The Complexities of Moving Toward Simplicity

2. Funds with a 0.52% expense ratio: I believe in ultra-low-cost diversified funds. I have to analyze each one. What are the tax ramifications from the sales? Is the fund throwing off capital gains? (Mutual funds do, but that’s rare for ETFs.)

If the fund will eventually be sold by the owner (versus going to their heirs on a step-up basis), this is a timing issue. Delaying the capital gain is like an interest-free loan (with some risk tax rates could rise). For example, using a 4% rate, delaying a $10,000 tax bill is the equivalent of $400 value of an interest-free loan. We compare the expense ratio savings to that $400. If the client saves more, it is likely sold.

Sometimes it makes sense to sell some lots with smaller gains using a specific ID cost-basis methodology. If the client has some charitable intent, donating the most appreciated assets with long-term gains to a donor-advised fund is an even better solution. For shares being kept because of tax consequences, I tell the client to turn off dividend reinvestments so they aren’t buying more. Clients often recognize their mistake but forget to turn off dividend reinvestments and blindly buy more.

3. 143 individual stocks: Individual stocks have no expense ratio. But 96% of stocks, on average, return about the same as a short-term Treasury bill, according to a study by Hendrik Bessembinder at Arizona State University. While that may seem like a lot of holdings, does one stock, such as Nvidia, represent 75% of the total value? That would be a lot of risk.

In addition to the quantitative analysis, behavior often comes into play. For example, I may recommend selling half of a concentrated position. We sell half of the shares (with the smallest tax consequences) to minimize regret. If it continues to surge, they can feel good they kept half. If it tanks, they can feel good about selling half.

4. 50 individual municipal bonds with 4.1% “income.” Understandably, the client loves this tax-free income paying as much as a Treasury bond. Unfortunately, it’s an illusion. Muni bonds are almost always issued at a premium and will mature or be called at par. Translation: Much of this client’s “income” was just return of principal. The Municipal Securities Rulemaking Board (MSRB) is a self-regulatory organization that allows return of principal to be called income. Muni bond funds (mutual funds and ETFs) are regulated by the SEC and properly disallows return of principal in income calculations.

I explain that yield-to-worst is the client’s best-case scenario since, if bonds aren’t called. This means interest rates rose and they will earn a below-market rate for much longer. For example, this bond portfolio may be yielding only 3.4%, and it’s managed by a separately managed account (SMA) charging 0.70%, so the net is only 2.7%.

Unfortunately, muni bonds have large bid/ask spreads and are expensive to sell. The highest bid/ask spread I’ve seen was actually 10.25% and they are often in the 1%-2% range. The analysis here is looking at maturity and call dates as well as past bid/ask spreads. I typically keep bonds that are likely to mature or be called in the next few years and sell those longer-term with smaller historic bid/ask spreads. We take the remainder out of the SMA and hold them until they are called or mature.

5. Variable universal life: Often the client tells me I can skip this, as the cash value is small. This leaves me to break the news to them that this will likely collapse and, in some instances, it could become worthless and generate tax consequences. When I dig into the hundreds of pages on this kind of contract, I nearly always see that the insurance company has the right to increase the premium on the death benefit up to $1,000 per $1,000 of death benefits at age 99. These policies typically require much larger annual payments or they will collapse, unless they have a no-lapse rider which is rare since they are expensive.

I generally tell the client we are looking for the least-bad solution, because there is no good one. Obviously, if the client has health issues and a very short life expectancy, we keep that in mind in order for the beneficiary to collect the death benefit. But then we look at the total fees (cost of death benefit, additional mortality and expense (M&E), admin fees, sales loads, other riders, and sub-fund fees) versus penalties to get out. Often, a 1035 exchange into a much lower-cost annuity is the recommendation. Penalties often decrease annually so, of course, we would not surrender the policy a few days before it would decrease.

6. Private investments. These come in various shapes and sizes such as private equity, hedge funds, private real estate deals, direct lending, private placements in startups, and many others. Some are quite good, but most I’ve reviewed underperformed stock index funds with far more risk and little to no liquidity. Some will allow periodic redemptions though the underperforming funds typically gate redemptions, trapping the client’s money in with fees sometimes topping 10% (1,000 basis points).

In many cases, there are no options other than to ride them out and hope for the best. Sometimes there is an inefficient secondary market to exit. Sometimes the investment is so outrageous and so unsuitable that I send a certified letter to the chair of the audit committee of the brokerage firm that sold it letting him or her know I see legal liability for the firm that they should disclose to all shareholders. Sometimes that results in a call from the brokerage firm’s general counsel wanting the client and me to go away by making a settlement that cashes the client out.

Conclusion

As I mentioned, I believe simplicity is almost always superior when it comes to investing. Solutions such as ones that allow an investor to deploy cash to be safe and higher yielding are low-hanging fruit. Analyzing a permanent insurance product makes rocket science look simple. And taxes are nearly always a barrier to building a simple portfolio. That said, moving toward simplicity is key to meeting financial goals.

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Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisory firm. He has been working in the investment world of corporate finance for over 25 years. Allan has served as corporate finance officer of two multibillion-dollar companies and has consulted with many others while at McKinsey & Company.

Read more articles by Allan Roth