- International securities: Practice policy favors domestic U.S. securities. Domestic U.S. securities account for nearly half the market capitalization of total world securities and demonstrate high sector diversification. International securities frequently demonstrate strong positive correlations to domestic U.S. securities (notably, the strength of positive market correlations between the domestic U.S. equities market and global ex-U.S. equities markets has increased over time) with reduced tax efficiencies, increased expenses, uncompensated currency risks (exchange rate risks), idiosyncratic risks inherent to developing nations (e.g., political instability, fraud, lax regulation of securities markets, lax accounting standards), risks of expropriation of private investment and threats to property rights, limited access to markets, reduced investor knowledge and experience of markets, and potential increased portfolio complexity for U.S. based investors. Additionally, major domestic U.S. corporations, in aggregate representing the majority of domestic U.S. market capitalization, derive a significant proportion of their revenues from international sources; notably, the constituent corporations of the S&P 500 stock index derive nearly half of their aggregate sales revenues from international sales. With regards to fixed income securities, there is little diversification benefit derived from adding global ex-U.S. fixed income securities to a portfolio of high grade domestic U.S. fixed income securities (e.g., U.S. Treasury securities or investment grade U.S. corporate bonds).
- Dollar cost averaging (DCA): Practice policy favors lump sum investing, where funds are invested as soon as they become available to the investor. Time in the markets yields superior results to timing the markets. On average, markets trend upwards, rising more often than falling. Thus, a DCA strategy will generally net a higher average purchase price per share and fewer purchased shares than utilizing a lump sum investing strategy. Furthermore, DCA requires funds to remain uninvested or invested outside of the desired asset allocations until funds are fully invested, which distorts the investment portfolio’s risk and return profile from the desired risk and return profile until funds are fully invested. DCA is a form of market timing and remains an inferior investment strategy to lump sum investing.
- Rebalancing: Practice policy disfavors periodic portfolio rebalancing to fixed asset allocations (constant weighting rebalancing). A buy and hold or passive portfolio rebalancing strategy is favored, where new cash inflows are allocated to under-weighted asset classes. Asset allocation weightings will be adjusted over time towards fixed income securities and cash or money market securities based on the investment time horizon of the portfolio in order to manage portfolio volatility and mitigate market risks preceding liquidation of the portfolio. Ergo, judicious portfolio rebalancing is achieved. Periodic portfolio rebalancing to fixed asset allocations increases expenses, diminishes tax efficiency, and may reduce long term returns (higher performing assets are consistently exchanged for lower performing assets). Please reference “Investment portfolio construction” topic for further refinement.
- Real estate investment trust (REIT) index funds: Practice policy favors selective and limited use of REIT index funds for clients with limited or no private real estate asset ownership (e.g., ownership of a principal residence, secondary or vacation residences, or investment real estate). Deviating from a market portfolio by holding or purchasing individual sector or specialty funds is a detrimental strategy and is strongly discouraged; however, tilting a market portfolio with the addition of a REIT index fund (up to 10% of assets) may offer limited diversification benefits for clients with limited or no private real estate asset ownership. This must be balanced against increased portfolio complexity and reduced tax efficiency (REIT dividends are generally treated as ordinary income distributions, though may be treated as capital gain distributions or return of capital distributions depending on the nature of the distribution; the Section 199A Qualified Business Income deduction may apply to ordinary income distributions derived from REITs).
- Tax loss harvesting: Practice policy favors judicious tax loss harvesting if there is a substantial capital loss to harvest in order to convert other income (including earned income during working years) taxed at ordinary income rates (not to exceed $3000 per year) to long term capital gains taxed at preferential rates, to convert short term capital gains taxed at ordinary income rates to long term capital gains taxed at preferential rates, to achieve the benefits of tax deferred compounding, to defer income to future tax years when income and marginal tax rates may be lower (tax bracket arbitrage), and to potentially eliminate deferred income tax liability upon death consequent to step-to fair market value in basis for assets under Section 1014 (excepting any carryover capital losses which remain unused upon the final federal income tax return for the decedent, as unused capital losses are forfeited and cannot carryover to federal income tax returns for the decedent’s estate). Tradeoffs include (but are not limited to) increased transaction costs, short term capital gains treatment (rather than long term capital gains treatment) for sales of securities within the first year of the transaction, increased accounting and portfolio complexity (and associated costs), potential disqualification of qualified dividends, risk of increased tax rates in future tax years, tracking error risk, and wash sales resulting in disqualification of loss write offs in the current tax year (disqualified losses are added to the basis of the newly acquired replacement securities and losses are deferred until the eventual disposition of the newly acquired replacement securities, the holding period of the newly acquired replacement securities includes the holding period of the securities sold in the wash sale).
- Tax gain harvesting: Practice policy favors judicious tax gain harvesting if there is a substantial long term capital gain to harvest that falls into the 0% long term capital gains tax bracket based on projected taxable income. Tradeoffs include (but are not limited to) increased transaction costs, short term capital gains treatment (rather than long term capital gains treatment) for sales of securities within the first year of the transaction, increased accounting and portfolio complexity (and associated costs), increased AGI / MAGI and potential loss of preferential tax treatments, and potential disqualification of qualified dividends. Notably, wash sale treatment does not apply to tax gain harvesting.
- Margin borrowing: Practice policy disfavors margin borrowing. Desired portfolio risk is most effectively achieved via appropriate asset allocations rather than acquisition of margin debt. If leverage is desired, lower risk and lower interest rate forms of non-callable debt can be utilized with defined borrowing periods and fixed interest rates collateralized by stable assets (i.e., by leveraging real estate assets). Acceptable uses of margin leverage may include application of limited margin leverage (initial margin ≥ 90%, where initial debt ≤ 10% of collateral assets) at low interest rates to satisfy short term (≤ 1 year) credit and liquidity needs. Risks include (but are not limited to): rehypothecation risk (the re-pledging of your pledged collateral assets against a margin liability as collateral security against your creditor’s own debt obligations, which may then be further re-pledged to other creditors, risking your pledged collateral assets to any potential default within this chain of credit), variable and typically high interest rates, variable margin requirements (house margin requirements may exceed regulatory margin requirements and can be modified by the broker-dealer at any time without prior notice to borrowers), unpredictable margin calls and / or liquidations of account positions (margin debts can be called at any time and for any reason and account positions can be liquidated by the broker-dealer without margin calls or prior notice), possible lending by the broker-dealer of securities purchased using margin debt (see “securities lending”), possible inability to transfer positions from accounts with outstanding margin debt, compounding of margin debt due to negative amortization or capitalization of interest, and risk of realizing losses (which may exceed principal) during margin calls / liquidation events or upon the insolvency of collateral assets.
- Securities lending: Practice policy disfavors securities lending. Risks include (but are not limited to) receiving substitute payments in lieu of dividends (taxed at ordinary income tax rates rather than qualified dividend rates), counterparty risk of default which may exceed collateral, temporary loss of voting rights, variable loan rates, and lack of SIPC insurance on loaned securities.
- Fractional shares: Practice policy favors investing in whole share increments whenever possible (aside from mutual fund fractional shares). Tradeoffs of fractional shares investing include (but are not limited to) inability to transfer fractional share positions, risk of discontinuation of the program for any individual security or as a whole by the broker-dealer, inability to exercise shareholder or voting rights for fractional shares, possible truncation of dividend payouts due to rounding, and possible reduced liquidity of fractional sales.
The backdoor Roth IRA strategy
Individuals who are active participants in an employer sponsored retirement plan (those eligible to participate in a pension plan and / or those with elective
Bentley Makkar
December 14, 2024
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