Investing Strategies for the High Net-Worth Investor: Maximize Returns on Taxable Portfolios - Hardcover

GANNON

Hardcover

ISBN 10: 0071628207 ISBN 13: 9780071628204

Publisher: McGraw Hill, 2009

Synopsis

A proven model for achieving high returnson taxable investments

Investing Strategies for the High Net-Worth Investor showcases an investing approach that helps readers understand the unique challenges and opportunities that wealthy families face when building a diversifiedportfolio for multiple generations. Renowned private wealth manager Niall J. Gannon offers a framework for investing in tax friendly asset classes. Readers will gain critical insight for building a solid portfolio.

About this title

About the Author

Niall J. Gannon is the lead member of theGannon Group at Smith Barney and was named "portfolio manager of the year" by the Portfolio Management Institute and he is an active member of the Institute for Private Investors.

Excerpt. © Reprinted by permission. All rights reserved.

INVESTING STRATEGIES FOR THE HIGH NET WORTH INVESTOR

Maximize Returns on Taxable Portfolios

By NIALL J. GANNON

The McGraw-Hill Companies, Inc.

Copyright © 2010 Niall J. Gannon
All rights reserved.

ISBN: 978-0-07-162820-4

Contents

ACKNOWLEDGMENTS
INTRODUCTION
Chapter 1 Developing an Understanding of the Wealth Creative Process as a 
Long-Term Business Owner: How Did the Wealthy Achieve Their Success, and 
Do Those Same Traits Translate into Investing?
Chapter 2 Market History
Chapter 3 After-Tax Returns on Stocks versus Bonds for the High Tax 
Bracket Investor
Chapter 4 Asset Allocation for the Taxable Investor
Chapter 5 Municipal Bonds: The Forgotten Asset Class
Chapter 6 Are Alternative Investments a Necessary Component of a 
Diversified Portfolio?
Chapter 7 A History of Taxation at the Top Bracket and the Effect of 
Taxation on the Long-Term Compounding of Assets
Chapter 8 Strategies for Optimizing Portfolios: Taxation, Performance, and 
Fees
Chapter 9 Active versus Passive: How Does an Investor Decide?
Chapter 10 A New Way to Look at Risk
Chapter 11 The Investing Habits of Institutions
Chapter 12 The Investment Habits of Wealthy Families
Chapter 13 Multigenerational Planning
Chapter 14 A Case Study to Prove the Correlation between Earnings and 
Stock Price: Jones Pharma
Chapter 15 Train Wrecks: Avoiding the Most Common Mistakes as an Investor
Chapter 16 Wealth Management Strategies and a Comparison of Various 
Models: Family Office, Full-Service, and Direct Wealth Management Firms
ENDNOTES
INDEX

Excerpt

CHAPTER 1

Developing an Understanding of the Wealth Creative Process as a Long-TermBusiness Owner

How Did the Wealthy Achieve Their Success, and Do Those Same Traits Translateinto Investing?

To be a wealth manager is to embrace a paradox: Your most successful clients mayknow more about making money than you do. One of my favorite storiesillustrating this contradiction I heard at a conference for the Institute forPrivate Investors in San Francisco. Merrill Lynch wealth strategist AshvinChhabra described how a prospective client came to him and said, "Before we talkabout diversification, I want you to know that if I met you 20 years ago Iwouldn't be sitting here today." The point the client was making is that it washis lack of diversification and his ultra-concentration in one family businessthat grew his family's wealth in the first place. If he had instead invested hismoney in an index fund, he would have never become rich.

This is not to say that wealthy investors don't need diversified portfolios. Themajority of wealthy Americans are "self-made" individuals who've built their ownbusinesses. At the point at which most approach a financial advisor, they'reoften looking to reduce their exposure to downside risk. They may be about toretire from their business, sell it, or just feel that they've reached a stagein their lives where a diversified portfolio makes sense. But in building thatportfolio, it's important to never forget where the wealth originated. Andunderstanding this means realizing that there's a point where a diversifiedportfolio becomes so diversified and convoluted that it no longer represents acollection of individual businesses but the entire U.S. economy, the globaleconomy, or an arbitrary mix of assets, which may or may not be in as good shapeas the wealthy investor's original business. In other words, someone who madehis fortune selling the computer company he built from scratch to IBM probablyshouldn't be invested with 10 money managers who each owns 100 stocks because itbecomes impossible to tell if his money is invested in quality businessesanymore.

All of that said, the true value of diversification is that it can help wealthypeople stay rich. Perhaps nothing illustrates this better than the Forbes 400list. The list published annually by Forbes magazine since 1982 ranksthe 400 wealthiest Americans by their net worth. As is generally the case withwealthy investors, most of the people on the list are entrepreneurs or thechildren of entrepreneurs, some 271 of the 400 members in 2008 or 68 percentbeing "self-made" business owners. And yet the changes to the list reveal howfickle the fate of business can be. Since 1982, only 31 people from the originallist have stayed on it until today. Some of the members dropped off because theydied, but many others fell off because of a decline in their assets.

Yet the remarkable thing our research has discovered is that a "plain vanilla"portfolio of municipal bonds and stocks would have kept more people on the list.

As you can see from Figure 1.1, a member's net worth of $100 million in1982 needed to grow to $1.3 billion by 2008 for him or her to stay on the list.That amounts to an annualized return of 9.97 or about 10 percent. Meanwhile,from January 1, 1982, until December 31, 2008, the S&P 500 returned 9.63 percentannualized. A $100 million investment in the market would have turned into $1.2billion, almost equaling the return of America's wealthiest citizens. Even moresignificant, in 1982 the average municipal bond yielded a whopping 13.36percent. If a wealthy investor had bought $100 million in 30-year zero-couponmunicipal bonds in her home state and left the portfolio alone, by the end of2008 it would have been worth $2.6 billion—an annualized 13.36 percent taxfree. The tax-free part of the equation we shall see in subsequent chaptersactually led to a significant outperformance of munis for high net worthinvestors over stocks in recent decades, even when their yields weren't nearlyas high.

Of course, such calculations exist only in the purely academic world of indexes.In reality, investors on the list would have spent some of their portfolios'assets over time and in the case of a pure-stock portfolio, management fees andtaxes on dividends and capital gains would reduce returns. So the 10 percentgrowth rate in the net worth of Forbes 400 members was net of all taxes, moneymanagement fees, and personal expenses, while the stock or bond portfoliowasn't. And yet a tax-free muni portfolio would still have been enough, evenaccounting for most expenses and fees. Moreover, $100 million was the minimumnet worth to be on the list in 1982. Many of the list's members hadsignificantly more than $100 million that year. If the wealthier members hadtaken $100 million of their net worth and put it in long-term municipal bonds,or a balanced portfolio containing both stocks and bonds, and left theirportfolios alone, more than just 31 of the original Forbes 400 members wouldprobably still be on the list today.

Does this mean that wealthy investors should simply buy a stock or municipalbond index fund? Not at all. One of the key issues we revisit in subsequentchapters is a basic concept of investing that few investors seem to trulyunderstand—"past performance does not equal future results." Ultimately,the future returns of an investment portfolio depend on current economic andsecurities market conditions—yields and default rates in the case ofbonds, and valuations and earnings growth in the case of stocks. So it isimportant to bear in mind that while in 1982 the average muni yielded 13.36percent, in 2009 munis yield just under 5 percent. Similarly, the S&P 500 had anaverage price/earnings (p/e) ratio of 8 at the start of 1982, while at the endof 2008 it had an average trailing one-year p/e ratio of 61, according toStandard & Poor's.

Why after a severe bear market decline in 2008 would stocks in the index stillbe so expensive? That's because Standard & Poor's rightly incorporates indexmembers with no profits or losses into its calculations of valuations, and manybanks and financial companies had losses in 2008. Thus, despite significantstock price declines, there were fewer earnings to be added to the "e" portionof the p/e ratio. Assuming the profitless banks and other failing companies willsoon return to profitability and clean up their balance sheets—a bigassumption—analysts estimated at year-end 2008 that the index had aforward p/e ratio of 13.8, according to Baseline, a much more attractivevaluation. But all this begs the question as to why anyone would want to investin an index in which a significant portion of its members may be in deepfinancial distress. If wealthy investors made their money building greatbusinesses, why would they want to blindly be diversified into bad ones?Moreover, if stocks have declined so much, aren't there some great businesseswith legitimate earnings on sale right now that the index's high p/e ratiomasks? I would argue that wealthy investors would be better off investing inthose great businesses to diversify instead of in an index fund.

If you talk to America's wealthiest citizens, few seem keen on the indexingconcept or broad diversification in general. In an article titled "Secrets ofthe Self-Made 2008" Forbes editor Brett Nelson asked 20 questions to 17of the 400 list's entrepreneurs who had an average net worth of $4 billion. Thelast question was, "You have $100,000 to invest. What do you do with it?" Somementioned buying real estate, biotech startups, or alternative energy stocks,while others would invest more in their own businesses. No one recommended indexfunds, hedge funds, or diversified investments of any sort.

And yet if we look at this list a few years from now, probably many of itscurrent members will no longer be on it because of bad investments. So clearlysome sort of balance needs to be struck between the tendency of financialadvisors to build portfolios for their clients that are overly diversified andthe tendency of wealthy investors to bet the farm on a single idea and then loseit all.

INSTITUTIONAL MISALLOCATION

Unfortunately, the trends for wealthy investors who have diversified portfoliosare equally discouraging. According to a 2008 survey conducted by the Instituteof Private Investors, a wealth management, educational, and networkingassociation, the average wealthy investor has 35 percent of his or her portfolioallocated to stocks and 44 percent to alternative assets, 22 percent or half ofthat alternative allocation in hedge funds. By contrast, "boring" municipalbonds only accounted for 10 percent of portfolios. In fact, as we shall see insubsequent chapters, most wealthy investors' portfolios now resemble the famousYale University endowment in their asset allocations.

Although such a hedge-fund–oriented strategy has worked brilliantly forYale, I believe it is inappropriate for wealthy individual investors. It isimportant to realize that predictable and understandable investment performanceis much more significant to a family than it is to an institutional investor.The reason for this is that the high net worth investor, unlike an endowment,charity, or pension plan, can rely only on investment performance for the growthof capital. This is in stark contrast to, for example, a corporate pension plan,which can receive a cash infusion from the company when its investmentsunderperform. And if the pension plan ultimately fails, it can be taken over andbailed out by the U.S. government's Pension Benefit Guarantee Corporation(PBGC).

In particular, with university endowment funds such as Yale's the constant flowof new dollars from fund-raising activities provides their portfolios with thecapital to deploy new strategies and not worry so much about short-term losses.Some would argue that the presence of these predictable cash inflows allows themanagement of these endowments to take on greater risks with hedge funds andother alternative investments such as commodities. But most wealthy investors,when they approach a financial advisor, are of retirement age or approachingretirement age and plan to live off their portfolios. It is therefore imperativethat their advisors recognize that the wealth creative event—the successof their business—is in all likelihood a once a lifetime experience andthat there will be no entity like the PBGC to bail the family out if the advisorfails to manage the assets properly.

Hedge funds, as we reveal in later chapters, are about the worst possibleinvestment a wealthy investor can make. Their fees are high which incentivizesmanagers to generate returns by taking on inordinate amounts of risk vialeverage. This is true for both institutional and wealthy investors. But for theindividual high net worth investor hedge funds have the added drawback of beingincredibly tax-inefficient, employing high turnover strategies that produceshort-term gains taxed at the highest rates.

So why are financial advisors putting so many wealthy investors in hedge funds,while municipal bonds are often overlooked? Perhaps the reason is that manyadvisors don't really understand the needs of wealthy investors. Unfortunately,most of the investment advice provided at the major consulting think tanks onWall Street and across the United States is geared toward nontaxable pools ofmoney. The reality is that the ultra high net worth market is still relativelysmall compared to the institutional world of pensions, endowments, 401(k) plans,and mutual funds. Less than 1 percent of U.S. taxpayers are subject to the toptax bracket.

Ultimately, a boring portfolio of high-quality stocks and municipal bonds canoften satisfy the needs of wealthy investors with better after-tax returns andless downside risk. But not many advisors have been recommending such astrategy, perhaps because it is one that typically for a high net worth investorcomes at a relatively low fee. One thing I like to remind my clients is that a$1 billion portfolio compounded at 6 percent (after taxes and fees) over fourdecades translates into $4 billion. If this can be done in a manner that iscompletely transparent, generates cash flow along the way, and doesn't requirederivatives, margin, or "hoping" for high returns, does it not make sense toconsider?

A boring or more appropriately termed traditional portfolio also has a uniqueadvantage in that the income produced by its bond allocation provides apredictable cash flow that can be used to cover a wealthy investor's ongoingexpenses. This is especially so if the bonds are bought directly as opposed tothrough mutual funds. As long as an investor's individual bonds do not default,he knows they will pay him their coupon rate until they mature. That is veryuseful from a financial planning perspective. It helps the investor to not worrymuch about stock market fluctuations and focus more on her individual goals, andit helps her budget her expenses according to a predictable income stream. Bycontrast, no one knows how a hedge fund will perform in any given year, which iswhy such alternative investments are more suitable for institutional investorsthat don't pay taxes and can afford to take on the additional risk.

Thus a very basic allocation strategy for a wealthy family might be to livedebt-free, to own a portfolio of high-quality tax-free bonds for income, and toown a diversified equity portfolio that will generate dividends and wealth forfuture generations and fund the philanthropic works of the family. This isstraightforward. It is time-tested, completely transparent, and can beunderstood by even the least sophisticated members of the family. And yet so fewwealthy families seem to follow this strategy.

DO THE MATH

It is for all the above reasons that our central message to both wealthyinvestors and their advisors is to adopt an after-tax view of asset allocationand expected returns. In order to do that, we must clarify the elements ofcommonly used capital markets assumptions made by Wall Street and academia. Mostimportantly, we must develop habits for using this information to make informeddecisions in the future. When examining the building blocks of capital marketsreturns and conventional asset allocation studies, we've observed that theyoften overstate the after-tax returns on equity investments. It is ourconclusion that wealthy investors have been influenced by the studies, causingoverstated performance expectations. As a result, they often select assetallocation strategies with a high equity bias, high risk profile, and low taxefficiency.

In order to illustrate the remarkable difference in returns earned by taxableversus nontaxable investors, we should revisit the most popular study of assetclass returns. This of course would be the one by Chicago-based financialresearch firm Ibbotson Associates, which calculated the long-term return ofequities, bonds, and T-bills (Treasury bills) since 1926. Though Ibbotsondeserves credit for updating founder Roger Ibbotson and Rex Sinquefield'soriginal 1976 study to examine after-tax returns in 2006,6 its tax analysisunfortunately makes certain assumptions, which limit its effectiveness forwealthy investors. First, the study compares equity returns to U.S. Treasurybonds, which generally do not provide as high after-tax returns as do municipalbonds. But more significantly, the after-tax numbers are calculated only for themiddle income tax bracket rate of 28 percent rather than the top income taxbracket over time, which at its peak has been as high as 94 percent. Finally,the analysis does not include a liquidation of the portfolio at the end of thestudy, meaning the study's portfolio contains a large embedded capital gain thatremained untaxed. It is essential to understand the returns investors wouldexperience if liquidating an asset in the portfolio for either consumption orredeployment into a business or different asset class.

One of the goals of this book is to provide a more accurate analysis of theafter-tax returns of these asset classes. Indeed, the primary reason I wasspeaking in Vancouver was to discuss a study I had published with Michael Blumin 2006 titled "After-Tax Returns on Stocks versus Bonds for the High TaxBracket Investor" in The Journal of Wealth Management. Our study forthis book has been updated to include the period from 1957 through year-end2008. One of our main findings was that the outperformance or "risk premium" ofstocks versus bonds for wealthy investors was only 0.77 percentage points ratherthan the 4 percentage points experienced by nontaxable investors. For our studythe untaxed equity portfolio return on stocks is similar to the Ibbotson study,9.15 percent annualized. However, after subtracting taxes from the portfoliopaid at the highest rate in each of the years studied, the return dropped to6.24 percent. This compared to a compounded return on a high-grade municipalbond of 5.47 percent. We review our study's results in greater detail inChapter 3.

MULTIGENERATIONAL OBSTACLES

Though investing with taxes in mind is crucial for wealthy investors, developingsavvy estate planning strategies is equally significant. Regardless of how wella stock or bond portfolio performs, a wealthy investor's heirs will ultimatelybe confronted with the estate tax, which in 2009 was 45 percent and is set torise to 55 percent in 2011. (As an indication of this tax's completeunpredictability, it is set to drop to 0 percent in 2010 because of quirks inthe tax policies in The Jobs and Growth Tax Relief Reconciliation Act of 2003.)It is interesting to note then that only 19 percent of 2008's Forbes 400 memberswere heirs to fortunes. That fact is hardly coincidental.

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Excerpted from INVESTING STRATEGIES FOR THE HIGH NET WORTH INVESTOR by NIALL J. GANNON. Copyright © 2010 by Niall J. Gannon. Excerpted by permission of The McGraw-Hill Companies, Inc..
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Edition details

• Publisher: McGraw Hill
• Publication date: 2009
• Language: English
• ISBN 10: 0071628207
• ISBN 13: 9780071628204
• Binding: Hardcover
• Edition number: 1
• Number of pages: 320