s fast becoming part of many advisors’ toolkits. It can often provide a consistent means to achieve higher risk-adjusted returns, enhanced yields, and lower portfolio volatility. An option overlay utilizes a four-step process by:
1) Reducing the amount of risk, or beta, to bring the portfolio back in line with investor comfort levels;
2) Calculating the difference between current and optimal target exposures to protect against downside loss;