Flingin' It - 8/19/16

Flingin' It is an occasional version of the Accountable Update where I throw out a variety of topics that may potentially impact ATX Portolio Advisors' clients and friends. I will also share articles from other sources that I enjoyed or found interesting. I hope some of it sticks!

In this edition, I have a quick update on a proposal from the Treasury Department that could significantly impact estate plans for some readers. I also share a piece from DFA where the relationship between GDP growth and stock market returns is explored. Finally, I included an always entertaining article by Jim Parker from his Outside the Flag series. Enjoy!

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Popular Estate Planning Technique Curtailed By Proposed Treasury Regulation

Family Limited Partnerships (FLPs) have been a popular estate planning tool for high net worth families' over the past 15 years or so as a series of Tax Court rulings favored their use. On August 2, the Treasury Department proposed new regulations that will remove or severely restrict the primary tax benefit of FLPs, discounted valuations for lack of control and marketability of family controlled entities.

Currently, FLPs allow for the value of property placed into the partnership to be discounted, which can reduce the size of an estate, and ultimately estate taxes. General Partners, usually the older generation, can further reduce their holdings (and estate taxes) by gifting partnership interest to limited partners, typically the heirs, while retaining control of the property. 

Unable to get anything done in Congress, an increasingly assertive Obama administration is essentially taking authority through Executive action from the vacuum created by gridlock to further their agenda, in this case, estate tax reform. Since multi-millionaires are the only impacted group, don't expect much outcry from either side of the aisle as what essentially is a "1%" loophole, is closed. 

What should you do? The regulations must go through a 90 day comment period and wouldn't be enacted until 30 days after that. If you have an estate valued greater than $5.45 million as an individual or $10.9 million as a married couple, there is still time to call up your estate planning attorney to see if there is any need or opportunity to review or update your estate plan. 

If you would like to be introduced to a qualified estate planning attorney, feel free to get in touch to discuss your situation.

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Economic Growth and Equity Returns

A relevant question for many investors is whether their view of economic growth should impact how they invest.

Opinions about future economic growth often differ across market participants. For example, in a survey of more than 60 economists conducted by the Wall Street Journal in June 2016, estimates of US GDP growth in 2017 ranged from 0.2% to 3.7%.[1] A relevant question for many investors is whether their view of economic growth should impact how they invest. In this regard, they may be surprised to find that the historical link between annual GDP growth and equity returns has been quite weak.

Exhibit 1 shows annual GDP growth vs. annual returns for developed and emerging markets. These plots indicate that there has not been a strong relation between GDP growth and equity returns in the same year. For example, in developed markets country/year combinations[2] when GDP growth was positive, the spread in returns was substantial: 323 country/year combinations had returns above 10% while 192 country/year combinations had returns below −10%. We see a similar pattern in realized returns for developed markets country/year combinations when GDP growth was negative. Emerging markets show a similar pattern.

Exhibit 1.       Annual GDP Growth and Equity Market Excess Returns

Sources: World Bank, MSCI, Morningstar. Shorter time periods shown for some countries due to data availability. Past performance is no guarantee of future results. See Data Appendix for details.

Despite this weak relation between GDP growth and stock returns in the historical data, investors often ask whether shorter-term fluctuations in economic cycles impact stock returns in the near term. Stated differently, while on the surface Exhibit 1 presents a weak picture of GDP growth and stock returns in the same year, is there a relationship between the two that is not obvious from this exhibit? 

To address this question, we examine 23 developed markets from 1975 to 2014 and 19 emerging markets from 1995 to 2014.[3]  Each year, countries are classified as either high or low growth depending on whether their GDP growth was above or below that year’s median GDP growth, defined separately for developed and emerging markets. We then look at stock market returns of high and low growth countries over the following year. The return for each group of countries is the average stock market return of all countries in the group weighted by countries’ market capitalization weights.

Exhibit 2 shows that, historically, differences in GDP growth over the past year contained little information about differences in equity returns this year. In both developed and emerging markets, average annual returns were similar for high and low growth countries. In fact, low growth countries had slightly higher average returns than high growth countries, although this return difference was not reliably different from zero. In other words, there is no evidence that this return difference occurred by anything other than random chance.

Exhibit 2.       Equity Returns and Economic Growth in High and Low Growth Countries [4]

Sources: World Bank, MSCI, International Finance Corporation (World Bank). Past performance is no guarantee of future results. Filters were applied to data retroactively and with the benefit of hindsight. Returns are not representative of indices or actual strategies and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. Please see Data Appendix for more information.

Can superior forecasts of short-term future economic growth help improve investment decisions? To address this question, we extend the analysis and assume perfect foresight about GDP growth over the next year. We now study the returns of high and low growth countries over the same year we measure GDP growth. This is not an implementable strategy because investors do not have the advantage of knowing economic growth in advance. They must rely on GDP forecasts, adding additional uncertainty. Exhibit 2 shows that even under the assumption of perfect foresight, using GDP data would not have generated reliable excess returns for investors. In developed markets, low growth countries had higher average annual returns than high growth countries, whereas in emerging markets, high growth countries had higher average annual returns than low growth countries. Neither difference in returns was reliably different from zero. This suggests that markets quickly incorporate expectations about future economic growth, making it difficult for investors to benefit from growth forecasts even with the advantage of perfect foresight. Differences in equity returns across countries seem to be driven more by differences in discount rates than by differences in GDP growth, even under a perfect forecasting scenario.

conclusion

Many investors look to economic growth as an indicator of future equity returns. However, the relation between economic growth and returns in the historical data has been shown to be weak. This should not come as a surprise given that returns are determined by discount rates and investors’ aggregate expectations of future growth. Surprises relative to those expectations, whether positive or negative, may cause realized returns to differ from expectations. The evidence presented here suggests that differences in GDP growth contain little information about differences in stock returns in the same year and over the subsequent year. This means that it is difficult for investors to earn excess returns by relying on estimates of current or future GDP growth—even estimates that perfectly forecast GDP growth over the next 12 months.

[1].   “Economic Forecasting Survey,” Wall Street Journal, http://projects.wsj.com/econforecast.
[2].   Each observation in Exhibit 1 represents, for one country in one calendar year, the equity market excess return over one-month US Treasury bills as well as the rate of GDP growth. For example, one of the observations shows that in the US in 2014, the equity market excess return was 12.7% and GDP growth was 2.4%.
[3].   See Data Appendix for details. 2015 GDP growth data was not available for most countries at the time of writing.
[4].   A t-statistic is a measure for the reliability of an average return difference. Normally, a t-statistic of at least 2 in absolute value is necessary to reliably say that the result is different from zero.

Data Appendix

Developed markets since 1975 (unless stated differently):
MSCI Australia Index (net div.), MSCI Austria Index (net div.) (from 1980), MSCI Belgium Index (net div.), MSCI Canada Index (net div.), MSCI Denmark Index (net div.) (1980), MSCI Finland Index (net div.) (1988), MSCI France Index (net div.), MSCI Germany Index (net div.), MSCI Hong Kong Index (net div.), MSCI Ireland Index (net div.) (1988), MSCI Israel Index (net div.) (1999), MSCI Italy Index (net div.), MSCI Japan Index (net div.), MSCI Netherlands Index (net div.), MSCI New Zealand Index (net div.) (1988), MSCI Norway Index (net div.), MSCI Portugal Index (net div.) (1990), MSCI Singapore Index (net div.), MSCI Spain Index (net div.), MSCI Sweden Index (net div.), MSCI Switzerland Index (net div.) (1981), MSCI United Kingdom Index (net div.), and the MSCI USA Index (net div.).

All of the following emerging markets are included since 1995 for Exhibit 1.

For Exhibit 2, since 1995 (unless stated differently):
MSCI Brazil Index (gross div.), MSCI Chile Index (gross div.), MSCI China Index (gross div.) (from 1996), MSCI Colombia Index (gross div.), MSCI Egypt Index (gross div.) (1998), MSCI Greece Index (gross div.), MSCI Hungary Index (gross div.), MSCI India Index (gross div.), MSCI Indonesia Index (gross div.), MSCI Korea Index (gross div.), MSCI Malaysia Index (gross div.), MSCI Mexico Index (gross div.), MSCI Peru Index (gross div.), MSCI Philippines Index (gross div.), MSCI Poland Index (gross div.), MSCI Russia Index (gross div.) (1998), MSCI South Africa Index (gross div.) (1996), MSCI Thailand Index (gross div.), MSCI Turkey Index (gross div.).

A country is included in the analysis for Exhibit 1 in a given year if MSCI index return and GDP growth data are available and in the analysis for Exhibit 2 if MSCI index return, country weight, and GDP growth data are available. Returns are in USD. GDP growth is real GDP growth in local currency, converted to USD using constant 2005 USD as provided by the World Bank.

Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Past performance is no guarantee of future results. There is no guarantee an investing strategy will be successful.

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Outside the Flags

History on the Run

When news breaks and markets move, content-starved media often invite talking heads to muse on the repercussions. Knowing the difference between this speculative opinion and actual facts can help investors stay disciplined during purported “crises.”

At the end of June this year, UK citizens voted in a referendum for the nation to withdraw from the European Union. The result, which defied the expectations of many, led to market volatility as participants weighed possible consequences.

Journalists responded by using the results to craft dramatic headlines and stories. The Washington Post said the vote had “escalated the risk of global recession, plunged financial markets into free fall, and tested the strength of safeguards since the last downturn seven years ago.”[1]

The Financial Times said “Brexit” had the makings of a global crisis. “[This] represents a wider threat to the global economy and the broader international political system,” the paper said. “The consequences will be felt across the world.”[2]

It is true there have been political repercussions from the Brexit vote. Theresa May replaced David Cameron as Britain’s prime minister and overhauled the cabinet. There are debates in Europe about how the withdrawal will be managed and the possible consequences for other EU members.

But within a few weeks of the UK vote, Britain’s top share index, the FTSE 100, hit 11-month highs. By mid-July, the US S&P 500 and Dow Jones Industrial Average had risen to record highs. Shares in Europe and Asia also strengthened after dipping initially following the vote.

Yes, the Brexit vote did lead to initial volatility in markets, but this has not been exceptional or out of the ordinary. One widely viewed barometer is the Chicago Board Options Exchange Volatility Index (VIX). Using S&P 500 stock index options, this index measures market expectations of near-term volatility.

You can see by the chart above that while there was a slight rise in volatility around the Brexit result, it was insignificant relative to other major events of recent years, including the collapse of Lehman Brothers, the eurozone crisis of 2011, and the severe volatility in the Chinese domestic equity market in 2015.

None of this is intended to downplay the political and economic difficulties of Britain leaving the European Union, but it does illustrate the dangers of trying to second-guess markets and base an investment strategy on speculation.

Now the focus of speculation has turned to how markets might respond to the US presidential election. CNBC recently reported that surveys from Wall Street investment firms showed “growing concern” over how the race might play out.[3]

Given the examples above, would you be willing to make investment decisions based on this sort of speculation, particularly when it comes from the same people who pronounced on Brexit? And remember, not only must you correctly forecast the outcome of the vote, you have to correctly guess how the market will react.

What we do know is that markets incorporate news instantaneously and that your best protection against volatility is to diversify both across and within asset classes, while remaining focused on your long-term investment goals.

The danger of investing based on recent events is that the situation can change by the time you act. A “crisis” can morph into something far less dramatic, and you end up responding to news that is already in the price.

Journalism is often described as writing history on the run. Don’t get caught investing the same way.

[1]. “Brexit Raises Risk of Global Recession as Financial Markets Plunge,” Washington Post, June 24, 2016. 
[2]. “Brexit and the Making of a Global Crisis,” Financial Times, June 25, 2016. 
[3]. “Investors are Finally Getting Nervous about the Election,” CNBC, July 13, 2016.

About Jim Parker
Jim Parker is a Vice President for DFA Australia Limited, a subsidiary of Dimensional Fund Advisors. As head of the communications and marketing team in Australia, Jim helps create strategies to communicate Dimensional's philosophy and process in ways that engage clients, prospects, regulators, and the media. He does so through presentations, books, papers, and articles, including his "Outside the Flags" column and, more recently, his weekly "Coffee Break" links to interesting articles. 

Jim joined Dimensional in 2006 after 25 years working as a journalist in newspapers, television, radio, and online media. His specialty was financial journalism, particularly in relation to economics and financial markets. Jim holds a bachelor of arts in social and economic history from Deakin University and a journalism certificate from Auckland Technical Institute.

Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services. 

A Picture is Worth Thousands ($)

What do you think about when you walk into a place that puts the “Employee of the Month” picture on the wall? We've all seen them at auto dealerships, retail stores, and even some restaurants. I don’t know about most folks, but for me, that is generally the last person I want to speak to at a business.

“Why? Wouldn’t you want to work with the best employee,” you may ask?

Absolutely, but the “best” employee for the employer isn’t necessarily the best for the customer. That is why it may serve you well to avoid those with the glamour shots hanging on the wall.

I have a confession to make. I didn’t come to this realization by being suckered into an expensive undercoating on a car that never sees road salt in temperate Texas winters. Nor have I been swayed by one too many pretty waitresses stooping down to eye level to see if I need another margarita. (Actually, that one may not be entirely true.)

No, I came to this point of view after years of striving to be the employee of the month/quarter/year, or later as a manager, being the person who choose said employee. The honorees always had one thing in common, besides the photos, plaques, and trophies.

They sold the most stuff.

The titles varied over time. “Investment Representative”, “Financial Planning Consultant”, and “Account Executive” were just a few of the business card descriptions used at my old company. What they all had in common were that they were primarily measured, ranked, and promoted because of their success in “development”, aka, sales.

Wonder if regulators understand how it works? See FINRA’s descriptions on their website:

 “A broker-dealer is a person or company that is in the business of buying and selling securities—stocks, bonds, mutual funds, and certain other investment products—on behalf of its customers (as broker), for its own account (as dealer), or both. Individuals who work for broker-dealers—the sales personnel whom most people call brokers—are technically known as registered representatives. [emphasis added]

Registered representatives are primarily securities salespeople [emphasis added] and may also go by such generic titles as financial consultant, financial advisor, or investment consultant. The products they can sell you depend on the licenses they hold. For example, a representative who has passed the Series 6 exam can sell only mutual funds, variable annuities, and similar products, while the holder of a Series 7 license can sell a broader array of securities. When a registered representative suggests that you buy or sell a particular security, he or she must have reason to believe that the recommendation is suitable for you based on a host of factors, including your income, portfolio, and overall financial situation, your tolerance for risk, and your stated investment objectives.”[i]

Notice that nowhere in the description does it suggest that it is the RR’s job to put the customer’s interest first. Their job is to sell.

As a young employee, I was taught that success was meeting sales goals. The more goals I hit, the more recognition and money I received. When I was new to the sales role, the top performing RR in my office once advised me that if you weren’t generating an occasional customer complaint, you weren’t selling hard enough.

As a manager, I had a long-time top performing salesperson (who had had several brushes with customer complaints) say to me that as long as he exceeded his annuity goals that no one at the company had ever given him grief. He still works there today, in spite of my best efforts.

Over time, as you are recognized for meeting and exceeding sales goals, you accumulate mementos of the “achievements”. Little trophies, certificates, and photos commemorating the award trips and honors clutter the desks and walls of the top achieving RRs at every brokerage firm.

It can be addicting. Once you’ve tasted the nectar, you want more of it. To get more, you MAY work harder. At least that’s what senior management likes to tell themselves and Compliance departments hope to insure. But the reality is that corners get cut, half-truths are told to expedite sales, and the illusion of “expert” advice is presented in the most scalable (cookie cutter) way.

The realization that profits were prioritized over client portfolios didn’t happen overnight for me. It started with annual mandatory meetings to discuss why client accounts that we managed didn’t perform as well as they seemingly should have. Even as academic evidence[ii] began to mount that explained that the fees were the main drag on returns, no one ever suggested that the 1.75% combination of advisory fees + underlying mutual fund costs virtually guaranteed under-performance.

The bullet points provided by the company were designed as much to reassure the RRs to keep selling the high fee accounts as much as they were to provide talking points for wary clients. To underscore these conversations, managers were regularly treated to “Finance Updates” that clearly showed how important these highest fee “solutions” were to the bottom line.

The message was simple, if you wanted to get ahead, the path to success was to sell the most profitable (to the firm) products.

To be clear, I think the vast majority of brokers want to do the right thing for their clients. Like I said, many of my old company’s training efforts were designed as much to convince RRs that they were selling the best product as much as they were to handle customer objections. In fact, they were all just working within a system that is built to take advantage of the average investor that just doesn’t know any better.

How can you protect yourself from a system that some may describe as rigged? Start by looking at the pictures on the wall.

Another approach, of course, would be to seek out an independent advisor that puts your interests ahead of their own. One that is completely transparent about fees, portfolio construction, and performance. If that appeals to you, get in touch.

[i] http://www.finra.org/investors/brokers

[ii]EUGENE F. FAMA and KENNETH R. FRENCH, Luck versus Skill in the Cross-Section of Mutual Fund Returns, THE JOURNAL OF FINANCE • VOL. LXV, NO. 5 • OCTOBER 2010

Money For Nothing and College For Free?

$37,172

That is the AVERAGE student loan debt for a college graduate this year.[i] Considering that 71% of students graduating from four-year colleges carry some student loan debt,[ii] it is little wonder that an avowed socialist promising free college for everyone almost became the Democratic Party’s nominee for President.

Maybe we don't all agree on the policies for how to pay for anything, but it is hard to dispute the value of a secondary education. Researchers say college grads earn about $1 million more than those without degrees over their lifetimes.[iii] For that reason alone, we should try and encourage as many qualified folks as we can to go to college, right? If more students go to college, they in turn would earn more income. Earn more income, pay more taxes, take less public support, and generally feed a virtuous cycle.

The idea was so appealing to the masses that the Democrats have adopted free college and student loan relief into the party’s platform. Free college and no more debt. How could that be controversial? If you're getting the benefit, it sounds like a great deal.

Who isn't in favor of a government program that pays you money? I took the GI Bill and a paycheck from the US Army Reserves in college to help ends meet (with some strings attached). Just to be clear, I view taxes as a reasonable cost of living in a country that affords me and my family the freedoms and security we enjoy, albeit I sure wouldn’t mind if someone out there would like to pay mine. 

While we wait for that to be sorted out, I propose a more Accountable approach. One that doesn’t rely upon someone else paying their "fair share". 

Most of the time, when I discuss college planning with a client, we look at the cost of attending the schools that we think may be most appropriate based on Junior’s grades, ambitions, and preferences. We consider the type of school most likely to admit the prospective student along with the estimated costs of attending said institution. The average costs for college, according to my financial planning software MoneyGuidePro®, are $96,244 for an In-State Public College (4 years, including books, tuition, room/board) and $191,324 for a Private University.

Neither option is particularly cheap, but being flexible can result in dramatically different outcomes, financially speaking. Let’s look at a couple of scenarios that I’ve discussed with clients recently. Both had kids accepted into multiple public and private schools

The first student, we’ll call him Ken, wants to attend Baylor University. MoneyGuidePro® says it will cost $52,834 per year. Mom and Dad have saved up about $100,000 in a 529 plan, but figured they could contribute another $15,000 per year from current income. The difference of $51,336 over four years will have to come from either scholarships, Ken's earnings (yes, working through college is still legal), or loans. Because of their income level, they almost certainly will receive no tax credits or grants. It’s not hard to see how a loan balance approaching $40k for a typical student is easy to accumulate by graduation.

Let’s say Ken graduates in four years with $40K in debt. If he then pays it off over the following 10 years at an average interest rate of @ 6.5%, he’ll spend about $5,564 per year in principal and interest retiring the burden. 

The second student, Barbie, wants to attend Texas Tech University. Instead of going directly to Lubbock, she is open to staying home to attend Austin Community College for her first two years. The cost for ACC is about $10k per year, if Barbie lives at home. If she then transfers to Tech for her junior and senior years, her costs will increase to about $19k per year. Mom and Dad had been thoughtful enough and able to put away about $60,000 in college savings, so in this scenario, it looks very likely that Barbie will be able to graduate with no debt as long as she does her part academically.

Since she won’t have a student loan to pay off, she could spend the 10 years after graduation maxing out a contribution to a Roth IRA (currently $5,500 per year) instead of paying off a loan. Even if she decides to stop contributing at the end of that decade at age 31, those 10 years of Roth IRA contributions growing at 8% per year would be worth $1,272,281 at the current Social Security Full Retirement Age of 67. In other words, figuring out a way to pay for college with no debt could easily result in having $1,000,000+ more than Ken, all things being equal with earnings, by retirement age.

You know what they say? A $1,000,000 here (from being a college grad), a $1,000,000 there (from planning and discipline), and by retirement you could have some real money to Bern. 

At ATX Portfolio Advisors, we believe that education is one of the best investments we can make. To that end, when we manage college savings through a 529 Plan, we do not charge an advisory fee on those assets. If you would like to discuss college cost for a child or grandchild, get in touch.

[i] newyorkfed.org here and here and clevelandfed.org here

[ii]  Ticas.org

[iii] https://www.newyorkfed.org/medialibrary/media/research/current_issues/ci20-3.pdf